The State of Mortgage Lending in America

The Center for Responsible Lending (CRL) has released a report on the recent financial crisis and its impact on consumers.   The State of Lending in America and its Impact on U.S. Households assesses the impact of the financial crisis on American families and their financial security and looks at a range of current lending practices and their impacts. 

The report, written by Debbie Bocian, Delvin Davis, Sonia Garrison, and Bill Sermons, looks at the financial products that American households use for everyday transactions, to acquire major assets, and build savings and wealth and the ways in which predatory lending has sometimes corrupted traditional financial products and undermined their worth.  State of Lending is organized into three separate reports, the first two covering a spectrum of consumer loans, the third abusive debt collection, mortgage loan collection, and servicing practices.   

We will summarize the extensive portion of the report that deals with mortgage lending in two parts. The first reviews the role of various market players and the changes that have been made to the traditional lending model.  A subsequent article will summarize CRL's words about the impact of the housing crisis on individuals, communities, and the economy and on the challenges that must be met in the future.

The authors conclude there are two trends.  First, families were already struggling financially even before the crisis hit; managing the gap between stagnant family incomes and growing expenses by increasing their debt which in turn left them with less spendable income and often with long-term financial distress, foreclosures and crushing student debt.

Some are reaping benefits from the recovery and the rising stock market and improving job opportunities but millions have lost their homes and millions more may yet do so; one-fifth of mortgaged homeowners are underwater.  The impact was even greater on families of color who were three times more likely to be targeted with abusive subprime loans as other borrowers with similar credit records.

The authors say that, despite the housing crisis Americans put a high value on homeownership, associating  it with the American Dream and Americans' idea of how to acquire wealth.  Although not without risks, homeownership provides the opportunity to build equity both through appreciation of housing prices and paying down debt.   When traditional mortgages are used, homeownership provides a "forced savings" mechanism for households. 

Homeownership has long been a key source of economic mobility and financial security.  Home equity can be tapped to start a new business, pay for higher education, secure retirement and provide a financial cushion against unexpected hardships and ownership bestows a host of non-financial benefits on individuals, families, and communities. 

The federal government has long been involved in the mortgage markets. It worked to stem the tide of foreclosures during the Great Depression, addressed discriminatory redlining in the 1970s, and worked for decades to expand access to homeownership.  Many agencies within the government deal with housing and home ownership and government has long guaranteed mortgages for underserved communities through FHA and VA loans and now through explicit GSE loan guarantees.

Mortgages were once relatively simple transactions between lenders and borrowers. However, in recent decades, the mortgage market has become larger and complex and involves more participants. Today the main players are:

• The federal government which in addition to guarantees offers preferential tax treatment of mortgage interest, property taxes, and capital gains on owner-occupied homes. It provides capital liquidity and credit enhancements, and oversees mortgage-market participants.

• The GSEs also increase liquidity though their role in driving the secondary market without which private lenders would be able to extend far fewer mortgages.

• Private lenders fund almost all U.S. mortgages and fall into two basic categories, portfolio lenders and mortgage companies. Portfolio lenders use bank deposits to fund and hold loans in investment portfolios. Mortgage companies or banks rely on investments to finance their mortgages and on the sale of their mortgages to the secondary market to finance payments to investors.

• Brokers and Private Securitizers together have fundamentally altered the mortgage market over the last few decades. First, by relying on third-party originators (mortgage brokers) lenders could lower their fixed costs and expand operations into new markets without increasing staff or office space or invest heavily in consumer marketing. In 2005 half of all mortgage originations and 71% of subprime originations were brokered. Second, Wall Street financial companies, by issuing their own mortgage-backed securities (MBS) and selling these directly to investors, could avoid meeting loan standards set by the GSE regulators. As a result, the growth in the private-label securities market was heavily driven by subprime loans, which the GSEs could not purchase directly.

• Mortgage servicers collect and track mortgage payments from borrowers, manage escrow accounts, and remit payments from those accounts. They also manage delinquent loans and some provide foreclosure services and manage foreclosed properties. Although some lenders service the mortgages they originate, others sell the servicing rights to other lenders or independent servicers. The fundamental responsibility of a servicer is to "manage the relationship among the borrower, the servicer, the guarantor, and the investor/trustee of a given loan," however the specific guidelines that servicers must follow in each of their activities vary depending their contractual agreements with lenders.

Under a "traditional" lending model-where lenders both originated and held their mortgages-lenders had a vested interest in ensuring that borrowers could repay their loans. In the more recent "originate-to-securitize" system, the compensation of brokers, lenders, and securitizers was based on transaction volume, not loan performance.  This led to aggressive marketing and origination, lax evaluation of the borrowers' ability to repay, and to a new breed of dangerous mortgages often made with scant underwriting and marketed without regard to their suitability for the borrowers.

The growth in private-label securitization not only removed GSE standards from the equation but Wall Street encouraged riskier loan products by paying a higher premium for non-conforming loans. Subprime lenders targeted many of the same borrowers who had traditionally used the FHA and VA programs, saddling these borrowers with much riskier debt than those government programs, for which many could have qualified.  Then the agencies charged with rating the quality of mortgage-backed investments were assigning high ratings to securities backed by these dangerous and unsustainable loans leading investors to believe those products were safe.

Not all communities were targeted equally by sub-prime lenders. Borrowers of color were 30% more likely to receive higher-rate subprime loans than similarly situated white borrowers and borrowers in non-white neighborhoods were more likely to receive higher-cost loans with risky features such as prepayment penalties.  In the early years of the subprime market, flipping was common in the subprime market.  Each time refinancing occurred, fees and closing were rolled into the loan, stripping equity.  Loan terms were complex and prevented easy comparison shopping and mandatory arbitration clauses kept borrowers from pursuing legal remedies for illegal or abusive terms. One of the early abuses in the subprime market was single-premium credit insurance, which charged a high up-front fee to insure mortgage payments if the borrower couldn't make them. 

The abusive practices that led to the mortgage crisis were enabled by an out-of-date and fractured federal regulatory system.

• Federal regulation failed to adapt to the increasingly complex mortgage market and many participants were virtually unregulated at the federal level.
• Authority for interpreting and enforcing consumer protections was fractured among several agencies, none of which had protecting borrowers as its primary mission. Federal regulators hindered state level consumer protection by ruling they could not enforce strong state lending laws against nationally chartered institutions.
• When agencies did focus on consumer protection, they tended to rely on disclosure rules and nonbinding "guidance" over hard and fast rules. Consumer groups and borrowers were raising concerns over lending in 2000 but only in July 2008 did the Federal Reserve implement any rules about abusive, unfair, or deceptive practices

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 explicitly outlined new rules for mortgage lending in order to prevent specific types of market abuses and it established the CFPB as a new consumer protection agency.  Dodd-Frank mortgage provisions are designed to reorient the market back to well-underwritten, sensible mortgages and disfavors the loan terms common to the private-label securities market. 

Among the most important aspects of Dodd-Frank is the establishment of an "Ability-to-Repay" standard which requires originators to make a "reasonable and good faith determination based on verified and documented information that the consumer has a reasonable ability to repay the loan and pay housing expenses.  Dodd-Frank creates a preference against risky loan terms through a category of safe loans called "Qualified Mortgages" (QMs) giving litigation protection to lenders who conform to the ability-to-repay provision and a number of other QM requirements.  Dodd-Frank also banned single-premium credit insurance and mandatory arbitration, required escrows of taxes and insurance for higher-priced mortgages; and documentation of borrowers' income. 

Importantly, Dodd-Frank created the CFPB as an independent consumer watchdog agency to ensure that financial transactions, including mortgages, are fair and transparent and empowered it to enforce existing consumer protection laws and regulations and respond to new abuses as they emerge. The CFPB consolidates the functions of a number of agencies and will be able to regulate the practices of all mortgage-market participants, including banks, non-banks, brokers, and servicers.  Also, by leaving funding outside the appropriations process, Congress protected the agency from lobbying efforts to weaken the resources available for supervision and enforcement. 

A lot of blame for the recent crisis has been laid on the Community Reinvestment Act (CRA) and the affordable housing goals of the GSEs for encouraging loans to unqualified borrowers.  The facts do not support these claims.  CRA has been around for 30 years while the problem loans began within the last ten.  Only six percent of subprime loans were extended by CRA-obligated lenders to lower-income borrowers and those loans appear to have performed better than other subprime loans. GSE could not purchase or securitize subprime mortgages directly.  The share of subprime MBS purchased by the GSEs as investments from Wall Street firms was a fraction of that of the private sector.  Most of the GSEs losses, in fact, were from loans to higher income families, were tied to Alt-A rather than subprime loans, and did not count toward affordable housing targets.