Over-indebtedness, the subprime mortgage crisis, and the effect on U.S. cities.

• Author: Dickerson, A. Mechele

Introduction I. The Increased Availability of Consumer Debt A. Deregulation 1. Housing Purchases: Then 2. Housing Purchases: Now B. Responses to the Unaffordability Problem C. Technology D. U.S. Labor Markets E. Changed Norms 1. Thrift 2. The Myth of Homeownership II. Consumer Debt and the Financial Crisis A. Overall Debt Levels B. The Housing Crisis 1. Harm to Cash-Strapped Borrowers 2. Other Homeowners 3. Other Negative Externalities 4. Other Non-Homeowner Borrowers 5. Urban Areas C. Responses to Current Debt Levels III. Potential Responses by Urban Communities Conclusion INTRODUCTION

Too many people in the United States are overwhelmed by debt. While we were once a country of thrift, consumer indebtedness has become a ubiquitous phenomenon that affects people in both urban and rural areas and from all socio-economic groups. Because so many people are over-indebted, (1) the United States is in the midst of a severe economic meltdown and the magnitude of the federal government's intervention in the financial markets is surpassed only by the bailout efforts to end the Great Depression. (2)

The economic crisis was caused by the record number of defaults on subprime mortgage loans and the foreclosures that followed those defaults. For the last two years, U.S. homeowners--like consumers in the rest of the world--have felt the financial pain associated with rising fuel and food prices. The increase in the prices of those commodities, however, was not the reason homeowners started defaulting on their subprime mortgages. Instead, the U.S. subprime mortgage crisis was triggered by (and then morphed into a global financial crisis) the over-consumption of consumer credit generally and our gluttonous consumption of mortgage debt.

This Article discusses the rise in consumer debt generally, the harm that the current credit crisis has caused to the U.S. economy and global capital markets, and the specific threats that the current financial crisis pose to U.S. cities. Part I discusses the increased availability of consumer debt and how deregulated consumer credit markets, along with technological, demographic, and labor market changes, caused lending standards to become so relaxed that people were able to buy homes they clearly could not afford. Part I also notes how shifts in societal views toward thrift and borrowing have caused too many people to borrow too much in a desperate attempt to participate in the "American Dream" of homeownership.

Part II focuses on the current financial crisis. This Part presents current overall consumer debt levels and then discusses the harmful effects of the financial crisis on homeowners, the financial sector, and even groups that are unrelated to the housing industry (such as college students). Part II then briefly describes the initial responses to the financial crisis and the various, but ultimately failed, attempts to prevent the subprime credit crisis from spreading.

Part III suggests that, rather than wait for federal bailouts, localities take proactive steps (including purchasing foreclosed homes) to prevent this financial crisis from decimating their cities. The Article ends by stressing that the metastasizing mortgage crisis threatens to leave urban areas with a glut of abandoned homes and that an increase in distressed neighborhoods may reverse years of urban renewal projects.

1. THE INCREASED AVAILABILITY OF CONSUMER DEBT

   In the 1960s, it was not easy to obtain low-cost credit. At that time, low-cost credit principally existed in only two forms and was given only to consumers who had stable income and who could document assets that could be pledged as collateral. (3) The first type of low-cost credit consisted of long-term, conventional mortgages issued either by commercial banks or the U.S. government. (4) The second type consisted of installment loans from local commercial institutions or credit unions that were issued only after an official of the lending institution examined the borrower's income and assets in detail and concluded that the borrower was creditworthy. (5)

   Until the late 1970s, a borrower who wanted to obtain credit to purchase an item almost always would be forced to have a face-to-face meeting with the lender and, except for the wealthy, would be required to document their income and assets. (6) Borrowers who did not have assets they could pledge as collateral and people who could not (or would not) document that they had stable income would almost always be denied credit. The only type of credit that might have been available for them would be offered by local department stores or automobile dealers in the form of installment loans that would allow them to purchase items only from the lender that issued the credit. (7)

   That has all changed. Since the late 1970s, consumer credit has risen at astronomical rates in this country. (8) It is impossible to understand the current credit crisis without understanding why so many consumers started amassing so much debt. To understand that, one must ask why it has become so easy for so many borrowers to get so much credit. For the most part, the over-consumption of credit can be traced to the deregulation of the consumer credit market and to the resulting "democratization" of credit. (9)

   1. Deregulation

      Starting in the mid-1970s, the U.S. government deregulated the consumer credit market and made it easier and more profitable to extend credit to consumers. (10) With fewer regulatory controls and especially with relaxed usury laws, creditors were willing to increase the amount of credit they would extend to a group of consumers who had until then been deemed unworthy of credit. (11) Indeed, until the mortgage meltdown seized the credit markets, anyone (regardless of his credit risk) and anything (whether human or not) could reasonably expect to receive a credit card offer. (12)

      With interest rate ceilings largely lifted, extending credit to even high-risk borrowers became quite profitable. Lenders were willing to give credit even to borrowers with bad credit (in other words, subprime borrowers) (13) because they could charge significantly higher rates to compensate for any increased risk of default when lending to riskier borrowers. (14) The effect that a deregulated market had on consumer credit transactions can perhaps best be illustrated by the differences entailed in buying a home pre- and post-deregulation.

      1. Housing Purchases: Then

         People who wanted to borrow money to purchase a home in the United States up until the 1970s were required to make a significant down payment, then agree to make consistent monthly loan payments for an extended period of time, typically fifteen or thirty years. (15) That is, before deregulation, potential homeowners either had to make a down payment of at least 20% or had to purchase private mortgage insurance ("PMI") if they failed to pay 20% down. (16) Forcing borrowers to make down payments protected the lender by lowering the total mortgage debt (and, thus, the lender's total risk of loss) and also forced the borrowers to make up-front financial investments in their housing purchases. The down payment requirement ordinarily would be waived only for wealthy borrowers who actually had the funds to make the down payment but wanted to use their cash to make other investments. (17)

      2. Housing Purchases: Now

         Starting in the early part of this decade, interest rates started to fall and the United States experienced unprecedented home price appreciation. The rate of appreciation in some markets was astronomical. (18) Housing prices in the aggregate increased by more than 50% over the last decade and, in some regions, had annual increases of over 10%. (19) These skyrocketing housing prices benefited some homeowners and created vast sums of wealth for them. (20) These gains were not, however, evenly distributed and housing price appreciation ultimately created a significant unaffordability problem for renters who wanted to purchase homes--especially homes in some east and west coast markets. (21)

         The extended boom in house price appreciation actually fueled the consumption of housing (and of the mortgages associated with those houses) that otherwise would not have been possible. That is, while non-traditional loan products were offered ostensibly to make housing more affordable, these loan products actually aggravated the meteoric house price appreciation. By allowing cash-strapped borrowers with bad credit to buy a home with no money down, and by letting these borrowers make artificially low monthly payments, consumers who could not afford to buy these homes suddenly could afford to become a homeowner even though the loan products placed the borrowers at great financial risk.

         Of course, some borrowers may have been greedy by attempting to purchase a house they simply could not afford, and others may have engaged in outright fraud. For example, recent reports suggest that some borrowers intentionally inflated their incomes on liar loans, (22) rented or borrowed the credit scores of more creditworthy borrowers, paid to be added to the credit cards of people with good credit histories, or bought fake payroll stubs. (23) Other homeowners, however, especially first-time homeowners, appear to have been naive, unsophisticated, and genuinely seemed shocked to learn that it would be difficult to sell their homes once the housing market stalled. Likewise some seemed surprised to discover that, even though they had no equity in their homes, refinancing their high-cost loans was not an option. (24) Finally, information asymmetry appears to have caused some of these borrowers to accept expensive, non-traditional, mortgage products even though they did not understand the loan features (25) and even though they may have qualified for a lower-cost loan product. (26)

   2. Responses to the Unaffordability Problem

      Because of the low (and, in many years, negative) U.S. savings rate, (27) the down...