Housing is Local, and Lending Should Be, Too

From Five Ways of Looking at Risk.

History will recall 2005 as the year the credit bubble grew fattest--when in much of Florida and California, real-estate prices doubled in a matter of months. But in Cuyahoga County, Ohio, it was the year that nearly 12,000 homes were abandoned to foreclosure, leaving streets littered with boarded-up houses. Many of the home sales turned out to have been between speculators selling property to one another at rigged prices, using phony paperwork. Other borrowers fell prey to sub-prime refinancing that put cash in their hands but lost them their home.

At the time, Cleveland's calamity was a nonevent outside of Ohio, because the projected losses fit within the margins of investment bankers' risk models. Securities analysts wrote off the Ohio foreclosure wave as the byproduct of a declining Rust Belt economy, notwithstanding that the unemployment rate in Cleveland had been twice as high in the early 1980s. Nationwide, the foreclosure rate still stood at less than 1 percent, about as low as it had ever been.

Of course, Ohio was a harbinger of the dismal fate of the rest of the nation. So why were Wall Street analysts so blind? Perhaps it's that they literally could not see the destruction their funds had wrought--they were, after all, hundreds of miles away and dependent on a few points of outdated, deeply unreliable data. And even if those who packaged, repackaged, sold, or rated mortgage-backed securities had witnessed the men carting off aluminum siding or the teenagers using windows of abandoned homes for target practice, they could still avoid the consequences of the risk. <>In a world in which capital can instantaneously leap just about anywhere, we're now learning the hard way just how dangerous it is that the sources of finance that sustain home-owners and their neighborhoods have no meaningful connection to those people and places. This is a hazard that now looms much larger than the mortgage market. The supplanting of local economies with global ones, no matter the product, amplifies whatever risks already exist.

This challenge has already been painfully clear in the business of growing and processing food, in which a rogue peanut-processing plant in Georgia infects supermarket shelves nationwide and effluvia from factory farms poisons communities far from where the pork or poultry will be consumed. The sustainable-food movement has a word for its response: "locavore," a person who consumes food that is grown or processed nearby. Locavores do much more than limit the fuel consumption and climate impacts that ensue when tons of food get hauled all over the planet. They also seek to create a sustainable and safe system that ties producers and consumers together in a mutually beneficial ecological and economic pact.

The current machinery of mortgage making not only fails to encourage local connections between creditor and debtor, financial institution and community; by design it prevents such links. Investment banks are shielded from legal liability for harmful acts committed by the lenders whose mortgages they bought. They're further armored by the terms of the securities pools they helped assemble, which command lenders to buy back any loans whose underwriting turned out not to be up to the pools' declared standards.

Yet more than a legal and financial construct, evasion of responsibility looms as a social, political, and moral reality. Those who created and traded in the securities trusts were not players with any stake in the communities in which these loans were made. They could not be subject to boycotts, or concerned about status as a good corporate citizen, or care about what the local paper or blogger might write, or even harbor fond memories of a neighborhood's high school football team. Indeed, the mortgage-backed-securities pools themselves existed only as creatures of the law, without a single identifiable face or place of business. In business jargon, they lacked "reputational risk."

Real estate is unlike any other commodity, because its value is tied to its relationship to the community in which it sits. Until the last three decades, the financial institutions that funded the majority of home mortgages had deep connections to the places where they operated. They were savings and loan institutions, which before they turned into capital-pillaging machines in the Reagan revolution were descendants of a 19th-century financial self-help movement. S&Ls funded mortgages out of their cash deposits, and when they had more demand for loans than their deposits could sustain, they turned to Fannie Mae (starting in the 1970s, Freddie Mac) and sold them the loans.

S&Ls' reign at the heart of the home-finance business had enormous and ultimately fatal downsides. S&Ls were egregious practitioners of "redlining," the denial of credit even to low-risk borrowers if they were perceived to live in a blighted area. (Here, the S&Ls' intimate local knowledge was unhelpful, since underwriters were susceptible to negative views of "bad" neighborhoods, driven by race and class biases.) Then, by the late 1970s, the Fed's moves to rein in inflation provoked a mini credit crisis, as high interest rates depleted S&Ls' capital.

The mortgage-backed-securities market was engineered to supplant this constrained local economy with a free global one. It was born in a collaboration between investment bankers, economic advisers to President Ronald Reagan, and Congress. They set out to channel as much investment capital as possible into the financing of real estate. In doing so, they divorced the money behind housing from the places where the real estate sits--for better in the short term but ultimately, for worse.

This isn't the first time that this basic model--generate capital in the markets, then funnel it to borrowers via street-corner mortgage brokers--has led to disastrous results. Beginning in 1970, the government-owned corporation Ginnie Mae began creating securities out of Federal Housing Administration-insured mortgages and selling them to investors. Just like sub-prime mortgages, these loans were frequently sold by predatory brokers who descended on poor urban neighborhoods, set up cash-extraction schemes, and left in their wake tens of thousands of abandoned houses. Some cities, like Detroit, were permanently scarred.

The Community Reinvestment Act of 1977 grew out of neighborhood activists' efforts to fight the twin devils of redlining and destructive FHA lending and to obligate financial institutions to "meet the credit needs of the local communities in which they are chartered." But the Wall Street mortgage-securities market emerged outside of CRA's domain. That market's colossal failure opens up a precious opportunity to combine the best of both worlds--the global reach of the capital markets with local stewardship and scrutiny.

Some advocates are now looking to extend CRA to cover a much wider range of financial activity, making it possible for community leaders to push back against patterns of discrimination in lending practices. The resurgent role of Fannie Mae, Freddie Mac, and Ginnie Mae at the heart of the mortgage-securities market opens an opportunity for those agencies to build local responsibility right into the transactions, through qualification standards for lenders seeking to have their mortgages purchased by the pools, and penalties for irresponsible behavior by lenders' sales agents. Philanthropist George Soros and others have proposed adopting a Danish-style system in which bondholders and homeowners share identical risks. That holds promise, but one way to enforce it is to require that the bond be held by a local issuing institution, which, as a civic body, has a special stake in making sure that a loan performs and brings value to borrower and community alike.

Such civic banks already exist--they're community-development financial institutions, or CDFIs, chartered by the Department of the Treasury to serve neighborhoods and borrowers whose financing needs aren't adequately met by conventional banks. It is these lower-income borrowers who ended up turning in droves to sub-prime loans and their neighborhoods that have been the most devastated. CDFIs were powerless to compete with the flood of Wall Street-sponsored sub-prime products and the mortgage brokers hustling to sell them, but now that the mortgage-finance system is largely run by Washington, not Wall Street, CDFIs-which include credit unions and community banks--can play an essential role as a partner to Fannie Mae and other government-administered mortgage-finance agencies charged with keeping mortgage funds flowing to borrowers.

Lenders that wish to sell relatively high-risk mortgages to Fannie Mae or Freddie Mac could be required to first sell the loan or a stake in it to a CDFI. That idea has already been put to the test in a successful and carefully studied experiment. Beginning a decade ago, the Center for Community Self-Help, a CDFI in Durham, North Carolina, collaborated with Fannie Mae and the Ford Foundation to buy from other financial institutions $2 billion in mortgages for high-risk, predominantly low-income homebuyers, about one-third of them from North Carolina, and then made sure those loans performed through careful underwriting standards and follow-up counseling in the event borrowers ran into trouble (only a relatively small number failed, usually because they elected to refinance with cash-back mortgages from other lenders).

Self-Help's national model can work just as well on a local or regional level. It's time for "locavore" to be a principle that applies not just to the production and consumption of apples and milk but also to the financial system by which communities live or die.

Next: A Strong Safety Net Encourages Healthy Risk-Taking

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