Crashing the Subprime Party
How the feds stopped the states from averting the lending mess.
As the federal government scurries to prevent the subprime mortgage crisis from sending the economy into a deep recession, many of us are asking why it waited so long to intervene. As it turns out, the government wasn't exactly sitting on its hands. Instead, for reasons that now appear hopelessly shortsighted, an obscure federal agency torpedoed legislation from a handful of states that would have made institutional investors far charier of buying mortgage loans that were likely to go belly-up. If the legislation had been permitted to go into effect, the crisis we now face would probably look a lot less grim. The right question, then, is not why the feds did so little. It's why they did so much.
Historically, few lenders would make subprime loans—that is, mortgage loans to borrowers with poor credit. The risk of default was simply too great. For a variety of reasons during the 1990s, however, major institutional players became more willing to purchase subprime loans as investments. Those loans would be pooled with similar subprime loans, and slices of that pool would be bought and sold as mortgage-backed securities. With the rise of this new secondary market, a lender could issue a subprime loan and immediately sell its interest in that loan for a lump sum. The ready flow of capital from the secondary mortgage market led, predictably, to an explosion in subprime lending. Unscrupulous lenders could reap the greatest profits by issuing subprime loans packed with unfavorable terms and subject to exorbitant interest rates, and only then selling them for cold, hard cash. A rash of borrowers found themselves saddled with predatory loans they had no hope of paying off.
To combat this surge in predatory lending, several state legislatures decided to stanch the flow of easy credit to subprime lenders. In 2002, Georgia became the first state to tell players in the secondary mortgage market that they might be on the hook if they purchased loans deemed "predatory" under state law. This worked a dramatic change. Before, downstream owners of mortgage-backed securities might see the value of their investments drop, but that was generally the worst that could happen. Under the Georgia Fair Lending Act, however, players in the secondary mortgage market could face serious liability if they so much as touched a predatory loan. The AARP, which drafted the model legislation that formed the basis for the Georgia law, explained that imposing liability on downstream owners would "reduce significantly the amount of credit that is available to lenders who are not willing to ensure that the loans they finance are made in accordance with the law."
The secondary market has an extraordinarily difficult time, however, distinguishing predatory loans (bad) from appropriately priced subprime loans (good). Even if the line could be drawn with confidence, the market lacked the resources to gather the necessary information. As the General Accounting Office noted in its comprehensive review of predatory-lending legislation, "even the most stringent efforts cannot uncover some predatory loans."
Inevitably, then, the secondary mortgage market in Georgia's subprime loans ground to a halt. And that was the point: If buyers couldn't satisfy themselves that the loans they bought weren't predatory, they should take their money elsewhere. Georgia understood that impeding the capital flow to subprime loans might raise the cost of borrowing for some state residents—those who, for one reason or another, had poor credit but could and would repay high-priced loans. But Georgia judged that this was more than balanced by protection for its most vulnerable from the scourge of predatory lending and the wrenching costs associated with overpayment and eventual foreclosure. New York, New Jersey, and New Mexico made the same judgment and within two years had enacted their own versions of laws exposing downstream owners of loans to fines if they bought predatory loans.
Nicholas Bagley is an assistant professor of law at the University of Michigan Law School.
Photograph of a foreclosure sign by Justin Sullivan/Getty Images.