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Capital-22: The Paradox of Access by Russell Gentry From the Fall, 2007 issue of ValuesOpening underserved markets and giving nontraditional borrowers access to investment capital has been one step in a long trend of democratization in capital markets and banking. From South Africa to Florida, this trend has benefited millions of impoverished families and would-be entrepreneurs. It is a process that social investors have rightly applauded.
Recently, however, in the housing and credit markets the combined forces of tightening credit and stunted home price appreciation has drawn into stark relief the benefits and, increasingly, the costs of financial democratization and deregulation. The mechanics of how this occurred offer social investors a unique perspective into the often-competing goals of fair lending and credit availability.
Encouraged by deregulation, new sources of funding, and the search for growth in an otherwise mature banking industry, mortgage lenders began to market further down the economic ladder, offering loans to households that had until recently been ignored by traditional lenders. Additionally, first-time home buyers were lured by low monthly payments and the prospect of rapidly-appreciating home prices. The benefits of these phenomena are evident. Homeownership is at an all-time high. Nearly 70 percent of American households now own their homes, and economists and politicians alike will generally agree that home ownership offers clear societal benefits.
This situation, of course, has also led to the burgeoning “subprime” market, as interest-only loans and teaser rates entered the day-to-day lexicon of advertisements targeting an entirely new demographic of potential homeowners. Borrowers were enticed into complex mortgages, new products that seemed, on the surface, more affordable than traditional loans. Historically, most home buyers borrowed money for a new home at a fixed interest rate and amortization schedule, with the assurance that their monthly payment would remain static over the life of the loan. The new mortgages introduced over the past few years were different, and came in a variety of structures all sharing one similar characteristic: enticingly low payments and hidden, dangerously high risks. Many loans were structured with so-called “teaser rates,” interest rates that are fixed for an introductory period of usually three or five years and then allowed to float. Or, large “balloon payments” were structured into the payment schedule, decreasing the initial monthly payments while creating significantly higher interest costs and burdens later on. In other examples, payments were reduced by allowing the borrower to pay only the interest on the loan, with no monthly reduction on the principal amount, a situation perhaps more appropriately defined as “renting.”
Mortgage lenders knew full well the risks inherent in such loan structures. A rational lender under normal circumstances would, of course, avoid such duplicitous lending to borrowers with high likelihoods of default. But because of changes in the structure of mortgage financing, lenders were able to sell high-risk loans to investors on Wall Street and overseas, clearing the loans off their books and eliminating their exposure to defaulting borrowers. Through the use of new products such as collateralized debt obligations (CDOs), banks purchased the subprime loans from the original lenders, pooled them together, and sold them as stable, asset-backed fixed income securities, often with AAA credit ratings. Demand for these products originated from a wide variety of investors; from exotic hedge funds to money market funds. With the default risk effectively passed up the food chain to investors, the original mortgage lenders were free to continue lending, focused solely on selling “cheap” mortgages regardless of the risks. A single-minded drive toward sales with no regard for suitability or affordability laid the groundwork for the predatory lending practices being exposed today.
Paradoxically, gaining access to Wall Street’s seemingly infinite supply of capital was, on balance, a huge benefit to non-traditional borrowers. By purchasing CDOs and other mortgage-backed securities, Wall Street was effectively opening the doors to the vault: capital flowed freely down the food chain from investors to mortgage lenders, and ultimately to the borrowers themselves. This is, in essence, democratization at work: financial innovation connecting borrowers, lenders, and investors at ever decreasing costs.
How, then, do we balance this dichotomy of credit availability and unscrupulous, predatory lending? Does the responsibility for protecting borrowers lie with mortgage lenders, government regulators, or Wall Street investors? Or solely with the borrowers themselves? Broadly speaking, how do we keep the ubiquitous dream of economic prosperity and independence within the grasp of those persons most susceptible to predatory lending practices? How do we treat such a wide continuum of consumer knowledge and sophistication while broadening access to capital?
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