Potential Supreme Court nominee Judge Edith Jones asserts that “overspending and an unwillingness to live within one’s means ‘causes’ debt.”
29
She is probably right. These families certainly overspent, accepting medical care they could not afford and making child support payments that left them with too little to pay the rent. They also lived beyond their means, trying to hold on to their houses and cars even after they lost their jobs. But we are forced to wonder, what would Judge Jones suggest those families have done? Not gone to the emergency room when the chest pains started? Moved the kids into a shelter the day their father moved out? Paid MasterCard and Visa, even if it meant not feeding their children? It is doubtlessly satisfying to point the long finger of blame at personal irresponsibility and overspending. But only the willfully ignorant refuse to acknowledge the real reasons behind all that debt.
Interest rate deregulation dovetailed neatly with a seemingly unrelated phenomenon: the bidding war for suburban housing. The mortgage industry shook off its interest rate regulations just a few years after the credit card industry.
30
In the new world of unfettered mortgage lending, no longer would the middle-class family be restricted to a conventional 80 percent mortgage. The floodgates were opened, and families could get all the mortgage money they ever dreamed of to bid on that precious home in the suburbs—even if the price tag was more than they could realistically afford.
Competition for houses in good neighborhoods has always been stiff, and overloading on mortgage debt to purchase a better home has long posed a temptation for young families. A generation ago, however, it simply wasn’t possible to give in to that temptation; mortgage lenders didn’t allow it. But today the game is different. It has
become routine for lenders to issue unmanageable mortgages. The best evidence comes from the mortgage industry itself. Fannie Mae, the quasi-governmental agency that underwrites a huge fraction of home mortgage lending in the United States, advises families that “monthly housing expenses should not represent more than 25 to 28 percent of gross monthly income.”
31
Accordingly, anyone whose housing costs exceed 40 percent of their earnings would be considered “house poor,” spending so much on housing that they jeopardize their overall financial security.
32
But the label is misleading. Many of the “house poor” are not poor at all. They are middle-class families that overextended themselves in a desperate effort to find a home in the midst of a fearsome bidding war. Over the past generation, at the same time that millions of households sent a second earner into the workforce, the proportion of
middle-class families
that would be classified as house poor or near-poor has quadrupled.
33
The down payment—once a critical device for screening potential borrowers—has virtually disappeared. In the mid-1970s, first-time home buyers put down, on average, 18 percent of the purchase price in order to get a mortgage.
34
Today, that figure has shrunk to just
3 percent
.
35
While a small down payment may sound appealing to those of us who remember scrimping and saving before we could purchase our first home, it has a more ominous side. The family that can’t come up with a down payment pays higher points and fees, and many are forced by their lenders to purchase additional credit insurance. These families get mortgages they couldn’t have gotten a generation ago, but they pay a lot more for them. More important, families that don’t make a down payment are more likely to lose their homes, which is why traditional lenders required the 20 percent down payment in the first place. According to one study, families that make a down payment of less than 5 percent of the purchase price are fifteen to twenty times more likely to default than those who put down 20 percent or more.
36
The obvious solution would be to reimpose some standards in the mortgage market, but deregulation continues to reign supreme. Even as defaults are rising, President Bush argues that the federal
government should work to reduce families’ down payments even further—with no thought about how those low down payments may cost millions of families their chance at staying in their homes.
37
As regulatory control over interest rates collapsed, a new industry was born: the “subprime” mortgage lender. Subprime lenders specialize in issuing high-interest mortgages to families with spotty credit who are unlikely to qualify for traditional, low-cost “prime” mortgages. In the early days of deregulation, subprime mortgage lending was unheard of. But by the mid-1990s, banking giants such as Chase Manhattan and Citibank, fat with profits from credit card lending, were looking for new markets to tap.
38
They applied the same principles to home mortgage lending that had profited their credit card divisions so handsomely: Charge high interest rates and sell, sell, sell.
To give a sense of just how expensive subprime mortgages are, consider this: In 2001, when standard mortgage loans were in the 6.5 percent range, Citibank’s
average
mortgage rate (which included both subprime and traditional mortgages) was 15.6 percent.
39
To put that in perspective, a family buying a $175,000 home with a subprime loan at 15.6 percent would pay
an extra $420,000
during the 30-year life of the mortgage—that is, over and above the payments due on a prime mortgage. Had the family gotten a traditional mortgage instead, they would have been able to put two children through college, purchase half a dozen new cars,
and
put enough aside for a comfortable retirement.
Citibank and other subprime lenders typically defend their business practices by arguing that they are helping more families own their own homes.
40
But this is little more than public relations hot air. In the overwhelming majority of cases, subprime lenders prey on families that
already
own their own homes, rather than expanding access to new homeowners. Fully 80 percent of subprime mortgages involve refinancing loans for families that already own their homes.
41
For these families, subprime lending does nothing more than increase the family’s housing costs, taking resources away from other investments and increasing the chances that the family will lose its home if anything goes wrong.
Subprime lending has an even more pernicious effect. It ensnares people who, in a regulated market, would have had access to lower-cost mortgages. Lenders’ own data show that many of the families that end up in the subprime market are middle-class families that would typically qualify for a traditional mortgage. At Citibank, for example, researchers have concluded that at least 40 percent of those who were sold ruinous subprime mortgages would have qualified for prime-rate loans.
42
Nor is Citibank an isolated case: A study by the Department of Housing and Urban Development revealed that
one in nine
middle-income families (and one in fourteen upper-income families) who refinanced a home mortgage ended up with a high-fee, high-interest subprime mortgage.
43
For many of these families there is no trade-off between access to credit and the cost of credit. They had their pockets picked, plain and simple.
Why would middle-class families take on high-interest mortgages if they could qualify for better deals? The answer, quite simply, is they didn’t know they could do any better. Many unsuspecting families are steered to an overpriced mortgage by a broker or some other middle-man who represents himself as acting in the borrower’s best interests, but who is actually taking big fees and commissions from subprime lenders.
44
In some neighborhoods these brokers go door-to-door, acting as “bird dogs” for lenders, looking for unsuspecting homeowners who might be tempted by the promise of extra cash. Other families get broadsided by extra fees and hidden costs that don’t show up until it is too late to go to another lender. One industry expert describes the phenomenon: “Mrs. Jones negotiates an 8 percent loan and the paperwork comes in at 10 percent. And the loan officer or the broker says, ‘Don’t worry, I’ll take care of that, just sign here.’”
45
Every now and then a case comes to the forefront that is particularly egregious. Citibank was recently caught in one of those cases. In 2002, Citibank’s subprime lending subsidiary was prosecuted for deceptive marketing practices, and the company paid $240 million to settle the case (at the time, the largest settlement of its kind).
46
A former loan officer testified about how she marketed the mortgages: “If
someone appeared uneducated, inarticulate, was a minority, or was particularly old or young, I would try to include all the [additional costs] CitiFinancial offered.”
47
In other words, lending agents routinely steered families to higher-cost loans whenever they thought there was a chance they could get away with it.
Such steering hits minority homeowners with particular force. Several researchers have shown that minority families are far more likely than white families to get stuck with subprime mortgages, even when the data are controlled for income and credit rating.
48
According to one study, African-American borrowers are
450 percent
more likely than whites to end up with a subprime instead of a prime mortgage.
49
In fact, residents in high-income, predominantly black neighborhoods are actually
more
likely to get a subprime mortgage than residents in low-income white neighborhoods—more than twice as likely.
50
In many cases, these lenders don’t just want families’ money; they also want to take people’s homes. Banks have been caught deliberately issuing mortgages to families that could not afford them, with the ultimate aim of foreclosing on these homes. This practice is so common it has its own name in the industry: “Loan to Own.”
51
These lenders have found that foreclosing can be more profitable than just simply collecting a mortgage payment every month, because the property can then be resold for more than the outstanding loan amount.
52
So the lender rakes in fees at closing and high monthly payments for a few years, then waits for the family to fall behind and sweeps in to take the property. The lender wins every possible way—high profits if the family manages to make all its payments, and higher profits if the family does not.
The results are in. After two decades of mortgage deregulation, today’s homeowners are
three and a half times
more likely to lose their homes to foreclosure than their counterparts a generation ago.
53
This defies the economists’ expectations. Today’s record low interest rates and rising home prices should have translated into a
falling
rate of home foreclosure, not a rising one. The only explanation is a lending industry run amok. The rise in “loan-to-own” lending, the disappearance
of the down payment, and the explosion in high-interest, subprime refinances have taken their toll, as a growing number of families learn the painful consequences of getting trapped by a mortgage industry that has been allowed to make up its own rules.
And so it was that family spending was transformed in a single generation. In the late 1970s and early 1980s, consumer lending was deregulated, launching a complicated, potentially dangerous product on an unsuspecting public. The timing could not have been worse. Just as corporations were downsizing across America, just when a bidding war for decent family housing was heating up, and just when families lost the all-purpose safety net once provided by the stay-at-home mother, easy credit flooded in, looking just like a life raft to the family that was drowning.
Where the Money Is
“Why do you rob banks?” The question was put to Willie Sutton, famed bank robber of the 1940s. He replied, “Because that’s where the money is.” That’s how most businesses work: They make profits by dealing with customers who have money. And that is how the lending business used to work: Companies made loans to people who had the money (or soon would have the money) to repay them.
Much has been made about the changing nature of America’s debtors. Americans don’t have the same work ethic that they once did, people don’t work hard to pay their bills as they once did, and on and on. Even my [Elizabeth’s] elderly father agreed, telling me quiet stories of destitute families that labored for years to pay bills they had run up during the Great Depression. My father used to talk about Herring Hardware, a farm supply store that my grandfather had run in rural Oklahoma beginning back in 1904. When the Dust Bowl hit in the 1930s and families could no longer scratch a living out of their modest farms, many packed up and headed west, an exodus etched in the national memory by John Steinbeck’s
Grapes of Wrath
. Some of
those families never forgot the debts they left behind. Twenty years later, my grandfather would still get an occasional envelope with a few twenty-dollar bills and a handwritten note: “Grant, we finally got ahead a little. Put this on my account, and let me know if I owe you more. Aileen sends her best to Ethel.” My father would lean back at the end of one of these stories and remark that these were “good people, good people who followed through on what they owed.” Then he would pause and draw his mouth into a hard line. “Folks just aren’t like that anymore.”
But my father—and everyone else who talks about changing values—overlooks one very important fact: Borrowers aren’t the only ones who changed. Lenders changed too, arguably far more than the people to whom they were lending. Most Americans guard their credit ratings jealously, living with a slightly prickly sensation that they could be cut off if they fell behind or forgot to pay a bill. What they don’t realize is that when a borrower makes a partial payment, when he misses a bill, and when his credit rating drops, he actually gets
more
offers for credit.
54
He is not just down on his luck, behind on his bills, and short on cash; he has now joined the ranks of an elite group—The Lending Industry’s Most Profitable Customers.