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

v.

Libertarianism

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?