Rutgers Model Congress
Delegation: California Democrat
Committee: Senate Banking, Housing, and Urban Affairs
Topic: Subprime Mortgage Crisis
Delegate: Jonathan C. Chen
EAST BRUNSWICK HIGH SCHOOL
The dramatic increase of subprime mortgages is due in part to liberal lending between
2004 and 2006 (“What is a...” 1). By 2005, one in five mortgages was subprime, penetrating far
into inner-city areas across the United States (“The Downturn in…” 3). When people began to
default on payments, the housing market crashed, seeing the worst slump in 16 years
(“Responding to the Foreclosure Crisis” 1). The increased lending by banks and inability of
many lower class citizens to pay exorbitant interest rates has led to numerous foreclosures. Thus
California believes that in order to solve this subprime mortgage crisis, there must be increased
regulation when it comes to subprime lending.
In the past, banks paid for mortgage lending with deposit money from their customers.
As long as the people who owed money paid it back, the system worked. For people who were
not able to secure “prime” mortgages due to credit histories below 600, the subprime mortgage
was their best bet if they wanted money for a house (“What is a…” 1). For two years, the
payments would be fixed on these subprime mortgages. Afterwards, the rate would become
much higher and dependent on Federal interest rates, making these mortgages adjustable rate
mortgages (ARMs) (“The Downturn in…” 1). In order to make a profit, lenders had to charge
interest rates above prime to make up for the additional risk and high possibility of loss (1).
Often within 2-3 years, the interest rate would increase from the extremely low “teaser rate” to
26-45% more than what they were originally paying. This occurs even if LIBOR rates, which
ARMs are tied to, remained steady (Mortgage Secuitization” 3). The high-risk involved led to
one in ten homes being repossessed in the sub-prime capital of America, Cleveland. Nearly two
million families will be evicted as a result of not being able to afford the payments (“The
Downturn in…” 2).
With many subprime mortgages, mortgages are sold to bond markets after being pooled
together. This is not necessarily a bad thing, seeing that it funds additional borrowing, generates
capital, and spreads risk more broadly (Kroszner 1). Securitization, as this process is called,
increases liquidity and funding, because it reduces risks and efficiently allocates it (“FRBSF
Economic Letter” 2). Securitization means that no one holds on to risk. The investors not the
banks would be the ones who had long-term risks associated with these mortgages. Brokers
wiped their hands of the problem in 5-6 weeks, and banks in 8-10, leaving the investor to bear
the brunt of the problem (“Roots of the Crisis” 2). The major problem is that no one really
looked at the mortgages within the security. Ratings agencies would rate them, and give
complex mathematical models, with the end result being that no one knew whether or not the
mortgages were “actually affordable and sustainable” (1).
California strongly believes that there must be revisions in the loan approval process. In
order to stop irresponsible lending, the borrower must be educated about the loans that they are
about to take. If borrowers make educated decisions, then they would realize that many of these
ARMs only look good on the surface, carrying hidden costs underneath. Thus, banks should be
forced to consider the borrower’s ability to repay more carefully when approving loans (“The
Subprime Mortgage Crisis” 1). The Subprime Mortgage crisis affects everyone, and because
California is the epicenter of the crisis, it is definitely feeling the effects. Nearly 500,000
families in California will lose their houses to forclosure. This costs neighbors $67 billion, $30
billion in Los Angeles County alone (“The Subprime Mortgage Crisis: California…” 1).
The Democratic Party fully supports foreclosure prevention programs that help at-risk
homeowners. With more than 40% of home loans to Hispanic and African American borrowers
being subprime in 2006, minority groups have been devastated by the housing crisis. The
Democratic Party fully recognizes that in order to prevent another housing crisis, industry
standards must be increased. The party promises to pass a Homebuyers Bill of rights, ensuring
new lending standards for affordable and fair loans. Most importantly, Democrats are pressing
hrad to quickly implement the foreclosure prevention program enacted in Congress, which would
help prevent at-risk homeowners from evicted. The Democratic Party demands transparency the
financial institutions, and wants fair competition. By “reforming and modernizing regulatory
structures,” another housing crisis can be averted (“Renewing America’s Promise” 27).
President Obama announced the Homeowner Affordability and Stability Plan on February 17,
2009. Its main purpose is to refinance and prevent imminent foreclosure among 7-9 million
families (“Responding to the Foreclosure Crisis” 1). Democrats have not forgotten their
constituents and will work tirelessly to prevent the subprime mortgage crisis from occurring
again.
In order to deal with the root of the problem, the government must first address the
pressing situation. With millions of people at risk for foreclosure, the government must first step
in to help homeowners. A one-time tax break or credit towards their mortgage payments would
stave off foreclosure, as would the government stepping in to directly buy troubled mortgages
and writing them down. This could be paid for with a future tax on financial firms after an
industry rebound. Also, the government has the right and should step in to force banks to
renegotiate mortgages on terms that homeowners can afford. Most importantly, the interest rate
must be lowered, and if possible changing ARMs into long-term fixed-rate loans (Dreir 1). This
way, the bank has a long-term interest in the well-being of the borrower, rather than a short-term
interest in profit. A prime example of this is when the FDIC seized IndyMac and refinanced the
subprime loans, making them affordable to borrowers. This saves money, seeing that there are
no immediate losses of money, and there is still potential for the borrowers to pay back the
money with interest (“The FDIC Refinancing…” 1).
An alternative to this idea would address the steadily falling house-prices. Because many
people obtained mortgages at the height of the housing bubble, their mortgages are now worth
more than their house. It then becomes practical to default in order to escape negative equity,
when your collateral is worth less than the loan. The government should step in here and
mandate that if a house’s value falls a certain percentage, then the borrower and lender should
automatically revise the terms of the loan. A sizable decrease in value means that the lender has
no reason to be offering extra money to pay for a house that is not worth nearly as much as the
borrower applied for. Another solution would be to create mortgage-replacement loans, where
the government provides low-interest loans to mortgage holders, worth a percentage of their
outstanding debt (“A Helping Hand…” 1). In order for any solution to be deemed successful, it
must prevent borrowers from defaulting. Whenever a borrower defaults, money is lost, seeing
that the collateral the bank can seize is not worth as much as the mortgage itself. It is in the best
interest of lenders to do everything they can to prevent people from walking away from loans, so
that they can recoup their losses and hopefully turn a profit. The credit crisis will not go away
until “the incentive for borrowers to default is addressed” (2). Another potential solution is to
use a cram down approach. This method changes the law so that bankruptcy judges can reduce
loan amounts or interest rates on your primary residence. For far too long, Washington
loopholes have allowed the rich to get richer, but if the 1978 bankruptcy law preventing judges
from changing mortgage terms on your main residence is repealed, the people will benefit
greatly (Dreier 2). After addressing the root of the problem, prevention measures must be taken.
Regulation must be increased in order to strengthen oversight over banks, mutual funds,
and large financial institutions. The collapse of these puts the whole economy in danger, as seen
with AIG, Citigroup, Bank of America, and Fannie Mae and Freddie Mac. These bailouts cost
billions of dollars and are “an enormous problem” says Federal Reserve Chariman Bernanke
(“Bernanke Says Regulatory…” 2). Bernanke and Treastury Secretary Timothy Geithner both
agree that a regulatory overhaul should cover a number of areas. First and foremost, the
government must prevent “too big to fail” companies from taking too much risk by subjecting
them to more supervision. The government would also need to regulate all financial trading,
especially instruments like credit default swaps, which were a major cause of the economic
meltdown. A major point that Bernanke and Geithner stressed was the necessity of the creation
of an authority whose purpose would be to regulate risk especially within the biggest institutions.
Geithner is clear when he states that, “he days when a major insurance company could bet the
house on credit default swaps with no one watching and no credible backing to protect the
company or taxpayers must end” (“US Proposes Major…” 1). Regulation of credit default
swaps, a $60 trillion global market, would ensure the global economy, as well as the US’s
economy, against default. They are responsible for the fall of Lehman Brothers and AIG (2).
As one can see, there are many ways to solve the current economic crisis. The rampant
use of unfair subprime mortgages has put millions of American families at risk. The government
must step in to prevent foreclosure and eviction, because it is much more cost-effective to
prevent defaulting. Banks need to be proactive in renegotiating loan terms with borrowers,
especially when negative equity becomes a problem. The solutions that have been proposed
present a two-step approach to the problem. The US must first prevent foreclosure through any
method it sees fit. Whether it be forcing renegotiation of loan terms or the writing down of
loans, the US must do everything in its power to stop foreclosure. After the threat of eviction is
dealt with sufficiently, the government can turn its attention towards regulating the financial
institutions. The dearth of regulation allowed the economic climate to deteriorate to this point.
In order to prevent this from ever happening again, the government must be more strict when it
comes to regulating financial institutions. They cannot just get away with making exorbitant
profit and passing the risk on. They must take responsibility for their actions and recognize that
their financial well-being should be tied to the long-term interests of their borrowers. Although
the subprime mortgage crisis may be bad, it is not impossible so solve and deal with.
Works Consulted
“A Helping Hand to Homeowners.” The Economist. 23 October 2008. Online. Internet.
1 April
2009.
“Bernanke Says Regulatory Overhaul Needed.” CNBC. 10 March 2009. Online. Internet.
1 April 2009.
Chomsisengphet, Souphala, and Anthony Pennington-Cross. “The Evolution of the Subprime
Mortgage Market.” St. Louis Federal Reserve Bank. Online. Internet.
3 April 2009.
Costello, Miles, and Rhys Blakely. “Bush and Bernanke Set to Bailout Homeowners.” Times
Online. 31 August 2007. Online. Internet.
3 April 2009.
Dreier, Peter. “How to Fix the Mortgage Mess 101.” The Huffington Post. 30 September 2008.
Online. Internet. 2 April 2009.
Gramm-Leach-Bliley Act. 106th Congress. November 12, 1999. Online. Internet.
3 April 2009.
Kroszner, Randall S. “The Challenges Facing Subprime Mortgage Borrowers.” Board of
Governors of the Federal Reserve System. 5 November 2007. Online. Internet.
2 April
2009.
Laderman, Elizabeth. “FRBSF Economic Letter.” Federal Reserve Bank of San Francisco. 28
December 2001. Online. Internet.
2
April 2009.
“Mortgage Securitization.” Econbrowser. 11 January 2008. Online. Internet.
1 April 2009.
“Renewing America’s Promise.” 2008 Democratic National Platform. 25 August 2008.
Online. Internet. 3 April 2009.
“Responding to the Foreclosure Crisis.” Speaker Nancy Pelosi. Online. Intenret.
1 April 2009.
“The FDIC Refinancing Bad IndyMac Mortgages.” Interest.com. Online. Internet. 2 April
2009.
“US Proposes Major Shift in Regulations to Rein in Financial Industry, Prevent Future Crisis.”
Daily News. 26 March 2009. Online. Internet.
3 April 2009.
“What is a Subprime Mortgage?” Investopedia. Online. Internet.
2 April 2009.