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Race and the Housing Bubble

posted by Jean Braucher

While we wait to see if the second Obama administration will do anything new to help homeowners hit by the lingering mortgage crisis (finally replace Bush-holdover Ed DeMarco at FHFA to make way for debt relief?), there’s time to review a recent development that didn’t get the full attention it deserved.

I am referring to a lawsuit, Adkins v. Morgan Stanley, filed in the Southern District of New York in October by the ACLU. We don’t usually associate the ACLU with consumer protection in mortgage finance, and not surprisingly, it has brought a fresh perspective on the abuses that led to the housing bubble, highlighting race disparity in subprime originations.

Together with the National Consumer Law Center, the ACLU has brought a class action against Morgan Stanley charging that it financed a major subprime mortgage originator, dictated the nasty terms offered, and bought up a big portion of the resulting junk to feed its securitization maw.  The originator was New Century Mortgage Corp., which filed in bankruptcy in 2007.

The plaintiffs are African-American homeowners in Detroit who were sold New Century mortgages and who have ended up facing foreclosure. Also joining as a plaintiff is Michigan Legal Services, which has been swamped with mortgage cases in foreclosure ground zero, Detroit.

The legal theories used include the Fair Housing Act and the Equal Credit Opportunity Act, which are promising because these federal laws cover purchasing loans and also make disparate racial impact sufficient to make out a discrimination case. The 71-page complaint presents data that Detroit-area African-American customers of New Century were 70 percent more likely to end up in subprime loans than white borrowers with similar financial characteristics. The suit seeks a jury trial and disgorgement of ill-gotten gains, among other relief including appointment of a monitor (a good idea given the constancy of race discrimination in US housing finance practices).

A class action lawsuit like this one of course faces many challenges, but it is potentially a strong tool to get relief to the minorities who were hurt by racially disparate lending practices used in the boom years 2004-2007.  It could be a model for similar efforts against other securitizers in other parts of the country.

As a result of the mortgage crisis and ensuing economic crisis, minority wealth has declined dramatically in the US.  A Pew study found that median wealth of white households has grown to 20 times that of African American households and 18 times that of Latino/Hispanic households. Minority households have tended to have more of their wealth in their homes, so they were the hardest hit by the crisis, likely continuing intergenerational disparities in wealth by race.

At the core of the mortgage crisis is a problem of race discrimination in mortgage credit, one that has gone on for generations in different forms.  In the 1950s, post-war federal homeownership programs deliberately focused on racially homogenous neighborhoods. Financial institutions engaged in redlining, refusing to lend in minority communities.  This set up the conditions for reverse-redlining, targeting minority communities for subprime loans in the 1990s, a practice that revved up during the bubble.

Plenty of white people got subprime loans, too, but the race disparity was pronounced.  Race discrimination thus significantly contributed to a dynamic that put the entire economy at risk. A government report in 2000 found that subprime refinancings were five times more likely in African American neighborhoods than in white ones. Minorities are significantly more likely to be sold mortgages than to seek them out.

The crisis hit minorities hard. African Americans and Latinos have been much more likely than whites to face foreclosure.

Government efforts concerning the mortgage crisis first focused on shoring up the safety and soundness of financial institutions. Efforts on behalf of homeowners at risk have been much weaker. In the delayed blame game, there has been more focus on bad servicing practices than on even worse origination problems, although the Justice Department did bring two race discrimination cases against Wells Fargo and Bank of America, resulting in settlements totalling half a billion, small change given the scope of the problem.

The ACLU suit goes after the Wall Street middlemen that created the whole house of cards. Morgan Stanley made huge profits on fees when it put together securitizations. Those left holding the bag were the borrowers and the investors, the parties at the beginning and end of the securitization pipeline. The practices involved have been called “pass the trash,” and they made it possible for securitizers to avoid holding the risk of default. 

One of the named plaintiffs in the case brought by the ACLU is Rubbie McCoy, a single mother who was sold an adjustable rate mortgage with an initial rate of over 12% that could not fall below 10.74%. In addition to being high cost (the interest rate could go as high as 17.75%!), her loan had other characteristics common in New Century subprime originations purchased by Morgan Stanley, such as a very high loan to value ratio and prepayment penalties. The loan left Rubbie with a high debt to income ratio. The broker inflated her income in the loan documents and the appraiser inflated the appraisal of her home’s value.  See her talk here about the stress of living in the shadow of foreclosure while keeping her kids on track at school. 

This will be one to watch.

Comments

It's difficult to see how they reach MS on liability grounds if your post is accurate. Certainly there is no privity or similar nexus identified in this post. The "dictate the terms" allegation, which is the only thing I see that alleges conceivably actionable conduct of MS (there are also statements that they purchased loans and made huge profits, neither of which is tortious or discriminatory, but seem to trigger a negative opinion on your part), is probably just a plaintiff lawyer's spin on MS informing New Century what the market for MBS would and wouldn't absorb, which is hard to say is discriminatory or unfair, especially if accurate. And frankly somewhere in this world, there is probably someone making the opposite argument, that MS should be liable because it didn’t get sufficiently involved in terms of mortgages and thus allowed New Century to hurt people. One could go back to Prof Levitan’s posts on Scott Brown to see that argument being laid out.

Your post seems to conflate MS, New Century, and third parties – for example, when you recite wrongdoing by brokers and appraisers. But you quote no allegations attributing third parties' conduct to MS, and they would be implausible. It's just more of the theme of "guilt by association" that runs through this blog.

It seems that this blog reflexively espouses whatever rationale is suitable to get to a pro-borrower, anti-financial institution result: lenders lend too much, they're not lending enough; their credit standards are too tight and people are being frozen out, no, they're too loose and people are getting in over their heads; they're charging too much for poor people to access credit, no, they're charging too little upfront and sucking people in; they're dictating the terms, they're not exercising enough control over the terms; it's redlining, no it's reverse redlining, and so on. There's no ex ante principles at work, it's just: here's financial institutions on one hand, here's unhappy borrowers on the other. so the right rule is whatever transfers value from the financial institution to the borrower in the particular situation.

This is a race discrimination lawsuit. I don't think privity of contract is an element of a cause of action under the relevant federal statutes (and there is also a theory under a Michigan civil rights statute). Even if it were, theories of close connectedness or lender liability might be apt. The allegations are that Morgan Stanley financed New Century, dictated the terms it offered, and then was its leading customer. Also that the terms were worse on a racially disparate basis, controlling for financial characteristics.

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