During my sophomore year in college, my parents called me at my dorm room with some important news. Our scheduled weekly calls occurred on Sundays, so I answered this mid-week call with some trepidation. Instead of burdening me with bad news, my joyful parents called to let me know that they had paid off the mortgage on the home they had owned since the late 1970s.
With equal fanfare, my father took out another mortgage a few years later to help fund an expansion to his small business. My childhood home was both my parents' largest financial burden and their greatest asset, as it is for so many Americans, because of the peculiarities of the mortgage market in the United States. In this country, the mortgage market is prone to greater growth than in the rest of the world because other countries require more money up front and require repayment more quickly.
Recently, that market has undergone some serious and well-publicized volatility, leaving many homeowners vulnerable to foreclosure. According to some estimates, over two million mortgages are in danger of foreclosure this year. Some, like my parents, are not at risk because they have good credit, can afford the monthly payments, and live in an area where housing costs and taxes have remained stable. Others are not as lucky. Their ability to afford their monthly payments was compromised first by the falling market, then by mortgages they could no longer afford. Both types of homeowners have bought into the American dream of home ownership, fostered by a post-World War II federal government eager to see individuals as homeowners. However, the latter group is in serious danger of foreclosing on that dream.
Today's crisis is partly a result of the inability of some borrowers to make mortgage payments on the so-called "sub-prime" mortgages they have. These mortgages have very low "teaser" interest rates for a predetermined period ranging from one to five years, and then interest rates tend to rise dramatically after that period. But this is only part of the story. More importantly, the current crisis results from the history of the mortgage in the United States. In particular, the mortgage market developed into a two-tiered system with lower and upper class homeowners that has never been able to effectively cope with low-income homeowners who have been typically women, racial and ethnic minorities. Only by considering the market's history and attempts to rationalize and regulate it will a more complete story of the current sub-prime mortgage crisis emerge. That story and its history is a complex one that incorporates the mortgage market, attempts to regulate it, and the veracity of the "American Dream."
How Did We Get Here?
Although political leaders and the media often portray homeownership as central to the "American Dream," that dream is a variable experience framed not by individual desire to own a home, but largely by government and economic policies. The federal government has a long history of supporting homeownership. On one hand, this is because home owning follows a general "American" pattern of individualism and privacy that grew out of societal changes near the turn of the 20th century. On the other, homeowners are a succinct group, useful for counting and taxation purposes. In addition, homeownership requires a long-term investment that encourages stronger participation in the economy. Government support for homeownership started long ago, the income tax mortgage deduction came in 1913, and continued through the twentieth century.
Before 1929, the mortgage market was highly unregulated and chaotic, even though homeownership rates stayed between 45 and 50 percent after 1900. This mortgage market emphasized the personal relationship between the loan officer and the borrower. Mortgages then also had a much shorter term than we would recognize today. Fifteen years was the longest, but many mortgages had terms between three and five years, and most required renegotiation every three, six, or twelve months. Banks also required borrowers to put up substantial down payments, usually at least 40% of the house's price.
Mortgages before the Depression were not amortized, so borrowers were only responsible for interest payments during the loan, then a balloon payment at the end to pay off the entire principal. Consequently, in the period before the 1930s, the prevailing form of mortgages was the adjustable rate mortgage, the same type of mortgage that dominates the current conversation about sub-prime loans.
The first few years of the Great Depression demonstrated how vulnerable this mortgage market was to broader economic problems. Initially, the Federal Reserve raised interest rates in the months after October 1929, looking to offset future inflation. These higher rates hurt Depression-era borrowers because of the frequent renegotiations many of their mortgages required. Since interest rates were increasing, banks were in a better position to require higher interest rates during those renegotiations. In 1932, the worst year for mortgages during the Depression, about 10% of all mortgages entered the foreclosure process, around 2.4 million homes.
Although FDR's "First Hundred Days" restored faith in the consumer banking system, it took additional New Deal legislation to rationalize the mortgage market. In 1933, Congress passed the Glass-Steagall Act, which established the Federal Deposit Insurance Company (FDIC), and separated banks according to whether they were investment banks or commercial banks—a move that fundamentally altered the mortgage market because mortgages became one of the primary instruments of commercial banking.
It was only with the Home Owners Loan Corporation (HOLC) and the Federal Housing Administration (FHA)—two parts of the National Housing Act of 1934—that the U.S. government began to rationalize and regulate the mortgage market. HOLC was a short-lived (1933-1936) bureaucracy that offered direct assistance to refinance around a million non-farm homes by extending their mortgage terms up to 30 years, ultimately decreasing the borrower's monthly payments.
While the FHA did not mortgage homes directly, it served as an insurer of mortgages owned by borrowers who fit certain demographic criteria. Since the insurance that the FHA offered absorbed much of the risk in the mortgage market, banks felt more secure in lengthening terms and lowering rates throughout the post-World War II period, and consumers were more willing to enter these more secure, longer-term contracts that offered them more money at less cost.
By the end of the 1930s, the US government created a secondary market for "bundled" mortgages. These bundled mortgages were groups of mortgages that banks resold as investments to purchasers who absorbed the risk of default. The investors enjoyed the mortgage payments as the return on their investment. That secondary market injected capital into the mortgage market and encouraged banks to offer more mortgages, because banks could sell bundled mortgages more easily than single ones, and they had more capital after the sales of bundled mortgages to fund more borrowers.
The federal government created the Federal National Mortgage Association (Fannie Mae) in 1938, a unique government sponsored mortgage system designed to spread risk and foster rapid growth in home owning by guaranteeing FHA and other mortgages. These guarantees lowered the risk for both the borrowers and the lenders and further encouraged market growth. This market growth and government participation helped to make mortgages more affordable by eliminating some of the risk. After 1940, interest rates and down payments decreased.
Veterans from World War II onward also benefited from government policies that encouraged homeownership to help give economic incentives to wartime veterans. Starting with the GI Bill (1944), which offered loan assistance during World War II, and continuing through a series of acts that gave future generations of veterans similar benefits (in 1952, 1966, 1972, 1976, and 1985), the government had a clear policy of encouraging homeownership.
In 1968, the federal government spun off the Government National Mortgage Association (Ginnie Mae) from Fannie Mae. At the same time, the federal government also privatized part of Fannie Mae, in order to stop a monopoly in the growing secondary market for bundled mortgages. To bolster that effort, Congress also chartered the Federal Home Loan Mortgage Corporation (Freddie Mac). These corporations market the bundled mortgages as investment instruments to the public and further limited the risk to mortgagors and mortgagees.
The Veteran's Administration also offered mortgage assistance, bolstering the government's goals. This policy gave millions of veterans—who would otherwise not have the ability to afford their own homes—the possibility to own their own home through zero down payments and low interest rates. Unfortunately, these benefits were not equally enjoyed by veterans of all races because of bank and municipal policies that kept minorities from securing mortgages in suburban areas.
More recently, once opponents of regulation procured the partial repeal of Glass-Steagall in 1999, banks could once again engage in both investment and commercial activities with less government oversight. Through this change, banks were better able to package mortgages into larger investment portfolios in order to place onto the secondary market. After 1999, the system had almost no oversight. 6 Before 1999, banks often considered sub-prime mortgages too risky to constitute a large share in a bank's lending portfolio. This is because at the end of the mortgage's teaser period, borrowers are required to pay a substantial balloon payment, which covers the difference between the teaser rate and what the interest rate should have been, along with any sort of finance charges or other required principal payments.
This gamble is sometimes worthwhile if the homeowner expects to sell soon at a lofty profit, like when the housing market is booming, or if the homeowner expects a significant increase in his standard of living. In other cases, it is an almost insurmountable obstacle for the low-income homeowners who take these loans just so they afford their own home at all. Oftentimes, they might not know the whole story behind their debt instrument and overestimate their ability to repay their future debt.
The long story of how the American mortgage market got to 2008 shows how FHA policies and new mortgage instruments of the postwar period codified a two-caste homeowner population. On the top tier stood middle and upper class homeowners who had the income and other criteria required to secure a large enough loan to purchase homes in the burgeoning suburban market.
On the bottom tier was lower-class homeowners, mostly racial minorities or single women, who had a hard time finding enough FHA assistance. The housing market left the bottom tier of homeowners with the least desirable homes in the least desirable urban neighborhoods. These people suffered under the burden of riskier sub-prime and other high cost loans if they wanted to own a home. The appeal of homeownership and the security it offered kept them chasing after the American Dream.
Race and Class Issues
This issue of a two-caste homeowner society has never been resolved. In fact, during the two decades after World War II, when homeownership rates jumped 50 percent to include around two-thirds of Americans, FHA and so-called redlining policies kept many potential homeowners, particularly African Americans, from being able to acquire one, particularly in the suburbs.
The current crisis is the culmination of a half-century of this type of mortgage policy that has been ineffective in dealing with the problems of lower class homeowners. Supporters of that group, particularly Civil Rights groups, often looked towards federal regulation for succor. Regulations and policies addressing the needs of low-income homeowners, generally based on the Civil Rights Act, came into existence after the mid 1960s and required equality in lending practices.
These efforts were important in advertising credit rights and educating borrowers. However, policies that aimed at changing the credit/mortgage market at its source—the financial institutions—met with staunch resistance from those institutions. Since government policies encourage homeownership, many believe that it is the bank's duty to finance the home-owning dream. Banks were willing to accept this mission because it is profitable, but as mortgages became less profitable due to the costs associated with the New Deal era regulations, limits on interest rates, etc., that mission became more burdensome.
However, technological advancements in those industries may have limited the effectiveness of those regulations. During the 1960s and 1970s, credit-granting institutions became reliant on computerized scoring systems, including most famously the Fair Issac Corporation (FICO) credit-scoring rubric. In addition, mortgagees relied on automatic underwriting (AU) after the late 1980s as a way to streamline the credit process and ostensibly eliminate subjective discrimination. Instead, these processes would allow statistics to make decisions about an individual's credit ability.
Banks and even some consumer groups lauded this shift to a statistically discriminatory system as a way to lower costs and ensure fairness in the decision-making system. Of course, these compliments ignored just how these automatic-scoring systems would factor demographic factors not directly related to income or the ability to repay the loan. Only recently has FICO released to the public information about how its credit score is calculated, including an important factor they call "credit history." Put more simply, instead of creditors rejecting African-American and women borrowers because of race or gender, creditors can reject them based on insufficient income or insufficient "credit history," statistics that have a inverse relation to credit-ability. These scores allow FICO's customers, banks; to absolve themselves of responsibility for race and gender based income inequalities in the United States, and instead blame differences in wages between whites and blacks or men and women.
Partially because of wage disparity, the equity in their homes accounts for nearly 90 percent of African-American homeowners' total net worth. Here then, discrimination is more burdensome to African Americans than it is for white homeowners. Aside from the two million people who are in serious danger of losing their homes in 2008, many of whom are racial minorities, the economic rights organization United for a Fair Economy finds that the African American community will lose 71-122 billion dollars in wealth this year due to foreclosures in that community
This mortgage market environment also contributed to the higher percentage of African-American and Hispanic homeowners into sub-prime loans. Thirty percent of loans made to African-Americans were in the larger umbrella category of "high-cost" loans, while these loans only constituted 17% of loans to whites.
Women also suffer in this mortgage crisis. The Consumer Federation of America found that women were 32% more likely to receive sub-prime loans than men in the past decade. In total, the National Community Reinvestment Coalition found that women held 37% of all high-cost loans in 2005, when they only accounted for 28% of regular loans.
These numbers are even more striking when compared with findings from the National Association of Realtors, who found that around 25% of America's 8 million single mothers spent more than half of their income on housing, compared with less than 10 percent of income on average spent by single fathers. This disparity in spending made those women holding sub-prime mortgages after the balloon payment even more susceptible to foreclosure.
The Blame Game
The biggest question that surrounds the current controversy is about culpability over the problems of women and minorities described above. On one side of this debate are those who support free market policies that blame the borrowers themselves. One group of borrowers was speculators, who ultimately lost money on a risky investment when the housing market failed to keep up its meteoric climb.