The Financial Crisis of 2007-2010. The household debt bubble

Lucian Dronca

In a speech following the September 11, 2001, terrorist attacks and in the midst of

the accompanying U.S. recession, Federal Reserve Chairman Alan Greenspan made a

declaration that turned the world of the investment bankers upside down. Greenspan

declared that the FOMC (Federal Open Markets Committee) stood prepared to maintain a

highly accommodative policy stance for as long as needed to promote satisfactory

economic performance.

Translated from central banker speak, what Greenspan meant is that he is willing

to inflate the money supply and hence lower interest rates for as long as necessary to

“revive” the economy and repair it from the shock it received on that fateful day. What

this meant for investors in the U.S. Treasury bond market is that they were not going to

make any money on U.S. treasury securities for a very long time. Smart investors, diverted

from the bond market, scanned Wall Street for a similar low-risk, high-return investment

that could take the place of U.S. Treasury securities, and they fell in love with

residential mortgages.

On September 18, 2008, after months of economic anxiety and several massive

bailouts of distressed firms by the government, the stock market had its largest single-day

drop since September 11, 2001. Officials and commentators declared an economic

emergency and moved on two fronts. The Department of the Treasury and Federal

Reserve Board ("Fed") dusted off a 1932 statute and invoked the Fed's authority to

stabilize failing firms by lending them money, although some were allowed to fail.

As is always the case in financial crises, the government faced a dilemma. If it let

firms fail, they would be appropriately punished for their excessively risky investments.

But they would also bring down other firms, with the result that credit would dry up, and

economic activity would be stifled. The initial response was a series of ad hoc transactions

and measures designed to prop up failing firms, the so-called "regulation by deal." After

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some hesitation, Lehman Brothers was allowed to fail, with disastrous short-term

consequences because so many other firms had accounts with Lehman.

The Fed and other government institutions began pumping liquidity into the system

at unprecedented levels. They were apparently persuaded by the scale of the failures, the

quite obvious contagion effect, and independent evidence of a credit crunch, such as the

extremely high rate of interest that banks began to charge each other for interbank loans. It

soon became clear that a case-by-case approach would not be sufficient to address the

financial crisis.

For one thing, the financial crisis would require more resources than the Fed could

supply. On September 19, Henry Paulson, the Treasury secretary, submitted a bill to

Congress that would authorize the Treasury to borrow $700 billion and use it to purchase

mortgage-related assets. The bill provided that the secretary's purchasing decisions would

be final, and not subject to judicial review. Paulson apparently believed that by purchasing

mortgage-related assets, the government would help reduce uncertainty about banks'

balance sheets, allowing them to borrow if they turned out to be solvent.

Judicial review or other oversight would slow down this process when quick action

was essential. The boldness of the secretary's bill initially produced an enthusiastic

reaction, and the financial markets rose, but quickly the reception turned sour. Critics

argued that the bill was a "blank check" that gave the Treasury too much discretion and

subjected it to too little oversight; that the bill favored the rich, the investment banks, their

managers, their shareholders, at the expense of the taxpayer, while providing no relief to

distressed homeowners; and that Secretary Paulson, with the support of Fed Chairman Ben

Bernanke, sought to stampede Congress into action by holding out dire consequences if

inaction occurred, rather than acknowledging that Congress should hold hearings, solicit

the advice of independent experts, and deliberate.

House leaders of both parties with the support of Paulson, President George W.

Bush, and both candidates for the presidency greatly expanded the Paulson bill, partly in

response to these criticisms, but on September 29, the House voted down the revised

version by a vote of 228 to 205. The stock market crashed, with the Dow Jones Index

falling by 778 points. Senate leaders promptly took up the bill and overwhelmingly passed

a revised version on October 1. The Senate version largely retained the provisions of the

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House bill but added numerous, mostly unrelated provisions designed to appeal to the

marginal dissenters.

On October 3, this bill passed the House and was signed by the president. The

Emergency Economic Stabilization Act differed from the Paulson bill in numerous ways.

But most importantly, it did not reduce Treasury's power to purchase mortgage-related

securities; in fact, it expanded Treasury's power, authorizing it to purchase virtually any

security when doing so could help resolve the financial crisis.

Even before Treasury put into operation its plan to purchase mortgage-related

assets, it became clear that this approach would not be adequate, and Treasury announced

that it would inject equity directly into financial institutions by buying preferred stock, as

the Fed did with the American International Group (AIG). Indeed, Treasury later

announced that it would not use Troubled Asset Relief Program (TARP) funds to purchase

troubled assets at all, and would rely solely on equity purchases.

The White House, for its part, tried and failed to obtain a bill giving Treasury

specific statutory authority to prop up faltering automakers that offer credit as an adjunct

to their main operations. Despite the failure, Treasury used Troubled Asset Relief Program

funds to bail out the automakers in December 2008 and January 2009, relying on the broad

definition of "financial institution" in the Emergency Economic Stabilization Act.

Meanwhile, the Fed was increasing the money supply, buying up commercial paper, and

purchasing other assets that it traditionally left to the private markets.

The Obama administration followed the lead of the Bush administration in broad

outline, with small differences in emphasis, including greater attention to foreclosure

relief. Its major accomplishment in its first months was the enactment of a stimulus bill

that sought to address the underlying economic crisis. In a twist, on February 10, 2009, the

new secretary of the Treasury, Timothy Geithner, announced a new plan for using the

remaining $350 billion or so of Troubled Asset Relief Program funds. In addition to

measures for mortgage relief and further capital injections to banks, the secretary indicated

that Treasury would, in part, revive the idea of purchasing toxic assets. This time around,

however, the strategy would take the form of a joint public-private venture to buy the

assets, rather than direct government transactions.

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The Federal Reserve’s credit expansion to counteract the recession of 2001 was the

factor which provided the monetary fuel for the unsustainable financing of residential

mortgages. In 2001, for instance, Greenspan lowered the federal funds rate from 6.25

percent to 1.75 percent and by the middle of 2003, the federal funds rate had been lowered

even further to 1 percent, where it was kept until mid-2004. With interest rates at record

low levels, droves of Americans found it advantageous to borrow money. The housing

market swelled, and the housing bubble was created.

Housing is heterogeneous and prices are hard to measure. The concept of a market

price in the housing market is slippery, because every home is at least slightly different

from every other. An individual home is a unique combination of both structural and

neighborhood characteristics. The purchase of a home involves buying a bundle of

attributes: living space, heating and other systems, usually a parcel of land of some

dimension, a view, a number of rooms, various structural features (fireplaces, windows,

appliances, and so on), and others. It also involves buying into a specific location with a

specific natural environment, a school system, other amenities, a set of neighbours, a

crime rate, and a tax rate. The purchased home may be of good or poor construction

quality and (unless purchased new) may have been well or poorly maintained. Homes also

differ in their degree of accessibility. All this makes it very difficult to look at a property,

compare it with other properties, and know what it is worth.

From the midpoint of 2003 to the midpoint of 2007, real estate loans at commercial

banks grew at a remarkable 12.26 percent annual rate. This led to a continuous rise in the

price of homes and condos and the construction of new housing on undeveloped land – a

large share of which was financed using Alt-A and sub-prime loans.

Subprime mortgage lending in the US went through two phases—a first boom in

the latter 1990s and a larger second boom beginning in 2002. The first boom was marked

by a surge in subprime refinance lending. Most of these loans were ‘cash-out’ loans, in

which owner equity is extracted out of the home. Many involved very high fees to brokers

and third parties, and were structured to encourage repeated refinancing over brief periods

of time. Structured residential mortgage-backed securities (RMBS) represented the

principal funding source for the first subprime lending boom. But this securitization was a

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new form—private-label securitization—where the loans were pooled and securities

issued mostly by Wall Street investment banks.

In addition to the loans for existing and new homes being financed by subprime

loans, adjustable rate mortgages (ARMs) also grew drastically in number relative to the

age-old 30 year fixed-rate mortgage. Adjustable rate mortgages made up 20 percent of the

loans extended in 2001, but by 2004 they constituted 40 percent of the total number of

housing loans made. The advantage to having an adjustable rate mortgage is that when

interest rates are low, one’s mortgage payment is correspondingly low. These mortgages

were risky, however, because there existed the chance that unscrupulous individuals who

formed certain spending habits when interest rates (hence, mortgage payments) were low

could be in for a real shock when interest rates rose. Yet, in February 2003, despite this

risk and in the face of an already incredible rate of expansion in adjustable rate mortgages,

Greenspan called for banks to increase their adjustable rate mortgages percentages.

Greenspan urged this by presenting Fed research, which showed “that homeowners could

have gained tens of thousands of dollars in the past decade if they had let the interest rates

on their mortgages move freely instead of locking them at a certain level.”

Accompanying this unprecedented plunge in interest rates and rise in adjustable-

rate mortgages of the mid-2000s were a plethora of policy and institutional changes

motivated by the bipartisan political goal of bringing home ownership to underprivileged

and minority groups without considerations of the risks or costs involved. Thus, the

subprime market was originally developed to target borrowers with low credit scores

(resulting from long-term credit problems), who did not meet income verification

requirements or who otherwise could not qualify for traditional, prime market mortgages.

Investopedia, a Forbes Media Company, defines a subprime loan as “A type of loan that is

offered at a rate above prime to individuals who do not qualify for prime rate loans.” The

U.S. Department of Housing and Urban Development, in defining subprime lending, says

that “typically, subprime loans are for persons with blemished or limited credit histories.

The loans carry a higher rate of interest than prime loans to compensate for increased

credit risk.” One type, but not the only type, of subprime loan is a home mortgage.

Because of these borrower characteristics, subprime loans carry a higher risk of

default. Thus, subprime mortgages generally have higher rates and fees than prime

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mortgages. The term “subprime” is typically used by industry practitioners to refer to a

class of mortgage loans that represent a range or continuum of high-risk characteristics.

For example, a subprime loan might refer to: a borrower with a poor credit history, such as

a FICO score below 620; a loan issued by a lender who specializes in high-cost loans; a

loan that is included in a securitized pool of loans designated by a rating agency as higher

risk; or a “subprime” product type, such as a 2/28 hybrid mortgage, which carries a fixed

rate for the first two years and then resets into a higher rate.

Subprime lending, the extension of loans to those with less-than perfect credit at

higher rates, has developed almost overnight into a multi billion dollar industry. A lack of

effective regulation made it possible for some lenders to expand their business by

engaging in predatory and abusive practices. These include negative amortization, where

payments are structured so they do not even cover interest; prepayment penalties that keep

borrowers from refinancing at lower rates; excessive fees; loan flipping, where creditors

pressure borrowers to repeatedly refinance their loans and pay additional points (often

because they cannot afford the payments on their previous loans); and asset-based lending,

where the loan is based not on the ability to repay but on the equity in one's home. The

"predatory lenders," were resorting to high-pressure sales tactics, half-truths, and outright

fraud to convince borrowers to take out subprime loans with excessive fees and exorbitant

interest rates.

Subprime lending has been a longstanding public policy concern due to its impact

on minority, low-income, seniors, and other disadvantaged groups of consumers. In

addition to being more concentrated in low-income and minority neighborhoods, evidence

suggests that subprime borrowers are less educated and less financially sophisticated than

their prime market counterparts. In fact minority borrowers were steered into subprime

loans in some cases when they might have qualified for cheaper conforming loans or those

minority borrowers were given subprime loans that had fees or rates that were too high.

There are at least three dimensions along which mortgage lenders may treat similar

groups of borrowers differently. First, as discussed in much of the literature, they may

simply refuse to offer credit at all. Second, they may steer accepted applicants into less

attractive or more costly products, like subprime loans. Finally, even at a particular time,

they may price a given product differently for different borrowers.

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Yet, statistical research show that subprime loans were less expensive in

metropolitan areas with greater past rates of house price appreciation. This finding is

consistent with the idea that lenders may have expected higher rates of future house price

appreciation in these neighborhoods and thus were willing to accept lower mortgage rates.

Such a finding can help explain why subprime mortgages were also more prevalent in

markets with high house price appreciation, although the question of whether this was due

to excessive expectations of borrowers or lenders or both can not be definitively answered.

The expansion of political measures to “encourage” greater home ownership by

means of relaxed lending standards came in large measure from new changes in the

Federal Housing Administration’s accepted loan equity standards, a drastic new expansion

of the provisions set forth in the Community Reinvestment Act (CRA), and a new mission

adopted by the corporations Fannie Mae and Freddie Mac, under the pressure of the

Department of Housing and Urban Development (HUD), to increase the availability of

loans to low and moderate income groups.

Whereas the Federal Housing Administration had for a long while required a 20

percent down payment on mortgages, the 1990s saw a steady decrease in these

requirements until they reached a mere 3 percent in 2004. These depreciating standards

were induced to help the government’s mission of increased home ownership to

underprivileged and minority groups.

Beyond lowering mortgage standards to the level that low and moderate income

groups could now qualify, such devalued loan standards started to be applied to the prime

market and the same unsound practices were extended to borrowers who could have

qualified under the traditional underwriting standards. In fact, it was typical for loan

originators to encourage home buyers to buy bigger and more luxurious houses, as their

down payment could easily be adjusted to a mutually agreed upon level. From the home

buyer’s perspective, this seemed to make some sense too because, they were told, even if

the mortgage payments became onerous, one could simply sell one’s home for a profit in

the rapidly appreciating home market. In most of these individuals’ lifetimes, home prices

had always gone up. Thus, conventional wisdom hailed, home prices could never fall.

In short, the apparent progress in 2000s is not all that it seems. It is true, the old

inequality, which denied many, as minorities, access to homeownership, has slowly

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diminished. The result has been record growth in the rates of homeownership for

minorities and other members of underserved markets. But for many of these

homeowners, a new inequality has replaced the old. This new inequality is characterized

by less desirable loan terms, exposure to predatory practices, and a lack of consumer

protection. While we might reasonably argue that the new inequality is better than the old,

we must not lose sight of the fact that it is inequality nonetheless: recent gains in

homeownership for underserved markets have come at a price. Deep structural shifts in

mortgage markets over the past two decades have greatly expanded the capital available

for residential mortgage lending and have made the goal of homeownership a reality for

many. Access to fairly priced credit, however, remains inequitably distributed.

Neighborhoods once excluded from mainstream credit markets are now sites of

exploitation as lenders take advantage of market failures caused by historic discrimination

to maximize profits. Thus where lending discrimination once determined loan officers to

reject loan applicants because of their skin color-the new model of discrimination is

financial exploitation.

At this point, one might be wondering, “How could a bank go on making such a

preponderance of bad loans without facing massive defaults?” Enter Fannie Mae and

Freddie Mac. Fannie Mae, the Federal National Mortgage Corporation, and Freddie Mac,

the Federal Home Mortgage Corporation, were Government Sponsored Entities (GSEs).

They were financial centaurs, because of the fact that they had government charters,

government missions, and government privileges, but were driven by the profit motive, as

a result of being publicly traded corporations on the New York Stock Exchange. Their

government-endowed mission was to provide liquidity to the mortgage market by

purchasing mortgages from loan originators, then repackaging these loans into Mortgage

Backed Securities (MBSs), which investors could in turn purchase. Because the American

government believed Fannie and Freddie played an especially important role in the

affordable housing mission, they endowed these GSEs with special privileges that other

companies do not legally have. Such special privileges include access to a line of credit

through the Treasury, exemption from taxes, and an exemption from registering their

securities with the U.S. Securities and Exchange Commission (SEC). Perhaps of greatest

significance to this crisis is the fact that Fannie and Freddie also were implicitly (and

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correctly) believed to be guaranteed by government (i.e., bailed out) in the event of

bankruptcy. This was extremely important to the explosive growth of the mortgage

markets. Normally cautious lenders threw caution to the wind because they could easily

unload their loans to buyers at Fannie Mae or Freddie Mac. Under such conditions, what

was the incentive on the part of banks to make careful loans?

By the end of 2007, Fannie and Freddie held about 50 percent of the entire U.S.

residential housing market, “mortgage assets of $6 trillion, but a net worth (capital)

equivalent to less than 2 percent of that sum”. This was no accident, as ex-Fannie Mae

CEO Frank Raines remarked, “these assets are so riskless, that their capital should be

under 2 percent”.

The politicians advancing the goal of affordable housing for all did more than just

use faulty logic to vigorously defend the operations of Fannie Mae and Freddie Mac, they

also played the “moral card” against skeptics who wanted to reign in Fannie and Freddie.

Playing the “moral card” had the effect of challenging and even dividing the critics of

Fannie and Freddie, since many Republicans at the time shared the moral goal of home

ownership for all, but were divided as to what extent government should encourage it.

Seeing “home ownership for all” as a moral ideal also united and invigorated defenders of

Fannie and Freddie, however.

At this point some analysts consider that despite any “good intentions,”

government intervention is what caused this crisis. From this point of view, by combining

the government’s exemption from market discipline with the aggressiveness of private-

sector management, Congress has created a financial monster. This “monster” was, as it

has been shown, not a natural development of capitalism, but a deliberate creation of

government. The Government Sponsored Entities Fannie and Freddie were “monsters”

precisely because of the severe moral hazard they posed to the economy and the public.

Because of their implicit government guarantees, Fannie and Freddie were seen by U.S.

and foreign investors as risk-free. And, being perceived as risk free, these Government

Sponsored Entities could borrow an unlimited amount of money with virtually no

questions asked. This made it possible for these Government Sponsored Entities to avoid

(for a long period of time) the mechanisms of market discipline that all other players under

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capitalism are constrained by, specifically the need to create and maintain a strong

reputation in the marketplace.

Exempted from having to answer to the SEC (Securities and Exchange

Commission) or having any other real regulations or restrictions, Fannie and Freddie were

effectively outfitted with a false reputation and armed with a blank check book, then cast

out into the economy and naively expected to behave. What Fannie Mae and Freddie Mac

predictably did instead was to go gambling in the mortgage market on the one hand and on

the other fill the wallets of their stockholders, executives, and political insiders with

borrowed funds. When asked to help target low-income and minority individuals acquire a

mortgage, Fannie and Freddie happily agreed, then simply called in loan originators and

said to them, “We’ll take anything,” engaging in further gambling and borrowing.

Meeting the increasingly arbitrary goals of Congress was almost effortless and

trouble-free for Fannie and Freddie, for they merely had to borrow money with their

privileged “flawless” credit status. Whereas a typical bureaucratized company usually

finds itself bound to comply with detailed rules and regulations fixed by the authority of a

superior body, Fannie and Freddie had no rules or regulations to answer to, other than to

make a designated amount of risky subprime purchases and repackage these as mortgage-

backed securities.

Having unlimited funds, they could have their cake and eat it too, pursuing profit

for executives and shareholders and taking significant risks and even losses for their

government benefactors. This government-created moral hazard was a condition that

Fannie and Freddie took full advantage of, growing voraciously, like a “monster on

steroids,” until they exploded, taking other institutions down with them when they

collapsed.

Consequently, certain analysts consider that no more regulation is needed, but less:

The main idea is that, today, more than fifty regulatory agencies enforce tens of thousands

of rules on individuals and businesses; the average length of the Federal Register, which

lists regulatory rules, has recently hovered around seventy-five thousand pages. Yet, no

regulatory agency was able to stop this catastrophe, one of the largest in history. No

regulatory agency was able to identify the accounting fraud perpetrated by both Fannie

and Freddie in 2003, either.

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Other authors, especially sociologists, argue that anybody who has read an

introductory sociology textbook has probably been captivated by that intuitive paradigm of

injustice, the process of “blaming the victim.” According to this perspective, we deflect

attention from the real—usually structural—causes of misery by pinning responsibility on

those individuals who suffer the problem. Because Americans favour individual

explanations over structural ones we gravitate to victim blaming. Victim blaming has been

identified in the accounts of numerous social problems ranging from poverty to rape, from

children expelled from school to medically underserved communities. Many popular

analyses of the American nation’s financial troubles are also based on blaming the victim.

Consider, for example, the accusation that U.S. automakers were pushed to the

brink of bankruptcy by the wage demands of their workers. The Wall Street Journal

encapsulated this view when it published a reader’s letter under the peculiar headline

“UAW Sociology May Bring Down Detroit”. When a $14 billion emergency bailout for

U.S. automakers collapsed in the Senate in December 2008, CBS News (2008) reported

the view that the United Auto Workers were to blame for not accepting Republican

demands for wage cuts. One economist told CBS News (2008) that the UAW President

had just been “too unrealistic and too selfish,” but others saw the failed bailout talks as just

another political effort to kill organized labor.

The Mayor of Lansing, Michigan, shared this skepticism. He thought that Congress

deserved the blame for the stalled bailout. “Why don’t we put Congress . . .on merit pay

and see what they would be making. What has their productivity been? Give me a break”

(CBS News 2008).

Although management came in for its share of criticism, the auto workers hard hit

by the recession were faulted for their success in negotiating decent wages and good

benefits in better times. Media reports repeated the bogus claim that unionized workers at

the Big 3 were earning a remarkable $73 an hour. Retiree pensions were added to the

current workers’ wages and benefits to arrive at this wildly misleading figure. Typically

unreported were the painful sacrifices that workers had already made to keep a failing

industry afloat. The UAW had agreed to cut new workers’ wages by 50 percent the

previous year and had worked out an agreement to reduce the legacy costs of retirees. In

bailout negotiations, they had offered big concessions such as suspending the “job bank”

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program that let laid-off workers continue to draw paychecks. In weeks that followed, the

President said that the workers, along with bond-holders, part suppliers, and others, would

have to do more.

Another big blame game pins responsibility for the American nation’s economic

woes on individual borrowers. With the subprime mortgage crisis, the defaulting

homebuyer came in for contempt from some quarters. Writing for the Heritage

Foundation, former Congressman Ernest Istook (R-OK) criticized those who “blame

‘predatory lenders’ while disregarding evidence that ‘predatory borrowers’ milked a faulty

mortgage system for billions”. Even an industry analysis, however, concludes that

“broker-facilitated fraud represents the most serious mortgage fraud risk to lenders”.

Homebuyers needed the collusion of brokers and appraisers to fib on their loan

applications. With an eye on their own commissions and market share, brokers did not

turn down risky loan applications. Instead, they seduced naïve borrowers with shady

lending practices and winked at overvalued houses and inflated incomes. Ironically, even

an economics reporter for the New York Times sheepishly admitted to getting caught up in

the stampede to subprime borrowing.

Of course, whether they blame the borrower or the lender, these individualistic

accounts serve mostly to obscure the real structural causes of the subprime problem.

Sensible government regulation could have kept both borrowers and lenders from the

practices that were unsustainable. For instance, because financial organizations that loaned

money could quickly sell the mortgages to others, they had no incentive to worry about the

financial viability of borrowers. Regulations could have set limits on the investment banks

that bundled sub-prime mortgages, the rating companies that pronounced the derivatives to

be safe investments, and the universities, pension funds, too-big-to-fail financial

organizations, and even nations that bought the now toxic debt. They could have reined in

the adjustable (and sometimes deceptive) mortgages with low teaser rates, which well-

meaning borrowers found themselves unable to pay or refinance in a recession.

The homeowner is only the latest American consumer to be cast as a deadbeat. In

testimony to Congress in 1999, Alan Greenspan, then Chairman of the Federal Reserve,

opined, “Personal bankruptcies are soaring because Americans have lost their sense of

shame” (USA Today 2007). Touting the Bankruptcy Abuse Prevention and Consumer

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Protection Act (BAPCPA) of 2005, Tom Delay (R-Texas), then House Majority Leader,

pointed to unethical borrowers who knew they could use lax laws to stiff the lender. “Our

bankruptcy protections, which have always been available to debtors as a last resort, have

become just another part of financial planning for too many Americans,” DeLay asserted

(Republican National Convention Blog 2005). Signing the act, George W. Bush declared,

“Too many people have abused bankruptcy laws. They’ve walked away from debts even

when they had the ability to repay them”.

Any clear-eyed assessment of family economic problems has to contend with the

fact that we live in a consumer culture. Social scientists have criticized the American

penchant for spending beyond their means. Although these accounts certainly offer a dose

of “shame-on-us,” they also serve up structural explanations for pervasive materialism—

explanations that work against victim blaming. Sophisticated marketing and omnipresent

media have introduced everyone to the allure of pricy products and luxury labels. How

many women even knew there were $500 shoes before Sex and the City introduced them

to Manolo Blahnik’s 5-inch heels? The ready availability of credit permitted Americans to

indulge—with predictable hits to their debt levels and savings rates. Americans received

six billion credit card solicitations in 2005. On American college campuses, credit card

pitches have become as much a part of freshman orientation as free pizza. Bombarded

with this assurance of their credit-worthiness, is there any wonder that Americans

succumb to borrowing? The industry they are in league with, however, has evolved to

exploit them.

Other analyses emphasize that the escalating cost of necessities such as housing

and health care—not a taste for upscale goods—has weighed heavily on personal finances.

At one time, people used credit to front-load the purchase of a big ticket item (say, a

washing machine) that they could not afford right away. Grocery stores and gas stations

did not accept American Express. Some Americans held out. They had to capitulate when

a credit card became a necessity for anyone who needed to buy an airline ticket on the

Internet. In fact, people who pay cash for airline tickets today run the risk of being profiled

as terrorists. Americans started to use credit cards to pay for discretionary purchases as

well as necessities. Aggressively marketed plastic became a way to cope with economic

adversity and to smooth out consumption when income fell. And, of course, borrowing

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became a widely acceptable means for young people to invest in a better future. More

students graduated from college with daunting debts, including unsubsidized student

loans, which swelled due to unpaid interest while the borrower was in school.

Victim blamers argue that people with credit problems have ignored the

inconvenient truth about their budgetary limits. While the siren call of big-screen TVs and

other luxury goods may be the downfall of some Americans, others use credit to buy the

children’s school clothes, pay the utilities, and maintain some semblance of a decent living

standard when they are out of work. As the author Robert Manning notes, “Offering easy

credit during periods of economic distress and uncertainty masks social and economic

crises within the privacy of Americans’ suburban castles.”

These crises are now painfully visible. Talked into an unconventional mortgage

with plans to refinance to lower payments when house values climbed, homeowners find

themselves trapped by declining equity and turn to credit cards to hang on. In 2007, the

average family bankruptcy involved 21 percent more in secured debts (mortgages, car

loans) and 44 percent more in unsecured debts (credit cards, medical bills, and gas bills)

than a half dozen years earlier. In the seven-county California Central District, bankruptcy

filings almost doubled between 2007 and 2008.

Sociologists trace the origins of these crises to the shifting foundations of

inequality. A neo-liberal philosophy of market fundamentalism led the government to trim

the public safety net that workers counted on for protection against poverty,

unemployment, disability, and old age. These cutbacks came at a time when businesses—

citing the need to compete in a global economy—were outsourcing jobs to other countries

and reducing pay and benefits for U.S. workers who remained. More Americans found

themselves in non-standard employment—part-time jobs, temporary work, and contract

labor that offered less security, lower wages, and fewer benefits.

The economic crisis came early for some people and predates the latest recession,

which the National Bureau of Economic Research dates to the end of 2007. Even before

this recession, real median family income was declining. The biggest losses (nearly 8%

between 2000 and 2005) were incurred by the poorest 20 percent of families (The

Economic Policy Institute 2009). Income for families also became more volatile, subject

to steeper ups and downs.

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Not surprisingly, one money problem leads to another. For instance, not having

health insurance is a risk factor for credit card debt (if only because emergency rooms now

urge patients to put their bills on plastic). In 2004, 75 percent of American households

with members lacking health insurance owed on their credit cards, as compared to 55

percent of other households. The situation worsened when the recession arrived and the

housing bubble popped.

Even before the full-blown, national-scale US mortgage crisis of 2007, a key

concern in some US communities and among many community development groups was

the extent to which foreclosed, lender-owned homes were accumulating in different local

housing markets or submarkets. Despite the fact that local and state governments were

effectively unable to regulate or impede high-risk lending in their jurisdictions, it was

local communities that suffered the spillover effects of such lending, especially in the form

of vacant REO properties. REO properties are the result of completed foreclosure sales in

which the successful bidder at the sale is the financial institution.

As housing prices fell, mortgage holders found that they could not avoid default by

selling their houses, which were sold in foreclosure. As foreclosure rates increased, the

value of mortgage backed securities fell. Investment banks that held mortgage-related

securities were required, by mark-to-market regulations, to lower the value of these

securities in their portfolios. As the value of their assets fell, these financial institutions

became insolvent. They had hedged the risk by purchasing derivatives but these

derivatives turned out to be worthless because counterparties also became insolvent.

Banks did not have to mark down their mortgage-related assets, but by the same token

their own lenders could not price those assets, could not assume that the banks were

creditworthy, and thus became reluctant to lend to them.

In the US, the foreclosure process varies significantly across states. There are two

general regimes for foreclosure: judicial foreclosure, in which a court supervises the

process; and statutory—or nonjudicial—foreclosure, where the process is not supervised

by a court and the auction occurs typically under the supervision of the lender’s agent.

Typical foreclosure periods — the time between the initial formal notice by the

lender and the foreclosure sale — can vary from less than 40 days to more than a year and

tend to be shorter in nonjudicial states. At the end of the foreclosure period, at the

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foreclosure sale, the court or the lender’s agent supervises an auction in which bidders,

including the lender, make bids on the property. In some cases, especially where local real

estate markets are brisk, third parties may bid on the properties. In many and often most

cases, however, especially during times of high foreclosure rates, few third party bids are

made, and the lender acquires the property by bidding the outstanding loan amount and the

property becomes (Real Estate Owned) REO at this point. Real estate owned or REO is a

class of property owned by a lender typically a bank, government agency, or government

loan insurer, after an unsuccessful sale at a foreclosure auction. Most REO properties are

presumed to be vacant; lenders typically evict homeowners and tenants of single-family

foreclosed properties upon taking possession.

The accumulation of vacant foreclosed homes has been viewed as a serious threat

to neighborhood wellbeing, particularly in low- and moderate-income communities, since

at least the 1970s. The clustering of REO properties in a neighbourhood may lead to a

number of problems. First, the growth of REO in a neighbourhood represents an increase

in the local supply of vacant homes. A surge in foreclosed properties may create a supply-

side shock to the local housing submarket and result in lower prices for nearby properties.

In stronger housing submarkets, an increase in supply may be easily absorbed, but in

markets where demand is not so strong, a surge in supply may cause significant drops in

values. Sudden declines in housing values may then have negative impacts on local

households, including making it difficult for those who want to sell their homes to do so

and making obtaining refinance loans or avoiding foreclosure more difficult.

Second, REO properties themselves may sell at significant discounts and

appreciate more slowly than those involved in traditional household-to-household sales. In

areas with many REO sales, then comparable values in an area, which are used by buyers

and appraisers to establish fair values for local home-buying activity, may become more

depressed, resulting in a spillover effect on non-REO sales.

A third way in which foreclosures may affect surrounding neighborhoods is

through negative spillovers on the quality of life in affected areas. Such effects might

occur if REO properties tend to exhibit signs of physical blight, including being boarded

up or vandalized, or if vacant REO become associated with incidents of violent or property

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crime. The neighborhood and public costs associated with REO properties are expected to

be significantly greater if REO properties sit vacant for substantial periods of time.

By early 2008, credit card companies were reporting that delinquencies were

climbing five times faster in states with high housing foreclosure rates (California, Florida,

Arizona, and Nevada) than elsewhere. By the end of 2008, credit card debt was rising at

the fastest pace in years. Since holiday sales tanked, consumers clearly weren’t splurging.

With home equity loans drying up, they were relying on plastic to pay their bills,

sometimes in a desperate attempt to stay in homes that had plummeted in value. When

they maxed out their credit cards to meet their mortgage, many were forced into

foreclosure and bankruptcy.

In many older cities with traditionally weaker economies and housing markets, but

also in some cities with relatively strong economies like Atlanta and Chicago,

delinquencies and foreclosures increased well before 2007. By the first quarter of 2006

subprime delinquency rates already exceeded 12% in states with more troubled

economies, like Pennsylvania, Michigan, Ohio and Indiana, but also in Georgia and

Tennessee, whose economies were still fairly robust at this point (Mortgage Bankers

Association, 2006). However, regions with very hot housing markets experienced low

delinquency rates at this point, with California, Arizona and Nevada having rates below

6%. This was because borrowers struggling with mortgage payments in hot markets could

often avoid default or foreclosure by quickly refinancing or selling their homes. By the

summer of 2007 foreclosure rates were accelerating in most large metropolitan areas, with

the steepest increases in markets where housing values were declining rapidly, including

places like: Riverside, CA, Las Vegas, NV, Phoenix, AZ, Sacramento, CA, and

Miami, FL. Surging foreclosures meant that foreclosed properties were beginning to pile

up rapidly in many metropolitan areas. Slowing housing markets and tightening credit also

prevented these markets from absorbing growing numbers of REO properties.

Now let’s discuss about those people who have trouble paying their rent and

mortgage bills. The recession can certainly be traced to the housing bubble. Easy financing

ran up prices. When the bubble burst, homeowners were left with houses worth less than

they owed on them and with payments bigger than they could manage. Banks and other

institutions were left with bundled subprime mortgages that were not going to get repaid.

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As banks failed and credit dried up, the economy slowed and unemployment climbed. As

the dominos fell, soaring defaults and evictions offered highly visible evidence of the

problems.

For the sake of argument, let’s examine the charge that Americans make a routine

practice of callously stiffing their landlord or mortgage lender. If this were the case, we

would not expect to see unprincipled tenants and mortgage holders foregoing their basic

needs or making serious sacrifices to keep their heads above water. Opportunists wouldn’t

be pawning their jewelry or going without electricity. They would ditch the house or head

to bankruptcy court long before it came to that. Statistical analyses shows that actually

people who are behind on paying for their housing do, in fact, take on these hardships and

more. The risk of hardship is much higher for Americans who fall behind on their housing

payments than for those who don’t. Compared to their counterparts who do not run into

problems paying the rent or mortgage, people who fell behind on housing payments are six

times more likely to be pressured to pay bills than those whose money problems did not

affect their housing payments. They are seven times more likely to be unable to purchase

needed food (23 percent versus 3 percent). They are ten times more likely to have their

utilities shut off and four times more likely to be unable to afford the health care they

need. Nine percent had their car or furniture repossessed, but virtually nobody without rent

and mortgage problems had to let these possessions go. Fully 26 percent of Americans

with rent and mortgage problems sold personal possessions to get money, but only 3

percent of others had to resort to pawn shops and garage sales. Falling behind on the rent

or mortgage also put people at much greater risk for other stressful experiences: going

bankrupt (5 percent vs. 1 percent), being evicted (9 percent vs. 0 percent), and even

becoming homeless (11 percent vs. 3 percent).

Americans who have problems paying for housing are not deadbeats who game the

system to live beyond their means. Having one financial problem implies a big package of

other hardships and a striking inability to meet even basic needs. In other words, people in

financial trouble juggle bills and give up heat, food, medical care, personal possessions,

cars, and even housing. This is hardly news to sociologists, but this chain of pain refutes

the idea that the sharp dealing by ordinary Americans is to blame for US broader

economic problems.

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For many Americans, the recession is a bewildering tragedy that has pushed them

to the brink of economic despair and tested their faith in American social institutions. On

this point, it is important to note that narratives blaming the victims for the current

economic crisis coexist with narratives that place responsibility on elites. Targeting

bankers, lobbyists, mortgage brokers, politicians, and economists, this angry populist

pushback (“occupy America”) embodies a withering sociological critique of power and a

demand for accountability and social justice.

Blaming the victim alerts us to the stigmatizing narratives that can add to the

suffering of those who are selling off their prized possessions, foregoing needed health

care, and losing their homes. While there are undoubtedly unscrupulous borrowers who

cheated a willing system, it is unfair to tar the victims of fraudulent brokers and a souring

economy. Individualistic explanations, whether they blame the homeowner or the broker,

divert attention from the structural reasons for the subprime mortgage crisis and the rising

wave of delinquencies and bankruptcies.

Succumbing to an ideology of free markets and minimal government, Americans

lacked commonsense regulatory controls. They also lacked the will to address rising

income inequality and economic insecurity. The subprime crisis was the result of a policy

regime that, rather than providing homeowners and neighbourhoods with access to credit,

was focused on providing global capital with access to neighbourhoods and homeowners.

In this, at least, it succeeded. The crisis has uprooted families and children from

communities and schools, damaged the credit history and economic opportunities of

households, and left neighbourhoods pockmarked with foreclosed vacant buildings.

The very fact that we have a subprime crisis to discuss about indicates that the

packaging and re-packaging of risk perpetuates more risk. This is because the definition of

what within the financial sector counts as risk in the first place has itself become an aspect

of market self regulation and therefore is distorted by the outbreaks of the bubble

dynamics which are a constant feature of financial capitalism.

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