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Economic downturn finds its roots in predatory lending

SwitzerlandMarina Relman, Washington International School
May 24, 2011

NEWS

In 2008 the United States stock market crashed due to the rapidly increasing effects of the rising number of housing foreclosures. Investment firms including Lehman Brothers and secondary mortgage buyers such as Fannie Mae began to fold and go into bankruptcy as the number of foreclosures increased and the monetary loss that resulted became astronomical. Not only did the housing crisis have a debilitating affect on the United States economy but it had a crippling affect on many of the country’s major cities. As minority communities in cities such as Baltimore and Memphis continue to struggle with depleting property values due to foreclosures, questions arise as to how this crisis came to be.

It was in 2007 that the U.S housing market began to plateau and fall resulting in thousands of foreclosures on homes where borrowers were invested in risky loans. Due to increased debt riskier borrowers receive loans with higher interest rates. The banks would therefore sell loans at high interest rates with promises of refinancing the mortgages after a few years. The banks told borrowers that they would refinance their loans at lower interest rates because they assumed the property value of houses would increase over time and therefore decrease the risk of the loan.

The problem was that property values did not increase as the banks had speculated they would and they were unable to refinance at lower interest rates. Instead interest rose and borrowers were faced with mortgages they couldn’t afford and would have to foreclose on their homes.

The banks, meanwhile, would sell the mortgages to secondary buyers where they were invested in mortgage backed securities such as pension funds. Some countries such as Iceland relied so heavily on mortgage backed investments that the their entire economy went bankrupt due to the mortgage crisis. The advantage of secondary buyers for the banks, however, was that they no longer had the risk that was associated with the loan. The risk fell on the secondary buyer.

Although banks simply blame foreclosures on the risk that comes along with the housing market others are sure that lending fraud was involved. For example banks would offer “teaser rates” in which they would give borrowers very low interest rates for the first two years of their mortgage and then tell the borrowers that their rate would increase or decrease based on the market flow. The market, however, caused the interest rates to skyrocket and monthly mortgage payments increased by hundreds of dollars for some homeowners.

In other cases banks would qualify borrowers for loans that they were not eligible for. Banks would allow people who were heavily in debt to take out loans that they knew the borrowers were not prepared to pay for. The banks were unconcerned, however, for they gathered the loan fee and then immediately turned the mortgage over to a secondary buyer and therefore only gained.

Finally, there was a type of fraud in which banks would offer subprime mortgages to borrowers who were eligible for prime mortgages. Subprime mortgages are given to homeowners who have more risk attached to their loan and therefore the subprime mortgages have much higher interest rates than the prime mortgages. In essence the banks would charge borrowers high interest rates when they actually had enough credit to be charged lower rates.

Not only did speculation of fraud increase as the foreclosures mounted but so did speculation of discrimination. In cities such as Baltimore and Memphis, the mayors started to notice that the trend in foreclosures was much higher in minority communities than in white communities. This cannot simply be attributed to the unequal distribution of wealth because banks have processes in which they evaluate the risk of loans and design the loans accordingly to prevent foreclosures. This means that in these cities it was not simply that the foreclosure rates were higher in certain communities but that the banks were proving to have gotten significantly more mortgages ‘wrong’ among minorities.

Both Baltimore and Memphis are suing Wells Fargo bank claiming that minorities were targeted by agents who simply wanted to gather the fee and turn over the loan. As a result risky subprime mortgages were given to under qualified borrowers who quickly foreclosed on their homes. The cities claim that the bank specifically targeted African American communities for they knew the borrowers were more likely to agree to risky mortgages due to inexperience and an eager to get credit.

The bank is therefore being accused of what is referred to as reverse redlining. Redlining is when someone is refused a loan or insurance because they live in an area that is deemed financially risky. In this situation, however, the bank is being accused of targeting the financially risky areas and taking advantage of them and is therefore referred to as reverse redlining.

The cities are keen to get monetary compensation because foreclosures have a terrible effect on neighborhoods. Many foreclosed houses are abandoned for long periods of time and therefore invite squatters, serve as locations for drug deals, are many times stripped of all valuable infrastructure such as appliances and copper piping and are often subject to fires and deterioration. All of these events call for city attention and money whether that is to board up houses or answer police and fire department calls.

In addition, once there is an abandoned home on a street, it lowers the value of the other properties on that block. It can be calculated that the property value of a home decreases in increments as the number of foreclosed homes increases in the area. This in turn decreases property tax and causes a loss in tax revenue for the city.

It is due to lawsuits such as these that the role of lending fraud and discrimination is being evaluated as a cause of the economic downturn in 2008.

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Tags: recession, banks, mortgages, fraud

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