Why the Banks Got Hit for $25 Billion

esterday, I wrote about the $25 billion settlement between five big banks and the Department of Justice in a landmark settlement over foreclosure abuses. But I wanted to make a point to explain in greater detail exactly why and what is happening in the world of foreclosures, mortgages and real estate.

The mortgage mess we got into really began in 1977 with a law signed by President Jimmy Carter called the Community Reinvestment Act (CRA) of 1977. Many politicians, particularly Republicans, like to say that it was the CRA that forced banks to lend to unqualified borrowers, but this is simply untrue.

The CRA only stopped banks from refusing to give loans to minorities or using a process called redlining. From the year it was signed until 2000 the rate of mortgage lending stayed about the same.

What changed was further deregulation that removed all authority from the mortgage industry. This is what created the subprime (sub meaning below, prime meaning good) mortgages that people often talk about. The truth is subprime mortgages actually went to a lot of people with good credit.

Mortgage brokers could give them out more easily and got paid more money by the banks for them, so naturally they issued more of them. What the people getting the mortgages didn’t know and often the mortgage brokers didn’t know was that the interest rates on the loans usually ballooned to the point where it cost significantly more than a traditional mortgage would. That’s why the banks were pushing them to the brokers who would then push them to the customers.

Once they ran out off qualified candidates to give the mortgages to they started finding anyone they could. So, in a complete reversal what had happened before the CRA, banks started looking almost exclusively for minorities (particularly African Americans) to give out subprime loans to. They used the CRA to justify this lending.

Eventually the process became so rampant that if a black or brown person walked into a bank looking for a mortgage they were almost guaranteed to be given subprime loans, no matter what their credit score or income. This happened at all the big banks. Some brokers had really nice nicknames for these mortgages like “ghetto loans.”

Of course the new homeowners were unable to pay their “ghetto loan” once the payment ballooned (often to twice or three times as much as the original payment) and would ask the bank for something called a loan modification. Loan mods weren’t uncommon, but because of the repeal of the Glass-Steagall Act in 1999 banks could sell mortgages to investors and now had no reason to help struggling homeowners because they no longer owned the mortgage and didn’t care if the owners paid it. In fact, most banks realized they could actually make more money by foreclosing and selling the home at a loss. (A great example of one bank that made out like bandits is here.)

So the banks jerked people around and did everything in their power not to modify their loan or allow them to refinance. There was so much evidence of this that the banks had no choice but to accept the ruling of the Justice Department and give the $25 billion in relief. That money is a drop in the hat for them, but will likely help out many struggling homeowners who are facing foreclosure.

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