The Subprime Mortgage Crisis: Everything You Wanted To Know And A Few Things You Didn't

Saturday, December 1, 2007 - 01:00
Joy Harmon Sperling

Editor: Ms. Sperling, would you tell our readers something about your background and professional experience?

Sperling: I have been practicing law for a little over 20 years. I joined Pitney Hardin in 1987, following a clerkship in the New Jersey Chancery Court, and I started in the litigation group. By the early 1990s, my practice narrowed somewhat, as I was engaged in the representation of mortgage lenders, primarily in suits brought by borrowers alleging improper fees and failure to disclose loan terms. Today I also represent lenders in actions against mortgage brokers, appraisers, originators of loans and closing agents to recover money owed in situations where we believe some wrongdoing has occurred.

Editor: You have been following the subprime mortgage crisis for some time. For starters, can you give us an overview of the problem?

Sperling: As I see it, the problem is the result of a number of unanticipated economic events all coming to a head at the same time. At the beginning of this decade, the government was encouraging lenders to develop mortgage products for borrowers who would not normally qualify for traditional loans, including borrowers without a good credit history or the ability to make a substantial down payment. As a consequence, lenders began to offer products that had adjustable interest rates, interest-only loans, and loans with prepayment penalties. Often the borrower was not required to provide documentation as to his financial condition or ability to repay. There were risks, but everyone seemed to recognize that this was the only way to get these otherwise unqualified borrowers loans so they could own homes.

The subprime market skyrocketed and, for a time, borrowers, lenders and investors benefited. The arrangement worked because real estate values continued to rise, enabling borrowers to refinance if faced with an increase in the interest rate or a prepayment penalty. With the high volume of activity, there was sufficient liquidity to permit the lender to foreclose with little cost in the event of a default. Liquidity meant that lenders could always sell their loans in the secondary market.

With the downturn in the real estate market, however, there were too many borrowers incapable of paying the now upwardly adjusting interest rates. In addition, those borrowers who had misrepresented their ability to pay in the first place were unable to rely on an increase in the equity in their homes to obtain additional funds - it simply was not there. Unable to refinance or to sell their property, events of default rose dramatically, with an estimated 15 percent of the subprime loans now in default. That made for a great many unhappy investors as well as lenders.

Editor: And the timing of the problem?

Sperling: The subprime market really took off in 2004-2005. Many of these loans were adjustable rate mortgages with a two-year adjustment period, which meant that the adjustment would come during 2006-2007. For all of the reasons we have discussed, a substantial number of borrowers were unable meet the adjusted rates. That, together with the failure of real estate to continue to increase in value, resulted in defaults. Had values of real estate continued to rise, the borrowers would have had some options and, in the case where lenders nevertheless were forced to foreclose, they, the lenders, would have had the ability to find purchasers for these properties. An unusual combination of factors, all coming together at the same moment - and often exacerbated by the presence of fraud in the loans - resulted in a situation where the value of the property pledged to secure the loan was actually less than the face amount of the loan.

Editor: Lenders - including some very sophisticated ones - are usually very good at assessing the risk of default. What went wrong?

Sperling: Putting it very simply, the lenders were left with an astonishing number of defaulted and fraudulent loans and no market in which to sell them. Sophisticated lenders do their homework, but I do not believe that the extent of the fraudulent loans was, or really could have been, anticipated. As to the impact of the interest adjustments two years down the road and the possibility of a flat or even declining real estate market, I don't think those possibilities were considered when the loans were made.

Editor: Is there any regulatory structure in place that might have given advance warning?

Sperling: The regulatory framework in this area is constantly developing. Federal banking institutions are subject to federal regulation and, because there is only one set of rules, compliance tends to be easier than for state regulated mortgage lenders. At the state level, lenders are subject to a myriad of laws making compliance more difficult. As a result of the recent "crisis," many states - Colorado, Minnesota, Massachusetts, Nevada and North Carolina among them - are attempting to legislate the concept of recommended loan products and to require a reasonable inquiry of the borrower's ability to repay. I think this goes too far. It essentially imposes an unreasonable burden on the lenders to predict the future and, at the same time, be in compliance with the astonishing complexity and diversity of state regulations, many of which do not have easily identifiable standards.

Editor: What kind of impact has this debacle - if that is not too strong a word - had on your practice over the past six months or a year?

Sperling: For my practice, the situation has kept me very busy. Having said that, let me add that this is not necessarily a good thing. We need to figure out a solution to the crisis rather than spending inordinate amounts of time or monies in litigation. Much of my work involves defending lenders against suits on the part of borrowers who do not wish to take responsibility for the loan documents that they signed. I also see lenders going after appraisers and brokers in an effort to recoup their losses.

The various initiatives underway at the federal and state levels appear to be encouraging some law firms to develop a subprime market specialty. To the extent that I have worked in this area for 15 years, I find this development ironic as those without a history of representing clients in this area are trying to capitalize on the crisis. Added to this fact is that every group - and that includes investors, lenders, mortgage brokers, consumer advocates, and a variety of state regulators - is focused on its particular interest and blaming the other groups for the crisis. What is not emerging is a general consensus that would get the market back on track. The real questions have to do with how we ensure a market that permits people to buy a home and to refinance when necessary, to understand the requisite fees to which they are subject, and to pay their loans on time. The discussion is simply not at that level at the present time.

Editor: What do you think the implications are from the crisis?

Sperling: The implications of this crisis vary from group to group. The lenders who are willing to weather the storm will come through this in fairly decent shape. They will be able to make loans, although the terms will be stricter than they were prior to the crisis. Some borrowers who would have qualified three or four years ago are not going to be able to obtain loans. I am not sure, of course, that permitting this type of borrower access to the market is a good thing for the borrower, and I think everyone is clear that it is not a good thing for the lender or for the market generally.

Editor: And the implications for the stock market?

Sperling: In any situation where a very important industry or industry sector, like the mortgage lending industry, is in the midst of a crisis, there can be a dampening effect across the entire economy. It is difficult to say how large the impact will be. However, real estate has always been a safe bet for investors, and I am hopeful that once we get the types of loans that brought about the current state of affairs under control, things will return to normal - by which I mean a real estate market populated by experienced and financially strong lenders and informed borrowers.

Editor: We have all lived through Enron, Worldcom and the corporate scandals that resulted in Sarbanes-Oxley and a whole new compliance structure. Are we looking at a similar response to the subprime mortgage situation?

Sperling: A number of states are already enacting laws that place tremendous responsibility - unfairly so, in my view - on brokers and lenders with respect to ensuring that borrowers have the ability to repay. At the federal level, Congressman Barney Frank of Massachusetts has proposed the Mortgage Reform and Anti-Predatory Lending Act of 2007. Some of his proposals are beneficial to everyone, including a licensing requirement for lenders as well as a net worth requirement. I think it is not in anyone's interest to have lenders in the market who lack experience or do not have a history of making loans, to say nothing of lenders without the means of backing up their loans. The Association of Residential Mortgage Regulators and the Conference of State Bank Supervisors are developing examination guidelines for non-traditional mortgages. Thus, a great many people are attempting to resolve the crisis and ensure that it does not reoccur. The result, I think, will be a compromise. The consumer advocates are going to launch a strong lobbying effort to try to place as much responsibility on the brokers and lenders as possible, while the latter will point out that putting everything on their shoulders will discourage them from making loans available to non-traditional borrowers. At the end of the day, I believe we will have a compromise that encourages lenders to continue making loans but only to borrowers who can afford to meet their obligation to repay.

Editor: What do you believe the ultimate fallout of this crisis will be?

Sperling: Unfortunately, I think that what is going to happen as a result of this crisis is that many people are going to lose their homes. The question is whether they should have been in this market in the first place. Similarly, I think that many lenders are going to go out of business. That is not a good thing, of course, but it may serve to make room for a stronger group of lenders and help to avoid this type of situation in the future. Investors, too, have lost a great deal of money, but I believe they have learned from the experience, as so many of us did in connection with the dotcom fiasco. At the end of the day I believe we will have a healthy and performing mortgage industry, one in which all who participate benefit.

Please email the interviewee at with questions about this interview.

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