The Center for Public Integrity (CPI) released an extensive report today that shows how complicit Wall Street firms were in fueling the subprime mortgage crisis. According to CPI, “at least 21 of the top 25 subprime lenders were financed by banks that received bailout money — through direct ownership, credit agreements, or huge purchases of loans for securitization.”
This, in itself, is not all that surprising. We wouldn’t be in our current situation if the big, systemically important firms hadn’t mucked around in the subprime world. But later in the report, CPI shows how this mass underwriting and securitizing caused a ton of trouble:
Unlike traditional mortgage lenders, who make their money as borrowers repay the loan, many subprime lenders made their money up front, thanks to closing costs and brokers fees that could total over $10,000. If the borrower defaulted on the loan down the line, the lender had already made thousands of dollars on the deal. And increasingly, lenders were selling their loans to Wall Street, so they wouldn’t be left holding the deed in the event of a foreclosure. In a financial version of hot potato, they could make bad loans and just pass them along.
Thanks to securitization, the subprime lenders didn’t actually care about mortgage defaults, because they were so far removed from the original mortgage by the time a borrower stopped paying. But the Wall Street firms would also turn right around, sell the loans to institutional investors, and use the money raised to buy more subprime loans, in a vicious cycle of buying, selling, and lending. Thus, we had this phenomenon:
In 1994, the median loan after adjusting for inflation was $120,000…The median income of borrowers was $73,000. That’s a loan-to-income ratio of 1.65. So borrowers were taking out loans that amounted to 165 percent of their salary…By 2005, the peak of the subprime lending boom, the median loan grew to $183,000 while borrowers’ median income remained roughly the same. That amounts to a loan-to-income ratio of 2.46. That meant the typical loan amounted to 246 percent of annual income.
Of course, there were many factors contributing to this rise in percentage of income devoted to housing, including some non-quantifiable societal trends. But the fact remains that lenders and investors alike risked less and less on a loan, which helped push standards lower and lower.
So what to do? The House Financial Services committee has passed a bill that “would require lenders, bond investors and others involved in the repackaging of home loans into securities to retain a minimum of 5 percent credit risk,” which will move the the full House and the Senate. At least this would prevent all of the risk from being passed down the line, and make lenders care (somewhat) if a borrower defaults. This can’t be the last step taken to rein in Wall Street, but its certainly a good place to start.