The Subprime Bomb Explodes

Homeownership is not only the most tangible expression of the American Dream, but a social good that promotes healthy families and communities.

The subprime mortgage market is an egregious example of the impact of social and economic inequalities in the United States. To a startling extent, it was government policy that made it possible.  Federal regulations essentially sanctioned the bifurcation of the credit market into a regulated prime market for people with assets and an unregulated subprime market mainly for low-income borrowers. In the subprime market, predatory lending was able to flourish; traps in the fine print like the one Carol Mackey encountered were just part of the deal. Those consigned to the subprime market either played by these rules or lived without access to credit.

Moreover, other government policies were in effect driving families into the subprime market. As the subprime market was surging after deregulation, government was slashing public housing assistance.¹ President Bush championed homeownership for low-income families, encouraging them to become part of what he called “the ownership society.”

But in the end, subprime lending did not increase homeownership rates among low-income families. The people most often targeted by predatory lenders were existing homeowners.² In many cases, borrowers were misled into using a subprime loan to refinance even when they qualified for a loan at the prime rate.

The rules of the subprime market were written for lenders who were reaping the rewards of high-interest-rate loans, not for the borrowers who got locked into unsustainable mortgages. The biggest investment banks on Wall Street, like Lehman Brothers and CitiBank, had previously been prohibited from selling real estate. They lobbied hard for the rules to be changed, and they entered the subprime market as soon as new regulations allowed them to.

Investment banks went beyond making money from subprime loans. They also packaged thousands of the loans into exotic financial instruments known as mortgage backed-securities and traded these around the world. Because the securities had the imprimatur of some of the largest U.S. financial institutions, traders had little reason to think what they were purchasing was really just junk, but that is basically what they were getting: securities whose collateral were loans about to go into default. Nobody seemed to care as long as housing prices were rising—not the borrowers, the lenders, the government regulators asleep at the switch, or the insurers of the securities.

Inflation Adjusted House Prices, 1975-2010

But when prices suddenly stopped rising, the global financial system ground to a halt. It seems inexplicable now that government policymakers did not act to deflate the housing bubble before the disastrous consequences ensued. In Cuyoahoga County, home to Cleveland, a city scarred by the blight of subprime foreclosures, local authorities tried to pass statutes against predatory lending. But they were overridden by the governor who was heavily indebted to mortgage lenders for contributing to his reelection campaign.³ In Washington, DC, Federal Reserve Chairman Alan Greenspan dismissed concerns by his own advisors about a housing bubble.⁴ Recent history shows us that this must have been a bubble; housing prices were simply rising much too rapidly. The bursting of a stock bubble less than a decade earlier and the recession that followed should have made Greenspan wary of ignoring a new asset bubble. Moreover, because there were trillions more dollars of wealth tied up in the housing market than in the stock market, a recession following a housing bubble was bound to be worse.

Between 2009 and 2013, more than 8 million foreclosures are projected—that’s one in six houses that have a mortgage.⁵ Subprime loans issued in 2005 and 2006, the peak years of subprime lending, have almost no chance of escaping foreclosure unless they are renegotiated. One outcome of the foreclosure epidemic has been a rise in homelessness. Homeless people are never an easy group to count, but a survey conducted by seven of the nation’s leading organizations on homelessness found a 10 percent increase in the use of shelters due to foreclosures.⁶ People in shelters are one demographic of the homeless population and the easiest to count. But shelters are often inhospitable environments for families with children. The fortunate ones are taken in by friends or relatives. Others are forced to sleep in cars, abandoned buildings, or similarly wretched places.

Issues