Subprime's Silver Lining

By Justin Fox

In early March, Boston College management professor Alicia Munnell gave a lecture at Yale on pension policy. "I was there, talking about retirement things," Munnell recalls, "and somebody looked at me and said, 'Are you responsible for the collapse of the subprime market?'" The question wasn't entirely out of left field. As director of research at the Federal Reserve Bank of Boston, Munnell co-authored a bombshell 1992 study that concluded that mortgage lenders systematically discriminated against blacks and Hispanics--even when one adjusted for income and creditworthiness.

Munnell's work propelled her into a big job in the Clinton Administration and led to new legislation and regulations aimed at pressuring banks to increase their presence in poor and minority neighborhoods. These new laws had the desired effect: home ownership among minorities, and Americans in general, began to rise steadily--the first such sustained increase since the 1950s. In 1998, 57% of black mortgage applicants were turned down; by 2004 the figure had dropped to 26.8%. For low-income applicants, mortgage denials went from 44.3% in 1998 to a low of 19.8% in 2003.

That was one remarkable result of the surge in subprime mortgage loans to borrowers with iffy credit records. The other remarkable result is that it is ending really badly--in a wave of foreclosures that could, at worst, cost billions, throw millions of people out of their homes and cause a recession.

What happened? Declining global interest rates left investors searching for anything that would pay higher yields. Eager to oblige, Wall Street investment bankers devised ever cleverer ways to package ever riskier loans into high-yield securities. And mortgage lenders came up with ever more creative loan terms to attract customers. This lured "unsophisticated borrowers who had difficulty fully understanding how these products would affect them when interest rates rose and housing prices edged off," says Eugene Ludwig, a former top banking regulator who now runs Promontory Financial Group.

Federal regulators stood by while this went on, but don't blame Munnell's study or the desire to encourage lending to minorities. "The point of that study was never to say, 'Let's go out and lend to people who aren't going to be able to carry the debt,'" Munnell argues. Sure enough, federally supervised banks and S&Ls and mortgage buyers Fannie Mae and Freddie Mac seem to have avoided big hits.

The boom in risky mortgage lending was driven instead by firms beyond the reach of the feds. Some of these state-regulated mortgage lenders belong to the same corporate families as banks, but they weren't subject to visits from the same finger-wagging federal bank examiners. As a result, the subprime lenders made all manner of dodgy loans, and that could go on only for so long.

This is the way of financial innovations, which tend to be used to excess at least once until people figure out what the true risks are. It's also why those on the financial cutting edge (like hedge funds) are often barred from pitching their products to anyone but the wealthy. That mortgage lenders were allowed to flog their negative-amortization, adjustable-rate mortgages and balloon loans without restriction does not reflect well on either Congress or state regulators. Now Congress is likely to do something about subprime lending.

Edward Gramlich, a former Federal Reserve Board member now at the Urban Institute, says Congress should sic bank examiners on subprime lenders and ban certain kinds of loans--especially those involving balloon payments. But Gramlich, author of the forthcoming The Rise and Fall of the Subprime Mortgage Market, also sees benefits in the subprime boom. "There seem to be more gainers than losers, and unless the losers lose a lot more per household, the net gains would seem to outpace the losses," he wrote in February. So, yes, things may have gotten out of hand. But neither should we clamor to return to a status quo where almost 60% of African Americans who want to buy a house are told they can't.