Meanwhile, Wednesday's batch of press reports noted, among other things, that a "Looming Crash Prompts [the] Most Hires for Distressed Debt Since 2002," an "Economist Sees U.S. Recession 'Right Now,'" and "Foreign [Ownership of] U.S. Notes Rise[s] to 80 Percent."
It wouldn't be surprising to find that this growing disconnect between Wall Street and Main Street is causing some old-timers to question their mental acuity, or maybe even their sanity. Or, to wonder whether there might be something physically wrong with them. Like, for example, a previously undiagnosed visual impairment or even a chemical imbalance that causes those who are afflicted to see things in a way that is curiously at odds with almost everyone else.
But after a brief period of dizziness and disorientation, it usually doesn't take long for the harsh realities of a fast-spreading economic malaise to clear the mind and bring things back into proper focus.
In many ways, the following three articles, which detail the travails of the once high-flying housing market, tell a tale that will be repeated many times over, in countless markets, sectors, businesses, and lives, during the coming economic tsunami. They chronicle a dizzying rise and a relentless fall that will eventually leave widespread chaos, destruction, and suffering in its wake.
In the first report, "Subprime Fiasco Exposes Manipulation by Mortgage Brokerages," Bloomberg 's Seth Lubove and Daniel Taub shine a glaring light on a key driver in the destabilizing overleveraging of America: greed.
Taher Afghani was working for discount retailer Target Corp. near San Francisco when friends told him about the riches to be made in California's Mortgage Alley.
It was 2004, and the U.S. real estate market was on fire. Down in Southern California, a hub for lenders specializing in loans to people with weak, or subprime, credit, Afghani's pals were making a fortune pushing risky mortgages on homebuyers. After tagging along with a buddy on a company trip to Los Cabos, Mexico, Afghani quit Target, headed south and began hustling loans at Costa Mesa-based Secured Funding Corp.
"I had never seen so much money thrown around in one weekend," Afghani, 27, says of the Cabo getaway. "It was crazy. All these kids, literally 18 to 26, were loaded -- the best clothes, the cars, the girls, everything." Soon Afghani, who'd made $58,000 a year managing a Target distribution center, was pulling down $120,000.
Mortgage salesmen like Afghani, many of them based in Orange County, near Los Angeles, lie at the heart of the once-profitable partnership between subprime lenders and Wall Street investment banks that's now unraveling into billions of dollars in losses.
After years of easy profits, a chain reaction of delinquency, default and foreclosure has ripped through the subprime mortgage industry, which originated $722 billion of loans last year. Since the beginning of 2006, more than 50 U.S. mortgage companies have put themselves up for sale, closed or declared bankruptcy, according to data compiled by Bloomberg.
Lenders such as Irvine, California-based New Century Financial Corp.; Orange, California-based ACC Capital Holdings Inc.; GMAC LLC's Residential Capital home lending unit; and General Electric Co.'s WMC Mortgage Corp. division have slashed more than 5,000 jobs. On May 22, Santa Monica-based Fremont General Corp., whose loans helped trigger the subprime crisis, agreed to sell its commercial real- estate unit for $1.9 billion.
The upheaval in Orange County, home of Disneyland and birthplace of Richard Nixon, has sent shockwaves throughout the financial world.
Brokers are merely the first link in a chain stretching from mortgage companies, which originate loans; to wholesale lenders, which bundle them together; to Wall Street banks, which package the bundles into securities; and finally to commercial banks, hedge funds and pension funds, which buy these investments.
The pain has only just begun. As home prices sink and mortgage defaults climb, bond investors who financed the U.S. housing boom stand to lose as much as $75 billion on securities backed by subprime mortgages, according to Newport Beach, California-based Pacific Investment Management Co.
Companies from Detroit-based General Motors Corp. to Zurich-based UBS AG have fallen into the subprime sinkhole.
At GM, profit plunged 90 percent during the first three months of 2007 because of mortgage losses at its 49 percent-owned GMAC finance company.
Swiss banking giant UBS said in May that it would shut its Dillon Read Capital Management arm after the hedge fund manager lost 150 million Swiss francs ($123 million) in the first quarter, partly on subprime investments.
Subprime originations fell 10.3 percent to $722 billion in 2006 from a record $805 billion in 2005, according to JPMorgan Chase & Co. Credit Suisse predicts a 40-60 percent slide this year.
The party is over in Orange County. These days, Secured Funding's once-buzzing office building in Costa Mesa, near John Wayne Airport, is gutted.
The imprint of "Secured Funding" is all that remains of the corporate logo that once graced the outside of the two-story building. Above it is a "For Lease" sign advertising the 82,333- square-foot (7,649-square-meter) building.
"They cut way back," a construction worker says, shrugging. What little remains of Secured Funding is now housed in a building across the near-empty parking lot, where a receptionist tells a caller: "Our wholesale division is closed. We're no longer doing business with brokers."
The subprime industry -- and investors' losses -- would never have gotten so big were it not for a small army of independent mortgage brokers and hustling salesmen like Afghani, who was fired in October.
Afghani and other subprime veterans say their job was to reel in borrowers, period. Never mind whether customers needed loans or could manage payments.
Making the Pitch
Afghani says sales pitches typically focused on what a borrower could do with all of that money rather than on fees buried in paperwork or annual interest rates as high as 10.5 percent at the time, at least 2 percentage points more than the rates that banks charge people with good credit.
"Even with explanations, most borrowers didn't really understand what types of loans they were getting," says Maureen McCormack, another former Secured Funding employee. "They just cared about the monthly payment."
The sales job was made easier with exotic mortgages such as so- called no-doc loans, which enable borrowers to get loans without having to supply evidence of income or savings, and option ARMs, adjustable-rate mortgages that let people pick how big a payment they will make from month to month. The loans offer upfront teaser rates at the cost of tacking the deferred payments onto the balance of the loan.
"Heavy sales pressure has been part of the most-egregious lenders for a while," says Kurt Eggert, a professor at Chapman University School of Law in Orange, California, who has studied the role of aggressive sales tactics in subprime lending and sued lenders on behalf of elderly borrowers caught up in home equity scams.
Sold to Wall Street
However brokers snared customers, lenders in California typically sold the loans to big banks or Wall Street firms. Under U.S. law, investors who buy mortgages or securities backed by them are typically not susceptible to lawsuits alleging fraud on the part of brokers.
Such protection partly explains why the U.S. mortgage-backed- securities market has ballooned. The market more than tripled since 2000; $2.4 trillion of MBSs were issued last year, according to the Securities Industry and Financial Markets Association in New York. Last year was the first time more than half of the securities issued were backed by subprime and other nonconforming loans, according to the trade group.
"The market is driven by volume and passing along the risks associated with it," says Paul Leonard, director of the California office of the Center for Responsible Lending, a Durham, North Carolina- based consumer advocacy group. "With the appetite of the secondary market, neither brokers nor originators had much accountability."
Down the Chain
Lenders push sales of subprime loans as far down the chain as possible to vast networks of brokers. While independent brokers account for about half of all mortgage originations, they handle as much as 70 percent of subprime originations, according to the Mortgage Bankers Association of America.
Many of the biggest subprime casualties, including Fremont General; Kansas City, Missouri-based NovaStar Financial Inc.; and New Century Financial, would never have grown as fast as they did without their ability to outsource the bulk of their sales to outside brokers and salesmen.
New Century, before tumbling into bankruptcy on April 2, used a network of 47,000 mortgage brokers and 222 branch offices to grow to $59.8 billion in annual loans last year from just $400 million in its first year, in 1996, according to company filings.
Fremont originated a peak of $36.2 billion in subprime loans in 2005, up from $3.3 billion in 2001, largely through "independent loan brokers," according to company filings. The company ended its subprime business in March.
Even before the bottom fell out of the subprime market, NovaStar and other lenders were defending themselves against lawsuits that accused the companies of using independent brokers and branch salesmen to exploit borrowers with high-cost loans.
A lawsuit filed against NovaStar in federal court in Memphis, Tennessee, in April 2006, for example, centers on allegations that NovaStar used mortgage brokers to prey on minority borrowers, in this case a 61-year-old black woman who claims to have heard pitches for "easy money" on a local gospel radio station.
Among other allegations, the plaintiff, Mae Jackson of Memphis, claims she was never informed about the terms of the loan, including the amount, the interest rate or the closing costs. In her complaint, she attacks NovaStar's practice of using mortgage brokers who employ "deceptive high-pressure tactics to foist these unfair and discriminatory subprime loans onto unsuspecting minority borrowers."
In court filings, NovaStar pins the blame on the mortgage broker, Memphis-based Worldwide Mortgage Corp., which filed for bankruptcy in April 2006. In a separate statement, NovaStar says that contrary to the plaintiff's portrayal of herself as naive, Jackson was a "real estate investor who owned five properties at the same time." Neither she nor her attorneys have provided any evidence of discrimination, NovaStar says. Jackson couldn't be reached for comment.
Like many subprime lenders, NovaStar spread its tentacles by tapping into a broad base of mortgage brokers and so-called net branches. A net branch enables an independent broker to set up shop under NovaStar's or some other company's banner with little upfront investment, much less a state license, and quickly begin brokering loans to kick upstream to the parent.
NovaStar made great use of the technique: By the end of 2004, it had expanded its number of branches to 432 from four at the beginning of 2000. At their peak in 2003, NovaStar's branches brought in $1.2 billion of loans, a fifth of the total $6 billion in subprime loans originated by the company that year.
"The branches represent a competitive advantage for NovaStar as we seek greater market share," the company said in its 2003 annual report.
Several lawsuits filed against NovaStar paint a more sinister picture. They claim the company played fast and loose with state licensing requirements in an effort to make results look better than they might have without the aid of the branch loan sales.
"NovaStar had woefully failed to comply with federal and state regulations as a result of defendants' efforts to expand the company's business at all costs," alleges one 94-page complaint filed in November 2004 in federal court in Kansas City and certified as a class action this past February. The firm is facing at least seven class actions, according to Bloomberg data.
Among other allegations, the Kansas City lawsuit claims NovaStar fraudulently puffed up borrowers' assets to qualify customers for loans. One unnamed former employee, identified as a "loan officer" who worked in California from 2002 to '03, told plaintiffs' lawyers that employees would apply an "X-Acto knife and some tape" to borrowers' W-2 forms and paychecks to qualify them for loans.
The same employee said that on other occasions, the company would temporarily deposit $5,000 in the bank account of a potential borrower to inflate his or her assets. NovaStar would either take the money back or increase the loan fees, according to the lawsuit filed by co-counsel Milberg Weiss & Bershad LLP of New York.
"NovaStar believes it is irresponsible to continue to print the false and inflammatory allegations regarding lending activities contained in this lawsuit, given that the plaintiffs have never produced any evidence to support them and they are not actually a part of the underlying claim," NovaStar spokesman Richard Johnson said in a statement.
Johnson says three state and federal licensing and compliance actions involving the branches filed against NovaStar that are detailed in the lawsuit amount to much ado about nothing.
"None of NovaStar's operations in these states, or nationwide, were materially affected or in danger of being materially affected, in any way, and therefore those actions did not require disclosure at the time," Johnson said in his statement.
The company announced in April it was exploring "a range of strategic alternatives," including a sale.
The proliferation of lightly licensed sales branches was enabled in part by a patchwork of regulations that cover independent mortgage brokers and lenders. While banks are overseen by federal and state regulators, mortgage brokers and independent sales outfits are overseen by a menagerie of state authorities, some of which also look after barbers and masseuses.
In California, which accounts for about 40 percent of subprime borrowing in the U.S., no one even knows how many people are originating loans, according to an October 2006 report by the California Association of Mortgage Brokers. That's because while the state licenses individual mortgage brokers, anyone can work for a big lender under the umbrella of a single corporate license. The group estimated that a minimum of 600,000 people were peddling loans in the state last year.
"In other words, the corporation can hire a loan originator right off the street and have them originating loans that day without any education, licensing or individual accountability," the report said.
"That's the way the law is in California," says Mark Leyes, director of communications of the state's Department of Corporations. "We license the entity. They can have people working for them who are not licensed by us."
Such loose regulatory oversight, combined with California's frenzied real estate market, helped make the state a natural destination for the subprime business.
Even NovaStar, while headquartered in Kansas City, maintained a large presence in Orange County. Half of the 20 biggest U.S. subprime lenders were in California, including three in Orange County's Irvine, according to Inside Mortgage Finance, a Bethesda, Maryland-based industry newsletter.
Orange County was also the home of Secured Funding, which specialized in home equity loans, or second mortgages, to people with lousy credit. The firm was founded in 1993 by Lorne Lahodny, who eventually built it into a 1,000-employee operation in Costa Mesa that closed more than $1.25 billion of loans by 2005, according to a company fact sheet. Neither Lahodny nor his partner in Secured, John Lynch, responded to messages left by phone and in person at their offices.
Secured Funding's success was fueled by sales leads generated by millions of pieces of direct mail and Internet trolling, Afghani and other former salesmen say. Typical of the direct mail was a credit card offer. When potential customers called to activate the card, they were instead hooked up with a Secured Funding account executive such as Afghani.
Afghani describes chaotic office scenes that recall "Boiler Room," a 2000 movie about stock brokers at a Long Island wire house. To spur sales, Secured Funding broke its salesmen into color-coded teams.
"If you weren't turning those calls into applications, they would drag you out and make your life miserable," he says. "The turnover was unbelievable," says Afghani, who says he watched eight people pass through the neighboring desk in seven months. "If you didn't cut it right off the bat, you were just fired."
Dane Marin, who worked at Secured Funding for a year, says managers harangued everyone. "If you weren't on the phone very long, you'd get an e-mail saying, 'Get your head out of your ass,"' he says.
Afghani says he and fellow brokers dispensed with details about rates and fees and instead talked up how borrowers could use home equity loans to pay down other debts. "It was easier than financing a car," Afghani says of getting a mortgage.
At times, Secured Funding salesmen broke the rules, according to at least three lawsuits filed last year in federal courts in St. Louis and Milwaukee. The plaintiffs accuse Secured Funding of accessing their credit reports without permission for the purpose of sending them unsolicited loan offers.
In one case, Secured Funding sent the plaintiff a "personalized Platinum Equity Card" offering "$50,000 or more in cash" just for calling Secured's toll-free telephone number. In the other two lawsuits, Secured sent bogus $75,000 checks that reassured the recipients their "Less Than Perfect Credit Is OK!" Afghani says the firm was blasting consumers with as many as 4 million pieces of mail a month.
In answers to the complaints, Secured Funding denied wrongdoing. The company said it followed federal regulations when accessing "consumer reports" to pitch customers.
Lakers and Limos
Secured Funding's attorney in the lawsuits, Richard Gottlieb of the Chicago office of Dykema Gossett PLLC, resigned in April, citing "irreconcilable professional differences" with Secured Funding. Gottlieb declined to comment.
However the leads came in, Secured Funding's salespeople made sure the fish stayed on the hook. "You would say anything to get the loan through," says Cristopher Pike, who worked at Secured in 2005 and '06.
Secured Funding hung photos of sales incentive trips, like the one to Cabo, around the office. As sales boomed in early 2006, limos would pull up at the office to take salesmen to Los Angeles Lakers basketball games, Pike recalls. The parking lot was so clogged with luxury cars that employees had to valet-park or board a shuttle bus to get to the office.
Charlyn Cooper, a former Secured underwriter, says she kept an electric scooter in her trunk to travel as far as a mile from her car to the office. "They all used to laugh at me," says Cooper, who was dismissed in October. "They had a van that would come by and pick you up from your car, but the van was always full."
Cooper's job was to rein in the salespeople and make sure paperwork was legitimate so Secured Funding could sell its loans upstream. She says Secured Funding unloaded most of the loans on HSBC Holdings Plc's HSBC Finance unit, which has been racked by the subprime blowup. The bank said profit at its U.S. unit plunged 39 percent during the first quarter, primarily because of an increase in U.S. loan defaults, including the second-lien loans that were Secured Funding's specialty. Provisions set aside for credit losses almost doubled to $1.7 billion.
Secured Funding salespeople didn't always appreciate Cooper's scrutiny of loans, she says. "Sales guys are always going to cry because they work on commission," she says. Salesmen such as Afghani made as much as $3,250 on each loan.
Cooper cross-checked borrowers' stated salaries to, say, weed out any custodians or maids who claimed they earned $10,000 a month. "There's that push-pull with sales because they're like, 'Why are you arguing with me,' and I say, 'Sorry, a bus driver is not making $10,000 a month,'" Cooper says.
Many subprime sales techniques are now spilling out in the lawsuits, advocacy reports and Congressional hearings that predictably follow such industry meltdowns. Several lawsuits illustrate the lengths to which the big wholesalers, and ultimately Wall Street, were able to outsource the selling of the loans as far down the chain as possible. Fremont General's Fremont Investment & Loan, Wells Fargo & Co.'s home mortgage unit and a rogue's gallery of mortgage brokers come under such scrutiny in a lawsuit filed in August 2006 in San Mateo County, California, state court.
Claims of Fraud
Plaintiff Johnnie Damon claims he was "fraudulently induced" to take out a $484,000 loan from Irvine-based mortgage broker Peak Funding Inc., which allegedly falsified Damon's financial records to qualify him for the loan. Damon claims he asked for a reverse mortgage, which enables homeowners to borrow money in the form of payments charged against their home equity, and instead got a "traditional refinance loan" without his knowledge.
Also without Damon's knowledge, the claim says, the mortgage broker falsified information on his loan application, such as his monthly income, to qualify him for the loan.
Fremont sold servicing rights on the loan, which is the right to process monthly payments, to San Francisco-based Wells Fargo and flipped the loan itself to Paris-based Societe Generale SA. Wells Fargo is also named as a defendant for ignoring "fraudulent and predatory lending practices" in the loans it purchases and services, according to the lawsuit.
The complaint also alleges that Fremont, prior to its recent decision to exit the subprime business, was using mortgage brokers to do its dirty work.
"Fremont has a history of intentionally turning a blind eye to fraudulent and predatory lending practices by the mortgage brokers who generate home loans for the company," the lawsuit alleges without citing any other specific examples.
Expanding on the accusations, Damon's attorney, Aaron Myers of Howrey LLP, says Fremont funded a loan made "by a bunch of crooks who completely misled the borrower, falsified his income, coerced him into the loan and then tricked him into sending the loan proceeds back to the company."
In answers to the complaint, all of the defendants deny the accusations.
"Wells Fargo's trivial role in this case is punctuated by the fact that it has not caused the plaintiff any harm," Wells Fargo's attorneys said in an Oct. 10, 2006, court filing, adding that they put a hold on the loan after the dispute erupted. "Wells Fargo does not belong in this case."
Robert Cannone, a former chief financial officer and director of Peak Funding who's also listed as a defendant by name, says the firm closed last October after it ran out of money. He neither admits nor denies wrongdoing.
"I'm so embarrassed," Cannone says in a telephone interview. "I feel really bad." He says that of the 100 loans made by Peak, this is the only one in dispute. He says an employee connected with the Damon loan "went off the reservation."
When the boom went bust, even people on the periphery of the industry got caught in the downdraft.
Carrie Feinman worked in Scottsdale, Arizona, in the wholesale prime lending division of New Century Financial, which acquired nonsubprime loans from smaller lenders and mortgage brokers.
The relative health of her side of the business, which New Century acquired from Royal Bank of Canada in 2005, couldn't stop New Century's troubled subprime lending from dragging the entire company into Chapter 11 on April 2.
Feinman says the news that the company was filing for bankruptcy came out of the blue, leaving her and most other employees out of pocket on unused vacation time and severance pay.
"We were shocked," says Feinman, who's looking for a job. "If I had quit the week before, I would have gotten my vacation time. You wonder why no one is loyal to employers anymore."
'Enough Is Enough'
A month after leaving Secured Funding, Afghani took a new job at Irvine-based Solstice Capital Group Inc., another subprime lender. HSBC, the same bank that had been buying loans from Secured Funding, bought Solstice last year for $50 million. Afghani quit in April, vowing to find a new line of work.
"Enough is enough," he says, adding the good times are long gone. "I'm so rock bottom I had to move out of my apartment in Irvine and live rent free with my girlfriend."
The hard knocks have taught him a lesson, Afghani says. "It was tough love and a great learning experience to live within your means and not end up like the individuals on the other side of the phone," he says.
In the next article, "An ATM That's Out of Money," the Washington Post's Nell Henderson reports on how much the economic landscape is changing in the wake of the burst housing and subprime bubbles, and why neither problem is likely to remain "contained" for very long.
For a long time, Paul and Amy Woodhull's house on Capitol Hill was a honey pot. Through multiple refinancings over nearly a decade, they pulled out money to fix it up, buy a car, pay down credit cards, buy three other properties and improve them, too.
Now the pot is dry. The Woodhulls are feeling squeezed by bills, but with interest rates up and home prices down, they're reluctant to touch their home equity again. They called their six children into a family meeting recently, and Amy laid down new rules: No more impulse purchases or frivolous shopping trips. "We're going to have to save our pennies," she declared.
That seems to be the new motto in many an American household.
For years, as the bull market in housing gathered steam, people used their homes as glorified ATMs, pulling out money for all sorts of reasons. The trend helped support continued economic growth and recovery from the 2001 recession.
But now people are reining in their spending, raising concern that their collective decisions could nudge a sluggish U.S. economy into recession.
Already, a small slowdown in the growth of consumer spending and a big plunge in home construction helped cool U.S. economic growth to a weak 1.3 percent annual rate in the first three months of this year. The nation's retail sales fell in April, and many retailers are reporting disappointing sales so far this month.
Economists are dividing into two camps: the highly pessimistic and the slightly pessimistic.
The gloomier analysts predict the overstretched consumer will soon pull back sharply, no longer able to tap rising home equity to make up for lackluster wage growth, rising debt-service costs and gasoline topping $3 a gallon.
In this scenario, rising home foreclosures and tightening lending standards will prolong the housing downturn. As consumers and businesses curtail spending, unemployment is expected to rise above 5 percent by year-end from a low 4.5 percent now.
"The consumer has been spending beyond his means and is now on the ropes," said economist Nouriel Roubini, chairman of consulting firm Roubini Global Economics. His warnings have been dismissed by many mainstream economists, but he turned out to be right last summer when he predicted a more severe housing slump than commonly expected. Now, he said, "I see a quite significant chance of recession, well above 50 percent."
But many other economists, including those at the Federal Reserve, are not quite as worried. They think the surge in home sales and prices earlier this decade boosted consumer spending on the margins. Meanwhile, the primary drivers of consumer spending are employment and income growth, which have held up over the last year, they say.
Consumer spending did slow in the first quarter, but to a strong 3.8 percent annual rate of increase from a torrid 4.2 percent pace at the end of 2006. Now many analysts expect consumer spending to lose steam, likely rising at a pace below 3 percent in coming months. That would hold economic growth to a moderate pace, but wouldn't be a severe enough pullback to pitch the nation into a recession, they say.
In the Washington area, where unemployment is below the national rate, real estate professionals are among the most affected. For example, Larry Chartienitz of Chevy Chase, the Woodhulls' realtor, said that during the housing boom he thought of paying $5,000 on a piece of jewelry for his wife's birthday or of flying off for a weekend getaway.
But after seeing his income drop by half last year, he's cutting back. For his wife's most recent birthday, he skipped the jewelry. "I wanted to reserve it in case I might need it for something else," Chartienitz, 61, said. And he's more likely to drive than fly on a weekend leisure trip.
Carlos LaCosta, 25, a Woodbridge real estate agent, said his income soared so fast during the housing boom that he bought a 19-foot 2006 Larson Senza boat for $20,800. Now, he said, his income is down enough that he's not eating out as much, doesn't shop at Hugo Boss as much, and doesn't pick up the tab as often when he's at a bar with friends.
However, many others, including some involved in housing, say they aren't feeling an acute pinch. Mark Merlino, general manager of Merlino Construction Group, was the primary contractor on the Woodhulls' multiple renovation projects during the boom. These days, Merlino said he still has "plenty of work" in the area.
In addition to boosting income in the real estate industry, the housing boom spurred consumer spending in two other ways.
First, rising wealth -- whether in stocks, real estate or other assets -- indirectly encourages people to spend more. One common rule of thumb is that a $1 increase in wealth generates 3 to 5 cents of extra spending, but some research suggests the "wealth effect" from housing is bigger over time.
And America's housing wealth skyrocketed as prices climbed earlier in this decade. According to Fed data, homeowners' equity -- the value of their homes minus mortgage debt -- grew to nearly $11 trillion at the end of last year, or double the value at the end of 1998.
The Woodhulls caught the train at just the right time. They bought their rowhouse for $254,000 in 1998, renovated and expanded it, and estimate that it's now worth more than six times that amount. Even after spending hundreds of thousands of dollars on improvements, their mortgage debt is less than half the value of the house, they estimate.
Second, the housing boom also fueled spending directly by turning homes into cash machines. As prices rose and interest rates fell, Americans extracted trillions of dollars in extra cash through home sales, mortgage refinancings and home equity loans.
Homeowners gained an average of nearly $1 trillion a year in extra spending money from 2001 through 2005 -- more than triple the rate in the previous decade -- according to a study by former Federal Reserve chairman Alan Greenspan and Fed economist James E. Kennedy. That's the "free cash," as the authors call it, left over after closing costs and other fees deducted from equity withdrawals.
Most of the money extracted during those boom years, nearly two-thirds, came from home sales, the authors found. Another 21 percent came from home equity lines of credit, while 15 percent came from mortgage refinancings.
About a third of the free cash gained during this period was used to buy other homes, they calculated. About 29 percent was used to acquire stocks and other assets. About 12 percent went to home improvements. And nearly a fourth, 23 percent, went to consumer spending, including paying credit card bills and reducing other non-mortgage debts.
The amount of free cash extracted has fallen sharply since the peak in 2005, to $217 billion in the last three months of 2006, down by almost half from a peak of nearly $400 billion in the third quarter of 2005. Analysts disagree about whether these changes will affect consumer spending.
The Woodhulls, however, have no doubt that their rising home wealth provided the fuel for extra spending. "Without the housing boom, we wouldn't have spent any of this," Paul Woodhull, 50, an independent radio show producer, said as he guided a visitor through his home, with its restored parquet floors and antique crown and ceiling moldings in the front, and the modern kitchen and sunny family room addition in the back.
The couple also pulled money out of their rowhouse to buy another rowhouse as an investment, and to buy a beach house in Delaware. Later, they refinanced the beach house to buy another one next door. They also refinanced at times to take advantage of falling interest rates, lowering their mortgage payments, which freed up more cash. Grand total: nine refinancings in nine years.
That means the Woodhulls have multiple mortgage, insurance and property tax payments for their four properties, as well as costs of upkeep and utilities. Plus, they have six children to feed, dress, educate and care for.
"Jeez, we've got all these payments every month," said Amy, 48, a radio network executive. "Now, when I look at sending my son to college in a year, I can't refinance again. Rates aren't falling. . . . I'm kind of stuck. What are my options? Sell a property into a down market? I'm really feeling quite caught -- like panicked caught."
How consumers cope with these pressures will determine whether the economy stays on keel this year. In the case of the Woodhulls, they know they could sell their home if they really needed cash. For now, though, they're planning to hunker down until the housing market picks up.
"I would love to put a deck on the roof," Paul said. "If this thing goes up in value more, maybe we'll do it."
In the last report, "'Subprime' Aftermath: Losing the Family Home," the Wall Street Journal's Mark Whitehouse goes beyond the the economic consequences of the collapsing property bubble to examine the social costs, which may ultimately prove far more costly than the money lost from a sharp markdown in prices.
For decades, the 5100 block of West Outer Drive in Detroit has been a model of middle-class home ownership, part of an urban enclave of well-kept Colonial residences and manicured lawns. But on a recent spring day, locals saw something disturbing: dandelions growing wild on several properties.
"When I see dandelions, I worry," says Sylvia Hollifield, an instructor at Michigan State University who has lived on the block for more than 20 years.
Ms. Hollifield's concern is well-founded. Her neighbors are losing interest in their lawns because they're losing their homes -- a result of the recent boom in "subprime" mortgage lending. Over the past several years, seven of the 26 households on the 5100 block have taken out subprime loans, typically aimed at folks with poor or patchy credit.
Some used the money to buy their houses. But most already owned their homes and used the proceeds to pay off credit cards, do renovations and maintain an appearance of middle-class fortitude amid a declining local economy. Three now face eviction because they couldn't meet rising monthly payments. Two more are showing signs of distress.
"This has stripped us of our whole pride," says April Williams, 47 years old, who has until August to pay off her mortgage or vacate the two-story Colonial at 5170, where she and her husband have lived for 11 years. "There's going to be no people left in Detroit if they keep doing this to them."
The fate of people on West Outer Drive offers a glimpse of a drama that is playing out in middle- to lower-income, often minority-dominated communities across the country. In addition to putting families into homes, subprime mortgages and the brokers who peddle them are helping to take families out of homes in which they've lived for years, eroding the benefits that proponents on Wall Street and in Congress have long touted.
The borrowers' difficulties raise questions about how the extension of easy credit to large swaths of the U.S. population will ultimately affect people and the broader economy -- questions that have gained in urgency as a sharp rise in defaults has policy makers wondering what, if anything, they can or should do.
Much of the focus in the subprime debacle has been on the demise of bubble markets in balmy locales such as California and Florida. But the subprime market has also channeled a surprising amount of money into some of America's poorer and more-troubled local economies.
In 2006 alone, subprime investors from all over the world injected more than a billion dollars into 22 ZIP Codes in Detroit, where home values were falling, unemployment was rising and the foreclosure rate was already the nation's highest, according to an analysis of data from First American LoanPerformance. Fourteen ZIP Codes in Memphis, Tenn., attracted an estimated $460 million. Seventeen ZIP Codes in Newark, N.J., pulled in about $1.5 billion. In all of those ZIP Codes, subprime mortgages comprised more than half of all home loans made.
The figures show the extent to which the new world of mortgage finance has made the American dream of homeownership accessible to folks in previously underserved communities. By some estimates, subprime lending has accounted for as much as half of the past decade's rise in the U.S. homeownership rate to 69% from 65%. But as the experience of West Outer Drive illustrates, the flood of cash has also encouraged people to get into financially precarious positions, often precisely at the time when they were least able to afford it. In doing so, it may have temporarily alleviated -- but ultimately worsened -- some of the nation's most acute economic problems.
"The market was feeding an addict at its neediest point," says Diane Swonk, who spent 19 years analyzing consumer credit in the Midwest and now serves as chief economist at Chicago-based financial-services firm Mesirow Financial. "Individuals will resist reductions in their standard of living with everything in their power, including mortgaging their futures."
If events unfold as some predict, subprime lending could end up eliminating more homeowners than it created. One study by the Center for Responsible Lending, a nonprofit that focuses on abusive lending practices, forecasts that the subprime boom will result in a total of 2.4 million foreclosures nationwide, most of them on homes people owned before taking out the loans. That outweighs even the most optimistic estimates of the number of homeowners created, which don't exceed two million.
To understand how the legacy of subprime lending looks on the ground, take a ride around the West Outer Drive area with Carlton McBurrows, who grew up in the neighborhood and now works as a community organizer for Acorn, an advocacy group that provides financial counseling to lower-income families. On one recent spring day, he counted four empty houses with big red refuse bins outside -- a sign that banks, having taken possession of the homes, were tossing out all the belongings and debris left behind by the previous inhabitants.
"This is a phenomenon that I've never seen before, and I've lived here all my life," he says. "I think this is just the beginning."
As opposed to other parts of urban Detroit, which tend to be plagued by burned-out homes, the area around the 5100 block of West Outer Drive has remained a place where people try hard to keep up appearances. Originally largely Jewish, the neighborhood became a bastion of home ownership for upwardly mobile blacks beginning in the late 1960s. Though the area's fortunes have slipped somewhat as people have moved out to the suburbs, it has boasted such famous residents as Aretha Franklin, Marvin Gaye and Berry Gordy, the founder of the Motown record label.
"It was like when you made it to Outer Drive, you'd made it," says Deborah Herron, 52, a former administrative assistant who lived in the area for 35 years.
Back in its heyday, the idea that West Outer Drive could suffer from a glut of credit would have seemed far-fetched. Many blacks moving into the neighborhood had to either depend on federal mortgage programs or buy their homes outright. That's because banks actively avoided lending to them, a practice known as "redlining" -- a reference to maps that designated certain neighborhoods as unduly risky. Various attempts to get the money to flow, such as the Community Reinvestment Act of 1977, which pushed banks to do more lending in the communities where they operated, had only a limited effect.
But beginning in the mid-1990s, the evolution of subprime lending from a local niche business to a global market drastically rearranged lenders' incentives. Instead of putting their own money at risk, mortgage lenders began reselling loans at a profit to Wall Street banks. The bankers, in turn, transformed a large chunk of the subprime loans into highly rated securities, which attracted investors from all over the world by paying a better return than other securities with the same rating. The investors cared much more about the broader qualities of the securities -- things like the average credit score and overall geographic distribution -- than exactly where and to whom the loans were being made.
"You have no time to look really deeply at every single borrower," says Michael Thiemann, chief investment officer at Collineo Asset Management GmbH, a Dortmund, Germany-based firm that invests on behalf of European banks and insurance companies. "You're looking at statistical distributions."
Suddenly, mortgage lenders saw places like West Outer Drive as attractive targets for new business, because so many families either owned their homes outright or owed much less on their mortgages than their homes were worth. Lenders seeking to tap that equity bombarded the area with radio, television, direct-mail advertisements and armies of agents and brokers, often peddling loans that veiled high interest rates and fat fees behind low introductory payments. Unscrupulous players had little reason to worry about whether or not people could afford the loans: The more contracts they could sign, the more money they stood to make.
"The pendulum has swung too far in the other direction," says Dan Immergluck, a professor of urban planning at Georgia Institute of Technology who has written a book on redlining. "We have too much credit, and too much of the wrong type of credit."
Minority-dominated communities attracted more than their fair share of subprime loans, which carry higher interest rates than traditional mortgages. A 2006 study by the Center for Responsible Lending found that African-Americans were between 6% and 29% more likely to get higher-rate loans than white borrowers with the same credit quality.
Subprime mortgages accounted for more than half of all loans made from 2002 though 2006 in the 48235 ZIP Code, which includes the 5100 block of West Outer Drive, according to estimates from First American LoanPerformance. Over that period, the total volume of subprime lending in the ZIP Code amounted to more than half a billion dollars -- mostly in the form of adjustable-rate mortgages, the payments on which are fixed for an initial period then rise and fall with short-term interest rates.
"A lot of people were steered into subprime loans because of the area they were in, even though they could have qualified for something better," says John Bettis, president of broker Urban Mortgage in Detroit. He says a broker's commission on a $100,000 subprime loan could easily reach $5,000, while the commission on a similar prime loan typically wouldn't exceed $3,000.
The boom in subprime lending paved the way to home ownership for many people: Over the past three years, three people on the 5100 block have used subprime loans to buy homes. In at least two of those cases, though, the experience has not gone well. Raymond Dixon, a 36-year-old with his own business installing security systems, borrowed $180,000 from Fremont Investment & Loan in 2004 to buy a first home for himself, his wife and six children, across the street from Ms. Hollifield at 5151 West Outer Drive. After all the papers had been signed, he says, he realized that he had paid more than $20,000 to the broker and other go-betweens. "They took us for a ride," he says.
Bishop Charles Ellis, senior pastor of the Greater Grace Temple in Detroit, says he has heard many similar complaints from people in the area who, either because they were new to the process or had good experiences in the past, had put too much trust in subprime-mortgage brokers. Still, he believes many bear responsibility for their predicaments. "If you have a contract in front of you, you have to read that contract," he says.
Mr. Dixon defaulted on the loan after the monthly payment jumped to more than $1,500 from $1,142 -- a rise he says put too much strain on his income from his security business. The foreclosure process began in late November, and Mr. Dixon says he expects an eviction notice this week. A spokesman for Fremont said the company, which is in the process of exiting the residential mortgage business, has taken measures to reduce defaults but does not comment on specific customers.
Up at the north end of the block, Jennifer Moore and her husband, John, bought a two-story beige-brick house in December 2004. She says her husband had excellent credit, but in the rush to buy his "dream house" he agreed to take out two subprime loans from EquiFirst Corp., one for $164,000 and the other for $41,000 -- a "piggyback" arrangement that allowed him to avoid a down payment. Ms. Moore said the real-estate agent told them they could refinance into a fixed-rate loan within two years, after which the payments on the larger loan were scheduled to reset.
Mr. Moore's death in 2006 scuttled the refinancing plans. Now Ms. Moore, a 56-year-old clerical worker for Wayne County, has fallen behind on the monthly mortgage payments, which she says rose earlier this year to $2,200 from about $1,450. After more than 30 years as a homeowner, she now expects to lose the house -- including the back porch she built to take in the sun and the library she decorated with her son's baseball and basketball trophies. "I'll get an apartment," she says. "I'm not going to buy another place." An EquiFirst spokeswoman said the company doesn't comment on specific customers.
For many who already owned their homes, offers of easy credit came at a time when a severe economic downturn had left them in need of money to maintain middle-class lifestyles. Since the year 2000, the decline of the auto industry has cost the Detroit metropolitan area about 20,000 jobs a year, helping turn the shopping areas near West Outer Drive into scenes of defunct businesses, payday lenders and liquor stores. According to the latest data from the Internal Revenue Service, households in the 48235 ZIP Code reported an average adjusted gross income of $32,902 in 2004, up slightly from $32,817 in 2001 but down 6% in inflation-adjusted terms.
April Williams was feeling the pain of the downturn back in 2002, when she saw an ad from subprime lender World Wide Financial Services Inc. offering cash to solve her financial problems. At the time, production slowdowns at Ford Motor Co. were squeezing her husband's income from an assembly-line job, and they'd heard rumors that more cutbacks were coming. Still, after a loan officer from World Wide paid a visit, they became convinced they could afford stainless-steel appliances, custom tile, a new bay window, and central air-conditioning -- and a $195,500 loan to retire their old mortgage and pay for the improvements. The loan carried an interest rate of 9.75% for the first two years, then a "margin" of 9.125 percentage points over the benchmark short-term rate at which banks lend money to each other -- known as the London interbank offered rate, or Libor. The average subprime loan charges a margin of about 6.5% over six-month Libor, which as of Tuesday stood at 5.38%.
"I knew better than to be stupid like that," she says. "But they caught me at a time when I was down."
She wasn't alone. Locals say West Outer Drive became a beehive of renovation activity in the first half of the decade, even as the economy sagged. Up the block from Ms. Williams, Ordell Walker, who says he left a job at DaimlerChrysler several years ago, put in a new driveway, glass-brick windows on the basement and stairwell, and much more. To get the cash, he jacked up his mortgage to $205,000 from $108,000 in 2002, partly with the help of World Wide. "A lot of people took the cash," he says. "I wish I'd never done it myself."
Last year, the Michigan Office of Financial and Insurance Services revoked World Wide's license amid allegations of fraud. Jeff Arnstein, who was a team leader at World Wide in 2002 and who Ms. Williams says processed her loan, said he didn't remember the specific case but he believed the loan was properly underwritten. "My heart goes out to them," he said. "But it's not the fault of the mortgage company that put them in their loan." Mr. Arnstein now works for First Mortgage Corp. near Phoenix.
Both Ms. Williams and Mr. Walker have found themselves in a predicament now common among homeowners in Detroit: They've tried to sell their houses, but can't find buyers willing to pay what they owe on their mortgages. After two years on the market, Ms. Williams says her house has attracted a high bid of $140,000, nowhere near the $211,000 debt she must settle to avoid eviction. That leaves her with no option but to abandon the house -- the worst possible outcome for the neighborhood, because it means the property could end up gutted with a big red debris bin out front.
Kevin Lightsey, a local agent at Keller Williams Realty, says he doubts such foreclosed homes are likely to find new owners willing to live there. "Nobody's going to want to buy into a neighborhood with 20% foreclosures," he says. "You end up with no neighborhood." First American LoanPerformance estimates that, as of March, about one in three subprime loans made from 2002 through 2006 in the 48235 ZIP Code were more than 60 days in arrears, meaning they were either already in foreclosure or well on their way there. Even loans made in 2006 had a delinquency rate of about 17%.
Some subprime borrowers on the 5100 block of West Outer Drive say they are doing fine and planning to stay put. Kevin Ransom, a 42-year-old investment banker who grew up in the area, moved into the red-brick Colonial across from Ms. Hollifield in 1999, leaving behind a job in New York. He bumped up his mortgage debt to $208,250 from $170,100 back in 1999, and put the money into a new roof, marble floors, custom ceilings and a finished basement. He says his income has grown enough to make the monthly payment, which has risen to about $1,700, from $1,200 when he took out the most recent loan in 2002.
"I always had a desire to come back home and try to be in a community," says Mr. Ransom.
Still, he's worried about the way some of his neighbors are losing interest in their homes. Consider Jacqueline McNeal, a school principal who has lived in the house two doors north of Mr. Ransom since 1995. In 2002, she says, she took out a $112,700 loan from Full Spectrum Lending, a subprime arm of Countrywide Financial Corp., to pay off department-store bills, provide financial help to some out-of-work relatives and retire her old fixed-rate mortgage. But last year, as the interest rate on her loan rose to 12% from an initial 8.75%, she fell behind amid a litany of difficulties, including a teachers' strike and problems with the payment of her back property taxes. A Countrywide spokesman said there was nothing inappropriate in the origination or the servicing of the loan.
Now in foreclosure, Ms. McNeal has until early July to come up with the money or be evicted. She doubts she can sell the house, and the missed payments have dented her credit to the point where she can't get another loan. So she's letting the dandelions grow.
"You have two options -- to sell it or to refinance it," she says. "But if you can't do either, what can you do?"
Time to buy stocks?