Subprime Usury
At this time of year in particular, many indulge in a certain amount of nostalgia that includes watching It’s a Wonderful Life. And indeed, that account of a bygone era offers valuable lessons in the context of the recent financial turmoil. At that time, mortgages were held on the books of banks, so it was in the interest of the lender to make sure the borrower could repay the loan. Like George Bailey, the banker and the borrower’s interests were often aligned. That is not the case today, in the era of securitization. Today, instead, the mortgage originator provides a mortgage product, and immediately sells this mortgage on to an entity specializing in the packaging of loans into tradable securities. The advantage, we were told, is that risk would be more easily diversified and loans would become cheaper and more accessible. What happened instead is that usury raised its ugly head.
In a recent article in the Wall Street Journal, Rick Brooks and Ruth Simon look at recent developments in mortgage lending. The present some interesting findings. In 2005, the peak year of the subprime boom, 55 percent of subprime mortgages went to people with credit scores high enough to qualify for conventional loans on better terms. By 2006, this rose to 61 percent. For sure, not all borrowers are innocent. Some knowingly took out highly risky loans, hoping to make a quick profit by flipping a house in an environment where house prices increased forever. But there is a darker side to the story. As Brooks and Simon show, “lenders or brokers aggressively marketed the loans, offering easier and faster approvals — and playing down or hiding the onerous price paid over the long haul in higher interest rates or stricter repayment terms .” Mortgage agents were compensated for persuading borrowers to take loans with higher interest rate. They frequently persuading borrowers to spend more than they could afford, or take out exceptionally risky and completely non-transparent loans.
It was the profit motive, pure and simple. Mortgage brokers collected 1.88% of the loan amount for originating a subprime loan, and only 1.48% for conforming loans. And especially since they no longer held the loan on the books, and would not be exposed to default, it was in their interest to push subprime loans that exposed customers to high interest rates and greater financial risk. When the default came, they could wash their hands.
But the game does not stop there. The loans that were originated by the mortgage lenders were turned into asset-backed securities and combined into massive CDOs. These CDOs had three tranches, based on risk. In the event of default, the holders of the top tranche would get their money first, and so forth. Hence the bottom tranche was inherently risky, and was bought by hedge funds and others seeking high returns. But remember: these high returns come from the fact that borrowers were saddled with mortgages with higher interest rates than warranted and all kinds of non-transparent penalties. I believe that used to be called usury.
It is worth recalling what the Church has said about usury in the past. From the Second Lateran Council (1139):
”We condemn that practice accounted despicable and blameworthy by divine and human laws, denounced by Scripture in the Old and New Testaments, namely, the ferocious greed of usurers; and we sever them from every comfort of the Church, forbidding any archbishop or bishop, or an abbot of any order whatever or anyone in clerical orders, to dare to receive usurers, unless they do so with extreme caution; but let them be held infamous throughout their whole lives and, unless they repent, be deprived of a Christian burial”
Pretty harsh.
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Yes – the Church’s words would apply equally to those with checking accounts, savings accounts, IRAs / 401(k)s, etc., for usury was not then the charging of overweening interest (as later Catholic social thought might have it), but simply lending money at any interest. See this article by Hilaire Belloc: http://www.catholictradition.org/Classics/belloc2-2.htm
[Link works now. Usually I'm good about catching those kinds of things.]
While personally I’m closer to thinking a Sharia mortgage is the only appropriate mortgage, there is an argument to be made that inflation should be compensated and other typical lending expenses. I think we can agree that a mortgage exceeding say 12% in the present in environment is usurous.
I would agree that charging someone excessive interest can indeed be the sin of usery, and that there was some of that going around in the recent mortgage frenzy.
However, from what I understand a lot of these loans are simply intro-rate loans. I actually have one of these, for instance, secured via Catholic Home Loan (the name and donation structure certainly not a guarantee of virtue, but hey…)
While one would be foolish to get into an intro-rate loan without thinking about it, the product is not itself necessarily userous, I think. Basically, the intro rate which then goes to adjustible rate after a fixed amount of time constitutes a bet on the part of the lender that the rates will go up in 3-5 years, and a bet on the part of the borrower that they won’t.
Another thing that may well come into play is that for many young families, it’s a pretty reasonable bet that they’ll be better off in 3-5 years than they are at the moment, and so taking the risk of a slightly higher mortgage payment after refinancing to fixed rate in several years is worth the lower immediate payment.
So yes, usery is a problem that is alive and well in our modern age, (as is greed and pride, which fuel it on the borrower side) but I don’t think a subprime = usery equation is necessitated.
DC
But starting in a historically low period for interest and having no where to go but up, this was a potential disaster for the poor and hopeful if faced with a salesperson who was given to short talk on what could happen. Some very poor and uneducated people from the ghettos etc were getting into these loans while not realizing that they could be reset to twice what their original payment was… if interest rates rose on their index like the Libor….and they did not have prospects of doing better income-wise in several years as the young educated couple could look forward to.
For flippers it was ideal because they would never see the reset since they would only pay the teaser rate while they flipped the house.
The sin is often in the salesperson of the mortgage and exactly how he or she explained it….and what they glossed over or short talked when they had a needy client. Mortgage salespeople can make a lot of money though they make nothing for months when they start unless they are with the banks. But they can make above average money later on as they get a number of mortgages in the hopper. And there begins the temptation.
And how the government did not step in on some of these no doc mortgages and interest only mortgages….is beyond me. In the former, one did not have to prove employment and in the latter, if one opted to pay interest only… month after month, one’s actual mortgage grew higher than one agreed to pay for the house…..it was like a credit card wherein one could pay only a minimum but unlike a credit card it came with negative amortization as the result….one’s mortgage principal was actually growing at the back end as that industry calls it.
In the past it has always been most profitable to sell originated loans in the secondary market (securitization) BUT retain the “servicing rights.” This means that the originating bank/company continues to process the payments from the borrow for (if I remember correctly) 25 basis points (1/4 percent of the loan payment. Selling the loans ensured that the banks had more money to lend out, didn’t incur any credit risk (at least in theory) and earned some easy money on the side.
One big problem is the fact that the securitization agreements usually had some fine print that required the originating agency to buy back the loans at the sales price IF there was some problem that caused the loans to go south.
This last situation was usually well mitigated by the originating agency having a strong credit culture. “No doc” and “low doc” loans were anathema when I was around the business, but I could see changes creeping in when I got an honest job.
Nowdays, all bets are off and I don’t have a clue as to whether any of what I mentioned about remains true.
Thus endeth today’s lesson on mortgage lending.
Remove the last period from the link – it should then work.
[Thanks.]
Easy credit helped lead to the highest home ownership rate in our history, 68.9%.
http://www.infoplease.com/ipa/A0780145.html
Home ownership rates were far lower in the mythical days of George Bailey.
http://www.census.gov/hhes/www/housing/census/historic/owner.html
Enhanced government regulation of credit will of course succeed in drying up credit for those most in need of it. Far better to simply let the market deal with the situation by having lenders take their losses for foolish loans and having borrowers learn to read and understand documents before placing themselves into debt. Treat everyone as adults who bear the consequences of their acts.
M.Z.,
As the Catholic Encyclopedia notes, “the best authors have long since recognized the lawfulness of interest to compensate a lender for the risk of losing his capital, or for positive loss, such as the privation of the profit which he might otherwise have made, if he had not advanced the loan. They also admit that the lender is justified in exacting a fine of some kind (a conventional penalty) in case of any delay in payment arising from the fault of the borrower. These are what are called extrinsic grounds, admitted without dispute since the end of the sixteenth century, and justifying the stipulation for reasonable interest, proportionate to the risk involved in the loan.”
http://www.newadvent.org/cathen/15235c.htm
Since the risk of nonpayment varies, I don’t think you can say that charging interest above a certain set rate (such as 12%) is always usurious. One would have to look at whether the profitabilty of the lending institute was significantly greater than for other forms of investment.