April 2, 2013

Bankrupt Stockton: Was the mortgage meltdown a government-sponsored affinity scam?

With the city of Stockton, CA in the news as its municipal bankruptcy winds its way through the courts, I was struck by this 2010 San Francisco Federal Reserve paper on the kitchen table dynamics of how so many people in Stockton and Oakland wound up with mortgages they couldn't afford. One short answer: minorities trusted co-ethnic mortgage brokers to treat them fairly out of racial solidarity.
Sought or Sold? Social Embeddedness and Consumer Decisions in the Mortgage Market 
Carolina Reid,  
Federal Reserve Bank of San Francisco 
Working Paper, December 2010

Stockton is a Central Valley exurb of the San Francisco Bay Area. In the 2000s, new developments went up all over Stockton, but then around 2007, it became one of the foreclosure sore spots of the country, helping set off the Great Recession of 2008.

My theory of the mortgage meltdown has been that it was inextricably tied up with “diversity.”

But, what do I mean by “diversity?” I use the word to signify:

- a demographic reality;
- an ideology or attitude (“Diversity is our strength,” as Dan Quayle said);
- government, activist, corporate, and media projects intended to operationalize that ideology and intimidate skeptics into silence;
- and to signify what many, from the highest to the lowest in our society, view as a get-rich-quick opportunity.

Dr. Reid's little study of mortgagees in Stockton and Oakland is important for understanding the Who? Whom? aspects of the Minority Mortgage Meltdown. 

Since almost nobody in our culture publicly dissents from Diversity, or really even notices anymore how much it keeps us from noticing what is in front of our noses, we are left with only two ideologies:

Double Down on Diversity

The Randians have the problem that while a lot of government programs exacerbated the mortgage meltdown, good old hog-stomping greed played a huge role as well.

The Double Down on Diversity conventional wisdom about how the problem is, as always, Rich Old White Men blocks us from noticing that the Rich Old White Men who were up to their elbows in this debacle (e.g., Angelo Mozilo, George W. Bush) were outspoken enthusiasts for Double Down on Diversity themselves. Indeed, the Double Down on Diversity view prevents us from noticing the High-Low coalition in which elites use designated victim groups as mascots to get more of what they want, even though it is central to understanding the way of the world in the 21st Century.

If we drop both sets of ideological blinders, one thing we notice is that an overlooked aspect of the fiasco was the role of minority mortgage brokers in putting their co-ethnics into terrible loans. This isn't a huge aspect to the story, but it's an enlightening one.

Since 1968, the government had built a system based around the notion that the problem was white people denying loans to people of color. Over time, the more optimistic and/or aggressive industry participants became true believers. There had been a big push over the years to diversify the mortgage broker profession, both from the government for diversity reasons and from private interests for profit-seeking reasons. It seemed a happy illustration of the virtues of MultiCulti Capitalism.

Not surprisingly, with everybody -- regulators and regulatees -- in vociferous public agreement that the solution was to Double Down on Diversity – hire more minority mortgage brokers so minorities can get more mortgages – the real problem turned out to be the opposite: the minority mortgage brokers pocketed big commissions putting minorities who should never have gotten a mortgage at all into a mortgage, and pocketed bigger commissions by putting creditworthy minorities who should have gotten a prime interest mortgage into a higher commission subprime one. 

Dr. Reid's paper is based on interviews with 33 people in Stockton and 47 in Oakland. In this little study, 66 of the 80 homebuyers were nonwhite. Interestingly, 84% of the respondents enjoyed the services of a mortgage broker of the same race/ethnicity as themselves.
The anecdotes also provide insight into why so many borrowers ended up in loans that they could not afford over the long term, and why borrowers with prime credits cores—particularly among Hispanic and Black borrowers—received a subprime loan. Did borrowers actively “seek” out subprime loans, or were they “sold” loans by unscrupulous brokers and lenders?
In the interviews, three key themes related to social embeddedness emerged. ... social networks to help them identify mortgage brokers and lenders, and particularly for the immigrant and African‐American respondents, revealed a strong preference for brokers who were part of the local community [i.e., racial community, not geographical community). This preference was driven by perceptions that outsiders would not treat them fairly, and that a broker who “understood” their situation would be more likely to result in a positive outcome.

Keep in mind here that “positive outcome” to most of these minority borrowers means getting your hands on the front door key, and “treat them fairly” means letting them get a house, not making sure it’s a mortgage they can afford. Reid provides numerous examples of get rich quick greed among her interviewees. A lot of people in Stockton and Oakland figured they'd flip the house for big money right away, so few read their contracts, even if they were literate in English.
The shared identity that borrowers felt with their brokers, coupled with the broker’s perceived expertise about the mortgage process, led borrowers to trust their advice and not seek external validation of the information provided. As I show using the quantitative data, this led to mortgage outcome sthat were not necessarily in their best economic interest.  
One of the strong themes that emerged from the interviews was the extent to which respondents of color expressed their desire to work with a broker from their own community or background, and that they turned to friends and family members to identify a broker or lender that had a history of serving other families in the community.  
In, numerous interviews, borrowers said that they turned to their social networks and relations in the neighborhood to identify a local mortgage broker who would be willing to “work with someone like me.” Part of this was driven by a lack of trust in traditional lenders, and several respondents in Oakland noted a historical distrust of banks in the community. 

By lack of trust, they mean, I suspect, resentment that banks in the community didn’t trust them to pay back loans. Of course, that it turned out the the bad old banks were right about them won't make them like the bad old banks more.
….Empirical research studies, however, have revealed that during the subprime boom, yield spread premiums coupled with a push for a greater volume of loan originations provided a financial incentive for brokers to work against the interests of the borrower(e.g. Ernst, Bocia and Li 2008). In addition, since there was no statutory employer‐employee relationship between lending institutions and brokers, there were few legal protections to ensure that brokers provide borrowers with fair and balanced information. This aligns with the “trust” that social relations engender. … 
In both Stockton and Oakland, respondents did not seem to be aware of the potential for perverse incentives on the part of brokers, and instead trusted them fully to actin their best interests.

… The quantitative data, however, shows that the decision to “trust” a broker often worked against the best financial interests of the borrower, especially for minority borrowers. Research has shown that regardless of their FICO score, Blacks and Hispanics were much more likely to receive a high‐cost loan, especially when that loan was facilitated by a mortgage broker. This hold strue even when we control for other factors, such as local housing and mortgage market conditions, fico score, and loan to value and debt to income ratio. 
Indeed, in a multivariate model that controls for the majority of underwriting variables, we find that origination by a mortgage broker has a large statistically significant effect on the likelihood of getting a high cost loan for certain borrowers, and that this effect is greater for Hispanics and Blacks. (Figure 5) The marginal effect of using a broker is 22 percent for Hispanics, and 18 percent for Blacks. While it may not seem like an extremely large effect, it is approximately equivalent to a 200 point decrease in a borrower’s FICO score. In contrast, white borrowers who used the services of a mortgage broker were 4 percent less likely to get a high cost loan, suggesting that in their case, on average, brokers helped them to navigate a better mortgage product based on their risk characteristics. 
So, were these loans “sold” or “sought”? While certainly not conclusive, the interviews suggest both are true. First, mortgage brokers in Oakland and Stockton were specifically targeting their services to borrowers with lower FICO scores, and much of the marketing focused on reaching borrowers with poor credit records. (Figure 6) Second, borrowers with lower credit scores actively sought out mortgage brokers who they had heard would help them wade through the paperwork and get a mortgage approved. What was less clear from the interviews was whether or not brokers had intentionally duped borrowers into taking on irresponsible loan products.

In Reid's sample, four of her 80 interviewees were also mortgage brokers themselves. They all felt fine about what they did, and few of her other minority interviewees blasted their brokers. Most felt pretty warmly about their brokers still. The affinity part of affinity fraud really works.

Affinity scams in which people are duped into trusting that a promoter has their best interests in heart because he's a fellow whatever are sadly common. Affinity fraud and Ponzi schemes (which the Housing Bubble was a variant of) frequently go together.

Yet, I'm not sure if anybody has previously pointed out how the government, media, activist, and social pressure to diversify the mortgage industry turned places like Stockton into a government-endorsed affinity fraud Ponzi scheme?


Dave Pinsen said...

If memory serves, Barry Ritholz was skeptical that pro-diversity policies played a significant role in the mortgage bust when you first blogged about this. Now that quantitative research is lining up behind your thesis, have you considered reengaging with Ritholz about this?

Nair said...

It can't be that minorities would hurt other minorities, so it must be that evil white men were intentionally hiring minorities, knowing that those minorities would intentionally scam other minorities and make loans that would seriously screw up the banks the white guys work for in the long run and have their pensions tied up with, er, uh something like that. Except for that last part. Down the memory hole with that.

countenance said...

As we've seen in very recent political history, "Doubling Down on Diversity" and "Libertarianism" are one and the same (cough cough, Rand Paul, cough cough)

May I be so haughty as to offer a third (or should that be second?) option to the "choice" between DDOD and libertarianism?

White nationalism.

sunbeam said...

That's a lot of words to basically say (even if it wasn't what you thought you were saying) that mortgage lenders had a product to push, so they picked the most effective people to sell to the target.

Where I live, I kind of cringe when I see a sign for a "Christian" business, or hear someone use that as a selling point.

Kind of like how there used to be a correlation between being a Deacon in the church, and also being an insurance salesmen.

To go back to your argument, these lenders weren't holding the mortgages. They were being sold as quickly as they got them made, in ungodly combinations of financial instruments only a quant could love.

Anyone who knew anything at all about this, knew it was going to blow up.

If anything, I kind of think some of these minority salesmen probably didn't really understand the whole system. Their job was to make reassuring noises, make sure everything was signed. I doubt many of them really understood interest, or where these mortgages were going to go. They probably got a genuine warm fuzzy from thinking they were helping people and making a difference.

And a few did understand what was really going on, and cynically played the "race card" to rip off members of their specific ethnicity.

So what? A story as old as the hills.

You might even say it is the American Way.

I don't see how anyone puts the blame for this on anyone but the lenders, the regulators, the elected officials who set up or allowed to be set up the whole system, and the Fed that threw a lot of low interest rate gas on the fire.

These people knew what they were doing. And they had a pretty good notion how it was going to end I wager.

Yet they did nothing. And why not? It's not like it was any skin off their ass after all.

When you make arguments like this, you can't have it both ways.

Or do you really expect people that buy lottery tickets to understand that paying 70% of your income on a mortgage payment is a bad idea, or that that balloon payment is going to explode like the hammer of the gods in two years.

After all, the sales guy probably told them "you can always renegotiate" or "we can do something in a couple of years."

What is scary to me is that I really think a lot of them believed their own bullshit.

Bill said...

Heartiste/Roissy published a very instructive inside look at this a few years ago:

My Time Inside The Housing Bubble

...the Vietdon looked carefully around the room, eyeballing each one of us.

“This is good, very good.” He was smiling and nodding his head. “The way it works here is simple. Trust. You earn the client’s trust and your business takes off. They trust you, they sign on the dotted line. So, for instance…” He pointed at the Asian women. “These ladies are assigned to female clients. Asian women in particular. They will trust them.”

The Asian girls snickered and one uncrossed and crossed her legs. I watched her crotch as she did this.

The Vietdon continued. “And my boys over there…” The Hispanic guys laughed. “They get the Hispanic clients. This is the way it works in this business. Now let’s be real. Most of our Hispanic clients aren’t high rollers. They’re struggling, making ends meet. They got families. They need houses to put those families in. They work hard. To get them to sign on the dotted line…” (He loved that expression.) “…you’ve got to put their minds at ease that you’re looking out for them. They trust someone who looks like them, you know?”

More nods of agreement from the Jose contingent.

“Then we’ve got our white guys.” At saying this, the Vietdon smiled broadly. “You guys, you go out in the field with a casual button down, one button at the top undone, nice shoes, real tall all-American look, and people with money trust you. I get some white clients… not too many because, you know, we mostly deal with the underserviced community…” (The group chuckled.)

Mr. Anon said...

They unwisely chose to be members of the wrong ethnic group.

jody said...

perhaps the poster who pretends to be nick diaz will comment, as stockton is the hometown of the real nick diaz.

want to take credit for mexicans bankrupting stockton, nick diaz? or do you only post when you're not recovering from getting beat down by plucky canadians named georges?

ben tillman said...

And a few did understand what was really going on, and cynically played the "race card" to rip off members of their specific ethnicity.

Where's the ripoff?

They put no money down for a chance to flip a house for several hundred thousand in profits. That's a bonanza.

Anonymous said...

Steve: Have you read the Michael Lewis book The Big Short? It provides an interesting account of the other half of these deals; namely, the manner in which these mortgages were packaged and sold as bonds by Goldman Sachs et al and insured by the likes of AIG and how it all fell apart to the cost of everyone other than those who looted the system.

Anonymous said...

Stockton is not a "exurb" of SF. It's a town/city in its own right that goes back almost to the Gold Rush. It's well situated at the northern end of the San Joaquin Valley amidst rich farmland and on the San Joaquin River, which connects via the Delta through the Suisun Bay into the Eastern SF Bay. It is, or was, one of the busiest inland river ports in the US for well over 100 years.

None of that is to take away the point that the city has been overwhelmed by demographic disaster.

Dutch Boy said...

Interesting that members of ethnic groups from "low trust" societies grow trusting in the good ol' USA. Perhaps a tad of "Americanization", e.g., like the absurd amount of trust Americans have for government officials and government in general.