The Credit Crunch: It's Not a Subprime Problem

On August 31, George W. Bush captured the essence of the credit debacle in a speech that addressed why many homeowners are facing the real possibility of foreclosure. In uncharacteristic fashion, he delved into the details of global markets and securities; he provided nuances about overly optimistic assumptions and future performances.

As soon as his speech ended, the television talking heads immediately commented that it was nice of the president to provide a mini-seminar on the mortgage industry . . . if only we understood it -- chuckle, chuckle.

Then they quickly reverted to the standard argument that our current credit crunch is due to one factor and one factor only: subprime mortgages that were given to poor people with bad credit. But this time President Bush got it right.

Defining our credit rupture as a subprime problem conjures up images of a mysterious, irresponsible underclass, screwing up while all the conscientious people suffer as a consequence of their mistakes. Nothing could be further from the truth. Our problem lies in adjustable rate mortgages, which were accurately explained by the president. These loans "start out with a very low interest rate and then reset to a higher rate after a few years." Most adjustable rate mortgages, also called ARMs, were pushed by unscrupulous financial institutions.

According to University of Michigan economist Mark Perry, only 5 percent of financed homes have subprime adjustable rate mortgages while other adjustable rate mortgages make up 24 percent. And a study released in March by financial services giant Credit Suisse, reveals the average dollar value of adjustable rate mortgages from 2004 to 2006 ranged between $289,000 and $583,000, while the averages for subprimes was under $200,000. Thus, a far larger percentage of our mortgage debt is tied up in loans that are not subprime.

The crux of our credit crisis lies with four key factors:

1. Adjustable rate mortgages issued to all classes of buyers, including prime and jumbo (any loan over $417,000) loans.
2. Wall Street investment banks -- Goldman Sachs, Morgan Stanley, and others -- where lucrative fees were generated for underwriting loans with knowledge of relaxed standards applied to every type of mortgage.
3. Hedge funds that fueled market excesses by gobbling up these risky investments.
4. Lenders who incentivized mortgage professionals to push risk-intense loans by paying higher commissions. Wells Fargo, CitiMortgage, and Washington Mutual rank among the highest volume lenders of adjustable rate mortgages across all classes loans.

Beginning in 2003, as interest rates dipped to record lows and continuing into 2007 as interest rates spiked, questionable lending practices were the norm for the majority of the country's largest banks. Their actions were supported by the most prominent investment banks and hedge funds, which sugarcoated the investment risk by purchasing the loans. Then dramatic elevations of delinquencies across all loan classes during 2006 presented early warning signs ignored by government regulators.

While some borrowers went looking for an adjustable rate mortgage as a low payment entry into a home purchase, most homeowners were enticed into them by trusted loan officers or mortgage brokers. This credit meltdown does not belong on the backs of some imagined downtrodden group, disparagingly referred to as "subprime." Responsibility and consequences for business policies need to be placed on the financial institutions that reaped profits from widespread suspect lending practices.

At the time of this writing, there is a chorus of "Let the markets fix it," echoing throughout the financial community. It was the financial market that created this mess, while investigators, regulators, and legislators did nothing to stop the impending mayhem.

In addition to a sinking housing market and increased mortgage interest rates, most sources of consumer and business financing will be affected by this credit disaster. Our credit card interest, fees, limits, and grace periods will change to lower lenders' risk; automobile financing rates will rise; business loans -- from capital equipment for a small company to leveraged buyouts of corporations -- will become more difficult to secure as financial institutions restrict risk; and more stringent limitations on consumer credit usage mean credit ratings will diminish more easily.

Millions of consumers and business owners, few of whom had any involvement with this widespread economic destruction, must bear the burdens it delivers. The financial industry needs oversight now to prevent future devastation. It is time for investigators, regulators, and legislators to protect the public from the greed of a few at the expense of many.