America's Exploding Mortgage Crisis Reveals That Home Ownership Isn't Paradise for Everyone
Anyone who has given the headlines even a passing glance recently knows the subprime mortgage industry is in deep trouble. Since 2006 more than 20 subprime lenders have quit the business or gone bankrupt. Many more are in serious trouble, including the nation's number two subprime lender, New Century Financial. The subprime crisis is also hitting Wall Street brokerages that invested in these loans, with reverberations from Tokyo to London. And the worst may be yet to come. At least $300 billion in subprime adjustable-rate mortgages will reset this year to higher interest rates. CNN reports that one in five subprime mortgages issued in 2005-2006 will end up in foreclosure. If these dire predictions come true, it will be the equivalent of a nuclear meltdown in the mortgage and housing industries.
What's conspicuously absent from the news reports is the effect of the subprime lending debacle on poor and working-class families who bought into the dream of homeownership, regardless of the price. Sold a false bill of goods, many of these families now face foreclosure and the loss of the small savings they invested in their homes. It's critical to examine the housing crisis not only from the perspective of the banks and the stock market, but also from the perspective of the families whose homes are on the line. It is also critical to uncover the systemic reasons for the recent burst of housing-market insanity that saw thousands upon thousands of families getting signed up for mortgage loans that were highly likely to end in failure and foreclosure.
Like most Americans, I grew up believing that buying a home represents a rite of passage in U.S. society. Americans widely view homeownership as the best choice for everyone, everywhere and at all times. The more people who own their own homes, the common wisdom goes, the more robust the economy, the stronger the community, and the greater the collective and individual benefits. Homeownership is the ticket to the middle class through asset accumulation, stability, and civic participation.
For the most part, this is an accurate picture. Homeowners get a foothold in a housing market with an almost infinite price ceiling. They enjoy important tax benefits. Owning a home is often cheaper than renting. Most important, homeownership builds equity and accrues assets for the next generation, in part by promoting forced savings. These savings are reflected in the data showing that, according to the National Housing Institute's Winton Picoff, the median wealth of low-income homeowners is 12 times higher than that of renters with similar incomes. Plus, owning a home is a status symbol: homeowners are seen as winners compared to renters.
Homeownership may have positive effects on family life. Ohio University's Robert Dietz found that owning a home contributes to household stability, social involvement, environmental awareness, local political participation and activism, good health, low crime, and beneficial community characteristics. Homeowners are better citizens, are healthier both physically and mentally, and have children who achieve more and are better behaved than those of renters.
Johns Hopkins University researchers Joe Harkness and Sandra Newman looked at whether homeownership benefits kids even in distressed neighborhoods. Their study concluded that "[h]omeownership in almost any neighborhood is found to benefit children. ... Children of most low-income renters would be better served by programs that help their families become homeowners in their current neighborhoods instead of helping them move to better neighborhoods while remaining renters." (Harkness and Newman also found, however, that the positive effects of homeownership on children are weaker in unstable low-income neighborhoods. Moreover, the study cannot distinguish whether homeownership leads to positive behaviors or whether owners were already predisposed to these behaviors.)
Faith in the benefits of homeownership -- along with low interest rates and a range of governmental incentives -- have produced a surge in the number of low-income homeowners. In 1994 Bill Clinton set -- and ultimately surpassed -- a goal to raise the nation's overall homeownership rate to 67.5% by 2000. There are now 71 million U.S. homeowners, representing close to 68% of all households. By 2003, 48% of black households owned their own homes, up from 34.5% in 1950. Much of this gain has been among low-income families.
Government efforts to increase homeownership for low-income families include both demand-side (e.g., homeowner tax credits, housing cost assistance programs) and supply-side (e.g., developer incentives) strategies. Federal housing programs insure more than a million loans a year to help low-income homebuyers. Fannie Mae and Freddie Mac -- the large, federally chartered but privately held corporations that buy mortgages from lenders, guarantee the notes, and then resell them to investors -- have increasingly turned their attention to low-income homebuyers as the upper-income housing market becomes more saturated. Banking industry regulations such as the Community Reinvestment Act and the Home Mortgage Disclosure Act encourage homeownership by reducing lending discrimination in underserved markets.
The Housing and Urban Development department (HUD) has adapted some of its programs originally designed to help renters to focus on homeownership. For instance, cities and towns can now use the federal dollars they receive through HOME (the Home Investment Partnerships Act) and Community Development Block Grants to provide housing grants, down payment loans, and closing cost assistance. The American Dream Downpayment Initiative, passed by Congress in 2003, authorized up to $200 million a year for down payment assistance to low-income families. Private foundations have followed suit. The Ford Foundation is currently focusing its housing-related grants on homeownership rather than rental housing; the foundation views homeownership as an important form of asset-building and the best option for low-income people.
While homeownership has undeniable benefits, that doesn't mean it is the best option for everyone. For many low-income families, buying a home imposes burdens that end up outweighing the benefits. It is time to re- assess the policy emphasis on homeownership, which has been driven by an honest belief in the advantages of homeownership, but also by a wide range of business interests who stand to gain when a new cohort of buyers is brought into the housing market. The Downsides of Homeownership
Low-income families can run into a range of pitfalls when they buy homes. These pitfalls may stem from the kinds of houses they can afford to buy (often in poor condition, with high maintenance costs); the neighborhoods they can afford to buy in (often economically distressed); the financing they can get (often carrying high interest rates, high fees, and risky gimmicks); and the jobs they work at (often unstable). Taken together, these factors can make buying a home a far riskier proposition for low-income families than it is for middle- and upper-income households.
Most low-income families only have the financial resources to buy rundown houses in distressed neighborhoods marked by few jobs, high crime rates, a dearth of services, and poor schools. Few middle-class homebuyers would hitch themselves to 30-year mortgages in these kinds of communities; poor families, too, have an interest in making the home-buying commitment in safe neighborhoods with good schools.
Homeownership is no automatic hedge against rising housing costs. On the contrary: lower-end affordable housing stock is typically old, in need of repair, and expensive to maintain. Low-income families often end up paying inflated prices for homes that are beset with major structural or mechanical problems masked by cosmetic repairs. A University of North Carolina study sponsored by the national nonprofit organization NeighborWorks found that almost half of low-income homebuyers experienced major unexpected costs due to the age and condition of their homes. If you rent, you can call the landlord; but a homeowner can't take herself to court because the roof leaks, the plumbing is bad, or the furnace or hot water heater quits working.
Besides maintenance and repairs, the expenses of homeÃ‚Â°Ã‚Â©ownership also include property taxes and homeowners insurance, both of which have skyrocketed in cost in the last decade. Between 1997 and 2002 property tax rates rose nationally by more than 19%. Ten states (including giants Texas and California) saw their property tax rates rise by 30% or more during that period. In the suburbs of New York City, property tax rates grew two to three times faster than personal income from 2000 to 2004.
Nationally, the average homeowner's annual insurance premiums rose a whopping 62% from 1995 to 2005 -- twice as fast as inflation. Low-income homeowners in distressed neighborhoods are hit especially hard by high insurance costs. According to a Conning and Co. study, 92% of large insurance companies run credit checks on potential customers. These credit checks translate into insurance scores that are used to determine whether the carrier will insure an applicant at all, and if so, what they will cover and how much they will charge. Those with poor or no credit are denied coverage, while those with limited credit pay high premiums. Needless to say, many low-income homeowners do not have stellar credit scores. Credit scoring may also partly explain why, according to HUD, "Recent studies have shown that, compared to homeowners in predominantly white-occupied neighborhoods, homeowners in minority neighborhoods are less likely to have private home insurance, more likely to have policies that provide less coverage in case of a loss, and are likely to pay more for similar policies."
With few cash reserves, low-income families are a heartbeat away from financial disaster if their wages decline, property taxes or insurance rates rise, or expensive repairs are needed. With most -- or all -- of their savings in their homes, these families often have no cushion for emergencies. HUD data show that between 1999 and 2001, the only group whose housing conditions worsened -- meaning, by HUD's definition, the only group in which a larger share of households spent over 30% of gross household income on housing in 2001 than in 1999 -- were low- and moderate-income homeowners. The National Housing Conference reports that 51% of working families with critical housing needs (i.e., those spending more than 50% of gross household income on housing) are homeowners.
Most people who buy a home imagine they will live there for a long time, benefiting from a secure and stable housing situation. For many low-income families, this is not what happens. Nationwide data from 1976 to 1993 reveal that 36% of low-income homeowners gave up or lost their homes within two years and 53% exited within five years, according to a 2005 study by Carolina Katz Reid of the University of Washington. Reid found that very few low-income families ever bought another house after returning to renting. A 2004 HUD research study by Donald Haurin and Stuart Rosenthal reached similar conclusions. Following a national sample of African Americans from youth (ages 14 to 21) in 1979 to middle age in 2000, the researchers found that 63% of the sample owned a home at some point, but only 34% still did in 2000.
Low-income homeowners, often employed in unstable jobs with stagnant incomes, few health care benefits, limited or no sick days, and little vacation time, may find it almost impossible to keep their homes if they experience a temporary job loss or a change in family circumstances, such as the loss of a wage earner. Homeownership can also limit financial opportunities. A 1999 study by economists Richard Green (University of Wisconsin) and Patric Hendershott (Ohio State University) found that states with the highest homeownership rates also had the highest unemployment rates. Their report concluded that homeÃ‚Â°Ã‚Â©ownership may constrain labor mobility since the high costs of selling a house make unemployed homeowners reluctant to relocate to find work.
Special tax breaks have been a key selling point of homeownership. If mortgage interest and other qualifying expenses come to less than the standard deduction ($10,300 for joint filers in 2006), however, there is zero tax advantage to owning. That is one reason why only 34% of taxpayers itemize their mortgage interest, local property taxes, and other deductions. Even for families who do itemize, the effective tax saving is usually only 10 to 35 cents for every dollar paid in mortgage interest. In other words, the mortgage deduction benefits primarily those in high income brackets who have a need to shelter their income; it means little to low-income homeowners.
Finally, homeownership promises growing wealth as home prices rise. But the homes of low-income, especially minority, homeowners generally do not appreciate as much as middle-class housing. Low-income households typically purchase homes in distressed neighborhoods where significant appreciation is unlikely. Among other reasons, if financially-stressed property owners on the block can't afford to maintain their homes, nearby property values fall. For instance, Reid's longitudinal study surveyed low-income minority homeowners from 1976 to 1994 and found that they realized a 30% increase in the value of their homes after owning for 10 years, while middle- and upper-income white homeowners enjoyed a 60% jump.
"Funny Money" Mortgages and Other Travesties
Buying a home and taking on a mortgage are scary, and people often leave the closing in a stupor, unsure of what they signed or why. My partner and I bought a house a few years ago; like many buyers, we didn't retain an attorney. The title company had set aside one hour for the closing. During that time more than 125 single-spaced pages (much of it in small print) were put in front of us. More than 60 required our signature or initials. It would have been difficult for us to digest these documents in 24 hours, much less one. When we asked to slow down the process, we were met with impatience. After the closing, Anna asked, "What did we sign?" I was clueless.
Yet buying a home is the largest purchase most families will make in their lifetimes, the largest expenditure in a family budget, and the single largest asset for two-thirds of homeowners. It's also the most fraught with danger.
For low-income families in particular, homeownership can turn out to be more a crushing debt than an asset-building opportunity. The primary reason for this is the growing chasm between ever-higher home prices and the stagnant incomes of millions of working-class Americans. The last decade has seen an unprecedented surge in home prices, which have risen 35% nationally. While the housing bubble is largely confined to specific metropolitan areas in the South, the Southwest, and the two coasts (home prices rose 50% in the Pacific states and 60% in New England), there are also bubbles in midwestern cities like Chicago and Minneapolis. And although the housing bubble is most pronounced in high-end properties, the prices of low-end homes have also spiked in many Ã‚Â°Ã‚Â©markets.
Current incomes simply do not support these inflated home prices. For example, only 18% of Californians can afford the median house in the state using traditional loan-affordability calculations. Even the fall in mortgage interest rates in the 1990s and early 2000s was largely neutralized by higher property taxes, higher insurance premiums, and rising utility costs.
This disparity might have put a dent in the mortgage finance business. But no: in 2005, Americans owed $5.7 trillion in mortgages, a 50% increase in just four years. Over the past decade the mortgage finance industry has developed creative schemes designed to squeeze potential homebuyers, albeit often temporarily, into houses they cannot afford. It is a sleight of hand that requires imaginative and risky financing for both buyers and financial institutions.
Most of the "creative" new mortgage products fall into the category of subprime mortgages -- those offered to people whose problematic credit drops them into a lower lending category. Subprime mortgages carry interest rates ranging from a few points to ten points or more above the prime or market rate, plus onerous loan terms. The subprime mortgage industry is growing: lenders originated $173 billion in subprime loans in 2005, up from only $25 billion in 1993. By 2006 the subprime market was valued at $600 billion, one-fifth of the $3 trillion U.S. mortgage market.
Subprime lending can be risky. In the 37 years since the Mortgage Bankers Association (MBA) began conducting its annual national mortgage delinquency survey, 2006 saw the highest share of home loans entering foreclosure. In early 2007, according to the MBA, 13.5% of subprime mortgages were delinquent (compared to 4.95% of prime-rate mortgages) and 4.5% were in foreclosure. By all accounts, this is just the tip of the iceberg. However, before the current collapse the rate of return for subprime lenders was spectacular. Forbes claimed that subprime lenders could realize returns up to six times greater than the best-run banks. In the past there were two main kinds of home mortgages: fixed-rate loans and adjustable-rate loans (ARMs). In a fixed-rate mortgage, the interest rate stays the same throughout the 15- to 30-year loan term. In a typical ARM the interest rate varies over the course of the loan, although there is usually a cap. Both kinds of loans traditionally required borrowers to provide thorough documentation of their finances and a down payment of at least 10% of the purchase price, and often 20%.
Adjustable-rate loans can be complicated, and a Federal Reserve study found that fully 25% of homeowners with ARMs were confused about their loan terms. Nonetheless, ARMs are attractive because in the short run they promise a home with an artificially low interest rate and affordable payments.
Even so, traditional ARMs proved inadequate to the tasks of ushering more low-income families into the housing market and generally keeping home sales up in the face of skyrocketing home prices. So in recent years the mortgage industry created a whole range of "affordability" products with names like "no-ratio loans," "option ARMS," and "balloon loans" that it doled out like candy to people who were never fully apprised of the intricacies of these complicated loans. (See sidebar for a glossary of the new mortgage products.) These new mortgage options have opened the door for almost anyone to secure a mortgage, whether or not their circumstances auger well for repayment. They also raise both the costs and risks of buying a home -- sometimes steeply -- for the low- and moderate-income families to whom they're largely marketed.
Beyond the higher interest rates (at some point in the loan term if not at the start) that characterize the new "affordability" mortgages, low-income homebuyers face other costs as well. For instance, predatory and subprime lenders often require borrowers to carry credit life insurance, which pays off a mortgage if the homeowner dies. This insurance is frequently sold either by the lender's subsidiary or else by a company that pays the lender a commission. Despite low payouts, lenders frequently charge high premiums for this insurance.
As many as 80% of subprime loans include prepayment penalties if the borrower pays off or refinances the loan early, a scam that costs low-income borrowers about $2.3 billion a year and increases the risk of foreclosure by 20%. Prepayment penalties lock borrowers into a loan by making it difficult to sell the home or refinance with a different lender. And while some borrowers face penalties for paying off their loans ahead of schedule, others discover that their mortgages have so-called "call provisions" that permit the lender to accelerate the loan term even if payments are current.
And then there are all of the costs outside of the mortgage itself. Newfangled mortgage products are often sold not by banks directly, but by a rapidly growing crew of mortgage brokers who act as finders or "bird dogs" for lenders. There are approximately 53,000 mortgage brokerage companies in the United States employing an estimated 418,700 people, according to the National Association of Mortgage Brokers; BusinessWeek notes that brokers now originate up to 80% of all new mortgages.
Largely unregulated, mortgage brokers live off loan fees. Their transactions are primed for conflicts of interest or even downright corruption. For example, borrowers pay brokers a fee to help them secure a loan. Brokers may also receive kickbacks from lenders for referring a borrower, and many brokers steer clients to the lenders that pay them the highest kickbacks rather than those offering the lowest interest rates. Closing documents use arcane language ("yield spread premiums," "service release fees") to hide these kickbacks. And some hungry brokers find less-than-kosher ways to make the sale, including fudging paperwork, arranging for inflated appraisals, or helping buyers find co-signers who have no intention of actually guaranteeing the loan.
Whether or not a broker is involved, lenders can inflate closing costs in a variety of ways: charging outrageous document preparation fees; billing for recording fees in excess of the law; "unbundling," whereby closing costs are padded by duplicating charges already included in other categories.
All in all, housing is highly susceptible to the predations of the fringe economy. Unscrupulous brokers and lenders have considerable latitude to ply their trade, especially with vulnerable low-income borrowers.
Time to Change Course
Despite the hype, homeownership is not a cure-all for low-income families who earn less than a living wage and have poor prospects for future income growth. In fact, for some low-income families homeownership only leads to more debt and financial misery. With mortgage delinquencies and foreclosures at record levels, especially among low-income households, millions of people would be better off today if they had remained renters. Surprisingly, rents are generally more stable than housing prices. From 1995 to 2001 rents rose slightly faster than inflation, but not as rapidly as home prices. Beginning in 2004 rent increases began to slow -- even in hot markets like San Francisco and Seattle -- and fell below the rate of inflation.
In the mid-1980s, low- and no-downpayment mortgages led to increased foreclosures when the economy tanked. Today, these mortgages are back, along with a concerted effort to drive economically marginal households into homeownership and high levels of unsustainable debt. To achieve this goal, the federal government spends $100 billion a year for homeownership programs (including the $70-plus billion that the mortgage interest deduction costs the Treasury).
Instead of focusing exclusively on homeownership, a more progressive and balanced housing policy would address the diverse needs of communities for both homes and rental units, and would facilitate new forms of ownership such as community land trusts and cooperatives. A balanced policy would certainly aim to expand the stock of affordable rental units. Unfortunately, just the opposite is occurring: rental housing assistance is being starved to feed low-income homeownership programs. From 2004 to 2006, President Bush and the Congress cut federal funding for public housing alone by 11%. Over the same period, more than 150,000 rental housing vouchers were cut.
And, of course, policymakers must act to protect those consumers who do opt to buy homes: for instance, by requiring mortgage lenders to make certain not only that a borrower is eligible for a particular loan product, but that the loan is suitable for the borrower.
The reason the United States lacks a sound housing policy is obvious if we follow the money. Overheated housing markets and rising home prices produce lots of winners. Real estate agents reap bigger commissions. Mortgage brokers, appraisers, real estate attorneys, title companies, lenders, builders, home remodelers, and everyone else with a hand in the housing pie does well. Cities raise more in property taxes, and insurance companies enroll more clients at higher premiums. Although housing accounts for only 5% of GDP, it has been responsible for up to 75% of all U.S. job growth in the last four years, according to the consulting firm Oxford Analytica. Housing has buffered the economy, and herding more low-income families into homes, regardless of the consequences, helps keep the industry ticking in the short run. The only losers? Renters squeezed by higher rents and accelerating conversion of rental units into condos. Young middle-income families trying to buy their first house. And, especially, the thousands of low-income families for whom buying a home turns into a financial nightmare.