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I apologize in advance for the long-winded response.... This is a very big question. I will attempt to make a few points, but for much more detail and important points not covered here, I refer you to my recent book, _Foreclosed: High-Risk Lending, Deregulation, and the Undermining of the American Mortgage Market_ (D. Immergluck, Cornell Press, 2009, http://www.amazon.com/Foreclosed-High-Risk-Deregulation-Undermining-Americas/dp/0801447720 ). The book gives a good deal of attention to the development of U.S. mortgage markets from the early 20th century (and earlier) through the 20th century and into the 21st. It deals very much with this question. In brief, a few points (from the book and elsewhere): First, I would characterize it much less as homebuyers and homeowners "turning away" from the "plain vanilla" long-term, fully amortizing, constant payment mortgage that generated the rise on subprime and exotic loan products. Rather, deregulation and other forms of (mostly federal) governmental support given to "alternative" and high-risk products starting in the 1970s provided a strong set of incentives to market and fund high-risk loans in various ways. Lenders and mortgage brokers received higher fees and made more money (at least in the short term) from these submarkets than from traditional products. The origination of the subprime industry, in particular, originated in the refinance/home equity market, where aggressive "push marketing" was used. Brokers originating such loans could easily make 5-10% in fees on such loans, while originators of prime fixed rate loans would make more on the order of 0-2% in fees. Brokers also received "yield spread premiums" (additional up front fees) from lenders for placing borrowers in higher interest rate loans (this was not illegal in any way). Second, the proliferation of first, adjustable rate, and, then, subprime and exotic loan products was directly facilitated by federal preemption of state consumer lending laws, especially in the 1982 Alternative Mortgage Transaction Parity Act (http://uscode.house.gov/download/pls/12C39.txt ), which allowed for the preemption of most state laws governing adjustable rate loans. This law was seen as a critical factor for expanding securitization in the mortgage market (first via the government sponsored enterprises Fannie Mae and Freddie Mac, and later via the private label -- mostly Wall Street -- securitization market). Adjustable rate loans, in particular, were a vehicle for pushing interest rate risks onto borrowers, making them more amenable to securitization via private markets. Investors would face less interest rate risk in holding bonds whose payments would move some with interest rate fluctuations. More complex securitizations schemes that pieced apart interest rate risk arrived later, making fixed rate loans easier to securitize as well. Third, subprime and exotic loans, and sometimes prime adjustable rate loans, became tools for lenders to offer "affordability products" in high-cost housing markets. Lenders created products with very low down payments (often using piggy back second or third mortgages), below-market interest rates for the first few years, interest-only or negative amortization schedules, and other schemes to force loan payments to be "artificially" low in early years so that folks could qualify for larger loans. Especially in markets with substantial pent up demand for homebuying and/or in inelastic (in the short term at least) housing markets, this put upward pressure on house prices, accelerating house price appreciation. As prices rose, there was in turn even more "demand" for affordability products, so lenders continued to "innovate" by layering these risk-inducing loan products on top of one another. This occurred the most in the bubble market regions such as California, Florida, Las Vegas, and similar areas. and essentially provided the helium for rising prices. However, these same products were used in most parts of the country fairly extensively. So "innovative" financial products helped create "virtuous cycles" of property appreciation that led to greater demand for more innovative products, etc. As long as foreclosures remained low (because people could sell their house to the next buyer), the cycle continued. As foreclosure mounted and property values flattened and then dropped, the cycle quickly reversed into a vicious one with falling values begetting more foreclosures begetting falling values, and so on. Fourth, remember that the long term fully amortizing products standardized by the FHA and other agencies also reduced down payment requirements a good deal (and eliminated much of the need for usurious second mortgages), while also providing a long-term fixed rate. This effectively lowered the costs AND risks of borrowing as well as lowering the down payment barrier. Adjustable rate mortgages (ARMs) and exotic products did offer some purported benefits to borrowers (I have not yet mentioned quick and easy approval, limited income documentation, and other features of the subprime market), some of which effectively lowered monthly payments in the near term. For those expecting to sell or refinance in the near to mid term (and who expected home values to always rise) this may have seemed like a wise thing. None of this is to say that adjustable rate loans cannot be useful in some contexts; and they tend to make more sense for short-term investors or speculators purchasing property or refinancing when long term interest rates are high relative to short term rates. But they do shift risks from lenders/investors to homeowners. When combined with other subprime or exotic features, default risks tend to go up very quickly. But whether these products used on a wide scale is a good thing from a policy perspective continues to be widely debated. Hope this is helpful. -Dan Dan Immergluck Associate Professor City and Regional Planning Georgia Institute of Technology www.prism.gatech.edu/~di17 H-Urban: http://www.h-net.org/~urban/ (including logs & posting guidelines) Posting Address: h-urban@h-net.msu.edu / mailto:h-urban@h-net.msu.edu (Click)
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