This is the Wizards of Money, your money and financial management series, but with a twist. My name is Smithy and I’m a wizard watcher in the Land of Oz.
This is the Part 18 of the Wizards of Money and it is entitled “Where Wall Street Crosses Auburn Avenue”.
Introduction Audio – Foreclosure Sale on the Fulton County GA Courthouse Steps & Excerpt from Interview with Bill Brennan at Atlanta Legal Aid
Introduction
In this, the eighteenth edition of the Wizards of Money, we’re going to look at what’s driving today’s record rate of home foreclosures – from sub prime lending to abuses of the homeownership programs initiated during the Great Depression.
Home foreclosure is the process whereby a mortgage lender takes over a property when a borrower is late on loan payments. To study today’s alarming trends, we’ll need to follow the capital being pumped into various lending abuses all the way back through the predatory pipeline, and ending at the major Wall Street players. We’ll examine the roles played by major financial institutions, and those unregulated and mysterious things known as “Hedge Funds” and “Special Purpose Vehicles”.
We start our journey through the predatory pipeline in the city of Atlanta, one of the major accumulation points for predatory capital, primarily in low income and minority neighborhoods. We’ll go back to a time when capital flows in this area worked very differently. Then we’ll come back to the present to follow the modern capital flows back to their source.
To understand the driving forces behind today’s record foreclosure rates nationwide, we’ll talk with Charles Gardner, Director of the HUD Homeownership Center for the Southeastern United States and we’ll talk to Bill Brennan, Director of Atlanta Legal Aid’s Home Defense Program.
But first, let’s start with a walk around downtown Atlanta.
Atlanta’s “Freedom Walk”
In December of 2002 there was much celebration in Atlanta over the fact that Georgia has now produced two Nobel Peace Prize winners – Martin Luther King Jr and, most recently, former president Jimmy Carter. In fact, the King Center and the Carter Center, dedicated to both the memory and missions of these two Peace Prize winners, lie only about one mile apart and there is a walking path connecting the two. This walk, starting on Auburn Avenue, birthplace of King and home to the King Center, has been described as that from “Civil Rights to Human Rights” in the local Atlanta news and follows a road called “Freedom Parkway”.
“What a lovely walk!” I thought to myself on a recent sunny winter’s day. So I started walking along Auburn Avenue, ready for my Freedom Walk. However, somewhere along the way I messed up and took a wrong turn. Pretty soon, none of the streets I was walking down looked very much like a Freedom Parkway to me. Certainly financial freedom was not evident – instead, foreclosure was, with some streets dotted with several homes in foreclosure.
Perhaps I was walking in circles, but later on in the day I ended up on the steps of the Fulton County Courthouse in downtown Atlanta. Lining the steps throughout the day were a bunch of mumbling lawyers with piles of papers that they were reading, one after the other just like this:
Excerpt: Fulton County Courthouse January 2003 Foreclosure Sale
These lawyers were auctioning off the thousands of Atlanta homes in foreclosure that hit their books in the month of December. Most of the homes were going straight back to the banks. Don’t be fooled by the location of the auction – just because it takes place outside the courthouse, “outside” is the operative word. There’s none of this “getting your day in court” when it comes to foreclosure here.
I got some foreclosure statistics from the Atlanta Foreclosure Report and did a little analysis on where most of these homes were that were being auctioned off by the collection of mumbling lawyers on the courthouse steps. Consistent with studies done on foreclosure in other cities, the data showed the highest rates of foreclosure in predominantly African American neighborhoods. Pondering all this, I departed the courthouse steps and headed back towards Auburn Avenue.
The Almost Forgotten History of Black-Owned Financial Institutions
Back along Auburn Avenue, I passed by the modern Atlanta Life Insurance Company building and then, heading east towards the King Center, passed by many buildings in disrepair. You can just make out the words on the signs of some of the buildings, and, if you know your history, you can try and imagine what was going on in and around them years ago – for Auburn Avenue was once the hub of black economic activity in Atlanta and a key source of capital for African Americans.
Along this stretch of Auburn you pass by the Apex Museum, and you can watch a movie called Sweet Auburn – Street of Pride. Here’s an excerpt:
Excerpt: Sweet Auburn – Street of Pride.
That excerpt from the Apex Museum’s video “Sweet Auburn – Street of Pride”, narrated by Cicely Tyson and Julian Bond, includes a short history of some of the major black-owned financial institutions that emerged during the early twentieth century, some of which are still with us today. (The web site of the Apex Museum is www.apexmuseum.org.)
It’s definitely not easy to read about the history of black owned financial institutions, for not very much history has been written about them. Professor Alexa Benson Henderson at Clark-Atlanta University wrote a book in 1990 called “Atlanta Life Insurance Company: Guardian of Black Economic Dignity” where she described this hole in American history as follows … “I was discouraged…by the dearth of sources, printed or otherwise, on many of the significant individuals, groups and organizations that have been associated with black business development in Atlanta and elsewhere. Sadly, many of these inspiring stories are lost forever.”
The Atlanta Life book opens a window to a whole branch of US financial history that has been largely ignored. Black-owned financial institutions sprung up in many places following the end of slavery, initially taking the form of community and church-based mutual aid associations. In the late nineteenth and early twentieth centuries there was no federal tax and no such thing as social security, unemployment insurance, Medicaid and so forth. As always, those at the bottom of the economic ladder were the most vulnerable to the contingencies of sickness, accident, job loss, death or imprisonment of a breadwinner.
Out of this environment and out of necessity grew a slew of mutual aid associations in black communities. In such a mutual aid group the cost of these risks is pooled by everyone paying a small weekly or monthly premium. Out of this pool are paid the costs of the few that experience the covered contingencies, such as death benefits to widows and orphans and weekly payments if you get sick and can’t work. In this way the community as a whole bears these risks. This arrangement is more conducive to community development than having every member bear risk individually, which would tend to bankrupt whole segments of society.
Out of this collection of mutual aid societies in the South ultimately grew several extremely successful life insurance companies that, despite tremendous obstacles, are still with us today, including Atlanta Life on Auburn Avenue and North Carolina Mutual, born in another hub of black capital accumulation – Durham, North Carolina. These institutions have performed the near impossible – surviving for a whole century and through a period of brutal segregation, discrimination, the Great Depression and through having to win the confidence of their own communities in black owned and operated financial institutions.
Around the time these insurance companies were starting to grow, another key segment of black finance was emerging – the black owned banks. For example, Citizens Trust Bank opened up on Auburn Avenue in 1921 to meet the credit needs of the black community, to promote savings and the old-fashioned principles of “thrift”, and to promote homeownership. Through all that happened in the twentieth century, Citizens Trust Bank is also still with us today.
These and other black-owned institutions played a significant role in the accumulation and distribution of capital in African American communities throughout the twentieth century. It is no coincidence that the communities around them, such as the Auburn Avenue area, developed into economic hubs. Banks and insurance companies pool deposits and premiums and then invest them in things like home mortgages, office buildings and business loans. To the extent these pooled funds were invested back into local communities, further economic development of the communities was assured.
Physical Desegregation, Financial Segregation
Well, as the years went by and even as segregation continued, white financial institutions began to see that money could indeed be made off black customers and they began to compete fiercely for this business. Ronald H. Bayer’s book “Race & the Shaping of Twentieth Century Atlanta” sums up this situation as follows: “The success of these black institutions had proved to the white financial community that blacks were good mortgage, bank and insurance risks. … The decisive factor has not been the [white] citizenry’s quickened sense of charity or prosperity. As the men along Auburn Avenue often murmur wryly … “Dollars, you see, are not segregated”.
Often with deeper pockets, bigger marketing budgets, more experience and privileged access to the legislature, white financial institutions had many advantages in acquiring black customers, to the detriment of the customer base of the black institutions.
As the era of state sanctioned segregation was coming to an end in the South in the 1960s and 70s, a different form of segregation was already rampant in both the North and South – financial segregation. The dominance of white institutions providing financial services to black customers soon led to a situation where accumulated capital from premiums and deposits were not being reinvested back into those communities but, rather, flying away to ventures in other areas. In such a situation capital is increasingly drained out of the local community.
1968: Dr King’s Death and Ginnie Mae’s Birth
Social tensions in the aftermath of the assassination of the civil rights leader from Auburn Avenue, Dr Martin Luther King Jr., created the necessary pressure for the passage of the Fair Housing Act (also called the Dr. Martin Luther King Jr. Civil Rights Act) in 1968. This act outlawed most housing discrimination and gave HUD, the US Government Department of Housing and Urban Development, responsibility for enforcement.
On a related issue, this year also saw the birth of the government corporation known as Ginnie Mae, the Government National Mortgage Association, who we met in Wizards of Money Part 15. Ginnie was charged with a very important task – to facilitate the flow of capital into home loans for low and moderate income neighborhoods.
How did she do this, you might ask?
Well in 1934, during the New Deal regulatory blitz of the Great Depression, the National Housing Act came into effect. This act established the Federal Housing Administration or FHA to insure home mortgages. What this means is that the government provides a guarantee to mortgage lenders in low-to-moderate income neighborhoods that they will get their money back if a borrower defaults. These government guaranteed loans, known as FHA loans, encouraged banks to make loans in many low-to-moderate income, and minority, neighborhoods, and this loan program is administered by HUD.
Let’s here some background on the FHA loan program from Charles Gardner, the Director of HUD’s Southeast Region home-ownership program. Since the current statistics show so many FHA loans in foreclosure, we’ll also hear about what happens when an FHA loan goes into default, and the home is foreclosed on.
Excerpt from HUD Interview 1. 0.00 -3.00 & 12.30 – 15.00 (5.0)
As things turned out, the FHA loans by themselves still didn’t encourage enough capital to flow into home loans in these under-served neighborhoods and so Ginnie Mae was created in 1968. As noted in Wizards Part 15, Ginnie would buy up lots of government insured mortgages, mostly from the FHA program, and pool them together to create new securities known as mortgage backed securities. Then she guaranteed timely payment of principal and interest to the investors in these new securities. These new, pooled securities were very attractive lots of investors with lots of capital to invest, such as insurance companies and pension funds.
And so Ginnie Mae began to facilitate the flow of more and more capital into the FHA loan program serving low-to-middle income and minority communities. Her relatives known as Fannie Mae and Freddie Mac were created as privately owned counterparts to facilitate the flow of capital into conventional loans requiring a 20% down-payment, and not insured through a government program.
Ginnie, Fannie and Freddie started something pretty revolutionary but, unknowingly, they had also created a Monster! Before long the Investment Bankers along Wall Street caught on to the art of doing what Fannie, Freddie and Ginnie had done and began pooling and making new securities out of everything and anything that had cashflows that moved.
Securitization is the process of pooling together lots of individual debts like mortgages or credit card debt or auto loans, and bundling them altogether to create new securities called asset-backed securities. These new securities, backed by the cashflows generated from the pool, are more attractive to investors than investing directly in individual mortgages and credit card debt.
The process of securitization has taken the financial world by storm and its rapid development is perhaps the most important development in finance in a century.
Coming into the 21st century, securitization has been responsible for exponential growth in the financing of things that otherwise may have only gotten dribbles of capital – from non-stop credit card offers to predatory mortgages and home equity loans, to FHA loans – the list goes on and on.
To understand how securitization has facilitated predatory lending, we must travel along the securitization pipeline and trace a home loan from the unsuspecting home buyer through the mortgage broker, all the way back to Wall Street, the banking giants, the secret hedge funds, the insurance companies and other investment funds.
We start our journey with a borrower in a low to middle income community. There are two types of customers: Those that already have a mortgage and some equity in their homes, and first time homebuyers.
The Predatory Pipeline: From the Home Buyer Back to Wall Street
First we’ll hear about the first type of borrower, the most likely target of the predatory lending pipeline, from Bill Brennan, the Director of Atlanta Legal Aid’s Home Defense Program.
Excerpt 1 from Bill Brennan Interview on Sub-Prime Lending (0-8.33) 8.5
The sub-prime loans we were talking about here should not be confused with FHA loans, which are very different and which we will talk about separately.
The home loan process starts with the mortgage originator or broker. Many of these originators are “fly by night” shops, often smaller operations, or seedy subsidiaries of the big banks. In cases of fraudulent sales – falsified loan applications and the like – it’s these players who are often directly responsible for the fraudulent act. What many of these predatory loans have in common is that the borrower finds an offer of credit attractive but does not understand the mathematics behind the transaction. They mistakenly trust the lender to do the calculations for them and do not realize they are paying too much for credit. When they can’t afford their payments a few years down the track, they will lose their home.
The shady originators are generally not well capitalized nor regulated, which is why so much fraud happens at this point. Their primary sources of capital are the mortgage subsidiaries of the big banks that buy the mortgages from these small operators.
The mortgage subsidiaries of the big banks, such as Chase Manhattan, Wells Fargo, Citigroup, Deutsche Bank and Washington Mutual, buy up these mortgages in bulk and bundle them together to create pools out of them in things called Securitization Vehicles or Special Purpose Vehicles (SPV). The cashflows from the SPV, or pool, are then used to make new financial instruments called asset-backed securities.
These asset-backed securities issued against a single pool of home loans come in several varieties known as “tranches”. The securities known as the senior tranches are the first to get paid out of the home loan payments coming out of the pool. Then there are the most junior tranches that get paid last. Hence the senior tranches are very safe investments and it’s really the junior tranches that bear the risk of default by borrowers and losses realized on foreclosure. Because the senior tranches are safer investments they are very attractive to insurance companies and the like. Because the junior or, sometimes called toxic, tranches are very risky and bear most of the risks of default in the pool, they must offer very high returns to attract investors. This is exactly what the investment vehicles known as the “hedge funds” love.
Hedge funds are unregulated, managed investment vehicles funded by the capital of the extremely wealthy and designed to earn super returns for them. They are not regulated because of the so-called sophistication and wealth of their investors. Because of this, they have no capital requirements or safety net requirements – like the type of safety net that banks are required to hold to protect depositors funds, and that we discussed in Wizards Part 2.
The role of hedge funds, and other investors who take up the risky tranches of securitizations, is critical. Without them, securitizations would not be as prevalent as they are today because, in order for the banks to reduce their own risks and front their profits on mortgage lending, they have to be able to sell these risky tranches. The fact that both hedge funds and others in this pipeline are not regulated means that safety and soundness of mortgage financing overall is reduced, and that the profitability of it is greatly increased.
This system design, and its extraordinary profitability, have facilitated massive flows of capital into sub-prime and predatory lending in the past decade. Ultimately, the primary reasons for the high profitability of predatory lending are:
1) The information gap between the two ends of the pipeline. At one end you have the borrower who knows little to nothing about the mathematics of finance. At the other extreme, unbeknown to most borrowers, you have the masters of the most sophisticated financial system that has ever existed. Such information gaps mean huge profits. This translates into extra shareholder returns, over and above normal returns, of 20% or more on shareholder investments. I’ll post these calculations to the Wizards of Money web site at www.wizardsofmoney.org
2) Loan Values Less than Value of Home: This means that the lender really can’t lose on default and foreclosure and, again, risks are lower than what’s priced into the interest rates on these loans. In many cases the borrowers themselves are the primary bearers of risk, but the pricing of the loans rewards lenders for the risk.
3) Avoidance of Legal Liability and Regulatory Restraints: Because most of the fraud happens with the small mortgage originators, the big suppliers of capital are not held accountable for it, and capital continues to flow to the next dodgy operator. Also, because banks securitize the bulk of these loans they can profit from them up-front and sell the securities to unregulated entities with no capital or “safety net” requirements. This makes the market more profitable.
Here’s Bill Brennan again…
Excerpt 2 from Bill Brennan Interview on Sub-Prime Lending (20.25-20.55)
In the recent set of national and local foreclosure statistics it is clear that foreclosures related to sub-prime loans are on the rise. And so are those related to FHA loans. Let’s turn our attention to what’s going on in the FHA loan market.
The FHA Loan Pipeline
In the statistics for Atlanta, FHA loans in foreclosure account for about one third of all recent foreclosures. Interestingly, I also noted that almost 20% of these were FHA loans that were bought by subsidiaries of JP Morgan Chase & Co. Not only is Chase Manhattan one of the largest issuers of the Ginnie Mae securities made from FHA loans, but JP Morgan Chase has been employed by the government for years as the main pooling and banking agent for the whole Ginnie Mae program.
This reminded me of an article I read recently in the Wall Street Journal about a home loan scam in Pennsylvannia where homes were being over-appraised by fraudulent appraisers and ultimately facing foreclosure because people couldn’t afford the loans. The supplier of capital here was Chase Manhattan Mortgage who claimed no knowledge of what was going on.
Over-appraising the value of homes lies at the heart of many FHA loan program abuses. You see, in this case, the FHA insurance program guarantees that the lender will get all their money back if they lose money on foreclosure, so over-appraising and over-lending that leads to foreclosure can be very profitable.
I decided to ask HUD about what was going on with the high rates of FHA loan foreclosures in Atlanta. Here’s Charles Fowler:
Excerpt 2 from HUD Interview (4.13 – 5.20)
Bill Brennan at Atlanta Legal Aid had a lot more to say about what’s going on:
Excerpt 3 from Bill Brennan Interview on Sub-Prime Lending (9.39 -12.31 & 13.30 – 15.05) 4.5
Then I asked HUD about why Chase Manhattan was such a popular name with the FHA loans in foreclosure:
Excerpt 3 from HUD Interview (10.40-12.00) 1.5
Again, Bill Brennan had a lot more to say
Excerpt 4 from Bill Brennan Interview on Sub-Prime Lending (15.26-20.25)5.0
Well, in the fight to stamp out both predatory lending and FHA loan abuses, some progress is being made.
Progress in Clamping Down on Predatory Capital
On the HUD side of things, Charles Fowler told me about the HUD loss mitigation program on FHA loans:
Excerpt 4 from HUD Interview (12.08 – 12.40)
Also, the day I visited HUD they released a new rule about holding lenders accountable for the work of appraisers, which should help reduce over-valuations and the FHA abuse known as “asset flipping”.
Bill Brennan told me about some of the good lenders:
Excerpt 5 from Bill Brennan Interview on Sub-Prime Lending (20.56 – 22.58) 2
Finally, we also discussed the new Georgia Predatory Lending Law, the toughest in the country and revolutionary in that it creates legal liability all the way up the predatory lending pipeline to the big financial players and capital suppliers. Here’s Bill Brennan discussing the law that he worked with others for many years:
Excerpt 5 from Bill Brennan Interview on Sub-Prime Lending (23.50-27.55 & 28.50-29.50) 5
Finally, here’s some words of advice:
– If someone offers credit aggressively, it’s probably a great deal for them and a bad deal for you.
– Get to know your own credit score (known as the FICO score) and get a copy of your own credit report form someone like Equifax, so that you known exactly what creditors know about you.
– Don’t think of the mathematics of finance as a humdrum and dreary topic – because that type of thinking is exactly what makes the predatory pipeline work! If people thought finance was as exciting as the superbowl the dodgy sectors of finance would be devastated!
That’s all for the Wizards of Money Part 18. Wizards of Money has a web site with references, text and background materials at www.wizardsofmoney.org and also you can e-mail me at smithy@mindspring.com
