Subprime’s Footprint

While immediate steps are necessary to stem foreclosures, a comprehensive solution requires a broader brush.

In recent weeks, political will has begun to amass in support of federal efforts to stem subprime foreclosures. In particular, the Federal Reserve’s actions to prevent the collapse of Bear Stearns emboldened proponents of foreclosure assistance, who saw the Fed’s intervention as a bailout of Wall Street. At the same time, the spillover effects of subprime foreclosures on the broader economy have quieted critics of federal intervention.

The result has been increased congressional attention to the issue, with the House recently passing legislation that would allow FHA refinancing of troubled loans. Given President Bush’s promise of a veto, the prospects of the current bill appear dim. However, the willingness of a number of congressional Republicans to support foreclosure assistance raises the possibility of a legislative package under the new administration in early Spring 2009.

In Shelterforce’s Spring 2008 issue, John Taylor (“Help Now, Not Later”) outlines a pragmatic approach to mitigating the tide of subprime foreclosures. This response is deeply needed, and action must be taken to aid struggling homeowners. However, such actions should be viewed as a short-term response to the foreclosure crisis and not as a comprehensive solution to the issues raised by subprime lending.

These interventions, designed to prevent foreclosure, do not address the underlying market failures that led to widespread origination of risky mortgage products. In the short term, the market may appear to be self-correcting, as new subprime originations remain at a fraction of their 2005 and 2006 levels. However, investors’ newfound caution should not be expected to persist, especially as housing markets begin to recover.

Instead, regulators must expect lenders to continue to develop new and increasingly complex credit products. This reality must be central to a forward-looking revision of federal lending regulations, one that focuses on protecting consumers’ interests while permitting (and even encouraging) such innovation. After all, the initial growth of the subprime industry — through higher-cost, fixed-rate mortgages — was once hailed for creating unprecedented access to homeownership for many underserved groups.

The confusing truth of the subprime mess is that the culprit is not the availability of non-traditional products, per se, but rather the increasing gulf between the financial sophistication necessary to navigate the mortgage market and the ability of consumers to do so on their own. To be sure, some borrowers accepted undue risk, speculating on sustained growth in home prices. Many accepted mortgages that in hindsight were unsustainable in the long-term. However, we now know that the primary mistake of many of these households was to trust their mortgage lender, assuming that lenders would not approve loans that carried substantial risk of failure.

Regulators have thus far approached this issue by promoting financial education and consumer choice, a position that expects consumers to accumulate expertise to rival that of mortgage professionals. In contrast, a well-functioning mortgage market requires that consumers’ interests be equally represented at all stages of the mortgage transaction. Succeeding in this regard requires a legislative package that both broadly addresses the fallout from subprime foreclosures and enacts basic changes in the federal approach to mortgage regulation. Unfortunately, a long-term solution to these issues is complicated by two factors:

  • 1. The fallout of the foreclosure crisis is concentrated in underserved communities and extends beyond the homeowners who are directly facing foreclosure.

The tragedy of the current crisis is that the impacts are concentrated in communities that have the least ability to withstand a wave of foreclosures. In study after study, researchers have documented higher rates of subprime activity in neighborhoods with high proportions of low-income and minority residents. (See “Losing Ground,” by Sarah Ludwig, Shelterforce, Summer 2007.)

Researchers at the Federal Reserve Board and the University of Pennsylvania recently examined the distribution of subprime lending activity across neighborhoods in seven major U.S. cities. Even after adjusting for differences in credit quality, subprime activity is strongly associated with a neighborhood’s income, educational, and racial/ethnic composition.

The direct result is that the residents of these neighborhoods will disproportionately bear the costs of foreclosures. Furthermore, the impact of an individual foreclosure is shared by the borrower who signed the risky mortgage contract and the borrower’s neighbors, including those who prudently searched for and originated low-risk mortgages. While the impact of a foreclosure on nearby property values is greatest in direct proximity to the foreclosed property, the effect has been shown to extend for several blocks. When multiple foreclosures are present, the effect can be devastating to the whole neighborhood.

In many communities, high foreclosure rates have left many homeowners owing more than their home is currently worth, a recipe for further foreclosures. Unless federal regulations convincingly eliminate the presence of problematic lending practices in these communities, this process all but ensures that mainstream lenders will remain wary of extending mortgage credit in these communities, even to well-qualified borrowers. In this way, the footprint of subprime foreclosures is left on entire communities, requiring policy responses that couple efforts to mitigate the extent of foreclosures with support for community-based lending activities.

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