The wrong way to lend to the poor

The wrong way to lend to the poor
By John Gapper
Copyright The Financial Times Limited 2007
Published: March 18 2007 18:06 | Last updated: March 18 2007 18:06


For confirmation of the old adage that the rich get richer and the poor get poorer, take a look at the US housing market. Lavish Wall Street bonuses mean that apartments and houses for the well-off in New York are still rising smartly in price. Meanwhile, in the poor US city districts where many blacks and Latinos live, something very nasty is going down.

Global stock markets shuddered last week at the prospect that an implosion in the subprime mortgage market would pull the US into recession and crimp world growth. Subprime mortgage lenders such as New Century Financial are in trouble because so many borrowers have defaulted on their mortgages as interest rates have risen and homes have fallen in value.

Since I had never heard of subprime mortgages until recently, I spent some time last week discovering what they are. This is what I was told.

Imagine a man who is married with two children and who has a low-paying job as, say, a school janitor. It is 2004. He rents an apartment and has watched enviously as property prices and rents have risen sharply in the US housing boom. He decides that, for the first time, he should be able to make money by owning property too.

He does not go to see his bank because he had trouble with his bills in the past and he is afraid of being humiliated. Instead, he walks into the office of a mortgage broker who got one of his friends a loan. He explains that he does not get paid a lot and has hardly any savings but he wants to buy a house. “No problem,” the broker says, “take a seat.

“Your credit score’s not great and your income’s not high but we can deal with all that. The first thing to decide is what mortgage you want. Everybody used to choose 30-year fixed rate loans but you might prefer one that starts off with low payments. You need to buy furniture, and paint the place, so it gives you breathing room for a couple of years.

“As for the income, don’t worry: just tell me you’re paid rather than coming up with the paperwork. There are some fees but we can just wrap all of those up in the loan so you don’t have to pay the money upfront. Here’s what your monthly payments will be. Not bad, is it? Just sign here, here, and, oh, here, and we can get things going with the bank.”

If all this sounds ominous, it is. Our janitor has just acquired an exploding Arm (adjustable-rate mortgage) which is as painful as it sounds. His interest payments were fixed at 7 per cent for two years, since short-term interest rates were low in 2004, but he got into arrears on property taxes, because the bank did not follow the customary practice of collecting them monthly.

“No problem,” says the broker, when he returns the next year with his tale of woe. “Great to see you again. You were wise to buy that house because it’s gone up in value. We’ll just refinance the mortgage to cover some of these bills. Just sign here, here, and, oh, here.”

By 2006, house prices have started dropping in his city and, in the middle of the year, the mortgage payments are reset. His 6 per cent fixed rate jumps to 10 per cent, with a further rise to 12 per cent in prospect: his Arm has exploded. He cannot pay and goes back to his broker. But he is not greeted warmly this time: there is no home equity left to support another refinancing.

Bye-bye, home. The mortgage securitisation trust that diced up the credit risk of his mortgage into tranches for different pools of credit investors calls the bank that made the loan and tells it to repossess the property. The house is boarded up and auctioned, which pushes down the sagging prices of houses on the same street even further.

It adds up to a sorry tale of human nature and financial incentives. The broker earned a higher fee for selling our janitor an exploding Arm rather than a fixed-rate loan and by getting him to self-certify his income (which involved him paying a higher interest rate). By not escrowing taxes, the bank made it more likely that he would incur a prepayment penalty of 3 per cent of the mortgage.

As long as prices rose, equity could be extracted by the mortgage broker and the lender (and the Wall Street banks that securitised the mortgages) each time the janitor had to refinance. Indeed, they had a vested interest in his loan being unaffordable and in him requiring a new one. The credit risk had been securitised away and they gained another round of fees.

When the property market dipped, the music stopped. Here are some figures to reflect upon. Some 52 per cent of loans made to black people in 2005 were subprime and 80 per cent of these subprime loans were exploding Arms. About 70 per cent of subprime loans were booked by brokers who had no fiduciary responsibility to the borrowers they advised.

Martin Eakes, chief executive of Self-Help, a lender and credit union, has estimated that 2.2m families could lose their homes to foreclosure because they are unable to pay their mortgages. He thinks it could become “the largest loss of African-American wealth in American history”, one that was largely avoidable if borrowers had been better advised and had been given more suitable loans.

Poor people will always pay more than rich ones for credit because they are more likely to default. The cost of sound advice, which they need, can add to fees. Nor can those who took out loans be absolved of responsibility for their plight. But, examining what has happened in the US mortgage market, even the staunchest advocate of caveat emptor must despair.

john.gapper@ft.com