How the Subprime Scandal Started

According to a Senate report, the starting point of this crisis was in 1997, during the reign of the Clinton Administration. It was then that a period of housing price appreciation began - increasing by nearly 85% until 2006. Home prices jumped by 124%. This was unusual, having occurred only once before in American history, right after World War II.

Soon the housing sector was driving the American economy. Within the next few years, seven million families bought homes with subprime loans.

Homeowners who may have been cash poor, became house rich, by dipping into inflating home equity either by refinancing or taking out low-cost equity loans. As this business boomed, underwriting standards began to "deteriorate." The banks and other lenders had found a new way to make money - and fast. These loans helped homeowners stave off foreclosures.

They were made possible by deregulation lobbied for by financial institutions, credit card companies, and homebuilders, the industries most likely to benefit.

As John Atlas and Peter Dreier explain in the American Prospect, they won support from the Democrats and Republicans under the cover of the "Reagan Revolution" to undercut reforms made in the 1970s.

In the 1970s, when community groups discovered that lenders and the FHA were engaged in systematic racial discrimination against minority consumers and neighborhoods - a practice called "redlining" - they mobilized and got Congress, led by Wisconsin Senator William Proxmire, to adopt the Community Reinvestment Act and the Home Mortgage Disclosure Act, which together have significantly reduced racial disparities in lending. But by the early 1980s, the lending industry used its political clout to push back against government regulation.

This was also the period of major bank consolidation through mergers and the S&L crisis, which saw the closures of scores of banks and major losses because of illegal practices including mortgage lending.

A few bankers were prosecuted but most were bailed out by the Congress. As a blog named the Last Hurrah explained: "Without understanding cause, or the reason for these plain Jane savings organizations in sustaining middle and working class home ownership - Congress just bailed out the lenders who had the wit to reorganize, and let it go at that. Essentially they financed the next bump in housing inflation, whether it be in inflated prices for existing homes, speculation in lots for tear-downs in good areas, or McMansion housing far from jobs and culture in the exurbs, that requires vast investment in infrastructure on the part of existing home owners and the states."

Interest rate ceilings imposed by state usury laws dating from "reforms" in the 1980s were then rolled back. The lenders understood that these changes meant that now they could target a large potential market who wanted home ownership but could not qualify. And they could charge them high fees and interest.

The subprime loan was crafted for this community and promoted as a reform, a positive way for minorities to become part of the American Dream of homeownership for all. In this period, the Bush administration was hyping the promise of the "ownership society."

(Now, given the foreclosure rate, ownership may actually decline under his "watch.")

Most subprime borrowers were sold loans called "2/28" and "3/27" hybrid adjustable rate mortgages (ARMs). These loans typically had a low fixed interest rate - called a "teaser rate "by the industry - but
only applicable during the first two-year period. After two years, the rate is reset every six months based on an interest-rate benchmark. In many cases, payments rose 30%, which made them un-affordable to people whose wages and income were barely rising. By 2004, 90 percent of the subprime loans had these ARMs.

Bear in mind also that the most vulnerable and hence "higher risk" subprime borrowers - many with low FICO credit scores and poor credit histories - were charged substantially higher interest rates and fees than other borrowers. They were more likely to be subject to prepayment penalties, which make it costly to refinance loans. It was known in the industry that these are the borrowers who are most likely
to default or become delinquent in payments and face foreclosure.

No one can fully explain why housing prices went up so quickly either, leaving the door open to explanations based on deceptive and fraudulent practices such as inflated appraisals.

Quickly, so-called "intermediaries," unregulated and often unscrupulous mortgage brokers, hustled their way into the housing market and quickly dominated, taking a vast market share by a variety of tactics ranging from deceptive advertising to block-by-block solicitations to get people to buy and sell, always promising more than they can deliver.

These efforts were buttressed by large-scale advertising campaigns for firms like DiTech - which used an actor/comedian known for his appearances on Saturday Night Live - to hype the mortgages being backed by the General Motors Acceptance Corporation. (For a while the car company was making more on loans than selling automobiles.) Online lenders then joined the carnival of competition with more ads. Media companies raked in several billion from this advertising, which provided little incentive to expose these practices.

Speculators fielded street teams known as "birddogs," rewarded for hunting down and signing up prospects. Abusive, illegal, and predatory practices were common. They enticed. They seduced, and in some cases, they threatened. I was told by a mortgage professional in the know that muscle was used, and that people were murdered in property battles.

According to the Joint Economic Report, "For 2006, Inside Mortgage Finance estimates that 63.3 percent of all subprime originations came through brokers, with 19.4 percent coming through retail channels, and the remaining 17.4 percent through correspondent lenders. Their data show the broker share increasing from 2003 through 2006."

These companies were not regulated and did not come under safety and soundness regulations. The percentage of subprime mortgage securitized rose rapidly after 2001, reaching a peak value of more than 81 percent in 2005.

Underscore that: 81%!

As housing sales boomed, lenders just dumped their traditional criteria for originating loans. The Senate later found: "The share of loans originated for borrowers unable to verify information about employment, income or other credit-related information ('low-documentation' or 'no documentation' loans) jumped from more than 28 percent to more than 50 percent. The share of ARM originations on which borrowers paid interest only, with nothing going to repay principal, increased from zero to more than 22 percent. Over this period the share of subprime ARMs multiplied dramatically that were originated."