Subprime Slime

A few notes on the crisis, March 2008
Elvin Wyly, Dan Hammel, Markus Moos, and Emmanuel Kabahizi

CopyLeft 2002-2008 Elvin K. Wyly
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Images courtesy and copyright Kathe Newman, March 2008.
Defaults, foreclosures, and "vulture-investor" advertisements in Newark, New Jersey, February and March, 2008.
Subprime Goes Prime Time

America's long-running boom in subprime mortgages met its catastrophic end in 2007.  For years, an interdisciplinary group of scholars, attorneys, and activists diagnosed the gathering dangers in the sector, which is designed to provide high-cost, high-risk credit to low-income consumers and others with poor credit histories (Carr and Kolluri 2001; Engel and McCoy 2002; Mansfield 2000; Renuart 2004; Squires 1992, 2003, 2004).  It is universally recognized, by analysts across the political spectrum, that subprime lending is disproportionately concentrated among racial and ethnic minority individuals and neighborhoods.  For more than a decade, progressives have documented the proliferation of ever more aggressive tactics of deception, fraud, and legal-yet-abusive practices in the subprime market, and advocates sought regulatory reforms to combat the syndrome of racially discriminatory and "predatory" lending (Engel and McCoy 2002; HUD-Treasury Joint Task Force 2000).  Yet conservatives have applauded subprime lending as a case of benevolent, risk-based pricing, and have subverted nearly all reform efforts by appealing to the American ideology of consumer sovereignty:  if a consumer wishes to borrow money, and a bank is willing to lend, how could that possibly be bad or predatory?  Progressives' answers to this simple question were detailed, rigorous, precise, and thus easily ignored amidst a national credit binge fueled by falling interest rates and rising home prices. 

But if it was easy to ignore the complaints of scholars and advocates for working-class families and communities of color, it would prove more difficult to brush aside the concerns of the armada of securities analysts and bond traders working to protect the interests of capital.  Most American home loans are securitized almost immediately:  banks and mortgage companies make loans, then sell the obligations (and sometimes the 'servicing' rights) to investors in return for a fresh infusion of capital that can be used to make more loans.  In the conventional, prime market, loans are typically sold to one of the giant Government Sponsored Enterprises (GSEs), Fannie Mae or Freddie Mac; but the subprime market is dominated by private trusts and Special-Purpose Vehicles (SPVs) that acquire loans, pool them into packages of Mortgage-Backed Securities (MBSs) that are underwritten by Wall Street investment banks.  MBS shares are often held by national banks' off-balance sheet Structured Investment Vehicles (SIVs), and are also traded in various risk categories ('tranches') to individual and institutional investors on Wall Street and other global financial markets.  Since the mid-1990s, the specialized field that spawned all these acronyms - structured finance - seemed to have achieved financial alchemy, packaging individually risky subprime loans into high-yield MBSs that scored the highest, triple-A grades from bond-rating agencies (Dymski 2007; Engel and McCoy 2007; Fabozzi 2001; Peterson 2007).  In a climate of steadily rising home values, even the most egregious predatory schemes involved surprisingly low risks for investors, since borrowers who fell behind on their payments could be forced into a quick refinance -- generating new up-front fees charged against the borrower's home equity -- or into a quick distress sale to pay off the debt without entering foreclosure.  Brokers and bankers continued to enjoy healthy profits from up-front fees and charges, lenders earned healthy margins on sales to the secondary market, and once borrowers' repayment capacity or home equity was stripped bare, loan servicers would force sales to protect MBS investors from losses.  The only consistent losers were the homeowners stripped of their assets and now looking for homes to rent.

This system worked well for brokers, lenders, investment banks, bond-rating analysts, and investors.  Subprime originations mushroomed from $65 billion in 1995 to $332 billion in 2003 (Chomsisengphet and Pennington-Cross 2006: 37), and then to $625 billion in 2006 (Andrews 2007c).  These capital flows were simultaneously diffuse -- loans made in neighborhoods across America were securitized for shares sold to investors around the world -- and narrowly channeled through particular actors with specialized legal and financial expertise:  since 2000, a single Wall Street law firm, McKee Nelson, helped investment banks prepare securities filings for more than three thousand MBS deals worth some $2.7 trillion (Browning 2008).  Brokers and lenders became ever more aggressive in searching for borrowers who could be coaxed, cajoled, or simply tricked into taking out a loan to do home repairs, to pay off credit card or medical debts, or to refinance a previous mortgage.  Finally, though, in late 2006 the cadres of Wall Street analysts glimpsed the limits to subprime capital, as innovative aggression and competition had accelerated even after home prices had stalled in the previous year.  Speeds accelerated for delinquencies, defaults, and foreclosures.  The cohort of loans made in the fourth quarter of 2006 fell behind on payments within months, a pace faster than analysts had ever seen.  In early February, 2007, the upscale British banking empire HSBC issued an "unprecedented profit warning" (Tam 2007) thanks to the troubles of its notorious U.S. based subprime subsidiary -- a unit acquired five years earlier in a move that shocked the business press for the potential to stain an otherwise "squeaky clean," very "Presbyterian" reputation (Sorkin 2002).  HSBC struggled to reassure anxious investors by emphasizing that the trouble was confined to U.S. operations, and even more narrowly limited to the faster-than-expected defaults of subprime loans issued only a few months earlier.  This was not the most reassuring message for bond traders already nervous after former Federal Reserve Chairman Alan Greenspan had used the word "recession" in a private chat by satellite with Hong Kong investors (Andrews 2007a) and after rumors of a Chinese government crackdown on debt-financed stock purchases bled nine percent off the Shanghai index on February 27.  When the Dow fell 415 points the next day, Wall Street analysts quickly blamed the troubles in America's subprime mortgage sector.  The once-obscure "subprime" suddenly became a fixture of front-page, above-the-fold coverage of investor anxieties spreading around the globe.  At first, bankers and officials expressed faith that the damage was contained:  in March and again in May, the new Fed Chairman Ben Bernanke reassured Congress that the subprime crisis would not bleed into the broader economy (Andrews 2007a, 2007c), an assurance that he repeated for several months until the spreading disaster undermined his own confidence in the mortgage industry's practices (see Bernanke 2007:  2-4).  One investment strategist offered an early warning of unknown unknowns:  "It is impossible to get a number" on investment banks' subprime vulnerability, "...And I don't think they even know" (Anderson and Bajaj 2007:  C1).  Stock-index gyrations mesmerized the business press for months as the phrases "global credit crisis" and "subprime mortgages" fused together in the lead paragraphs of hundreds of stories explaining the finer points of structured finance -- MBS yields, risk tranches and 'mezzanine' securities, collateralized debt obligations (CDOs), and CDOs of CDOs (known among the literati of structured finance as CDO-squared).  Front-page news coverage also introduced a broad new audience to the detailed terminology -- long familiar to researchers, attorneys, and community activists -- of subprime industry practices used in so many low-income and racial minority communities:  prepayment penalties, penalty interest rates, yield-spread premiums, balloon payments, flipping, stripping, negative amortization, hybrid adjustable-rate mortgages (aptly dubbed HARMs), and the especially creative mortgage marketed as the NINJA loan (no income, no job or assets) (Perlstein 2007; see also Renuart 2004).

The situation worsened after November, 2007.  At high-level economic talks in Xianghe, Chinese officials told their American counterparts that "the subprime mortgage crisis that has shaken the U.S. economy and the weakening dollar are as much a problem for the global economy as Chinese exchange rates."  (Cha 2007).  "Tables Turned:  Poor Countries Wag Fingers at Rich Ones."  (Weisman 2007).  The OECD cautioned that the $50 billion in U.S. mortgage writedowns announced by financial institutions up to that point was only the beginning, and estimated that total losses could reach $300 billion (Dougherty 2007).  Beginning in late November, 2007, corporate earnings reports delivered a machine-gun barrage to market confidence, as investors and analysts realized the impossibility of assigning meaningful values to the intricate MBS shares, CDOs, and credit default swaps manufactured by the industry of promises and commitments among financial institutions:  as fourth-quarter results trickled in, the top of the heap of the writedown wreckage included Bank of America ($7.9 billion), Morgan Stanley (9.4), HSBC (10.7), UBS (18.4), Citigroup (22.1), and Merrill Lynch (24.5) (Bloomberg 2008:  C6).   The Fed joined forces with central banks in Canada and Europe to infuse $64 billion in short-term credit in an attempt to encourage lenders to trust one another again; markets rallied a bit when the European Central Bank raised the stakes with a full half a trillion dollars to ease liquidity shortages during the holiday, although the Governor of the Bank of England "conceded ... that the central banks, despite their ability to manufacture unlimited amounts of cash, are reaching the limits of their ability to ease the five-month old credit crisis."  (Dougherty 2007b:  C5).  Bargain-shopping began.  Countrywide Financial, the nation's largest mortgage lender in the previous year, was gobbled up by Bank of America at a steep discount.  Bear Stearns got a $1 billion infusion from China's state-controlled Citic Securities, Citigroup sold parts of itself to raise $7.5 billion from the Abu Dhabi Investment Authority, and weeks later $12.5 billion from the Kuwait Investment Authority, the Singapore Investment Corporation, and several other investors.  Merrill Lynch raised $6.6 billion from the Kuwait Investment Authority, the Korean Investment Corporation, and others, while UBS sold a ten-percent stake to the Singapore Investment Corporation and anonymous investors from the Middle East.  Morgan Stanley secured $5 billion for a 9.9 percent stake by the China Investment Corporation.  The Chief Financial Correspondent of the New York Times dryly observed that "The financial market crisis of 2007 may be remembered as the beginning of the nationalization of a large part of the financial system" (Norris 2007:  C1) -- in truth, a transnationalization, or what former Treasury Secretary Lawrence Summers dubbed "cross-border nationalization," driven by sovereign wealth funds scouring the wreckage of the American banking system for buying opportunities.

Market Imperfections and the Flat Subprime World

Amidst the disorienting worldwide maelstrom of business-press coverage, it is easy to overlook two foundational axioms that have framed mainstream discussion and public policy; these assumptions are the focus of our analysis.  First, the collapse of subprime securitization is assumed to result from regrettable but unpredictable mistakes and "market imperfections" (Federal Reserve 2007:  14) in the complex financial instruments connecting subprime borrowers to transnational capital markets.  Everyone has been hurt, the argument goes, in the "chain of misery" (Landler 2007) that stretches from inner-city homeowners facing foreclosure, to suddenly-unemployed mortgage brokers, bankrupt mortgage companies, depositors in British and German banks, investment bankers liquidating hedge funds with subprime exposure, individual investors holding bank stocks now shunned as "subprime slime" (Henderson 2007), and all the way to residents of tiny Narvik, Norway, who face deep budget cuts after municipal investments lost at least $64 million in complex securities backed by American subprime loans (Landler 2007).  These are unusual circumstances, the axiom holds, but there is nothing fundamentally wrong with the innovations of subprime lending or structured finance.  These innovations of "risk-based pricing," the argument goes, had finally solved the credit rationing problems of exclusion and racial redlining -- thus expanding access to credit and the American Dream of homeownership for low-income and minority families (for the clearest summary of this view, see Litan 2001).  The subprime boom just went too far, the industry's defenders claim, because brokers and lenders tried to help too many consumers who were more than willing to borrow beyond their means.  Put simply:  mistakes were made, borrowers must accept their share of responsibility, and the market must be allowed to adjust with the absolute minimum degree of public intervention. 

The second axiom holds that geography is empirically interesting but theoretically irrelevant.  To be sure, the subprime boom has etched out intricate urban and regional patterns; even the most conservative major newspaper in America, the Wall Street Journal, compiled detailed rankings and maps of "The United States of Subprime" (Brooks and Ford 2007), and published an in-depth analysis of billions of dollars of subprime capital "injected" into a middle-class Black neighborhood in Detroit (Whitehouse, 2007).  But these patterns are almost always understood as nothing more than the result of demand-side factors -- the needs, preferences, qualifications, or education of homeowners and homebuyers, or the distinctive circumstances of particular places.  Yes, conservatives acknowledge, places like Detroit are drowning in waves of foreclosures after years of subprime market penetration; but this is simply because Detroit is a special (basket) case, where consumers would be entirely excluded from credit were it not for the opportunities of subprime loans.  From day to day, the geographical details of this narrative change:  'ground zero' of the nation's crisis is Ohio's rustbelt Youngstown, Cleveland, and Akron (Birchall 2007), or Stockton, California (China Daily News 2007), California's Riverside County (Brenoff 2007) or Memphis, Tennessee (Ferguson 2007).  But the logic remains the same.  The spatiality of subprime credit is assumed to be a Pareto-optimal response to the geography of demand among consumers unable or unwilling to meet the standards for the prime market.  Put simply, after controlling for consumer qualifications, the subprime world is flat (cf. Friedman 2007).

In the rest of this paper, we provide a challenge and an alternative to these two foundational axioms.  Subprime lending exploits the legal and regulatory loopholes justified by risk-based pricing in order to provide opportunities to realize class-monopoly rent.  Even after accounting for the qualifications and risk profiles of borrowers, subprime America is anything but flat:  credit flows etch out intricate urban and regional geographies of class-monopoly rent that are rooted in generations of racialized inequalities currently being redrawn by immigration and regional economic change.  Our story unfolds in five parts.  First, we review the theories of credit rationing and risk-based pricing, which provide the dominant economic and policy explanations for the subprime boom and its associated racial-geographical disparities.  Second, we explain how contemporary inequalities in the subprime market should be understood not as market "imperfections," but as latter-day incarnations of Harvey's (1974) class-monopoly rent.  Third, we describe a protocol for measuring and mapping the racial and class dimensions of class-monopoly rent.  Fourth, we use this protocol to map the geography of the subprime boom at its peak (2004-2006) across several hundred metropolitan areas in the U.S.; we use several approaches to test whether variations in market penetration simply mirror borrower qualifications (as predicted by risk-based pricing), or reflect more systematic inequalities (as suggested by class-monopoly rent).  Finally, we map some of the new spaces being created by analysts, advocates, and attorneys in the Community Reinvestment Movement.