Monday, March 1, 2010

Power Elites Let the Country Down: The Subprime Meltdown

I want to lay a foundation for my study of the role of elites in energy related decision making. This study will also lay the groundwork for what I think are financial contentions about energy.

Power elites might be viewed as the trustees of society, and indeed one of the important things that members of the power elites do is to sit on boards of trust for major businesses, virtue making institutions, and other grand and prestigeous organizations. Yet during the Bush administration, something went very wrong with the trustee relationship. William Black recently told Paul Solman of NPR,
So, in September 2004, the FBI began publicly warning that there was -- quote, unquote -- "epidemic" of mortgage fraud, and it predicted that it would produce an economic crisis, if it were not dealt with. The FBI has also said that 80 percent of the mortgage fraud losses occur when lender personnel are involved.
Yet bond rating companies failed to assess detect the presence of fraudulent mortgages backing Billions of dollars of mortgage related investment until fitch the smallest of the three large bond rating services,
look(ed) at a small sample of these loans, finally, in November 2007. . . . They said, the results were disconcerting, in that there was the appearance of fraud in nearly every file we examined. And they said that normal underwriting would have detected all of those frauds. . . . the lenders . . . created incentive systems for the loan brokers and the loan officers that were based overwhelmingly on volume, and nothing on quality. We know that they gutted their underwriting standards. We know that you got in trouble if you were moral and tried to be a good officer and protect the organization from loss.
Amy L. Festante of New York Law School wrote,
The rating agencies enter the securitization process early on and assist in structuring the transaction. The three primary agencies are Moody’s Investors Services, Standard & Poor’s and Fitch IBCA. Their role is to protect investors, but they are hired by the underwriter to assess and assign credit ratings to the credit quality of pools of mortgages. The rating agencies are considered the “gatekeepers” of RMBS because bonds need to be rated before the issuers and underwriters can sell them. “The lack of a rating from at least one of the privileged raters, which effectively grant regulatory licenses to institutions that wish to issue securities, is the financial equivalent of a death sentence for a residential mortgage-backed securities offering.”29 The S.E.C. and other government regulators granted these agencies a nationally recognized statistical rating organization status (NRSRO), but they were not assigned a reciprocal responsibility to the public. This is a problem because the rating agencies are not held accountable to anyone. Therefore, they can enjoy their privileged regulatory status and their unaccountability up until the investors can no longer rely on them. . . .

The credit ratings are reflective of the agencies’ holistic approach to evaluation; they evaluate everything related to credit including (1) the real estate, (2) loan terms, (3) credit support structure, (4) legal structure, (5) pooling effects, and (6) all parties to the transaction. The external factors that are considered include the state of the economy, as well as relevant accounting, legal, tax, regulatory and other external influences. Their evaluation of loss potential includes a consideration of (1) frequency of default along with the severity of loss, (2) pool characteristics, (3) credit enhancement, and (4) deal structure.33 . . .

In addition to their initial ratings, the agencies continue to monitor these transactions and adjust the ratings as credit conditions change. The rating agencies also reevaluate the securities when states pass anti-predatory lending acts, because these measures cause the investors to back away from RMBS.34
Thus something must have been very wrong with the credit rating services. Not only did the qualify mortgage pools which contained predominately fraudulent loans, but they continued to do so for over three years after the FBI had warned about mortgage fraud.

There was reason for concern, even before the 2004 FBI warning. This failure of the elites is even more shocking because the subprime lenders engaged in predatory lending practices in addition to fraud during the 1990's. Jeanette Bradley and Peter Skillern stated in a January 2000 publication by the National Institute of Housing that described the experience of a recently laid off telephone worker, North Carolina, "Roberta Green" who was approached by a subprime Mortgage broker,
The man said he worked for a home improvement company and that he could find her a loan that would both pay for some remodeling on her house and leave enough cash to pay her bills.
Unfortunately for Green, the salesman actually worked as a mortgage broker for "American Mortgage," and he was not peddling home improvement but a refinancing of her existing home mortgage at a high interest rate. He invited Green to his office, where he chatted with her while he filled out a mortgage application for her. While he indeed gave her a "good faith estimate" – a form required by regulators that lists the proposed interest rate and fees on a loan – the loan he wrote up was not a home equity loan for the $6,000 she needed to pay off bills. It was a loan for $76,500 that refinanced her entire mortgage at a higher interest rate.

A couple of weeks later Green signed the loan papers and walked out with a check for $1,900. The signing went by so fast, Green didn't catch all that was written on the pages. But she trusted the broker and the lawyer in the room and felt she had a pretty good grasp of what she was signing.

What Green didn't realize was that her loan terms had changed since she received that good faith estimate. The broker had added $6,500 in fees to her loan, and changed the loan from a fixed-rate to a more expensive adjustable-rate mortgage.
Bradley and Skillern also noted,
Those most hurt by the growing subprime market are black and Hispanic borrowers. A September 1999 study by HUD shows that since 1994, conventional, prime lending to black and Hispanic borrowers has dropped, and that black borrowers are increasingly being turned down for prime rate loans in numbers that far outstrip whites. The same study shows that lending by subprime companies to minorities is on the rise. Not all subprime lending is predatory; higher credit risks are normally charged higher interest on loans. But the growth in subprime lending to minorities, when coupled with the decrease in prime lending, leads to concerns that minority borrowers with good credit are being shut out of conventional markets and channeled instead into more expensive, subprime loans.
They also note,
Mortgage brokers originate over 50 percent of subprime loans. Some make money in the same way prime-rate brokers do: they charge the customer a fee for finding a loan. Most make money from what is known as a "yield-spread premium," a kick-back from the lender in exchange for placing the borrower into a higher-interest loan than what she would normally qualify for. The higher the fees and interest rates a mortgage broker packs into a loan, the greater their compensation.

Predatory lenders often aggressively market to moderate-income and minority communities, through mail, phone, TV, and even door-to-door sales. Their advertisements promise lower monthly payments as a way out of debt. What they don't tell potential borrowers is that they will be paying more and longer. Worse yet, they will be entering a system that promotes a cycle of debt that has been compared to sharecropping, an economic system that is unequal and unfair.
They added a description of the loan resale practices that eeventually lead to the sub-prime market collapse,
Now Green is trapped into a high-rate loan because the penalties charged if she prepays the loan using a cheaper loan are so large she cannot afford to do it. Lenders typically add such penalties to subprime loans to keep borrowers from refinancing their loans. Without prepayment penalties, subprime loans are more difficult to sell on the secondary market.

Financial institutions raise more cash to make more loans by selling the loans they already made to the secondary market. Secondary market companies then "bundle" these loans together and sell them to insurance companies, pension plans, mutual funds, and other investors much as prime mortgages are bundled and resold.

Green's loan may be sold on the secondary market. Because her loan has a higher rate of return than a prime-rate loan, the lender will be able to charge more for it and make more money.
They noted the losers and beneficiaries of this transaction,
Before this loan, Green had built up $23,000 of equity in her home. After the loan, she had less than $2,000 left. More than half of her home equity was lost to excessive fees.

Green will also end up paying more over the long term. Her monthly mortgage payments jumped from $500 a month to $740 a month. Her increased debt service and loss of wealth means she will be even more vulnerable to economic shocks in the future, and more likely to lose her home through foreclosure.
The only difference between the Bradley and Skillern story about "Roberta Green" subprime loan, and post default stories on subprime lending practices, was that the default was hypothetical and that the authors failed to note that fraud was probably involved, because an unemployed worker, even one who had a good credit history, would have been at high risk for default, which the added payment was likely to bring about.

Well before the 2007 subprime meltdown, Gregory D. Squires pointed to problems that would lead to the market collapse,
the growth of subprime lending (higher cost loans to borrowers with blemishes on their credit records) in recent years, coupled with growing law enforcement activity in this area, clearly indicates a surge in a range of exploitative practices. Not all subprime loans are predatory, but virtually all predatory loans are subprime. Some subprime loans certainly benefit high-risk borrowers who would not qualify for conventional, prime loans. Predatory loans, however, charge higher rates and fees than warranted by the risk, trapping homeowners in unaffordable debt and often costing them their homes and life savings. Examples of predatory practices include:

* Balloon payments that require borrowers to pay off the entire balance of a loan by making a substantial payment after a period of time during which they have been making regular monthly payments;
* Required single premium credit life insurance, where the borrower must pay the entire annual premium at the beginning of the policy period rather than in monthly or quarterly payments. (With this cost folded into the loan, the total costs, including interest payments, are higher throughout the life of the loan);
* Homeowners insurance where the lender requires the borrower to pay for a policy selected by the lender;
* High pre-payment penalties that trap borrowers in the loans;
* Fees for services that may or may not actually be provided;
* Loans based on the value of the property with no regard for the borrower’s ability to make payments;
* Loan flipping, whereby lenders use deceptive and high-pressure tactics resulting in the frequent refinancing of loans with additional fees added each time;
* Negatively amortized loans and loans for more than the value of the home, which result in the borrower owing more money at the end of the loan period than when they started making payments.
Squires pointed to a study by The Joint Center for Housing Studies at Harvard University which found,
that mortgage companies specializing in subprime loans increased their share of home purchase mortgage loans from 1 to 13 percent between 1993 and 2000.
He also pointed out,
Economists at the Office of Federal Housing Enterprise Oversight found that subprime loans are concentrated in neighborhoods with high unemployment rates and declining housing values. Almost 20 percent of refinance loans to borrowers earning less than 60 percent of area median income in 2002 were made by subprime lenders, compared to just over 7 percent for borrowers earning 120 percent of median income or higher,
In fact the massive fraud that lead to the sub prime mortgage meltdown would not have been possible without the complicity of the bond rating agencies, and probably every organization and individual in the chain from the brokers who brought loan applicants into the bank to the financial institutions that sold fraudulent bonds to unsuspecting buyers. The coordination of such a huge fraud scheme would have required coordination at the elite management level. Furthermore the lack of response by Congress, the Bush Administration, the Federal Reserve,
the media, and state and local prosecutors to the repeated studies that suggested predatory lending practices, and the likelihood of large scale borrower default, and the 2004 FBI warning indicates at the very least negligence by power elites, and at worst outright complicity in wide scale systematic crimes committed by the financial and banking industry elites.

Now this is a blog about energy, and my focus will be the role of elites in the energy decision making process, but here my point is that American power elites are capable of arriving at something like a consensus that in reflects poor collective judgement, and in all likelihood systematic, socially engendered thinking errors. My readers should be neither shocked nor surprised, if I uncover evidence of widespread poor judgement on the part of American elites of all political stripes, It is very likely that many elite groups, benefited in some measure from the sub[rime lending mess, ands thus had a motive to not bring it under control. Bad judgement, especially if it is so wides[read to be systematic, often can be explained by motives.


Soylent said...

I'd like to direct your attention to two people in particular that I find very persuasive on this issue.

The first is William Kurt Black, senior regulator under the savings and loans scandal who helped dismantle it before it grew any bigger and helped put over 1000 people in jail. William is very good in describing the nature and extent of the fraud in the private sector but he is much too lenient on the government's role in this mess.

In particular, this presentation is very good:

The second is Peter Schiff who has a very good record in predicting the bubble; years in advance he went on numerous TV shows and faced varying ridicule and scorn for explaining that there is a housing bubble, why there is a housing bubble and how serious the damage will be when it collapses. He has a rather austrian leaning explanation of the failures on part of government and I find it largely convincing.

This in particular:

Charles Barton said...

Soylent, thank you for the comments and the information. My intention here was to point out the failure to control the housing bubble as a collective failure of the elites. The failure to detect, and to punish the massive, systematic fraud in the subprime mortgage market is also a collective failure of the elites. While this is fascinating stuff the lesson here is that elites cannot be counted on as trustees of the public interest.

Anonymous said...

Charles...all this nonsense in the speculative finance industry stems from the overturn of Glass-Stegal Act in 1989 by the first Bush admin. it was an excercized in bi-partisan stupidity that just goes to show "bi-partisanship" is a political weasal word.

Prior G-T, banks were mandated with in very narrow confines of lening. Savings and Loans could *only* lend on mortgages and small businesses. Commercial banks could only lend to large enterprises with a *clear return* and definable assets. They could overlap with savings and checking accounts, but that was it.

With profits beginning to dip in the 1960s, banks rangled out of the Reagan Admin the 'need to make more profits'. Thus the moves under that Admin. to overturn G-S.

It was designed so that they could make loans from the S&Ls and not pay them back. Legal theaft. Worse, actually than the recent bailouts. They allowed then S&Ls to be bought up by the big banks. These banks could take the assets of those banks and make loans to other banks to buy finance companies like brokerage firms (previously against the law under G-S) that could then start speculating on all sorts of things like the fake dirivative markets and even splitting up and selling mortgages...also forbidden under G-S.

We need, at a minium, Glass-Stegal back on the books.

DAvid Walters

Charles Barton said...

David, while it is quite true that protective New Deal regulations were eliminated, it is also the case that massive law breaking was part of the subprime episode. There was wholesale fraud on every level, what happened happened, because keepers of the public trust were asleep at the wheel at every turn.

Soylent said...

"The failure to detect, and to punish the massive, systematic fraud in the subprime mortgage market is also a collective failure of the elites."

The cynic in me wouldn't say it's a failure on their part. They made out like bandits blowing up the bubble and they seem to do quite well on the way down bending the tax payer over the table.

Charles Barton said...

Soylent, The bubble undoubtedly benefited a large grouping of the power elites, in a number of days, and it created an illusion that elite trusteeship was working far better than it in fact was. The collapse of the bubble however harmed the elite. The country lost as much as a quarter of its national wealth, and the loss of wealth damaged elite as well as popular interests. The 19 largest banks in the country are insolvent, and stay in business only at the sufferance of Congress All Congress has to do is reinstate the mark to market rule, and all 19 banks go down the tube.


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