R E S E A RC H O N M O N E Y A N D F I N A N C E · 2017. 5. 5. · R E S E A RC H O N M O N E Y A N D F I N A N C E Discussion Paper no 2 Racial Exclusion and the Political Economy

R E S E A R C H O N M O N E Y A N D F I N A N C E

Discussion Paper no 2

Racial Exclusion and the Political Economy of the Subprime Crisis

Gary A DymskiUniversity of California Center Sacramento (UCCS)

15 February 2009

Research on Money and Finance Discussion Papers

RMF invites discussion papers that may be in political economy, heterodox economics, and economic sociology. We welcome theoretical and empirical analysis without preference for particular topics. Our aim is to accumulate a body of work that provides insight into the development of contemporary capitalism. We also welcome literature reviews and critical analyses of mainstream economics provided they have a bearing on economic and social development.

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Gary A Dymski, Address: UCCS, 1130 K Street Suite LL22, Sacramento CA 95814, USA. Email: [email protected]. The author gives special thanks to Mariko Adachi, Philip Arestis, Glen Atkinson, Dean Baker, David Barkin, Etelberto Cruz, Jim Crotty, Silvana De Paula, Shaun French, Masao Ishikura, Tetsuji Kawamura, Costas Lapavitsas, Noemi Levy, George Lipsitz, Andrew Leyshon, Tracy Mott, Jesus Munoz, Anastasia Nesvetailova, Ronen Palan, Yoshi Sato, Tokutaru Shibata, Jan Toporowski, Thomas Wainwright, Michelle White, Clyde Woods, and two anonymous referees of this journal for their insightful comments on the work presented here, and he acknowledges the useful feedback he received from participants in the January 2008 Association for Evolutionary Economics conference, in the 2008 conference on Structural Change and Development Policies at the National Autonomous University of Mexico, and in seminars at Denver University, the University of Nevada-Reno, Nottingham University, and the University of Tokyo. The author is especially grateful to CEDEPLAR/Federal University of Minas Gerais for supporting the completion of this research.

Research on Money and Finance is a network of political economists that have a track record in researching money and finance. It aims to generate analytical work on the development of the monetary and the financial system in recent years. A further aim is to produce synthetic work on the transformation of the capitalist economy, the rise of financialisation and the resulting intensification of crises. RMF carries research on both developed and developing countries and welcomes contributions that draw on all currents of political economy.

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GaryADymski‐RacialExclusionandthePoliticalEconomyoftheSubprimeCrisis

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Abstract

Thispaperdevelopsapolitical economicexplanationofthe 2007‐09US subprime crisis which focuses onone of its central causes: thetransformationofracialexclusioninUSmortgagemarkets.Untiltheearly 1990s, racial minorities were systematically excluded frommortgagefinanceduetobankredlininganddiscrimination.Butthenracialexclusionincreditmarketswastransformed:racialminoritieswereincreasinglygivenaccesstohousingcreditundertermsfarmoreadverse than were offered to non‐minority borrowers. This papershows that the emergenceofthe subprimeloanis linked, inturn, tothe strategic transformation of banking in the 1980s, and to theunique global circumstances of the US macroeconomy. Thus,subprimelendingemergedfromacombinationofthelongUShistoryofracialexclusionincreditmarkets,thecrisisofUSbanking,andthepositionoftheUSwithintheglobaleconomy.Fromtheviewpointofthecapitalist accumulationprocess,these loansincreasedthedepthof the financial expropriation of the working class by financialcapital.Thecrisis insubprime lendingthenemergedwhensubprimeloans with exploitative terms became more widespread and weremade increasinglyonan under‐collateralized basis – that is, whenhousingloansbecamenotjustextortionarybutspeculative.


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1.Introduction

Most economists’ explanations of the roots of the 2007‐09global financial crisis havefocused on greed, myopia, and overreach by financial firms and homeowners, and oncredit‐rating agencies’ moral hazard.1 These diagnoses suggests that this crisishas thesamerootcausesasthe1982LatinAmericancrisis,the1980ssavingsandloancrisis,andthe 1997 Asian crisis: moral hazard due to flawed institutional design, combinedwithregulatoryfailure.2 So thislatestcrisisapparentlydemonstratesthatwhenincentivesandinformationareasymmetricallydistributed,andwhenfinancialmarketsareinadequatelyunsupervised, then myopic, risk‐taking, or incompetent borrowers and lenders cangeneratehugeeconomicandsocial losses.3 Theimpliesthatpoliciestooffset loanlosseswould becounterproductive:financialmarkets have to be taught about down‐side riskyetagain.4

Admittedly,financial crisesareahardyperennial inthecapitalistgarden.But thedepthofthestill‐evolvingeconomicmeltdownthathasresultedfromthiscrisissuggestedthatitshistoryshouldbeinterrogatedcarefully,notwrittenoutofthestory.

This paper argues that a key element in the 2007‐09 subprime crisis was thetransformationof racial exclusion inUSmortgagemarkets.Until theearly1990s, racialminoritiesweresystematicallyexcluded from participation inmortgage finance duetobanks’practicesofredlininganddiscrimination.Fromthatpointforward,however,racialexclusion in credit markets was transformed: racial minorities were no longer deniedmortgagecreditaltogether;instead,theywereincreasinglygivenaccesstohousingcreditundertermsfarmoreadversethanwereofferedtonon‐minorityborrowers.

The emergence of these subprime loans is linked, in turn, to banks’ strategictransformationofbanking inthe1980s, inresponseto theirowndifficultiesatthedawnof theneoliberal era.Banks,having shedtheir traditional rolesas risk absorbers,wereseeking out ever more ways to generate net income. They created financial assetsdesigned to provide services to different segments of their customer base in differentways,generatingsubstantialfee‐basedincomealongtheway.Theirsuccessfuldirectandindirect forays into higher‐risk loans for lower‐incomeandminoritymarkets, togetherwith the emergence of new outlets for higher‐risk debt, opened up the subprimemortgagemarkets.BoomregionalhousingmarketsintheUSthencreatedopportunitiesto spread subprime instruments to new homeowners well beyond the boundaries ofsegregated urban neighborhoods. The apparently endless supply of low‐cost liquidity,


1 See, for example, Krinsman 2008, Shiller 2008, and Tully 2007.

2 For representative analyses of these crises, see respectively Eaton, Gersovitz, and Stiglitz 1986, Kane 1989 and Kaufman 1990, and Krugman 1998.

3 Reinhart and Rogoff 2008.

4 Allen Meltzer wrote: “Capitalism without failure is like religion without sin. The answer to excessive risk-taking is ‘let 'em fail’. … Bailouts encourage excessive risk-taking; failures encourage prudent risk taking.” (Meltzer 2007).

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linkedtotheUS’suniqueglobalmacroeconomicposition,providedthefuelforthelarge‐scalemanufactureanddistributionofmortgage‐basedinvestmentvehicles.

As longassubprimeloanswere fullycollateralizedbyunderlyinghousingassets,bankscoulduseloansto boost theirprofitswithlittleincreasein risk.Fromtheviewpointofthe capitalist accumulation process, these loans increased the depth of the financialexpropriationoftheworkingclassbyfinancial capital.Theconditionsforcrisisemergedwhen lenders began issuing subprime loans on an under‐collateralized basis. Thishappenedwhen subprime loans were increasinglyused to coverover the growing gapbetweenmedian earned income and housing prices. As this happened, these housingloans became not just extortionary but speculative. Mortgage brokers and lendersheightenedthisshift,becausesodoingmaximizedtheirfee‐basedincome.Finally,crisisemergedwhen the housing price/credit pyramid grew larger than theincomeflowsoffinanciallyfragilehomeownerscouldsupport.

The approach developed here emphasizes that economic crises unfold in particularhistoricalandinstitutionalconjuncturesofglobalcapitalistprocesses.Financialprocessesare understood here as key sources of contemporary capitalist crises. Instability andaccumulation problems can arise from financial dynamics both due to fundamentaluncertainty infinancial processes anddueto the emergence of speculativecredit flowswithin the economy.5 Banks and financial relations are not passive elements inaccumulation processes, simply facilitating exploitation in production; they are activeelements that independentlyimpact the trajectoryof crises. In thecaseexaminedhere,lenders’innovationofprovidingminorityhouseholdswithaccesstomortgagefinanceviapredatoryloanswasanindependentrootofthecurrentcrisis.6

2.RacialExclusioninUSCreditMarkets

The post‐war period is often celebrated as a period of generalized prosperity for theworkingclassintheUS7andinEurope.8InthisFordistera,therealwageroseformanycategories of worker, permitting a substantial increase in living standards. Previouslyscarce consumer goods became widespread and residential homes became larger andmorecomfortable.ThisincreasedhousingconsumptionwasaccomplishedintheUS(not


5 Dymski 2006.

6 Throughout this paper, we refer to subprime loans as being predatory, and involving financial exploitation and expropriation. These terms all refer to the fact that these loans require higher-than-average interest rates and fees to be paid. Exploitative relations in the credit market should not be confused with the exploitation of labor from labor power. The question of the relationship between these lender-borrower relations and Marxian exploitation theory is addressed in Lapavitsas’ (2009) essay in this issue. On the links between racial exclusion and exploitation theory, also see Dymski (1992, 1996a).

7 Bowles 1982 and Bowles and Gintis 1982.

8 Glyn et al, 1988.

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ineverycountry)largelythroughexpandedhomeownership.9Theriseinhomeownershiprates from the 1950s through the mid‐1980s, then, provides one measure of relativehousehold prosperity. Of course, linking increased housing and domestic‐applianceconsumption to home‐building and homeownership also opened up important newvenuestomarketcompetition.Housingconstructionbecameevenmorepro‐cyclicalthandurable andnon‐durable investment expenditures.10 Further, those workerswho werehomeowners gained an interest in the maintenance of regulatory and economic‐stabilizationpoliciesthatgeneratedhigherhomeprices.

But itmustbeemphasizedthatthisgeneralizedprosperityexistedalongsidesubstantialracial inequality.11 Until the1970s,mostcities intheUShadde facto,andsometimesdejure,prohibitionsonwhereracialminoritiescouldlive.Mostminoritiesmovedtourbanareas from the rural south and thefields in the labor‐shortage periods accompanyingWorldWarsIandII.Theywereprohibitedfromhomeownershipinmostareasofcitiesby racial covenants – contractual agreements between prospective home‐buyers andhome‐sellersthat thehomes inquestionwould neitherbesoldorresoldto minorities.These social arrangements forced minorities to crowd into available, largely rental,housinginrestrictedportionsofthecity.Landlordscouldchargehigherrentsthanwouldotherwisehavebeenpossible,andtoexpropriateanextrashareofminorities’wagesandsalaries.

So theGoldenAgenevercrossed theraceline: AfricanAmericansandotherminoritieslargely functioned as a labor buffer‐stock, spatially segregated in lower‐incomeneighborhoodswith lowhome‐ownership rates.12 Federal housing policywas partly toblame for these patterns of spatial segregation and low home‐ownership. Since itsfounding in the 1930s, the Federal Housing Administration’s guidelines precluded thefunding of homes fromminorityormixed neighborhoods. This reinforced segregationand racial wealth disparities. Depository institutions were also to blame: they didn’tlocate branches in minority neighborhoods ormake loans there. In reaction, AfricanAmericans and other minorities established minority‐owned banks in many cities.13However,mostfinancial servicesandcreditwereprovidedin theseareasbylocalstoresand informal providers ‐ check‐cashing stores, finance companies, and pawn‐brokers.Somewerefranchisesandsomewerelocallyowned;virtuallyallchargedexploitativefees.The political momentum of the Civil Rights movement forced some changes in thissituation.Twonew laws, the1968FairHousingAct and1974EqualCreditOpportunityAct,extendedtheanti‐discriminationprinciplesofcivil rightslawtohousingandcreditmarkets,respectively.


9 Dymski and Isenberg (1998).

10 Dymski 2002.

11 Dymski 1996b.

12 Baron 1985.

13 Ammons 1996.

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Then a new trend emerged: the emergence of “white flight” from some urbanneighborhoods, in the 1960s and 1970s. This destabilized racial boundary lines, asminority households began to move into formerly all‐white areas. Banks and thriftsreactedbyreducingmortgagelendingthroughouttheinnercity.Ironically,thisledtothecreation of a multi‐racial community‐based movement opposing lenders’ “redlining.”14Thismovementcreatedthepoliticalpressurethat ledto theHomeMortgageDisclosureAct(HMDA)of1975andtheCommunityReinvestmentAct(CRA)of1977.Respectively,these acts provided a mechanism for monitoring bank loan‐making, and precluded“redlining”–theimplicitorexplicit refusaloflenderstomakemortgagecreditavailabletoneighborhoodswithlargeminoritypopulations.

The CRA required banks to meet the credit needs of their entire market areas, andprevented banks from claiming market areas that excluded minority and low‐incomepopulations. HMDA required all depository institutions to report annually on thedistributionoftheirmortgageloansbycensustract.AcademicsandcommunityactivistsusedHMDAdatato proveincityaftercitythatbank home‐ownershiploansweremademuchlessfrequentlyinminorityandlower‐incomeareasthanelsewhere.Forexample,a1991 studyofbanking, race, andincome inLosAngeles found that banksmadehome‐mortgage loans five timesmore frequently in low‐minority than high‐minority censustracts,controllingforincome.15

Communityadvocatesusedtheleverageprovidedbysuchstudiesto frametheirdemandfor“reinvestment.”Mortgagefinancewascentraltotheseadvocates’demands,asitwouldpermit more minorities to engage in wealth accumulation through homeownership.Depositoryinstitutionsarguedthattheydidnotredline:therewaslowdemandforhomepurchases in these areas, whichwere in any event highly risky. These assertions weresupportedbyeconomists,16 andby logic: insofarasthemortgagemarket iscompetitive,lendersinthatmarketwouldnotleave“moneyonthetable.” Inanyevent,HMDAdatawerenotrichenoughtoresolvethisdispute.

Thecrisisofthesavings‐and‐loan(thrift)industryinthe1980smadeitclearthatlendersinthemortgagemarkethadnotperformedoptimallyindecidingonwhichmortgagestomakeandunderwhat terms. The locally‐based thrift industrywas perceived as havingfailedinlargepartbecausemoralhazardhaddominatedprofit‐and‐lossconsiderationsinitsloan‐making.Inexchangeforthefederalassistanceprovidedtocleanupthemess,themortgagemarketwasopenedtonewlenders.Andtopermitnewentrantsintothesupplyside of the mortgage market, rules on bank‐holding company purchases of non‐banklenderswere loosened.Dueto pressure from CRA advocates, the 1989bailout bill alsorequiredmoreextensivereportingbymortgagelendersunderHMDA.

From1990on,lendershadtoreportannuallyonmortgage‐loanapplications,denials,andloansmade,includinginformationaboutapplicants’race,gender,income,andloansize.


14 Squires 1993.

15 Dymski, Veitch, and White 1991. For other studies, see the references in Squires 1993.

16 See, respectively, Benston (1981) and Holmes and Horvitz (1994).

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These data permitted researchers to test econometrically for racial discrimination inmortgagemarkets. These tests almost uniformly foundminority applicants to have asystematicallylowerprobabilityofloanapprovalthanwhiteapplicants.Whatsuchresultsmeantwascontentious.17 Forsome, this racial disadvantagedemonstratedthat lenders’racial animus toward borrowers outweighed other factors. For others, it represented“rational discrimination” based on the greater risks associated with loans made tominoritiesandtominorityareas.18

From the perspective of capital accumulation, the result that minority status per seaffectedloan‐marketdecisionsrepresentedaparadox:whywouldn’t profit‐seekingfirmssetasideracialbiasandmakeprofitableloans?Thisracialexclusionwouldreduceprofits,allthingsequal.Tworesponsessuggestplausibleexplanationsofthisparadox:first,whilelendersseekprofits,most lendinginstitutionsandlendingofficersarenon‐minority,andthus susceptible to perceptual racial bias (despite their commitment to profitmaximization);second,theperceivedrisksassociatedwithlendinginminorityareasandtominoritiesaresufficientlygreattodeterlending.

Thissituationwasabouttochange.Tounderstandhow,weneedto reviewthestrategictransformationofUSbanking.

3.USBankingfromtheGoldenAgetotheNeoliberalAge

After being reorganized during the 1930s Depression era, the US banking systemconsisted of a tightly controlled set of specialized institutions that provided differentcategoriesofcredit to differenteconomicsectors.Housingcreditwasprovidedprimarilybysavingsandloancompaniesandsavingsbanks(“thrifts”),whichattractedlonger‐termconsumersavings.

The evolution of US housing finance in the post‐War period reflected the federalgovernment’s commitment to expanded homeownership. The Federal HousingAdministrationprovidedalmost halfofall USmortgage funding inthe 1949‐59period,andguaranteedaportionoftheremainingmortgages.Further,federaldeposit insuranceunderwrote the deposit holdings that supported most outstanding mortgages. Thehomeownershiprateclimbedfrom44%in1940to61%by1960,to63%adecadelater,andthento66%in1980.

After having been a source of economic instability in the Great Depression,19 thesegmentedUSbankingsystem–includingthehousing‐financesubsystem–wasverysafe.Bank failuresvirtuallyneveroccurredfromthe1940suntil the1980s.Consequently,the


17 Dymski 2006 reviews the theoretical discrimination models and these extensive econometric debates.

18 Calomiris, Kahn, and Longhofer 1994, for example, characterize rational discrimination as an appropriate lender behavior.

19 Fisher 1933.

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FederalReserveusedthebankingsystemasakeyleverinstabilizingthemacroeconomicgrowth path. In the 1950s and 1960s, the Federal Reserve would reduce inflationarypressurebyengineeringcreditcruncheswhosepointofimpactwasthebankingsystem.20Thiswouldsloweconomicgrowth;expandingtheavailabilityofreserves,inturn,wouldstimulatemoreeconomicactivitybywayofincreasedhousingfinance(andotherformsoflending).

Because of its susceptibility to credit crunches, and because potential home‐buyersincomes vary pro‐cyclically, housing finance is highly sensitive to the business cycle.Housing construction outlays are more volatile over the cycle than durable or non‐durable investment spending.21 Figure 1 shows that fluctuations in mortgage debtoutstanding were more volatile than fluctuations in real GDP. Further, Figure 2demonstratesthattheratio ofunsoldhousesrelativeto homesalesvariesoverthecycleaswell–thisratioriseswhentheeconomyslows.

Source:OfficeofPolicyDevelopmentandResearch,USDepartmentofHousingandUrbanDevelopment


20 Wojnilower 1980.

21 Leamer 2008.

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Until the mid‐1970s, banks and thrifts navigated these chronic cyclical downturnswithout significant institutional stress.But then stressesstartedto emerge.Thetriggerwasashift intheglobalpositionoftheUSmacroeconomy.Adecadeofinstabilityinthe1970sundercutthestable,low‐inflation,high‐growthperiodthathadprevailedundertheBretton Woods system. By the late 1970s, macroeconomic turmoil had broken out:stagflation and interest rates well above banks’ regulatory maxima led to systematicdisintermediation–thelossofdepositorsto innovativesavingsoutlets,suchasmoney‐market money instruments. Banks’ credit supply to non‐financial businesses wasthreatened; large non‐financial corporations responded by creating the moderncommercialpapermarketandvastlyexpandingthescopeofcorporatebondmarkets.

Depository institutions, short of sufficient deposits to cover theirasset positions, wereforcedtoborrowathighnominalrates.Theinvertedyieldcurvecausedsubstantiallossesfrom realizedliquidity risk,especiallyin thethrift industry.Thrifts,originatorsofmostUSmortgages,werehit especiallyhard, because theirasset portfoliowasdominatedbyfixed‐rate,illiquidmortgages.

Thesebankingandthriftcrisesledto thepassagein1980and1982offederal legislationdesigned, respectively, toderegulatecommercial banks’ liabilityinstrumentsandtofreethrifts to undertake more asset‐side activities. This legislation unleashed a period ofcompetitivederegulationbetween federal and state regulators of thrifts.This led somestates’thriftstoundertakeill‐advisedspeculativeinvestmentsinthemid‐1980s,includingequityparticipationinspeculativehousingdevelopment.Asaresult,theproblemofthrift


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illiquiditywas transformed into a pandemicof failed investments andnon‐performingassets.

Consequently, someofthepost‐deregulationthriftscrashed,oftenspectacularly.Federallegislationin1989thenprovidedthefundingforcleaningupthesavings‐and‐loancrisis.Thesizeofthethrift sectorwasvastlyreduced;manyinsolventthriftsweremergedintocommercial banks. The macro‐instability in the early 1980salso precipitated the LatinAmerican debt crisis and a crisis of commercial‐bank solvency in several “oil‐patch”states.Theseeventsledtosubstantialcommercialbanklosses,andtoseveralUSmoney‐centerbankfailures.

Banks’ survival was threatened. Banks reacted in part by developing new businessstrategies.Banks’ first strategic shift involved the creation of upscale retail‐bankingstrategies, which focused on selling financial services to consumer and businesscustomerswithstableincomesandpositivewealthpositions.Thesestrategiessawbanksconcentratinginupper‐incomeareas,andsystematicallyavoidinglower‐income,African‐AmericanandLatino areas.Thesenewstrategies shifted thebalance from net earningsbasedoninterestmargintonetearningsbasedonfeesforfinancialservices.

Theseshiftstowarddesirableup‐marketcustomersandfee‐basedservicesweremutuallyreinforcing: the customers most sought by banks are targeted for the marketing ofstandardized financial services – credit cards, specialized deposit and investmentaccounts,andmortgageloans.Bothstrategicshiftsledtobankmergersaimedatmarketexpansion:soovertime,ashrinkingnumberofever‐largerbankswereservingevermoreoftheUSbankingmarket.

4.SecuritizationandtheMortgageMarket

AsFigure3shows,theoverallhomeownershiprateintheUS,whichhadrisensecularlyinthe1970s,beganadeclinefroma1980 peakof65.6%to a1986level of63.8%.However,theearly‐1980sthriftcollapsedidnotleadtoameltdownofmortgagefinanceintheearly1980s.Mortgagedebtoutstandingdid turnnegative(Figure1).But this 1980seventwasnodeeperadownturnthanthemid‐1970srecession;andGNPgrowthslowedevenmore.One factor in this downturnwas the sensitivityofmortgage‐backed securities rates tobalance‐sheet risk – a characteristic of themarket until a 1989 federal act bailed outsavings‐and‐loandepositorsandowners.22 AsFigure2aboveshows,theratioofunsold‐to‐soldnewhomesrose,buttoaslightlylowerpeakthaninthemid‐1970s.


22 Brewer III and Mondschaen 1992.

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Source:OfficeofPolicyDevelopmentandResearch,USDepartmentofHousingandUrbanDevelopment.USDepartmentofCommerce,BureauofEconomicAnalysis.

Thisprofoundinstitutionalcrisishadamuted effect fortwo reasons.First,thehousingmarketadjustedrapidlytotheincomedownturn.Between1974and1979,realhouseholdmedian income grew modestly (0.84% annually), while real median housing pricesclimbed3.6%perannum;seeTable1.Whenreal incomesweredeclining2%annuallyinthe1980‐82period,realhousingpricesfellalmostasfast.Whenrealincomesbeganrisingsignificantlyagainin1983and1984(2.3%perannum),housingpricesremainedstable,sothathousingaffordability(measuredbythehousing‐price/incomeratio)declined.Fortheremainderofthe1980s,bothvariablesrose,housingsomewhatfasterthanincome.

Second,the1980sthrift crisishadsucharestrainedimpactbecauseitonlyacceleratedatrend already in motion for US housing finance – from an intermediary‐based to asecurities‐market‐basedsystem.Asnoted,lenderspreviouslyheldmortgagestomaturity,exposing them to both default and liquidity risk. The new norm involved makingmortgages so as to sell them to the securities markets. The process of originating,servicing, and holding mortgages was split into its constituent parts, with each partpricedandperformedseparately.Oneimmediateimplication is that commercialbanks,mortgagecompanies,andotherscouldcompeteforfeesfromoriginatingmortgagesandfrombundlingandservicingthem.

Securitizing housing finance depended on the commodification of mortgages. In the1980s, securitisation necessitated standardized eligibility criteria. The criteria that


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emerged privilegedcustomerswithminimaldefault risk.This risk aversion hadseveralsources.First,thecomputationalchallengesembodiedincombiningmultipledimensionsof riskiness –and especially in calculating default risk onagiven bundle ofmortgagesthat were also subject to pre‐payment risk – required that default risk per se bestandardizedtotheextentpossible.Second,twofederally‐charteredagencies,FNMA(theFederal National MortgageAssociation) andFHLMC(theFederalHomeLoanMortgageCorporation)werebuyinganincreasingshareofmortgagedebt.Theseentitiesaccountedforjust16%ofallmortgagedebtoutstandingin1979;buttheirsharesurpassed25%by1986,andgrewsteadilyuntilitreachedapeakof43%in2003.Mostagency‐boughtdebtwasthenatleastimplicitlyguaranteedandsoldontothemarket.23Theagenciestheninsistedonlow‐risk(“plainvanilla”)mortgages,whichsetminimallevelsfordown‐payment/loanratiosandformortgage‐payment/income ratios. This leads to the third factor: a large shareof thecustomers foragency‐backedmortgagesecuritieswereoverseaswealth‐holders,whowererelativelyrisk‐averse.

These changes rescued themortgage‐finance system by transforming it from a systemwith localized savings circuits, provided by numerous thrifts making decisionsautarchically,toanincreasinglynationalmarketdominatedbylendersusingmarket‐widecriteria.The‘relationship’lendingattheheartofthepost‐warsystemwasreplaced:creditallocation no longer relied on lenders deciding which borrowers’ micro‐characteristicsand motivations warranted risk‐taking, but instead involved identifying whichprospective borrowers met globally‐established thresholds. These thresholds markeddividinglinesamongborrowerswithdifferentgeneralizeddefault‐riskprofiles. Ineffect,growing macro‐uncertainty and institutional and technological innovations resulted intherepositioningofrisk assessmentonthebasisofstandardizedmacro‐parameters,notmicro‐decisions.

Withagrowingpopulationofmortgageoriginatorsgeneratingstandardizedcredit,andagrowing demand to hold this mortgage debt, loan‐making was separated from risk‐bearing.Andasthismarketwasinitiallystructured,bothdefaultandliquidityriskwouldbereduced.Depository institutionscouldmakelong‐termmortgageswithoutabsorbingliquidity risk. In turn, the funds and firms buying mortgage debt could, if they heldlonger‐termpayout commitments (suchasinsuranceorpension funds)turn,matchthematuritydatesoftheseliabilitieswiththoseoftheirassets(themortgagestheybought).So liquidity risk couldbe transferred and substantially ameliorated.Andgiven astableinterest‐rateenvironment andcautious lending criteria, the default ratewould remainlowandpredictable.

Fromthemid‐1980stothemid‐1990s,mostmortgageswereconformingconventionalloans,underwritten bythequasi‐governmental agencies, FNMA and FHLCC, andheldin these


23 What governmental guarantee exists for FNMA paper is unclear; see note 10.

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agencies’portfoliosuntil,inmostcases,theyweresoldoff.24Theseagenciesaccommodatedtheneedformoresecuritizedmortgagesbycreatingmorepass‐throughsecurities–thatis,securitieswhoseshareholdershaveclaimson theunderlyingmortgagecash‐flows.Theseagencies’ effortsweresupplementedbytheexpandedeffortsofprivatemortgage insurers;theseprivatecompaniesspecializeinloansthatare“non‐conforming”becausetheyexceedFNMAloan loans ‐‐“jumbo” loanslargerthanareallowedunderFNMA. Inanycase, theupwardlimitforFNMA‐qualifyingloanswasincreasedby63%between1989and1985,afterrising just22%inthepreviousfouryears.Insum,maintainingthestrengthofUShousingfinance did not require the invention of new institutions in the 1980s – only anadjustmentoftheseinstitutions’parameters,andamarket for thefinancial papertheseinstitutionshadtosell.

This returns us to a key point.What kept mortgage flows relatively resilient was theuniqueposition of theUSwithintheglobalNeoliberal regime.Asnoted,acrisis intheglobaleconomy–andinthepositionoftheUSwithinit–spurredthechangeinbankingstrategy,andnecessitatedatransitiontoanewhousing‐financemechanism.Whatmadethistransitionrelativelyseamlessvis‐a‐visUShousingfinance(Table1)wasthatmuchofthe rest of the worldwas caught in low‐growth traps or crises. Since the US was theprincipal global source of reserve currency and had huge current‐account deficits, itneededsystematiccapital‐accountinflows.

The fact that the US appeared to be a global safe haven was then triply fortuitous.Mortgage‐backed securities responded to the needs of offshore investors: securitiesimplicitlybackedbythegovernment,payingmorethanTreasuries,anddenominatedintheworld’sreservecurrencyduringaperiodofglobalfinancialdisorganisation.25Further,theUSmacroeconomy needed overseas buyers for its securities, so as maintain cross‐borderbalances.Andfinally,thesesavingsinflowspermittedtheUS to re‐establish lownominalinterestrates.Lowratesminimizedtheimplicitfinancialrisksonthemortgagesbeingpackagedandtradedinsecondarymarkets.Intime,theseriskswouldbeexposed.

Thistripleglobalfinancialconjuncturewaseventuallyunwoundinpartbecausethissafe‐havensituationinvitedexcessiverisk‐taking.Tounderstandhowthishappened,wemustfirstunfoldthenextstepintheevolutionofracialexclusioninUScreditmarkets.

5.RacialExploitationfromRedliningtoPredatoryLending

The1980s,aswehaveseen,forcedtherethinkingoflong‐establishedbankingprocesses:how housing is financed and how banks generate earnings finance mechanism andbanking strategies were in transition. The steady deepening of wealth and income


24 Whether these agencies have implicit governmental backing is, and remains, contentious. FNMA was removed from the federal budget in 1968; and FHLCC was created as a separate entity to facilitate secondary-market sales of mortgage-backed securities in 1970. Both now operate as independent, wholly-private entities. However, the notion that these entities are implicitly backed by the US government is widely held (see, for example, The Economist 2007a.

25 Dymski 2008 develops the argument about the US role within the international system at length.

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inequality, combined with strong competition for upscale customers, led banks todevelop strategies to capture and hold business from lower‐income and minoritycustomers. One magnet for banks was the astronomically‐growing market for cross‐borderremittances,ofwhichbankshadatinyshare(about3%intheearly2000s).26

A particular challenge in accessing lower‐income financial markets was the highproportion of unbanked people in that market segment. According to the GeneralAccounting Office (2002), 28% of all individuals and 20% of all households lack bankaccounts, and thus were “unbanked.” Minorities are overrepresented among theunbanked; but more than half of unbanked US households are white. This segmentoffered large potential profits. Underbanked and unbanked households generate $6.2billioninfees–anannualaverageof$200perhousehold,evenfortheverypoor.27

So racialexclusion–therefusaltomakeloanstominoritycreditapplicants–waspartlyreplaced byextortionaryracial inclusion – providing access to credit to those formerlyexcluded from it, but only at terms and conditions that are predatory, that is, whichinvolve far higher costs and penalties for non‐compliances than ‘normal’ loans. Bankshave moved into these markets by acquiring subsidiaries and then designing specialinstruments aimed at lower‐income and minority customers they had previouslyoverlooked.Thesebanksthenmarketed,originated,anddistributedthesepredatoryloaninstruments.Sincethemid‐1990s,theseinstrumentshavebeengrowingatafreneticpaceinneighborhoodshistoricallysubjecttofinancialexclusion.Theseloansoftenhaveledtoexcessive rates of household and firm non‐payment, and thus to foreclosures andpersonal financial distress–wellbefore the2007mortgage‐marketmeltdown.Therearetwo principle categories of these loans: income‐based payday loans and housing‐basedsubprimeloans.

The payday loan– lower‐incomeUS households havemorevolatile incomes thandoother households, and hence need credit to close income‐expenditure gaps morefrequentlythanotherhouseholds.28 Butinobtaining credit,manysuchhouseholdslackthe financial track record to be fundable for credit cards or loans.29.This volatilityprovidesthepaydayloanmarketwithitsrationale.

Thepracticeofadvancingworkersaportionofthemoneytheystandto earnfromtheirpaychecks hasbecomeacommoncheck‐cashingservice.Thisformofcredithasspreadveryfast,ashastheinfrastructureoflendersdisbursingit.Unheardofin1990,nowsome22,000storelocationsofferpaydayloans.Theseloanshaveamarketvolumeof$40billioninthe37statesthatallowthispractice.30Theaveragefeefora$100checkis$18.In2001therewere15,000storesintheUSofferingpaydayloans,with70milliontransactionsand


26 Orozco 2004.

27 Katkov 2002.

28 Gosselin 2004.

29 Information Policy Institute 2005.

30 The payday-lending statistics in this subsection are drawn from Bair 2005.

16

$2.6 billion in fees ‐‐ $37 per transaction, on average, with $173,310 in fees per storelocation.Feesfromthismarketreached$4.4billionin2005.

Somefinancialfirmsarenowdevelopingnewsourcesofinformationwhichcouldqualifyhouseholds forhigherlevelsofcredit,overlongertime‐frames.However,theabsenceofthisinformationhasnot inhibitedthegrowthof thesecreditmarkets.Thereasonithasnot isthestructuraltransformationofthemarketsforlower‐income–andultimatelyforlower‐incomeandhigher‐risk–collateralizedloansintheUSeconomy.

Whyhasthepaydayloansectorgrownsorapidly?Onthecredit‐supplyside,financingisoftenprovidedbylargebankholdingcompanies, by investment banksandhedgefunds(through intermediaries) interested in bringing structured investment vehicles (seebelow)tomarket.Onthedemandside,several factorshaveconverged.Oneisthefallingrealvalueofworkers’wages,andtheincreasedvolatilityofwageearnings.Amongpaydaycustomers,some29%earnlessthan$25,000peryear,and52%earn$25‐50,000peryear.AfricanAmericansandmilitaryfamiliesareoverrepresented.Some41%arehomeowners.Thereis recurrentuse;most customersusepayday loans7‐12 timesperyear.A second,relatedfactoristhereadyavailabilityofcredit inrecentyears; thishasencouragedevenlower‐wage workers to take on debt to meet living expenses or to acquire durableconsumables.

Afinaldemandfactorconcernschangingbankingpractices.Notethatthecustomerbaseforpaydayloansdoesnotincludetheunbanked:paydayloansrequirecheckingaccounts.Banks are charging increasingly high fees for returned (not sufficient funds or NSF)checks.Combinedwiththesechargesaretheincreasinglyhigh latefeesforrent,credit‐card,andutilitypayments.Some$22billioninNSF feesand$57billionin latefeeswerecollectedin2003(Bair2005).Thatis,theincreasingprobabilityofveryhighfeesforbeinglateduetoanoverdrawncheckingaccountpushesworkerstowardpaydayloans.

Subprime lending originated when lenders created predatory mortgages – that is,mortgageswithexcessivelyhighfees,penalties,andinterestrates–andbegantomarketthem to higher‐risk households who had restricted access to other sources of credit,especiallylow‐cost credit. Lenders’ marketingofthese loans focusedonredlinedareas,andonhouseholds that had traditionallybeendeniedaccess to credit.31 Initially,mostsubprimeloansweresecondmortgages.Thesewereattractivetoborrowersbecausetheypermitted owners of modest homes to gain access to money for whatever financialcontingencieswerebeingfaced.Fundsthatcouldbepulled“outofahouse”amelioratedthe deteriorating economic fortunes of worker households, especially the minorityhouseholdshitdisproportionatelyhardbydeindustrialisation.

Soon, subprime loans were marketed to those seeking to acquire homes. From theviewpointofcommunityadvocates,theseloans’ termsandconditionswerepredatory;forbank apologists, they were legitimate responses to some home‐seekers’ special riskcharacteristics. Inanycase,manyhouseholdsformerlyexcluded from accessto longer‐term credit – especially lower‐income and minorities – were now offered credit on


31 See, for example, California Reinvestment Committee 2001.

17

exploitative terms. In 1998, for example, subprime and manufactured housing lendersaccounted for34percentofall homepurchasemortgageapplicationsand 14 percent oforiginations.Inthissameyear,subprimeandmanufacturedhousinglendersmadeafifthofallmortgagesextendedtolower‐incomeandLatinoborrowers,andathirdofallthosemadetoAfricanAmericanborrowers.32Subprimelendinggrew900percentintheperiod1993‐99, even while othermortgage lending activity actually declined.33 A nationwidestudyof2000HMDAdatafoundthatAfricanAmericansweremorethantwiceaslikelyaswhitestoreceivesubprimeloans,andLatinosmorethan40%‐220%morelikely.34

A set ofspecialized –andoftenpredatory–lendersemerged,usingaggressivebusinesspractices to sell loans. This new class of lenders reflected the drastic changes in thissector. Thelargest subprimelender,AmeriquestMortgageCompany,beganlifeasLongBeach Savings in 1979. Itmoved to OrangeCounty, California in 1991, and gave up itsbanking license in 1994 and focused insteadon retail and wholesale sales of subprimemortgages.In1999,LongBeachSavingssplitintotwo:apublicsubsidiary,whichwassoldto Washington Mutual in 1999, becoming that bank’s subprime trading arm; and aprivately‐heldsubsidiary,Ameriquest.whichwasforcedto settleaconsumerprotectionlawsuitfor$325millioninJanuary2006(basedonpracticesin49states).35AWashingtonPostaccountofthissettlementindicatesthecharacterofabusesundersubprimelending:“Undertheagreement,Ameriquest loanofficerswill berequiredto tellborrowers suchthingsaswhataloan'sinterestratewillbe,howmuchitcouldriseandwhethertheloanincludesa prepayment penalty. Loan officerswho do notmakethat disclosurewill besubject to discipline. The companywould also be forbidden from giving sales agentsfinancial incentives for pushing consumers into higher‐interest loans or prepaymentpenalties.”36

The subprimemortgage loans and payday loans alreadyhad some common structuralfeatures that later opened the door to the broader subprime markets of the 2004‐06period:(1) theywerebasedonsomecollateral (homesandpaychecks),whichhadvaluenomattertheincome‐basedcash‐flowsoftheeconomicunitstowhomtheseloansweremade; (2) they represented higher‐risk assets, whose holders could anticipate higherreturnsincompensationfortheserisks;(3)thelendersoriginatingtheseloansneededtomovethispapersystematicallyofftheirbalancesheets.Whatthisnewsetoffinancialmarketneededto growprecipitouslywerecustomersthatwould readily buy securities comprised of highly risky loans. The requisite customergrowthwouldsooncome.


32 These statistics are drawn from Canner et al. 1999.

33 ACORN 2000.

34 Bradford 2002. Also see Staten and Yezer 2004 and McCoy and Wyly 2004.

35 Gittelsohn 2007.

36 Downey 2006.

18

6.PressuresandStrategicAdaptationsin1990sConsumerCreditandHousingmarkets

For banks, doing business systematically with lower‐income and previously‐excludedhouseholds requiredanewconsumer‐bankingbusinessmodel.Thecoreconceptin thismodel isthatriskiercustomerscanbesuppliedwithcreditifthecombinationoffeesandattachableassetsissufficient topermit theoveralltransactiontopencilout.Sinceequityin homes represents most households’ primary asset, the logic of subprime mortgagelendingisreadilygrasped.Thelogicunderlyingthepaydayloanindustryissimilar–nextmonth’spaycheck serves asa guaranteeagainst loss. The successof this newmodel isevident in theSurveyofConsumer Finances: data fortheperiod 1989‐2004 shows thathouseholds in the two lowest‐income quintiles have had surging levels of debt, notparalleledbyproportionateincreasesinassetlevels.

Muchofthepressurefordebtbuildupinthisperiodstemmedfromforcesinthehousingmarket. The trajectory of federal housing policy for lower‐income households wasincreasinglybiasedtowardhome‐ownership.Thecentralpublichousing program inthe1980s and 1990s was Section 8 housing, which provided housing rental vouchers toselected qualifying households but did nothing for the supply of affordable rentalhousing. After 2000, the Bush Administration pushed the idea of universal homeownership, in part through converting formerly public rental housing into owner‐occupiedunits.Thescaleofbothpubliclow‐incomerentalandhomeownerprogramswasfarlessthanthepotentiallyeligiblepopulations.Boththecreationofnewlower‐incomecredit channels and the absence of federal programmatic capacity led US householdstowardmarket‐basedinnovationsinhomeownershippractices.

Thisgrowthinthedemandforhomeownershipisevident intheempirical evidence.AsFigure3shows,afterthecrisisyearsofthe1980s,USmedianhouseholdincomeroseuntil1990; it then declined through 1994, and then grew rapidly again until 2001. Housingpriceswerealsorising;butasFigure4 shows,theratio ofmedianhome‐purchaseprice‐to‐medianincomeroseonlyslightlybetween1983and2000.Table1showsthat,asinthe1980s, aggregate real housing prices were at least partially responsive to real incometrajectories. In the 1991‐94 period, real median household incomes fell; real medianhousingpricesrose, butbylessthan1%perannum,mustmoreslowlythaninthe later1980s.Whenrealincomesgrewagaininthe1995‐99period,housingpricesdidtoo,butasomewhatlowerrate.


19

Source:OfficeofPolicyDevelopmentandResearch,USDepartmentofHousingandUrbanDevelopment.USDepartmentofCommerce,BureauofEconomicAnalysis.

TheUShomeownershiprategrewfrom64%to69%between 1994 and2004(Figure3).Figure 5 illustrates, in turn, that while whites’ homeownership rates increasedsystematicallyfromthemid‐1980sonward,African‐AmericanandLatinohomeownershipratesgrewatslightlyfasterthanthatforwhites.Trendsinnewhomeconstructionmovedtheentiremarketupscaleinthe1980s:Figure4showsthatnew‐homeprices,whichwerealmostatparitywithexisting‐homeprices in1982, roserapidlytoapremiumof28%by1990. After the early‐1990s recession – that is, during the period of minorities’homeownershipraterisingasfastaswhites’–thenew‐homepremiumfellbelow10%.

Figure 4: Housing Price-to-Income Ratio and

New-Home/Existing-Home Price Ratio, 1972-2008

2.4

2.8

3.2

3.6

4

1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005

1

1.07

1.14

1.21

1.28

Median home-purchase price/median income

New home price/existing-home price (RH Axis)


20

Source:OfficeofPolicyDevelopmentandResearch,USDeptmentofHousingandUrbanDevelopment.

Theincreasingstrengthofhousingdemand–spurredintohyperdrivebytheextortionaryinclusionofAfricanAmerican andLatino homeowners – is tracedout in Figure2. Thepercentage ofexisting‐houses‐for‐sale to existing‐houses‐sold fell systematically from apeakof68%in1991toalowof33%in2004;thatfornewhomesfell from64%to35%inthe same time‐period. Subprimemortgages shaped this ever‐hottermarket: therise ofminorityhomeownershipratescoincidedwithadecliningnew‐homepremium;andthehousingshortagecreatedanenvironmentinwhich it becameas easyto sell anexistinghome as a new one. The construction industry boomed, and existing homeownersexperiencedrapidequitygains.

Somuchforthedemandside;howaboutsupply?Thesubprimelendingsectorhasgrownso explosively in the past several yearspreciselybecausethe links required to connectloan‐makingwith thesecuritisationof diverse, andoften risky, credit claims were putinto place. This riskiness, due to evermoreadventuroushouse‐price‐to‐income ratios,paledincomparisonwith theapparently ceaseless upward riseofhousingprices.WallStreet investment banks channeled an ever‐increasing amount of funds to subprimelenders:securitisationsinthismarket alreadyaveraged$80 billionannuallyby1998and1999.Further,WallStreet insurersbackedthemortgage‐backedsecuritiesthatsubprimelenderssoldoffintothemarkets.37

Figure 5: US Homeownership Rates by Race/Ethnicity, 1996-2007

(Percent of all households who are homeowners)

39

42

45

48

51

1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

64

67

70

73

76

African-American

Hispanic

White non-Hispanic (RH Axis)


37 Henriques and Bergman 2000.

21

The large fees to bemade in the loan‐origination and securitisation process, and theready availability of low‐interest money‐market funds – linked in turn to themacroeconomic capital‐account‐dependency of the US economy – attracted manysupply‐side players to these markets. This supplier influx has led to ever moreinterpenetrationbetweenmajorbankingcorporations,financecompanies,andsubprimelenders. Major banking corporations have undertaken or attempted numerousacquisitions. Some bank holding companies purchased subprime lenders. CiticorpacquiredAssociatesFirstCapitalCorporation,whichwasthenunderinvestigationbytheFederal Trade Commission and the Justice Department. In another case, First UnionBancorpboughttheMoneyStorein June1998 –andthenclosedit inmid‐2000 after itgeneratedmassive losses.38 In 2003, HSBCbought Household International, parent ofHousehold Finance Company, after settling charges that it had engaged in predatorylending. Associates First represented a step toward Citi’s goal of establishing itsCitifinancialsubsidiaryasthenation’slargestconsumerfinancecompany.39Inanyevent,thisconsumer‐lending subsidiaryhelpedto stabilizeCiti’scash‐flowduring aperiod inwhichmostmegabanks’earningsslumped.40

So the1990spreparedthewayforthesubprimecrisisadecadelater.Theinitialpremiseof securitisationwas thehomogenisationofrisks. Securitisation centeredonborrowerswhose risk was low and who were expected to pay. Federal agencies’ underwritingunderlay a large share of themarket. Then, due to heightened financial competition,morerelaxedattitudesaboutrisk‐taking,andincreasesincomputability,thispremisewassystematicallypunctured.Lendersoriginatedandsoldoffheterogeneoushousing‐basedloans,sometimestoborrowerswhoselonger‐termpaymentprospectsweredoubtful.Thecombination of high fees and penalties, along with sufficient pledged collateral, madetheseloansprofitable.Butwhatthe1990sbroughtwasnotjustanewhousing‐financeinstrument,thesubprimeloan,butanincreasinglyefficientpipelinefororiginatinganddistributingrisk.Subprimelendersatoneendofthispipelinemademortgageloans,thensoldthemtobanks,whichin turn manufactured securities that could be held or sold to investors. Before, themortgage‐backed securities built from “plain vanilla” mortgages had attracted buyersmoreinterestedinrisk‐aversionthanreturn‐maximisation.Butthestructuredinvestmentvehicles(SIVs) intowhichsubprimemortgagesweremadecreated higher‐risk, higher‐returnoptions.41Manydifferenttypesofcollateralizeddebt,notjustsubprimemortgages,werecombinedon the asset side of SIVs. The relative transparency associated with pass‐throughsecuritieswasreplacedbyopacity.Thisprovidedbanksanopportunity tomovediversetypesofdebtoff theirbalancesheets–withfees tobemadeeachstepoftheway.SIVsfound ready funding in the money markets. High profit rates left many corporations


38 Berman et al. 2006.

39 Oppel and McGeehan 2000.

40 Sapsford et al. 2001, Business Week 2007.

41 According to Mollenkamp et al. 2007, the first SIVs were created for Citigroup in 1988 and 1989.

22

awash in funds; and the prospect of sustained low nominal interest rates – linked, asnotedabove,to theUScapital‐accountsurplus–madeit seemquitenatural tofundSIVswithcommercialpaper.Indeed,“asset‐backedcommercialpaper”becamecommonplace.Ignoring liquidity risk, SIVs seemed a sure‐fire way to generate interest‐margin‐basedincomewithminimal–orevenno–equityinvestment.Thenextstep,soontaken,wasforhedgefundsandprivate‐equityfundsto get into thegame.WhethersuchSIVinvestorswere taking on the default risks implicit in the assets underlying these securities wasunclear; indeed, as opacity replaced transparency in the mortgage‐backed securitiesmarket, SIV investors lost track of what risks they were bearing. Further, credit riskderivativeswereoften used to shift risksonto thirdparties.42 In anycase,SIVsquicklybecamea$400billionsector.AstheWallStreetJournalputit,SIVs“boomedbecausetheyallowed banks to reap profits from investments in newfangled securities, but withoutsettingasidecapitaltomitigatetherisk.”43

Thethirdsignificantshiftinthe1990slayinbanks’directorthird‐partylendingpracticesin inner‐cityareas.Previously,banks’ reluctancehadledto creditstarvation inminorityand lower‐incomeneighborhoods.Now cities were awashwith credit.Banks set up orcontracted with intermediaries tomake and securitizehuge volumes of subprimeandpaydayloans.Thesamelendermightmakeexploitativeloansinsomeportionsofacity,while making prime loans elsewhere. Lenders, banks, and markets came to regardaggressive and even expectationallyunsustainable terms andconditions fora subset oftheir borrowers asnormal businesspractices. And thesepractices soonmigrated frominner‐cityareastothebroadermarkets.

7.TheSubprimeExplosionandCrisisinthe2000s

Once securities markets accepted heterogeneous assets not backed by iron‐cladunderwriting,thesemarketsweresettoabsorbeverriskiermortgagesandotherfinancialclaims.44 Asnotedabove,thedemandforresidential real estatebeganto takeoff inthelate 1990s.Thisassetboomsoonblossomedinto amania:homeownerswho hadhomeswantedbiggerones; thosewho weren’t yethomeownerswantedto get into thehousingmarket,evenatpremiumprices.The fact thatmanypotentialhome‐buyershadneithertheincomenorsavingsto support “plain vanillamortgages”–whichprescribedthatnomorethan30%ofincomespentonhousing,and20%downonanymortgageloan–fedafeelingofdesperation,of“nowornever”, especially inmarkets experiencing the fastestpriceappreciation.

Lenders’andbrokers’successfulexperienceincreatingloansforborrowerswithveryriskyparameterssuggestedtherequiredsolution:tocreateloanstailoredtothespecialrisksofthosewhose income and down‐payment profiles had not kept pace withmany cities’


42 The Economist 2007b.

43 Mollenkamp, Solomon, Sidel, and Bauerlein 2007.

44 The failure of Franklin National Bank in 1974 due to incautiously gathering non-homogeneous risks into real-estate investment trusts (Sinkey 1981), should have served as a warning.

23

white‐hothousingmarkets.Sincehousingpriceswererocketingupward,buyerscouldbegiven loans foramountsmore than 80% of theirnewhomes’ prices; or they couldbegiventwoloans,oneforthe80%‐‐makingtheloanpotentiallysellabletoFNMA‐‐andanotherfortheother20%oftheprice.

At thelevelofmacro‐aggregates,what triggeredthehousingmarket’sbubblephasewasthecontinuedexpansionofrealhousingpricesevenwhilerealincomesstagnated.Table1shows that realmedian householdincomedeclinedby 0.21%per annum from 2000 to2005,whilerealhousingpricesrose5%perannum.Consequently,asFigure5shows,themedian‐housing‐price‐to‐median‐incomeratio roserapidlyasofyear2000.However,asFigure 3 shows, whilemedian household incomepeaked in 2000, thehomeownership‐rate peaked only in 2004. As Figure 4 shows, African‐American and whitehomeownershipratesbothpeakedin2004(thatforLatinospeakedprematurelyin2002,thenrosesteadily).Thebubblebeganburstingby2005:after2004,unsoldinventoriesofbothexistingandnewhomesroseprecipitously(Figure2).

In effect, the concept of subprime was stretched along a different dimension of themortgageinstrument. Previously,subprimeloanswent primarily toborrowerswhohadbeen shut out of mainstream credit markets, as section 5 showed. As of the 2000s,however,subprimealso referredtoloansmadeto homeownersunabletosupport “plainvanilla” mortgage packages. These borrowers might be permitted to take on loans atspecialdiscountratesforlimitedperiodsoftime.Togetpotentialbuyers“into”ahome,aloan could be made at a below‐market “teaser” rate for the first year or two of themortgage.Anygapbetweenmarketand“teaser”ratescouldbeamortized,andtheentiremortgage refinanced at a risk‐adjusted market rate after the “teaser” rate expired.Housing‐priceappreciationwouldeventuallynegatetherisksofa100%‐financedhousingpurchase;andanticipatedincomegrowthand/oranticipatedhousing‐pricegrowthcould,in turn, offset overly burdensome home payments. Fees and penalty clauses could beattachedaswarrantedtosuchpaper.

Ashousingpricesandaseuphoriaabouthousing‐priceincreasesintensified,especiallyinsomeregional hot‐spots, buyersweremore andmoreforced into “teaser” rates, hybridARMs, and so on.45 But housing‐priceappreciation so dominated the consciousness ofbuyersandsellersthatthehighfeesandhighexpectedpaymentsassociatedwithgettingintoaloanseemedmerelywhatwasnecessarytogetinwhilethewindowofopportunityremained cracked open. For certainly, reasoned buyers, future price increases wouldallowtherenegotiationofnon‐viabletermsandconditionsintwoyears,whenone’s2/28mortgageloan“flipped”frombelow‐marketentry‐levelratetofixedmarketrate.

Therisinghousing‐price/incomeratioexplainssomebutnotall ofthegrowingdemandforsubprimemortgage loans.Mortgagebrokersmanufactured someofit themselves.Asurveyof2005and2006experience found that 55%and61%thoseacquiring subprimemortgages, respectively, had credit scores high enough to obtain conventional loans.46


45 Wray 2007, p. 9.

46 Brooks and Simon 2007.

24

This study also found that the mortgage brokers selling these claims earned fees farhigherthanconventionalmortgageswouldhavenetted.

Onthesupplysideofthehousing‐financemarket,fundswereplentiful.Macro‐structuralcircumstancesremainedfavorable–theUS’scurrent‐accountremainedstronglynegative,sothatsavingscontinuedtoflowintotheUS.Themarketformortgage‐backedsecurities,whichhadbeenthelargestfinancial securitiesmarketintheworldfortwodecades,wasfamiliar to foreign investors. In particular, many UK and European banks rushed toacquire subprime paper.47 A strong dollar and low nominal interest rates negatedliquidityrisk.

Otherfactorsspurring supplywerebanks’ strategicshifts toward fee‐based incomeandrisk‐shedding, analyzed above, and hyper‐competition among lenders. For example, arecentWall Street Journal article highlighted the “once‐lucrative partnership” betweenWall Street and subprime lenders, which according to one insider involved: “.. fiercecompetitionfortheseloans...Theywereamajorsourceofrevenuesandperceivedprofitsforboththeinvestorsandtheinvestmentbanks.”48Inthisarticle,JeffreyKirch,presidentofafirmthatbuyshomeloans,isquotedassaying,“Theeasiestwaytograbmarketsharewasbypayingmorethanyourcompetitors.”Atstakewerelargeprospectiveincomeflowsfor investmentbanks, aswell as lucrativemanagement bonuses.Managingdirectors ininvestment banks averaged total compensation in 2006 of $2.5 million. Theseinducementsledmanyfirms to continueaggressivelyin thesemarketsevenaswarningsignsloomed.

Subprime loan volumes exploded in 2004‐2006, even as the housing boom peaked. In2001‐03period,mortgageoriginationstotaled$9.04trillion,ofwhich8.4%weresubprimeloans;and55%ofsubprimeoriginations,or$418billion,weresecuritized.Inthe2004‐06period, total mortgage originations were the same in nominal terms, $9.02 trillion.However, 19.6%ofall originations consistedof subprime loans, ofwhich78.8% ‐ some$1,391billion–weresecuritized.49 Further, asnotedabove,theopaquecharacterofSIVsandothervehiclesforsecuritisation led tomoretypesofcreditbeing includedon theseinstruments’ balance‐sheets. Among these were private‐equity funds’ bridge loans forleveraged buyouts, real‐estate acquisition loans, construction finance, credit‐cardreceivables,andsoon.

TheOnsetof the SubprimeCrisis.Like theAsian crisis in 1997, the subprime creditcrisisbuilt momentum through adomino effect involving interconnectedeventsoveralargegeographic area. Some 80 subprimemortgage companies failed in thefirst sevenmonthsof2007.Thebig credit‐ratingsagenciescameunderpressure to overhaul theirmethodsofassessingdefault risk in theUS subprimemarket.50 Astheydidso, banking


47 See, for example, Mollenkamp, Taylor and McDonald 2007.

48 Anderson and Bajaj 2007.

49 These data, from the Mortgage Market Statistical Annual, appear as Table 1 of Wray 2007, p. 30.

50 Pittman 2007,

25

firmsintheUSandabroadwereaffected.OnJune20,2007,Bear,Stearnswasforcedtoshutdown two subprimefundsitoperated forits investors.51 Sixweeks later,AmericanHome Mortgage closed its doors.52 Meanwhile, Countrywide Financial, which hadoriginated about one‐sixth of recent US mortgage loans, descended more and morevisiblyintocrisis.53

InAugust,theGermanbankIKBwasbailedoutbyDeutschebankandotherbankswhenit couldno longeraccess themoneymarketsto financeRhinelandFunding, anoffshorevehicle containing $17.5 billion of collateralized debt obligations, including some USsubprimemortgages.54Someofthelargestbanks,suchasGoldmanSachs,addedfuel tothe crisis by continuing to package andsell securities backed by subprimemortgages,evenwhilereducing theirexposureto subprimedebtontheirownbalancesheets.55 BySeptember,between16%and24%ofthesubprimesecuritiespackagedbyglobalbanksin2006wereatleast60daysinarrears–atotalof$73.7billionof60‐day‐delinquentloansinthesesecuritiesalone.

In2008,thesituationgotsuccessivelygrimmer.Manyhomeswentintoforeclosure.Manyofthesehadbeenmarketedtotheformerlyracially‐excludedandbuiltincloseproximityto areashistoricallysubjecttomortgage‐marketredlining.That is, evenwhensubprimelendinghadexpandedbeyondtheinnercityinthebubbleperiod,racialdividinglinesinurbanlandusehadremainedinplace. Sowhen thecrisishit, it hadadisproportionateimpactonminorityandlower‐incomeneighborhoods;56 minorityhouseholds, themostlikelytobetargetedbysubprimelenders,werealsomostlikelyto liveinneighborhoodsinwhichsubprime‐basedforeclosurecycleswouldcauseterriblelosses.57

Further, short‐term credit for subprime paper and SIVs dried up. Consequently, evermoreglobalbanks,intheUSandabroad,wereforcedto takesubprimepaperbackontotheirbalancesheets,declaringlossesinthetensofbillions.Thesebankshadtoseekoutcapitalinjectionsevenwhiledrasticallytighteningcreditsupply.


51 Kelly, Ng, and Reilly 2007.

52 Dash 2007.

53 Hagerty and Richardson 2007.

54The Economist 2007c.

55Anderson and Bajaj 2007. Goldman’s new originations equaled $6 billion in the first 9 months of 2007; by December, 15 percent of these loans were already delinquent by more than 60 days

56 California Reinvestment Committee et al 2008.

57 Housing and Economic Rights Advocates and California Reinvestment Coalition 2007.

26

8.Conclusion

The meltdown in global banking and credit markets began when the end of the UShousingbubblein 2007precipitated arapidincrease inmortgagedelinquencies.Thesemortgages wereheld in securitized form in portfolios around theworld. So paymentsdifficulties at the base of the financial food‐chain led to seismic financial‐marketeruptionsatthetop.

One root of the still‐unfolding subprimecrisis, then, is banks’ transformation of theirrevenue‐generation strategies due to macro‐ and micro‐distress at the onset of theneoliberal age. This involved separating loan‐making from risk‐taking, that is, thecreation of risk from its absorption. These strategic adaptations, which apparentlyreduced the overall riskiness of financial intermediation, hada huge collateral impact:banksno longerhadtobalancetheprofit potential from loan‐making with thedefaultand liquidity risks to which loan‐making gives rise: a key brake on finance‐basedexpansionwasremoved.

Thisstrategicre‐orientationofbanksthentransformedthelandscapeofracialandsocialexclusioninUScreditmarkets.Ascenariooffinancialexclusionandloandenialbecameascenario of financial expropriation and loan‐making. Households previously deniedmortgageswerenowawardedhigh‐cost,high‐riskloans.Asdirectmarkets’ institutionalcapacitygrew, non‐bank lenders joinedbanksin providing – for ahigh fee– high‐risk,high‐cost loans. And when practices pioneered in predatory loan‐making to sociallyexcludedcommunitiesweregeneralizedandintroducedintothebroaderhousingmarket,the conditionswerecreatedboth fortheunsustainable explosion ofUS housing pricesandfortheunsustainablestretchingofthelimitsoffinancial‐marketliquidity.

Thethirdroot ofthecrisis isthelongdeclineinwagesoftheUSworkingclass.Asthepossibilitiesof adignified lifebasedonthewagesoflabor faded,USworkers’ desire toshare in the “Americandream” came to includehomeownership. But the gap betweenhousingpricesandincomeshasbeenwideningfortwodecades(Figure4).Ouranalysisofthe 1980s showedhowUSmedianhousehold income rose in the 1980safter thecrisisthen. But analysis of the post‐peak subprimeperiod indicates that US median incomeremainsflat(Table1)evenwhilehousingpriceshavefallen.


27

Source: Department of Commerce, Bureau of Economic Analysis.

Thismadehomeownershipmorecostlyandmoredesirableatthesametime.Forhousingseemedtogainmarketvalueatratesfasterthanevensubprimeborrowingrates.Ineffect,it became workers’ means of participating in the speculative gains to which the USeconomy had become addicted in the post‐industrial age. Ironically, the growing gapbetweenhousingpriceandincomewasmoderatedinpartthroughadaptationsthatbothrepresentedandworsenedtheworking class’spositional weakness –moretwo‐wageorthree‐wagehouseholds, theperfectionofmass housing production techniques, andtheuseofnon‐unionlaboronconstructionsites:allso thatworkingclasshouseholdscouldmoveinto‘affordable’unitsevermoredistantfromworksitesandurbancenters.

The fourth structural root of the subprime crisis emphasized here is the USmacroeconomiccontext. After thechaoticearly 1980s, theUS’s current‐account deficitand its status as a global “safe haven” created ready liquidity for the securitisationmachine.Thissituation,basedultimatelyon theuniquecircumstancesofUSmonetaryhegemony, was ultimately unsustainable.58 Here a second irony emerges. Subprimelending and opaque high‐risk securitisation, which was rooted in part in the readyavailabilityofliquidity, reacheditshighpointat preciselythe time– June2004 to July2006–inwhichtheFederalReservewasmakinga sustainedeffortto restrict liquidity.TheFed’seffortswereoverwhelmedbythecontinuinginflowsontheUScapitalaccount;linkedtotheUS’scurrent‐accountdeficit,theseinflowsseemedoutofthecentralbank’scontrol.When overseaswealth‐holders becameleeryof dollar‐based assets generally inthewakeofthegatheringsubprimecrisis,theFederalReservesimilarlyfacedlimitsinitsabilitytomanagethedamage.

!


58 Dymski 2008.

28

In sum, the sub‐prime crisis originates in the perverse interaction between America’slegacyofracialdiscrimination andsocial inequality, itsuniqueandultimatelyuniquely‐fragile global position, and its hyper‐competitive, world‐straddling financial sector. Toputitprovocatively,America’sracialchickenshavecomehometo roostinthesubprimecrisis.

The racial rootsof this crisis havealso drawn attention in the extended andvigorousdebateregardingpolicyresponsestothiscrisis.NewYorkTimescolumnistsBobHerbert(2007) and Paul Krugman (2007) have asserted that racial exclusion underlies thesubprimecrisis.Otherexpertshaveturnedthisargumentonitshead,byarguingthattheCommunityReinvestmentAct–which,aswehaveseen,waspassedinto lawinresponseto banks’ racial redlining– forcedbanks into speculativeloan‐making.59Theanalysisinthispaperletsusseehowprofoundlythis latterlineofreasoningtwiststhetrajectoryofhistory.Itisbanks’continuationoftheirhistorical–ifcontested–legacyofdenyingequalcredit‐market access led to the creation of new instruments of financial expropriationthat,oncegeneralizedandtransported intoaraginghome‐purchasemarket,has ledthebankingsystemandtheUSeconomytotheedgeofaveryhighcliff.


59 See, for example, Calomiris (2008) and Liebowitz (2008).

29

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