Mortgages

A Subprime Pioneer’s Notes on the Financial Crisis She Predicted

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Kathleen Engel started to notice something funny happening with home loans in 1999. She lived in Shaker Heights, Ohio, just a few blocks from the city of Cleveland. Out of nowhere, she’d found herself inundated with offers from loan brokers. They called on the phone, left flyers on her porch, sent her direct mail.

All the brokers were offering home equity loans. Engel’s neighbors were flooded with the same offers. When Engel called about the loans, she discovered a pattern: many loans offered low introductory interest rates that skyrocketed after just a few months; others contained costly balloon payments.

These loans were designed to fail, Engel realized. Within months, people on her block started losing their homes.

“I started asking, ‘Why are people making these loans?’ It didn’t make sense,” she says. “They were unsustainable from the get-go.”

Engel was a law professor at Cleveland State University. She became one of the first academics in the country to recognize the problem of subprime loans, the monster now known to be responsible for much of the 2007 recession, the largest economic downturn since the Great Depression.

Now Engel has teamed up with Patricia A. McCoy, a professor at the University of Connecticut law school and an expert on banking and retirement, to write a new book called “The Subprime Virus.” It documents how Wall Street financial firms caused the subprime mortgage bubble, and the recession that followed, by allowing their short-term desire for profits and bonuses overwhelm concerns about the long term health of their own institutions, Engel found. They did it by controlling all aspects of the market, from individual loan officers all the way up to the investors in complicated securities swaps, and convincing Congress and federal regulators to look the other way.

“The investment banks like to portray themselves as just innocent middlemen,” says Engel, who is now a law professor at Suffolk University in Boston. “That’s just not true. They made the market. They were in control.”

The Early Days

The loan offers that flooded Engel’s doorstep in Shaker Heights were fundamentally different than the loans that sunk the economy eight years later. In the early days, most subprime loans were made by small, independent companies, Engel found in her research. The companies targeted senior citizens, low-income people, and African-American and Latino neighborhoods.

This was no accident. Subprime lenders specifically chose populations of people they believed might mistrust banks, who had low income and little access to credit, and who the lenders believed were less likely to find the danger buried in the fine print. Brokers told people they could use the money to fix their roofs, upgrade windows, or send their grandchildren to college.

But the loans themselves were rapaciously predatory.

“I saw it in my very own neighborhood” says Engel. “It was predatory lending with exorbitantly high rates.”

To reel in borrowers, most loans started with low initial payments. But after a few months or years the interest rates would skyrocket, or the borrower would receive a bill for a large balloon payment of thousands of dollars.

Seniors on fixed incomes, as well as low- and moderate-income people, could not afford such loans. That actually worked to loan brokers’ advantage, however. Because each time the payments became too much, the broker would offer to refinance. Some homes were refinanced three or four times. The brokers reaped a new round of fees each time, even as the homeowner sank farther into financial ruin.

“By design, these subprime loans were unaffordable,” Engel says, because “they were based on lenders extracting equity from peoples’ houses.”

Wall Street Takes Control

But the subprime loan offers that appeared on Engel’s doorstep were not the same ones that brought down the world economy. In the early 2000s, major Wall Street banks and investment firms noticed that subprime lenders were making huge profits, so they bought their way into the business. Wall Street weeded out some of the industry’s worst practices, Engel found, such as flipping home equity loans to reap fees from the elderly.

As Wall Street took control, the deception became somewhat less predatory, but much more complicated. To assure their access to steady streams of new mortgages, firms like Lehman Brothers and Goldman Sachs bought their own subprime mortgage lending companies. They also lent money to banks and other financial institutions, which lent it out in the form of subprime mortgages.

“The goal was to have a constant stream of mortgages coming in,” Engel says.

The Real Money

That’s because the real money didn’t come from the loans themselves, but rather from securitization. That process involves gathering thousands of loans together into a pool, and selling bonds (also called securities) to investors based on the value of those loans. Each batch of loans was divided into slices, called tranches, and each tranche was reviewed by a ratings agency like Moody’s or Standard & Poor’s based on the likelihood that the homebuyers in that tranche would continue making their mortgage payments.

The process of rating investments is supposed to be independent, so that investors can trust that the ratings are accurate. But in this case, the same Wall Street firms that stood to earn billions of dollars in fees from issuing securities were the same companies paying for the ratings.

Securities with higher ratings sold at much higher prices than poorly rated ones. So the Wall Street firms bullied and cajoled the ratings companies into giving their bonds higher ratings than the bonds actually deserved, according to Engel.

A deal “could be structured by a cow and we would rate it,” an employee at Standard & Poor’s said in an email to a colleague.

The ratings agencies “did put their ratings up for sale,” Engel writes.

Side Bets Upon Side Bets

Wall Street firms figured out ways to squeeze more profits from the same securities deals by taking low-quality bonds comprised of lots of risky mortgages, bundling them together, and re-securitizing them. Then they convinced the ratings companies to label many of these dubious products as “investment grade,” too.

Financial firms even convinced ratings agencies to give top marks to super-risky products called credit default swaps, Engel writes. These swaps were bets on whether mortgage-backed securities would rise or fall in value. In many cases, they functioned like glorified bets at a casino, Engel says, in which neither side actually owned the investment they were betting on. In other times credit default swaps acted as a form of insurance, in which people who bought mortgage-backed securities on the belief the investments would rise in value could reduce their exposure to risk by buying a swap in which they bet the value would go down.

Either way, the explosion of credit default swaps meant that lots of money was being wagered based on mortgages that themselves were risky from the start.

“It’s like dog racing,” Engel says. “You could have a trillion dollars’ worth of bets on an issuance of a million dollars.”

Many of these transactions involved outright fraud, Engel found. Goldman Sachs sold purportedly safe securities to investors, while the company’s own traders bet that the securities would fail. Goldman won $1.35 billion in profit from the bets, according to a recent report by the Senate Permanent Subcommittee on Investigations.

Mortgages Came Second. Securities Came First.

Wall Street firms like to claim that they served only as middlemen, putting together securitization deals only after their bank clients had sold the mortgages. But that’s not really what happened, Engel found. In most cases, Wall Street firms already had set up securitization deals before the first homebuyer signed the first loan. Working hand-in-hand with ratings firms, the Wall Street dealmakers who arranged the deals figured out beforehand how much money they would make from origination and securitization fees. That way, they knew how much money they should lend to retail banks, which then used their own advertising and branches to recruit individual homebuyers. It also let Wall Street’s arrangers to set the reimbursement rates for brokers.

That’s why brokers worked so hard to push people into risky loans: Wall Street paid higher bonuses for risky loans than it did for safe, old-fashioned prime loans.

“People wonder why brokers and loan officers wanted to rip off their customers with high-cost products,” Engel writes. “The answer is commissions.”

Where Were the Cops?

Where were Congress and federal banking regulators, who are supposed to regulate such fraud and protect consumers? In Wall Street’s pocket, Engel found. A combination of campaign contributions and pro-market ideology kept Congress from intervening to stop the abuse.

Engel met low-level employees at the Federal Reserve who were concerned about the predatory loans consuming entire neighborhoods within just a few blocks of the Fed’s office in downtown Cleveland.

But the Fed’s leaders didn’t care. Many of them had been employed by Wall Street firms immediately before coming to work for the Fed, and many more went to work for Wall Street after they left government.

“There was the problem of regulatory capture,” Engel says, in which government agencies saw the leaders of Wall Street firms as friends and clients instead of people to be regulated.

Wall Street Wins, Even When It Loses

For years, investment firms got away with selling loans they knew posed a great risk of default. After all, by the time homeowners eventually defaulted, the firms had reaped huge fees from loan origination, securitization and credit default swaps.

But Wall Street found one more way to profit from homeowners’ misfortune. Many investment firms bought or created their own loan servicing companies, which handle payments from borrowers and pass the income onto investors. When a homeowner fell into foreclosure, most parties in the transaction lose. The homeowner loses the house. Investors lose monthly income. Cities lose property taxes.

Loan servicers win.

“When the property was sold at foreclosure, servicers recovered those payments plus any late fees charged to borrowers and the costs of foreclosing,” Engel writes. “This system of compensation created an incentive for servicers to move properties into foreclosure.”

Fraud and Deceit, From Top to Bottom

Add it all up, and Wall Street firms controlled the subprime market from top to bottom, Engel says. They controlled the sale of subprime loans, either directly through their own lending arms or indirectly by setting brokers’ pay rates. They controlled the securitization process. They controlled the ratings agencies. They manipulated investors into believing such risky securities were safe. And they used their political and financial clout to keep Congress or federal regulators from getting in the way.

“At the end of the day, financial institutions had their fingers in every piece of the pie and generated fees from origination through foreclosure,” Engel writes.

A Lesson, Rooted in 12 Years of Research

After 12 years spent investigating subprime mortgages, Engel finds that much has changed. The Dodd-Frank financial reform act, passed last year by Congress, will do much to clean up mortgage abuses, Engel believes.

“It does a really great job with the mortgage markets but it’s a little late,” Engel says. She pauses. “A lot late.”

Still, problems remain. Credit default swaps remain largely unregulated. New products like prepaid debit cards could cause serious problems for consumers, she worries.

Maybe the biggest problem, Engel says, is that many people have not learned the most important lesson from the subprime fiasco. Private industry does a tremendous job of finding innovative ways to make money. But relying on people to regulate themselves, especially when billions of dollars are at stake, may be unrealistic.

“Markets have bad memories,” Engel says. “We can’t rely on the market to solve these problems. They give us temporary fixes, but they don’t have sufficient incentives to police themselves.”

Image: Estitxu Carton, via Flickr.com

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