Collapse of the "Subprime" Mortgage Market in California
Increased foreclosures will have major impacts on the state, individuals, and businesses
Paul Leonard, center, testifies before California Senate Banking Committee
Testimony of Paul Leonard
California Office Director
Center for Responsible Lending http://responsiblelending.org
Before the California Senate Banking Committee
March 26, 2007
[Editor's note: Yesterday, the California State Senate Banking, Finance, and Insurance Committee held an informational hearing to inquire into the collapse in this state and the nation of the "subprime" mortgage market. You will be hearing more about this issue in coming days and perhaps years as it is predicted there will be a marked increase in defaults and delinquencies in home loans.
When "teaser" rates on adjustable rate mortgages expire and the interest rate, and therefore the monthly payments on a significant number of home loans goes up, it is predicted there will be more foreclosures, more houses on the market, which will depress prices further and make it difficult for some of these owners to "unload" their properties.
Since a booming housing market has been part of what has fueled the California economy, the committee, and the state are looking at solutions or ameliorative steps to be taken. This could further worsen the revenues the state collects and our budget deficit. For the individual families and individuals, the results can be devastating. Segments of home loans are considered "predatory" by many and that is another facet of this issue.
Here is the first part of Mr. Leonard's testimony. There are two other installments.]
Chairman Machado and members of the Senate Banking Committee: Thank you for holding this hearing to examine the problems of the subprime market and their impact on Californians and the state of California. I appreciate your inviting me to participate. Time could not be more precious, as my organization expects a California foreclosure rate of 21.4 percent – a rate that translates to a direct loss of more than 450,000 homes by the time the dust has settled.
I am Paul Leonard, director of the California office of the Center for Responsible Lending(CRL). CRL is a not-for-profit, non-partisan research and policy organization dedicated to protecting homeownership and family wealth by working to eliminate abusive financial practices. CRL began as a coalition of groups in North Carolina that shared a concern about the rise of predatory lending in the late 1990s.
CRL is an affiliate of Self-Help, which consists of a credit union and a non-profit loan fund. For the past 26 years, Self-Help has focused on creating ownership opportunities for low-wealth families, primarily through financing home loans. Self-Help has provided over $5 billion of financing to over 50,000 low-wealth families, small businesses and nonprofit organizations in North Carolina and across the country, with an annual loan loss rate of under one percent. We are also a responsible subprime lender. In fact, we began making loans to people with less-than-perfect credit in 1985,when that was unusual in the industry. We believe that homeownership represents the best possible opportunity for families to build wealth and economic security, taking their first steps into the middle class.
In my testimony today, I’d like to make two major points about the implosion of the subprime market and its impact on consumers, communities and the economy:
• Help Current Borrowers: Immediate action is needed to help borrowers who are trapped in damaging subprime loans that should have never been originated. Public officials at all levels of government must hold industry players accountable for their actions. Responsibility rests with lenders, servicers, investors and trustees to stem the tide of foreclosures by proactively modifying loans to make them sustainable. There is no longer any dispute that brokers and lenders have placed borrowers into loans that set them up for foreclosures, and the secondary market provided key support and high demand for this reckless lending. Specific remedies will vary depending on the homeowner’s situation, but examples of positive actions include converting loans to fixed-rate mortgages with affordable interest rates, writing down principal loan balances, and waiving prepayment penalties. For those borrowers with no equity and no hope of refinancing, the best we can hope for is a “soft landing,” but for those who have maintained a degree of equity in their home, this would mean a restructuring of their current mortgage to an affordable level.
• Strengthen Mortgage Laws to Prevent Future Problems: While the market has recently “corrected” to tighten underwriting standards, we must establish statutory underwriting standards to prevent a repeat of this crisis when housing prices turn upward. By implementing statutory requirements on all subprime loans—including an assessment of a borrower’s ability to repay; requiring escrow for taxes and insurance and income verification, as well as increasing accountability at all stages of the mortgage transaction and crafting a meaningful enforcement framework that enables state regulators to be more effective.
These points are underscored by the speed with which the subprime market has imploded. On January 31, 2007, the Senate Banking Committee convened a hearing to discuss nontraditional residential mortgage products, including the types of loans initiated by many subprime lenders who have since closed their doors.
What a difference a few weeks makes.
Since we last discussed this issue in your committee in January, Wall Street, federal regulators and the media have been in a frenzy as the subprime mortgage market has imploded before our very eyes. We have read reports in all of the nation’s leading papers, listened to talk, business and public radio broadcasts and cable and network news reports of the implications of the implosion on housing prices, the economy and borrowers faced with possible foreclosures.
Federal regulators have issued for public comment a new statement applying the principles of their earlier guidance on nontraditional mortgages to subprime hybrid ARMs – requiring new underwriting standards and disclosure requirements for federally-regulated institutions.
Freddie Mac, one of the two large government-sponsored enterprises has promised to stop buying any subprime hybrid ARMs that do not meet the federally-established guidelines.
And some of the nation’s largest subprime lenders – many based here in California – have ceased making new loans, announced massive layoffs and seem perilously close to outright bankruptcy. Thousands of California employees have been laid off. “Mortgage Insider,” Orange County Register by Matthew Padilla.
In my remarks today, I will focus on subprime home loans—the development and downfall of the market, its consequences—particularly for families in California—and potential solutions that will prevent similar crises from recurring in the future. I will also offer solutions to rescue current borrowers trapped in mortgages they cannot pay. As I will discuss in more detail, inequities in the market and massive foreclosures are having a devastating effect all over the nation. Regions of California (particularly in the Central Valley) are experiencing sharply increased foreclosures at the moment, and we estimate that the Golden State will lead the nation in foreclosures as our housing prices flatten.
The performance of the subprime market and subprime foreclosures matter because homeownership is by far the most important wealth-building tool in this country. For millions of families, it ultimately makes the difference between merely surviving between paychecks or building savings for a better future. Nearly 60 percent of the total wealth held by middle-class families resides in their home equity – the value of their home minus the amount they owe on it.
Communities of color are particularly vulnerable to damage in the subprime market. It is well established that African Americans and Latinos are paying higher costs for mortgages, according to data from both the Board of Governors of the Federal Reserve and my organization, the Center for Responsible Lending; our research has found that African American and Latino borrowers were commonly 30 percent more likely to receive a higher-rate loan than white borrowers.
Robert B. Avery, Glenn B. Canner and Robert E. Cook, in “New Information Reported Under HMDA and Its Implication in Fair Lending Enforcement,” Federal Reserve Bulletin (Summer 2005) found that after accounting for a borrower’s income, gender, property location and loan amount, African-Americans who took a loan to purchase a home were 3.1 times more likely than white non-Hispanic borrowers to receive a higher-rate home loan; for Latino borrowers, the same disparity stood at 1.9 times.
The San Jose Mercury News recently reported on the plight of subprime limited English borrowers in the San Jose area who have been victims of the subprime lending industry’s recklessness. Pete Carey, “The harsh side of the housing boom,” San Jose Mercury News, March 11, 2007.
In a nation where homeownership is so important to financial security, irresponsible subprime lending has the potential to push vulnerable consumers backward instead of forward. In California in particular, where skyrocketing home prices in recent years caused many families to wonder if they could ever afford to own a home, subprime adjustable rate products with discounted initial payments made homeownership temporarily accessible, but didn’t necessarily make homeownership any more affordable.
The bottom line is that access to homeownership means very little if it ultimately ends in home “losership.” Over the past nine years, the subprime market has produced more than two trillion dollars in home loans, but only a relatively small portion of these loans have supported first-time ownership—the majority of subprime loans are refinance loans. Between 1998 and 2006, only an estimated 1.4 million first-time homebuyers purchased their home with a subprime loan. Yet over that same time period, there have been many more foreclosures on all subprime loans. In our recent research on subprime foreclosures, CRL estimated that over 2.2 million borrowers who obtained subprime loans will lose or have already lost their home to foreclosure. When we update the analysis to include subprime originations for fourth quarter 2006, the total number of projected subprime foreclosures increases to 2.4 million.
[All figures in this analysis cover only loans to owner-occupants in the 50 states and the District of Columbia secured by a first-lien on a single-family home, condominium, townhouse, or a unit in a planned development. 1998-2004 figured derived from a proprietary database of subprime loans sold in the secondary mortgage market between 1998 and 2004. We modified 2005-2006 estimates from Inside Mortgage Finance and SMR Research Corporation to account for these criteria.]
That means that since 1998, subprime lending has led to a net loss of homeownership for almost one million families. In fact, a net homeownership loss occurs in subprime loans made in every one of the past nine years.
ur numbers are conservative for two reasons. First, the proprietary database used consists of loans sold on the secondary market, and contains a higher proportion of subprime loans for used home purchase than the overall subprime market. Second, the foreclosure projections were developed by CRL for its recent study Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowner (see full cite in note 7 below), and are based on conservative assumptions. Since that report was published in December 2006, other analyses suggest that foreclosures in the subprime market could actually be higher than CRL’s projections. See, e.g., Lehman Brothers projects 30% losses over time for subprime loans originated in 2006 (Mortgage Finance Industry Overview, p. 4. Lehman Brothers Equity Research, December 22, 2006). If Lehman Brothers’ foreclosure projections for 2006 are incorporated with CRL’s projections for prior years, the total number of subprime foreclosures originated 1998-2006 climbs to 2.7 million households.]
Ultimately, the perfect storm of risky loan products, rising home appreciation and aggressive and deceptive marketing to the riskiest of borrowers and a weak regulatory oversight has led us to the subprime market implosion that we are here today to discuss. Much of the press attention, and in fact today’s hearing, is focused on whether the collapse will spread to the prime market or its impacts on the national economy. These are important questions. But let us not forget: the most disastrous affects will be felt by borrowers who face the loss of their homes and the ruin of their credit records for years to come.
I would like to address two major themes this afternoon: How we as a state and nation were steered into this crisis, and how we can get out with the best possible outcomes for the most borrowers in trouble. I’d like to start with discussing the characteristics and consequences of the subprime market, and end with recommendations to prevent a recurrence of this or similar crises, as well as offer lifelines to those borrowers who need help immediately.
