“Sub-prime lending is based on active deception”
Financial institutions are on a continuous hunt for innovation. Governments’ policy frameworks generally support that. However, the financial crisis has shown that innovation is not necessarily good. According to Elvin Wyly, Associate Professor of Geography at the University of British Colombia and visiting professor at the University of Amsterdam, “companies will innovate in ways that maximise profits. Eventually this will trigger a lot of deception. At the height of the credit boom, financial institutions were sending teams of brokers into streets and neighbourhoods to find customers willing to pay very high fees and interest rates.” How could this happen? Now that the financial crisis has almost come to an end, at least to some, it is time to go back in time and see how and why the crisis developed in the United States.
For centuries people have gone to the United States to live the so-called American dream: an ideal vision of a life with a nice house, a successful career and a stable family. Elvin Wyly believes the American dream is closely connected to debt ownership. People ‘own’ a house, but only because they have a mortgage that allows them to. This mortgage culture is one of the main causes of the financial crisis.
For years, mortgages had been distributed on the basis of inequality. In the years when most mortgages were standardized, easy to understand, and simple to compare, racial and ethnic minorities often did not get access to mortgages. Before 1975, the year when the Home Mortgage Disclosure Act (HMDA) was adopted, this was also an easy thing for financial institutions to hide, because there was no requirement that they provide information on the loans they were making to different groups or communities. As legislation improved and community activists pressured banks, the mortgage situation got better, and a significant number of racial and ethnic minorities were able to get access to good, fairly-priced mortgages.
However, in the 1990s, the American mortgage market was strongly deregulated, which made it possible for the risky sub-prime mortgage system to develop. Especially ethnic minorities and the elderly often seemed an easy target as they had always been - and still were – frequently excluded from the ‘normal,’ fairly-priced mortgages. Thanks to an expanding secondary market where mortgages were pooled together for investors, the profits from lending had less to do with the slow-steady repayment of interest (a relationship that gave a lender a direct interest in the borrower’s ability to repay) and more to do with short-term, up-front fees, hidden charges, and revenues from loan sales or other speculative activities. This meant that enormous profits could be extracted from even the riskiest loans that were destined for quick default – especially as long as house prices continued to increase, and defaulting borrowers could be forced to give up their homes to repay investors who had bought sub-prime securities. In the boom that lasted until 2007-2008, there was a lot of money for brokers, lenders, and investors around the world: everybody seemed to benefit – except, of course, the victims of risky, predatory loan schemes.
The roots of sub-prime lending
Some groups in American society were particularly easy targets for sub-prime mortgages. But where did the idea of sub-prime lending come from? According to Elvin Wyly, demand cannot explain the entirety of the high-risk credit boom. “The prime, competitive, good credit fluctuates according to the costs and the economic fundamentals. However, the sub-prime market, because it is profiting from deregulation and a certain degree of deception, did not follow these traditional demand driven patterns. In the year 2004-2005, interest rates in the United States were going up, but we were still seeing increases in sub-prime lending volume. Parts of the sub-prime market were much more supply driven than demand driven.”
A new opportunity for profit
If it appears that the sub-prime lending system was consciously created, Wyly would probably agree. “Financial institutions are always searching for new profit opportunities”, he states. In this case, the new way that was found seemed to be deception. “In the realm of mortgages, the first line of regulatory defence has always been the disclosure of information to consumers. However, there are only very few people who actually fully read and understand all the terms created by financial institutions, especially if they pack all kinds of fancy little terms into the mortgage, such as balloon payments and pre-payment penalties. During the sub-prime boom, teams of brokers were sent out into streets and neighbourhoods to actively find people and put them into sub-prime schemes. Community activists have informed me that at the final stage the terms of the contract would have been changed. This is what I call active deception.”
Even though legislation was very obviously being disregarded and people were actively being deceived, only a few seemed to notice what was going on. Wyly explains why. “Many of these companies involved in sub-prime lending remained very small, so they could stay below the government’s radar screen. They would be set up to extract as much as they possibly could, declare bankruptcy and reorganise the next day.” This changed between 2002 and the collapse of 2007-2008, as many large, multinational financial institutions began to see the profit of the sub-prime market and bought up small lenders or created specialized subsidiaries to engage in high-risk sub-prime lending.
Financial education and information?
During the sub-prime boom, many people in the United States were lured into sub-prime mortgages because they did not understand the terms. Generally, mortgages do not form a product that is easy to understand, even if it is a good one. Could financial education possibly be an answer to this? Wyly thinks so, but only on very special terms. “Many people did indeed not understand the terms of contract. However, there are also a lot of middle class or wealthy people who do not understand these kinds of things, but did not get exploited. There is obviously a knowledge gap when it comes financial issues, but for some people this gap carries a very significant penalty, and for others it does not. Whenever the industry attempts to fight off legislation, it says that we need financial education. The reason why they support that is because it fits nicely into an explanation that blames consumers for ignorance or a lack of sophistication I agree we need more financial education, but on an entirely different model. I think we need to give children and adults ‘economic self defence’ classes in which students are taught to protect themselves from advertising, marketing or email scams, and all the other tactics used to sell goods and services of dubious quality (not just sub-prime mortgages). In today’s society, the consumer has to protect him- or herself from an increasingly aggressive infrastructure that is trying to put a price on every aspect of social life. That is most probably not exactly what the industry has in mind, but that is what I would suggest.”
In addition to education, Wyly believes freedom of information is also important. “As consumers we have very few rights to information about the financial sector, mortgages or lending.” In Wyly’s opinion, the Home Mortgage Disclosure Act (HMDA) from 1975, which forced companies providing loans to make their loan data fully available to the public, was only a legislative start that now needs to be expanded. “Also small companies must be obligated to report their data, so they are not able to fail to report or hide what they are doing. The personal responsibility of the lender should be ensured in the end.”
In his work, Wyly displays great interest in community activists. He does not see himself as one though. “No, I am not good enough to be one. I am only a student of community activists who teach me. When I work with activists who are really working with the local consequences of things such as sub-prime mortgages I feel very modest and privileged to be taught by them. Part of what I would like to do in my research is to find out what these people need in their daily practice and adapt my work accordingly.”
Sub-prime lending: A love story?
Here and there Wyly’s work touches upon issues in the same way as Michael Moore’s movies ‘Bowling for Columbine’ and ‘Capitalism: a love story’ do. Just like the filmmaker, Wyly also has a clear message. “We should give up the almost religious doctrine that markets always make the right decisions. There must be limits. Elizabeth Warren, a prominent law professor who heads a government oversight panel for the financial bailout in the U.S., has noted that consumers are better protected when they buy a toaster than when they shop for a mortgage. Laws and regulations are in place to ensure that when you buy a toaster, it won’t burn down your house. In the same way we cannot allow brokers, lenders, or investors to put people into financial transactions that are clearly dangerous. In my opinion, a thirty year fixed rate mortgage for 180 percent of the value of the house for a borrower in their late 80s on a fixed income – one example of an actual loan made to an elderly African American widow in Ohio -- simply cannot be explained nor justified.”
© EUKN, Simone Pekelsma
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