Subprime Borrowers: Not Innocents

Consumers who took out adjustable-rate home loans they now can’t repay are primarily to blame for the subprime mortgage crisis. Pro or con?

Pro: Willing Customers

A simple look at the blunt reality reveals that borrowers themselves should assume primary responsibility for the current subprime crisis. Millions of borrowers, all over the country, knowingly signed mortgage contracts they cannot now afford to honor.

Provided that lenders did not engage in force or fraud—and there’s no particular evidence they did so on a large scale—borrowers should do whatever they can to live up to the contracts they signed. The policies of lenders and government certainly helped the current crisis develop—but ultimately, do not absolve borrowers of responsibility for their debts.

And in most cases, the mortgage lenders not only are innocent of the predatory practices borrowers complain about but also are feeling the pain right along with them. These lenders do not revel in the current circumstances. A lender typically loses about a third of its loan value through foreclosure; thus, no lender (or mortgage-backed securities marketer) has an incentive to make or purchase a loan it genuinely believes a borrower cannot pay.

With a very few exceptions, lenders have no desire to serve as landlords or take away people’s homes: A foreclosure causes almost as many problems for the lender as it does for the borrower. True predatory lenders, who engage in fraud or make loans they know borrowers cannot pay, inevitably end up in either jails or unemployment lines.

The government played some role in the crisis as well. Its tax system encouraged Americans to take out very large mortgages to get out of paying federal income tax. And the government’s 2005 bankruptcy reforms meant that rather than having their debts wiped clean, most middle-class Americans who file for bankruptcy have to set up five-year payment plans with creditors.

Not one of these factors, of course, mitigates the facts of the situation. Mortgage borrowers who signed legally binding contracts should have to honor those contracts, or at minimum, renegotiate terms with their lenders. Any suggestion that borrowers should avoid responsibility would undermine the fundamental principles of contract law that lie at the base of any modern capitalist economy.

Con: Collaborative Fiasco

Yes, a few borrowers bear some blame for subprime problems, although not for the whole crisis. These few are the crooks, the ones who falsified their financial statements and obtained loans fraudulently. They should be prosecuted. More numerous are the mortgage salespeople and real-estate brokers who both misled borrowers and falsified the applications to get mortgages the borrowers could not repay. They also should be prosecuted.

The subprime “crisis,” though, is much bigger and more complex. Most subprime borrowers applied for and got mortgages they thought would benefit them. They bought houses they otherwise could not have afforded. They expected that house prices would continue to increase, allowing them to refinance their mortgages or sell the property at a profit. Many guessed wrong, and they and the investors who ultimately provided the funds for the mortgages will take losses rather than gains. These borrowers are not responsible for the crisis. They just took advantage of opportunities offered to better their lives and finances.

Who, then, is responsible? Well, no one—and everyone. The mortgage salespeople and real-estate brokers received commissions. They benefited. But they are not responsible for the crisis; they (the honest ones) just did what people who sell cars or TVs do—sell the product. Indeed, the interest and repayment terms of mortgages must, by law, be clearly stated. It is the present and future value of the house that is hard to estimate. The initial lenders who securitized the mortgages benefited, which does not make them guilty of causing the whole crisis. The agencies that gave the securitizations too-high ratings were responsible, but (at least in retrospect) investors should have been more skeptical. Because investors were not sufficiently cautious, they have taken and—as the crisis unwinds—will continue to take losses. They are not responsible for the crisis; rather, they are the victims of less-than-competent risk managers.

Although borrowers are not responsible for the subprime mortgage crisis, neither are they its victims. They just gambled and lost. Hence, they should not be bailed out by taxpayers. Investors (or their agents, the mortgage servicers) may restructure their mortgages rather than foreclose. They will take a hit as will the many others who contributed to—but didn’t solely cause—the subprime mortgage crisis.

Opinions and conclusions expressed in the BusinessWeek.com Debate Room do not necessarily reflect the views of BusinessWeek, BusinessWeek.com, or The McGraw-Hill Companies.

Reader Comments

MandBinc

The American dream is not to have a house, 2.5 kids, and a three-car garage. It is to take $10 and turn it into $1 million.

Come the new year, all those people who cannot meet their current mortgage payments will be hearing from the local property taxman. They can't even pray for a disaster as they most likely didn't pay their insurance premiums either.

George Kumazawa

I didn't see anyone making money trying to give back part of the profits. They weren't forced to sign and buy larger homes, expecting larger profits.

Like my dad used to say: "Bulls make money. Bears make money. But pigs gets slaughtered."

TheQuant

I have to go with the con side of the issue. It is purely an American trait to sign on to a house mortgage and hope for the best.

The people making the big dollars, who need to enforce prudent underwriting standards, should take the hit. After all, they made big money on transactions and should bear the downside if it comes to pass. That's called business and investing. Too bad.

paula lowe

I actually take both sides of the issue. I have been a mortgage lender for 26 years, and clearly there have been clients over the years who gave the old head nod without truly understanding the loan product regardless of how many times we went over it.

The clients can read each document and have numerous conversations with the mortgage lender and still not understand what they have signed. Many of these people are college educated.

I believe there are people who committed fraud knowingly and others who were truly victimized. Still others face changes in their employment or family status that caused them to slip. I also believe that there are still others who simply no longer want the home (yet can afford to pay for it) and walk away. Sellers in the market may be willing to put their credit at risk to move on. They only need to wait a few years for their credit to recover. With little equity and little chance of selling in this market for any measurable profit, simply buy the home you want and let the other one go back to the bank. You can easily cry "foul." Look around--everyone else is doing it.

TKP

I understand the points made by both sides. I would suggest a thorough examination of loans made that are now in default. If the loan happens to be a "no documentation" loan or a loan that has the correct documentation with not enough income, yet issued, then in these two cases the lenders are guilty. If the borrower himself or herself falsified the documents to get the loan, then he or she is the guilty party. Of course, with the number of loans in question and amount of paperwork to be examined, this is not a feasible process.

Mark

The truth lies in the middle. First and foremost, lenders relied too heavily on FICO scoring and not the ability of the borrower to repay. The willingness to accept stated income and no-doc loans was driven by greed on the part of the lenders, who often sold these loans onto someone else. Also, allowing little or no down payment from the borrower encouraged speculators. A larger down payment discourages people from defaulting on loans and allows for easier refinancing.

That all said, the borrower is equally at fault for not doing due diligence on the mortgage. I suspect many assumed that if a lender was prepared to lend the money, that meant they were able to repay. If they did their homework and reviewed their household budget, many probably would have found that they were financially stretched. Many focused on the initial monthly payment and not the later payments (ignorance is no excuse). Many probably acted impulsively, worried that they might miss out on a house when prices were rising and multiple bids were prevalent. Finally, they were probably encouraged by the lender that they could refinance in a year or two to a fixed-rate mortgage. In which case they took that risk in the belief that prices would continue to rise and lost that bet. Irrational exuberance all around.

Prashant

I think we should point the finger at pay.

When Countrywide paid more commission on ARM mortgages than regular mortgages, it was to blame.

When the analyst at Moody's was paid to say that the mortgage was AAA, the company securitizing was to blame, because they threatened to take the business to someone less scrupulous.

When the broker was paid a higher commission to sell this security to his client than to look after his client's money, the brokerage house was to blame.

Everything is related to pay. Like Warren Buffet said, set the pay structure correctly and you will get the right result.

wei J

Not a single one innocent party is in this mess. First, my personal experience in California testifies that the lender, appraiser, and other parties in the financial industry are guilty of aiding or abetting the fraud in subprime finance. Just a simple rollback local TV commercials and a review of local newspaper ads will clearly tell the world that these guys were guilty of today's fiasco. I recall a local appraiser institute produced appraisers virtually overnight. Second, these debtors clearly knew what they were doing then. Most of the people I know were clearly playing the market and disregarding the risk. Many people in San Jose in my neighborhood were buying property like crazy for speculation. Now they are crying for sympathy for being victims. It would be ridiculous for the Fed to bail these parties out for the future well-being of the U.S. housing market. It's one thing to be sympathetic to them, and totally another to help those who consciously dug the pit for their own. Let them fail, and the U.S. won't collapse; in return we will get a healthy market and more rational financial industry.

Holly Garfield

The borrowers are part of the blame, but not the majority of the blame. The borrower is not a finance professional, and relies on the lender to make a loan that can be repaid. The lending policy-setters have the bulk of the blame for failed mortgages. But it does not stop there. Financial investors, lender loan packagers, creators of CDOs and SIVs, and investment resellers and buyers are the most to blame. Home builders who over-saturated the market have a share of the blame, too. The mess was not created by subprime borrowing. This was the initial step, but not a critical step.

Loan managers can see that the home price to income ratio was creating a bubble. The home builders creating an oversupply increased the bubble. This all publicly posted government information that loan policy-makers can readily see. They should have curtailed mortgage requirements back in 2005-06. Home builders should have known that they were creating a supply that could not sustain the price at the available demand.

The loan packaging tied a large amount of non-subprime loans to the sub-prime market. This created a situation in which these vehicles ended up with a risk level that was about the subprime risk, not the advertised risk. The rating agencies gave a rating of risk level that was actually better than the risk level of the best loans, a mathematical impossibility. Investors did not question the rating agency assessment even though it was impossible. Reselling created a paper path that was too long to follow to properly assess risk, yet investors bought anyway.

Everyone but the original home buyer is supposed to be an experienced professional. The errors made by these professionals were at the high school economics level. Combining risk under the circumstances is early statistics training.

Every complex problem has a solution that is simple, obvious, and wrong. This is a complex situation, and correcting it will not be simple or easy. These investment vehicles will need to be unwound so that they can be properly assessed, and the good loans can be decoupled from the bad ones. Most of all, investors that should have taken a closer look at the vehicles before buying will need to accept the losses they assumed in the purchase. Lenders will need to reassess loan acceptance standards, and also keep making the loans that are not defaulting. Failing to make good loans is as dangerous as making bad loans.

m

Seriously, if you buy in banking on a profit, you deserve to lose. And if you let the bank tell you what you can afford based on a formula, then you deserve to be taken. Budget, and figure out what you can afford, in good times and bad, and then go shopping for what you can afford. Otherwise, buyers deserve to be taking the hit.

Novista

Subprime slice of total mortgage market:
2002 - 08.3%
2003 - 12.0%
2006 - 20.0%

It's hard to imagine that minority slice of the American pie could cause a worldwide credit crisis, eh?

To the smug individuals who know they're smarter than the average bear and those "greedy, or ignorant, or speculators deserve to lose" you might check where your money market fund or pension fund provider really has the investments made.

Aside from subprime, who knows how many responsible and sensible borrowers hit a snag called major medical problem or the one labeled "You no longer have a job."

Sure there's plenty of guilt to go around. Even Fannie and Freddie got caught with their paws in the toxic cookie jar--GSEs that should have known better.

Maybe the biggest flaw of all was the ratings firms--it is just so much easier to help set up a creative investment vehicle, take the fee, and assign the AAA gold seal of approval. And that misled anyone down the food chain. Just ask the people involved with the Florida state investment fund.

As far as no evidence of any wrongdoing, well, we shall see. There were half a dozen mortgage outfits being investigated for outright fraud. Smoke, fire? And Countrywide's Mozilo has the SEC on his back--and that mob still somehow had a $51.1 Billion bailout in September. Hmm...

I'm afraid, in the long run, if there is actually a significant trickle-down to borrowers, it will do more harm than good. I strongly doubt most will be in better financial shape later on.

But I could be wrong. Maybe the short-term answer is an easy one: one application, one mortgage adjustment now. This winnows out the speculators right away. I would say let the banks take the hit of foreclosure expense and loss--thing is, so many mortgage were sold, and now no one really knows who holds what.

And do reflect on the fact that "asset securitization" was brought to you by those wonderful folks at the Department of Housing and Urban Development in 1970.

Have a good day.

Holly Garfield

Interesting point, Novista, on the subprime percentage. By 2006 the housing prices had risen to a point where they were so big a part of disposable income that price increases were clearly unsustainable. Housing starts were at a record pace. Both these statistics are easily followed and indicate immediate downward pressure on pricing. So where did the money for all of these subprime loans come from? By this point, any rate reset would be after the bubble burst, so the lenders should not be making that amount of money available on the high-risk market.

I also suspect that these same lenders massaged CDOs to sell the subprimes at a profitable price by putting them in with lower risk loans. Without CDOs, the loans might not be sellable in a subprime only package by that point. The CDO buyers should have checked the risk levels better before buying. Without these two steps, the subprime and housing bubble are big pests, but not nearly the damage we are seeing.

Airline accident reconstruction looks at the whole series of events leading to a crash. Stopping any one of the events will stop the accident, so the accident investigators look to stop the first step that can be avoided. That is where the solution lies. Here the increase in loan financing when a price bubble was imminent and the combining multiple-risk loans are the first steps in the current credit problems that can be stopped. Consumers will always ask for more home than they can buy; we can't stop that. Lenders can stop making the money available and can stop bundling multiple-risk loans. Packaging same-risk loans, then selling multiple packages to investors is the proper way to diversify risk.

Pete

Since doubling up is the traditional solution to high-priced housing, perhaps those who lied to get loans should be required to take in poor people as low-rent roomers. That way they could keep their houses and protect their credit, more of the loans would be repaid, and struggling people would have a temporary sanctuary--maybe even complete with Jacuzzis.

andrew

The most valuable words to Americans are "I own." But I have always thought the words "I owe" was a more accurate description. With a flood of subprime news in the last few months, apparently the most correct answer is "I owe too much."

Greed is the greatest common denominator here (as in most problems related to money), and I believe there's enough of it to spread around. From a macro view without regard to defaults and housing prices:

The good news is that there are now more newer homes for Americans to live in. The bad news is that housing is oversupplied. In the past few years, America focused too many of its precious resources on a (super) durable good and too little on other needs (can anyone say "education," "health care," or even "new bridges"?). Now, there is an oversupply of homes that will last another four to five years.

The result is that America will be forced to save more and sell some of our assets (companies and real estate) to foreign debt holders (a.k.a. margin call). In other words, the growth in American standard of living is going to slow down for quite a few years.

Steve H

Among those being labeled as liable for the subprime debacle, I've not seen any mention of regulators and legislators. If this fiasco is anything like the S&L disaster, we will discover that federal regulators and legislators (states too) had ample opportunity to reign in potential abuses but decided not to. Even now as we see the consequences of what happens when nonbank lenders are unregulated, Congress has cut out from legislation any attempt to end mortgage brokers from rewarding their employees for pushing borrowers into rates higher than they qualify for. Such premium spreads are an obvious abuse that illustrates brokers placing their own interests ahead of their clients', again something that remains legal. I wonder who will be among this generation's "Keating Five"?

Karriem K.

I guess we all know that the lenders changed the rules to allow more people to buy homes. They decided not to accept income verification and put terms together for people with low incomes banking on the economy giving them a raise more then 5%. What percentage of the population receives a huge raise? Probably not many in the last two to five years. That is why when the mortgage adjusted, the people's income could not handle it.

The lender is more responsible to blame, then the appraiser, borrower, and government for no oversight.

beedi

I'm looking at this micro- and macro-economically.

Micro: The home buyer was looking to make a quick buck by buying something he couldn't afford, because he presumed the market would appreciate more than his ability to pay. Anyone with an IQ of at least 75 knows that if he can't afford to buy something, he needs to pay it in installments, but if he can't even afford the installments, he needs to wait. But did that happen?

Macro: The financial institution looking to make a quick buck by creating an SIV it couldn't afford because it presumed the market would appreciate more than its ability to pay. Any financial institution with a collective IQ of at least 75 knows that if it can't afford to buy something, it creates it by leveraging a solid asset, but if it can't even gauge the value of the asset, it needs to wait. But did that happen?

Joe A

Are consumers responsible for the subprime mortgage crisis? No. At most, the individual consumer is responsible for the loan that he or she took out. But the crisis is broader than the impact that the loan failures are having on the parties directly involved. The crisis also includes the effects that the loan failures are having on the overall economy and on the financial system. It is not the responsibility of the individual consumer to be concerned with these issues--it is the responsibility of banking regulators. Purely for the sake of preventing a potential meltdown that would affect almost everyone, regulators should have prevented the questionable loans from being issued.

Nhappy

Borrowers, under their own free will, took out ARMs. Shame on them for not understanding their budgets, the loan terms, risks, and assuming (you know what happens when you "assume") that the market prices would continue to rise.

Lenders did not hold guns to buyers' heads.

ercook

To blame the small fish for a big-fish problem is risky business. Only the ones who take the bait are caught.


HHBear

At the end of every mortgage contract, just above the signature line, is a line that goes something like, "I have read the contract I am signing and agree to be bound by it."

That is the bedrock of contract law and our entire economy. Without the ability to enforce the contract as written, no lender would lend.

Do we now throw out our entire economic system because some borrowers were too cheap to hire a lawyer for a couple of thousand dollars and willy-nilly signed papers worth hundreds of thousands of dollars?

gettingshafted

At the time, it was like an orgy; everybody was doing it. How did I know that two years or so later, I would contract those full-blown nasty diseases?

tom weimer

The borrower vs. lender subprime debate is a complex question. But having worked for a large subprime lender, I can tell you that it is all about pumping out loans for fees. There was an utter disregard for solid underwriting practices. I was having a discussion with our CEO one day and we were discussing a first payment defaulted loan. The CEO said to me, "Before we refinanced him, his debt-to-income ratio was 110% and now it is a much lower 76%." I asked the CEO, "What difference does it make if they are 110 feet under water or a much better 76 feet under water? Is there any more oxygen?" He had no answer.

eric

Wow, I've learned so much just reading this forum. I live in Los Angeles, one of the hot spots in this crisis, and I'm seeing the results already. Angelenos are starting to lose their $500,000 lofts. It's threatening to destroy a lot of lives and possibly damage an already fragile economy. We've been marveling at how quickly and how high home prices have gone in the past two or three years. Although I was tempted to buy last year, I decided to hold out until after the bubble burst. That seems like a smart move in hindsight, because now it looks as though I might get one of those $500,000 lofts for considerably less.

The buyers had to know they couldn't afford their homes, so although I'm usually on the side of the little guy, I have to say I blame the buyers for signing their names to loans they knew deep inside they simply would not be able to afford if their situation (or their interest rates) changed. I say no government bailouts for anyone.

Chris in Kansas

I feel that the blame should be 50/50.

It seems that the buyer was too quick to buy the home. They did not do enough research into the market to see if the house would appreciate as they expected. I think that most subprimes were in a hurry to get on the bandwagon and didn't do enough checking.

On the other hand, lenders should have done a better job of underwriting. Approving a loan based on a credit score with no research into the true financial situation of the borrower is stupid. What would they expect to happen if they lent money to individuals who could not repay it after the ARM adjusted?

Remember, no one drop of water thinks it is to blame for the flood.

Dan in Boston

I feel that (as unfortunate as some unique circumstances may be), the blame stands with the borrowers--the willing customers of the subprime mortgage market, and, let's not forget, even the conventional loan market, as we're likely to see in the near future.

Home ownership is widely accepted as the American dream, yet few acknowledge another American traditional moral value: personal responsibility. When every single mortgage contract, including so-called-subprime, contains the (yes, often fine) print regarding the responsibilities of the borrower, and the loan terms upon rate adjustment--again, if the case--then the borrower confirms the ability and commitment to repay the lender on the mutually agreed upon terms. If not met--it's easy, as the contract says--the property goes back on the market one way or the other.

I myself live in a higher-than-average housing market, and for the past three years have been saving with my now-fiancée for a down payment on a house that we would eventually raise children in, budgeting everything, and not taking vacations (not even to visit our parents), only to realize day after day that the average single-family or why not two-family home prices have gone up yet another 3% to 5% from only the previous month. I can only make an educated assumption that the prices have been rising due to the demand of unqualified borrowers.

We are indeed already looking at a different market today, but it's fortunately on track to return to a market in which the price of a house is closer to its value for its loving owners, who are, or want to become, rooted in the community and sometimes participate in town meetings, who want to be in a good school district, maybe have a decent commute to their jobs, and everything else instead of speculative interests, like buy-and-sell-higher schemes, buy-for-resale/fixer-upper contractor jobs, quick-resale hopes, and the like.

We're hoping to buy our first home this summer, thanks to the irresponsible borrowers of the past six years, but we're going to make it home. Wish us and the young families like us luck.

dman

Someone needs to say something about this--http://www.fakepaycheckstubs.com. Is this legal? No wonder we have the subprime mess. We have lenders who use fake documentation to help push the loan through quickly so that everyone down the food chain (from loan processor to the loan officer to the actual lender) can make the commissions they were making during the booming 1990s. Now we are bailing out these crooks--sounds like the good ol' 1980s savings and loan bailout days to me.

Mark

@dman--you're right that people lied on their loan applications. Even if the loan officers assisted in this fraud, the borrowers still signed their names on the application.

But what of the actual lenders reviewing these fake documents? Couldn't they have picked up a phone and checked, or as Ronnie Reagan used to say, "Trust, but verify." We know the answer.

Join the Debate

 

Participate More!

Please send us your ideas for new Debate Room topics. If you're an academic, association officer, or other industry expert and would like to write a Debate Room essay, send us a query. Questions? See the

BW Mall - Sponsored Links

Buy a link now!