Howard Husock

Thursday’s Wall Street Journal makes clear that subprime mortgage delinquencies are not just a problem for the bond markets and homeowners—they’re a special problem for cities. The maps and tables of Where Subprime Delinquencies are Getting Worse show that subprime defaults are geographically concentrated and that much of that concentration occurs in cities. In Oakland, 12 percent of all subprimes are delinquent for 60 days or more; in Sacramento, 14 percent, Boston, 15 percent, Minneapolis 16.5 percent and Detroit, 24.6 percent. In New York City, more than 9,000 homeowners faced foreclosure in 2006, 50% more than in 2005, and the 2007 numbers are even worse so far.

Any delinquency reflects personal hardship, but such concentration can also mean neighborhood problems. If one’s neighbors are behind on mortgage payments, it’s not likely they will paint or do roof repairs either. Such are the ways neighorhoods—and tax bases—go downhill.

One might call this the “default and delinquency belt” phenomenon. I first saw it several years ago on the near-South Side of Chicago, where a community organizer (not Barack Obama) took me on a tour of the Back of the Yards neighborhood. He’d painstakingly assembled data on mortgage defaults—and could point out which houses on which blocks were in trouble. It wasn’t hard to tell. Some had been abandoned and taken over by drug gangs. Blue collar neighbors understood their life savings, tied up in their homes, to be at risk.

The questions arise, however, as to why such urban delinquency belts, as mapped by Journal, have come to be, and what, if anything can or should be done about them?

The meta-narrative in the press and amongst the politicians portrays those in arrears as victims of fast-talking “predatory” salesmen who have targeted the unsophisticated. One suspects the situation is a good deal more complicated than that, that there are multiple and overlapping causes.

One must keep in mind in discussing urban lending that it was not all that long ago (mid to late 1970s) when the concern of cities was redlining—a conscious policy of banks not to lend in urban areas. It was unappreciated by those leading protests that the banking system did not provide incentives for lending in areas where values may have been declining and borrowers were not good underwriting risks. Banks were highly regulated at the time and effectively limited in the interest rates they could set on mortgages. In such a circumstance, it made sense for banks to focus on the best credit risks in the best neighborhoods.

In the years since, the banking industry has changed beyond all recognition. Banks can now branch across state lines. Competition for customers has become fierce. The credit scoring system has developed, allowing lenders to judge individual borrowers with great precision. And deregulation has allowed lenders to set interest rates in line with the risk reflected by those credit histories. Such loans are what we are now calling subprime.

Just as significantly, new sophisticated secondary mortgage markets developed, which aggregated lots of both prime and subprime offerings in distinct bond offerings and brought them to investors around the world. No longer did individual banks have to hold on to loans themselves—“keep them in portfolio”—and bear all the risk. Thus were the stars aligned for a flood of loan capital to come to types of customers and areas which had not had loans on offer before. What’s more, all sorts of new loan “products” also emerged—mortgages with low “teaser” rates that would later adjust upward, for instance.

These loans are one part of the delinquency belt story. During the housing boom, it made sense for all sorts of lenders, buyers and owners to take big risks. If prices were going up, owners figured that even if they might have a hard time making payments, they could sell and pay off their mortgages, and still pocket a profit. The leveling off and in some areas decline in housing prices has changed that game. Owners are now stuck with negative equity homes worth less than their mortgages. That’s a precursor to delinquency and default.

Why would such loans be concentrated in cities? Because in the hyper-competitive banking market, lenders were looking everywhere for untapped borrowers. There can be little doubt that some fast-talking mortgage salesman emphasized the cash which owners could get if they took out a home equity mortgage. For cash-strapped owners in cities with lousy economies—Detroit or the old mill town of Danville, Virginia, for instance—this was a way to get extra cash. For owners in areas of rising home values, this was a chance to gamble on a continued rise. One can be sure that mortgage salesmen did not emphasize looming higher payments, and the problems these payments would cause for those living on fixed or limited incomes in the Detroits of the country, or the prospect of a home’s value actually declining. This would help explain high delinquency rates in cities such as Worcester, Massachusetts—where values had long been rising but where the harsh reality of a housing price decline has recently set in.

Add to all this the Community Reinvestment Act, federal legislation enacted a generation ago in the wake of the protests against “red-lining” that required banks to make loans in so-called under-served urban areas and to under-served racial minority groups. A bank’s CRA ratings as determined by federal regulators can stand in the way of the mergers and acquisitions which have swept the industry in recent years. But bankers have little incentive to do much due diligence when it comes to meeting CRA requirements which they’ve historically viewed as a cost of doing business. Subprime lending seemed to offer a better model in which loans to minority borrowers in under-served neighborhoods could also be profitable. No wonder the tap was open so wide.

What can be done at this point to help both subprime borrowers and the cities in which they live? Democratic politicians, including Hilary Clinton and Christopher Dodd, are, not surprisingly, calling for aid to beleaguered borrowers. But as City Journal contributing editor Nicole Gelinas has pointed out, this would pose a huge moral hazard—those who were prudent and careful about going into debt would, in effect, be asked to pay off the bills of those who didn’t. The Ohio Housing Finance Agency has, in this vein, already announced it will float $100 million in bonds to allow subprime borrowers to refinance with state subsidy. My 82-year-old father in suburban Cleveland, who has no mortgage but plenty of other bills, thus has to help those who took foolish risks. A bailout, in other words, is not the way to go. Neither is so-called “suitability” legislation, which would restrict lenders to offering mortgages which borrowers could afford, based on some regulatory standard. We will not help the upwardly mobile poor or others by stripping them of their autonomy this way.

Mayors should call on federal regulators to compile data on delinquencies among loans which have counted for “CRA credit”. They might then find out that something they thought was good for cities actually was not. Local governments and nonprofits should take the occasion of the “subprime crisis” to educate potential buyers and owners about the risks that come with debt. We are in the midst of a painful market correction, and while that’s how people learn, there is no doubt that there will be collateral damage for cities.

Howard Husock is the Vice President of Programs and the Director of the Manhattan Institute's Social Entrepreneurship Initiative. He was formerly the director of case studies in public policy and management at Harvard University's Kennedy School of Government.