Pressure from Wall Street Caused Spike in Predatory Lending

The investment banks’ pricing schemes and demand for large quantities of subprime mortgages encouraged predatory practices.

Through their relationships with subprime mortgage lenders, investment banks essentially set the underwriting criteria in the subprime market: they tell the lenders what types of mortgages they want to securitize, how much they will pay for them, and how many they want.^[1] During the subprime boom, the investment banks oversaw a loosening of underwriting standards and pressured lenders to originate excessive amounts of subprime mortgages so that the investment banks could create lucrative subprime-related bonds. The firms’ demands trumped the needs of American homeowners in determining the types of mortgages made available on the market. The result was a significant spike in predatory and abusive lending.

A. INVESTMENT BANKS SET LENDING STANDARDS IN THE SUBPRIME MARKET

Because investment banks provide subprime lenders with necessary funding, they wield a great deal of power in determining what sorts of loans are offered to subprime borrowers. The fact that Wall Street’s investment banks, and not subprime mortgage lenders, set underwriting criteria in the subprime market is acknowledged by leading lending experts:

Kurt Eggert, Professor of Law at Chapman University, in testimony to Congress, April 2007: “I think we've had a presentation of the secondary market as mere passive, you know, purchasers of loans and oh, they may select a loan, but it's really the lenders who decide loans. But if you talk to people on the origination side they'll tell you the complete opposite. They'll say, you know, our underwriting criteria are set by the secondary market. They tell us what kinds of loans they want to buy. They tell us what underwriting criteria they want us to use. And that's what we do because we're selling to them.”^[2] Eggert was responding to presentations offered by industry insiders who were testifying.

Allen Fishbein, Director of Housing Policy for the Consumer Federation of America: "They are providing the liquidity through the investments in this market and are responsible for really setting the standards that loan originators apply at the front end of the market.”^[3]

Though “the secondary market” can refer to ratings agencies and investors as well as investment banks, findings in Section IV will reveal the degree to which investment banks are the prime movers and power brokers in the secondary market.

B. INVESTMENT BANKS PAID HIGHER PRICES FOR LOANS WITH PREDATORY CHARACTERISTICS

Investment banks set underwriting criteria in the subprime mortgage market by telling lenders what types of loans they want to buy, how much they want, and what prices they want to pay. The nature of this process is illustrated by an excerpt from the 2006 annual report filed by Fremont General, the parent of Fremont Investment & Loan, a major subprime lender.

Fremont General: “The Company sought to maximize the premiums on whole loan sales and securitizations by closely monitoring the requirements of the various institutional purchasers, investors and rating agencies, and focusing on originating the types of loans that met their criteria and for which higher premiums were more likely to be realized. The Company also sought to maximize access to the secondary mortgage market by maintaining a number of relationships with the various institutions who purchase loans in this market.”^[4]

In October 2007 testimony to Congress, Jim Campen, executive director of Americans for Fairness in Lending, noted “Fremont, the largest high-APR lender in Boston in 2005 and the second-largest statewide, was well-known for the egregious quality of its loans, but seems to have been allowed to proceed unchecked at least through the end of 2006.”^[5] Fremont was sued earlier in 2007 by Attorney General Martha Coakley, who charged “unfair and deceptive conduct on a broad scale.” Goldman Sachs was the top purchaser of Fremont’s mortgages in 2006, with $5.3 billion worth of purchases.^[6]

The following are brief descriptions of a few of the types of loans that met the criteria of investment banks like Goldman Sachs during the subprime boom:

• Hybrid adjustable rate mortgages (ARMs). These loans carry low, fixed teaser rates (7-8%) that jump to much higher adjustable rates (14%+ pegged to an index) after two or three years. Often, subprime ARM borrowers’ ability to re-pay is judged based on the low, initial rate. Underwriters accept higher rates of re-financing and foreclosure by saddling these borrowers with prepayment penalties and judging ability to pay based on the value of the underlying asset – a widely recognized predatory tactic. ARMs went from 73% of subprime loans in 2001 to 91% by 2006, and are causing many of the subprime foreclosures today.^[7]
• Low- and no-documentation. A lack of documentation of income or residence means that the credit of the borrower cannot be verified and the loan is therefore riskier and carries higher interest rates. Lending without regard for the borrower’s ability to pay is widely considered a predatory tactic. These went from 28% of subprime loans in 2001 to 50% by 2006.
• Interest-only. Payments from these loans only cover interest on the mortgage, not principal, and leave the borrower in the vulnerable position of having to re-finance or sell their house down the road. These went from 0% of subprime loans in 2001 to 38% in 2005, before dipping down to 23% in 2006.

Investment banks paid more for each of these types of mortgages because the loans could be packaged into more lucrative securities. Higher interest rates on the loans themselves eventually translated into more bond-related revenues for the investment banks. But because they entail such prohibitive costs for homeowners themselves, these types of loans often signal predatory circumstances at origination.^[8]

In testimony before the US Senate in September 2006, Allen Fishbein, director of housing and credit policy at the Consumer Federation of America, noted that “traditionally, these types of loans were niche products that were offered to upscale borrowers with particular cash flow needs or to those expecting to remain in their homes for a short time.”^[9] In recent years, however, these mortgages began to be mass marketed to a wide array of borrowers, many of whom did not understand the underlying risks and expenses involved – and many of whom were not properly informed of these risks.

In addition to paying more for these types loans, the investment banks also pressured subprime mortgage originators to loosen their lending standards and make more of them.

Wall Street to Ownit CEO: make more low-documentation loans. William D. Dallas, CEO of bankrupt mortgage lender Ownit, said in an interview with the New York Times that he was told by investment banks – Merrill Lynch, in particular – that he should offer more low-documentation loans in which the borrower’s income is not verified, and that if he didn’t, he would be foregoing profits.^[10] Dallas reportedly disagreed, but complied with the demands of the banks. Ownit collapsed in December 2006.

In early 2007, Mortgage Banking noted that investment banks were rushing to acquire wholesale subprime lenders (which purchase loans from independent brokers) as opposed to retail businesses (which originate loans through their own offices and employees) because this would allow the investment banks to avoid liability for predatory lending practices.

Mortgage Banking: Investment banks averse to fair lending law compliance. “Retail lending, with its direct-customer interface, opens up the exposure to fair lending and compliance concerns, which Wall Street firms are averse to.”^[11]

C. CONGRESS: SUBPRIME EXPLOSION CAUSED SIGNIFICANT SPIKE IN PREDATORY LENDING

“The Subprime Lending Crisis,” a report released by the Joint Economic Committee of Congress, noted a “marked increase in predatory lending” in the subprime boom years, in part because the financial intermediaries in the subprime market are only weakly regulated.^[12]

The report linked the rise in predatory lending to a deterioration in underwriting standards, and had this to say regarding the reasons the subprime market accelerated, despite signs that the housing boom that had sustained many subprime borrowers could not continue:

“Since underwriting deteriorated from 2001 to 2005, and the accelerating housing price boom was giving subprime borrowers important help (see Part II), a cautious analyst might have questioned whether the improvements in subprime performance could be sustained. The financial intermediaries who expanded the supply of these loans were apparently not troubled by this issue. The reasons for their lack of curiosity may lie in the strong incentives they had for expanding the subprime market. ”^[13]

Those incentives can be traced to the massive revenues and bonuses generated by investment banks in the secondary market through structured financial products such as CDOs, as discussed in Part I.

One Fannie Mae study estimated that 50% of subprime borrowers could have qualified for prime loans.^[14] This is a clear sign that predatory lenders tend to steer subprime borrowers toward expensive, subprime loans in the interest of garnering more fees for their work.

D. CURRENT LAWS HELP INVESTMENT BANKS AVOID LIABILITY FOR BUYING PREDATORY LOANS

Whether or not they were aware of the predatory nature of loans they were packaging and selling as securities, the investment banks knew that they had virtually no legal liability related to the origination of the mortgage. This is due to the current legal framework surrounding lending, which is widely noted by predatory lending experts to be deficient in holding Wall Street accountable for predatory lending.

Once a mortgage lender sells a mortgage to an investment bank, the homeowner’s legal options virtually disappear.^[15] The most important legal hurdle in a securitization is the “true sale” of the mortgage note from the mortgage lender to the securitizer – the liability associated with the origination of the mortgage does not transfer in this sale. A legal doctrine known as holder in due course offers investment banks and investors this protection. Though investment banks may have purchased pools of mortgages full of predatory and abusive loans, they are, by and large, immune from any legal challenges by the homeowner.

Investment banks exploit this legal framework to reap profits from predatory and abusive loans. With no strong legal incentive to avoid buying these loans, investment banks fund subprime lenders regardless of potentially exploitative practices. In fact, as spelled out above, they appear to encourage these practices in order to boost the supply of subprime mortgages to securitize. In testimony to Congress in April, Christopher Peterson, a Professor at the University of Florida’s Levin School of Law, offered his take on why investment banks purchase predatory loans – and why they are responsible for problems in the subprime market.

Christopher Peterson, Professor of Law at University of Florida, to Congress, April 2007: “And if I could encapsulate it – the sentence that was said earlier was that no one would want to purchase a predatory loan. I think that that's false. Sure, you would. If you could purchase it and then especially if you could purchase it through a shell company that didn't have your fingerprints all over it and then you sold it to some sucker at a profit, then you'd want to do it, right? And you would pretend that you didn't know that it was a predatory loan, or you would actually not know that it was a predatory loan because you didn't check, right? Those are the – that's the situation when you would want to buy a predatory loan. And I think that's what's been happening.”^[16]

How does Wall Street avoid liability for packaging predatory loans? Lobbying power, according to the New York Times: see After the Binge.

E. LEHMAN BROTHERS’ 2003 LEGAL WIN EMBOLDENS WALL STREET TO BUY PREDATORY LOANS

In 2003, investment banks were further encouraged to purchase predatory loans without fear of substantial liability when Lehman Brothers was held minimally liable for funding First Alliance, a subprime lender based in California. First Alliance had been notorious for its predatory practices, often targeting elderly people and other vulnerable borrowers for extremely costly loans. This was well-known and well-documented, even by Lehman Brothers executives.

In 1995, before Lehman began funding the company and tapping into its profits, Eric Hibbert, a Lehman Brothers vice president, was dispatched to check out First Alliance’s operations.^[17] According to a June 2007 Wall Street Journal article, he penned a memo that described First Alliance for the bad actor that it was in no uncertain terms:

• First Alliance is a financial “sweat shop.”
• The company specializes in “high pressure sales for people who are in a weak state.”
• Employees leave their “ethics at the door.”
• The company made some loans “where the borrower has no real capacity for repayment.”

Despite clear signs that the company preyed upon its customers, Lehman Brothers went on to lend the company $500 million through a warehouse line of credit and sold $700 million worth of First Alliance loans.

After a 4-year fight, the investment bank was held responsible for just 10% of the damages done to the plaintiffs in the class action suit, and had to pay $5 million – a paltry sum when compared with the subprime-related revenues the investment bank continued to rake in.

Wall Street evidently took the outcome of the case as a green light to provide even more support to subprime lenders, regardless of the legality of the loans they were financing. The judgment was entered in late 2003, and subprime mortgage securitization went from $202 billion in 2003 to $401 billion in 2004, a 100% increase that constitutes the largest year-to-year jump in the history of subprime mortgage securitization.

Footnotes

^[1]An 11/7/07 conversation with Kevin Byers helped flesh out this understanding of the investment bank’s role in mortgage securitization. Byers is a CPA who has spent years investigating the mortgage finance industry. He has also put together a very useful guide to researching this subject matter, “Researching Subprime Residential Securitizations” (pdf).

^[2]Kurt Eggert, Testimony at “Subprime Mortgage Market Turmoil: Examining the Role of Securitization,” a hearing of the Securities, Insurance, and Investment Subcommittee of the Senate Housing, Banking, and Urban Affairs Committee, Federal News Service transcript, April 17, 2007. Written testimony can be accessed here.

^[3] “Wall Street Will Be Next In The Subprime Saga,” National Journal, April 11, 2007.

^[4] Fremont General, SEC 10-K filing for 2006.

^[5] Jim Campen, “Mortgage Lending in Boston Area: Statement of Jim Campen Executive Director Americans for Fairness in Lending,” Committee on House Financial Services, CQ Congressional Testimony, October 15, 2007.

^[6] Fremont General, SEC 10-K filing for 2006.

^[7] Joint Economic Committee of Congress, “The Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here,” October 2007. (pdf) The subsequent two figures are also pulled from this report.

^[8] This is noted by a wide array of sources, including the Congressional report above.

^[9] Allen J. Fishbein, “Calculated Risk: Assessing Non-Traditional Mortgage Products,” Testimony Before the US Senate Subcommittee on Housing and Transportation and Subcommittee on Economic Policy, September 20, 2006.

^[10] Vikas Bajaj, “East Coast Money Lent Out West,” New York Times, May 8, 2007.

^[11] Jeffrey M Levin, “The Vertical-Integration Strategy,” Mortgage Banking, February 1, 2007.

^[12] Joint Economic Committee of Congress, “The Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here,” October 2007. (pdf)

^[13] Joint Economic Committee of Congress, “The Subprime Lending Crisis: The Economic Impact on Wealth, Property Values and Tax Revenues, and How We Got Here,” October 2007. (pdf)

^[14] Fannie Mae Foundation, “Financial Services in Distressed Communities,” August 2001.

^[15] For more on the legal ramifications of mortgage securitization, see: Kurt Eggert, “Held Up in Due Course: Predatory Lending, Securitization, and the Holder in Due Course Doctrine,” Creighton Law Review, April 2002.

^[16] Christopher Peterson, Testimony at “Subprime Mortgage Market Turmoil: Examining the Role of Securitization,” a hearing of the Securities, Insurance, and Investment Subcommittee of the Senate Housing, Banking, and Urban Affairs Committee, Federal News Service transcript, April 17, 2007.

^[17] Michael Hudson, “How Wall Street Stoked the Mortgage Meltdown,” Wall Street Journal, June 27, 2007.