The Subprime Mortgage Mess: 5 Myths Put to Rest

Article excerpt

Sold to the American consumer as a chance for marginal borrowers to buy into the dream of home ownership, "subprime" mortgages are becoming the catalyst for an expected 1 million-plus foreclosures annually for the next few years.

Potential losses of $300 billion for homeowners and lenders -- and an undetermined amount of punishment to a $57 trillion U.S. financial system -- stalk global securities markets and seem poised to tip the nation into economic recession.

Yet despite the headlines of recent weeks generated by the response of markets and governments to the global credit crisis spurred by the subprime meltdown, much of its cause and effect remain shrouded in myth.

In interviews with the Tribune-Review, more than 20 of the nation's real estate, securities and regulatory gurus challenged some of those myths being spun as gospel.

Myth 1: The "subprime crisis" was unexpected and it will ruin the financial system.

To longtime hands at the Federal Deposit Insurance Corp., it isn't nearly as bad as the freefall in real estate and financial houses during the savings and loan crisis of the mid-1980s to early 1990s. Compared to S&L, the subprime mess might not be a "crisis."

"What was happening with subprime was unsustainable, but it's not necessarily new. What we faced during the S&L crisis certainly was far worse. I don't even like calling this a 'subprime crisis.' It's a 'subprime situation,' " said William M. Isaac, former chairman of the FDIC during the most turbulent years of the S&L implosion.

Today, Issac is a managing director at LECG, a global expert services firm in Vienna, Va.

"The good thing is that the banking regulatory system so far has done a good job containing the fallout. The subprime situation is not going to harm, in any substantial way, the banking industry. What we're seeing now is more of a sense of panic that will cause more financial losses than anything caused by non-performing loans."

When his watch over the FDIC ended, Isaac served on government panels to corral the S&L crisis and jump-start a home construction slump that had fallen to its lowest rate since World War II. Eventually, federal regulators bailed out most of the $168 billion in losses, closing 1,426 failed lending institutions.

"Subprime" loans emerged from that rubble. By the mid-1990s, changes in federal law and regulatory practices allowed banks to finance mortgages that typically would have been denied to borrowers because of low credit scores or lack of a substantial down payment.

According to the Federal Reserve, in 1995 subprimes accounted for about $65 billion in loans, about 5 percent of a mortgage market heavily weighted toward traditional "prime" borrowers with good credit, proven income history and willingness to put some of their savings down as a deposit. Nearly all loans began with a wannabe borrower's trip to a neighborhood bank.

Eleven years later, however, lenders OK'd nearly 10 times more subprime mortgages -- $625 billion worth -- with about 60 percent of those loans initiated by mostly unlicensed third-party brokers. Prime mortgages had come to make up only about one of every four new loans, according to the Federal Reserve.

Some of those brokers emerged as quick-buck salesmen who were unlikely to weed out potential buyers who couldn't afford the subprime loans they were accepting, according to litigators now bringing class-action lawsuits against some of those brokers.

"We now know that the (broker) community was rampant in fraud, was generally dishonest and took bad credit risks and then layered onto that bad credit, more lies and more deceptions and created investments that were worse than advertised," said Indianapolis- based attorney Tom Hargett, who has won major victories against firms tied to the subprime brokers.

But bankers didn't keep their hands clean. …