By Jesse Marx
By Chris Parker
By Jake Rossen
By Jesse Marx
By Michelle LeBow
By Alleen Brown
By Maggie LaMaack
By CP Staff
The interest-only mortgage? You might as well kill yourself now--that's suicide. There's a six-month, a three-year, and a ten-year. The ten-year has the highest rate. Interest-only loan rates last month went up half a percent, so the payment jumped. If Greenspan keeps raising rates, you're going to lose the house.
Regardless of how good your credit is, they always offer you an interest-only loan. Mortgage brokers want to qualify the person, because that's how they get paid. The commission is higher on an interest-only because the loan is bigger. If you make four $250,000 loans in a month, that's $8,000-$10,000 for the broker.
Let's say I work for Wells Fargo. I can't qualify you at the bank, but it has an arm, Wells Fargo Financial Services, that will qualify you. They all do--US Bank Financial, TCF Help You Lend, Countrywide--and they're all ready to explode. I think when you get caught up in the game, you're gonna get in trouble.
--A rising star in the Minneapolis office of a highly esteemed financial services firm on the explosively popular interest-only loan, which makes up one-fourth of all mortgages made in Minnesota this year.
The townhouse where John and Rosalie Marolt live is the sort of place where people typically just make do. A single small space does triple duty as living room, dining room, and kitchen. It's very sparsely furnished, and outfitted with pebbly-surfaced sheet vinyl and wood-tone cabinetry and other materials that look tired and cheap even though they're brand-new. The extra window it's afforded as the end unit looks out on mud and weeds and a sagging stack of trusses that hints at more rows of townhouses to come. Yet somehow it's clean and bright and cheerful.
The Marolts have been renting this place in Zimmerman, a dozen miles north of Elk River, for a year, ever since it became clear that they were going to lose the house they'd owned for 14 years, that the succession of ever-bigger mortgages that were supposed to keep their heads above water were in fact drowning them, that what they might have accumulated instead got siphoned off by a series of creditors who specialized in dangling lifelines to desperate families. They simply let go of the house, 1,000 square feet of hardboard siding and fake shutters in a rundown neighborhood a few blocks away, moved their things out, and let the sheriff deliver it back to the bank.
The paperwork documenting the various loans makes it clear that the Marolts are chronic debtors. As soon as one refi wipes out a car payment or a credit card balance of a few thousand dollars, they begin to accumulate new debt. But a look around the rented townhouse also suggests that if they are living beyond their means, they certainly aren't living high on the hog. There's no big TV, no stereo system, no shiny kitchen gadgetry. No vacation souvenirs or decorative touches. The only signs of spending are the cars, Rosalie's 2002 Saturn sedan and John's 2000.
Mostly, it looks more like they couldn't stay out of debt because they couldn't make ends meet. John, 59, recently retired from three decades working as a janitor for the Fridley schools. Rosalie, 56, worked at a grocery store decorating cakes. Including a disability payment John gets and a stipend for their adopted nine-year-old daughter, they were bringing home a little more than $3,000 a month, out of which they had to pay for insurance, too.
The Marolts know exactly how their finances got so out of control. "They say you should have six months living expenses in a savings account, but that's impossible when your wages don't keep up with inflation," says Rosalie. "We couldn't catch up, so we had to use [credit cards] to buy groceries. So we were always getting further and further in the hole."
Like millions of Americans, they paid off those credit cards with a home equity loan, which consumers are increasingly encouraged to think of as money in the bank. When those payments proved unmanageable, too, they began to listen to the telemarketers who called offering new mortgages held up as quick fixes to the Marolts' problems.
It seemed too good to be true. "Our credit isn't the best. If I were a loan officer, I never would have made us a loan," Rosalie says. "They keep on telling you, 'This is good for you, this will get you out of the hole.'"
For hundreds of thousands of people, easy credit has proven the modern-day equivalent of the plantation store: Every transaction puts them a little further from financial freedom. Adding insult to injury, the more the debtor needs the credit, the more expensive the terms are likely to be. With interest rates hovering near 40-year lows, people with low incomes and imperfect credit histories now routinely pay rates that were illegal 25 years ago. Rates routinely start above 9 or 10 percent; if homeowners can't refinance before introductory "teaser" rates expire, they often find themselves paying 15 percent.
At least in the short term, however, unrestrained borrowing has been terrific for U.S. business. With the stock market a continuing disappointment and salaried jobs being outsourced and replaced by low-wage service-sector jobs, credit has been the engine driving the U.S. economy since 9/11. "The [housing] bubble, and the easy money that's financed it, has been crucial to the economic recovery since 2001," writes Doug Henwood, author of After the New Economy and editor of the Left Business Observer. "By one measure (that of Asha Bangalore of Northern Trust), housing has contributed over 40 percent of the cycle's employment growth. Building and remodeling are contributing a near-record share of GDP. Real estate has accounted for 70 percent of the increase in household wealth over the same period."
In an effort to keep the money churning, and despite warnings from federal officials, even old-school mainstream lenders have loosened the terms on which they extend credit in recent months. Bankruptcies and foreclosures are no longer an obstacle to getting a credit card--just to getting one with an affordable interest rate. This year two-thirds of new mortgages are either interest-only loans, in which the borrower pays nothing toward the principal until a balloon payment for the entire amount comes due, or feature an adjustable rate, which delivers sticker shock, albeit in smaller increments.
As program manager for Lutheran Social Services Financial Counseling, Darryl Dahlheimer is described by local debt counselors as the Twin Cities' credit guru. "Lenders have never seen a loan they didn't want to make. They get fees and costs," he says. "Ford Motors made more money on their loans than by selling cars. Sears makes more on its Mastercard than from its stores. It's very profitable and tempting for mainstream financial institutions to get involved in this."
Which is very bad for consumers, he adds. "These loans are like Band-Aids on a burning garbage can."
In 1978, the U.S. Supreme Court handed down Marquette vs. First Omaha Service Corp., allowing banks to charge customers whatever interest rate was allowed by the laws of the bank's home state, not the borrower's. Quickly, first South Dakota and then Delaware eliminated their "usury laws," rules capping what interest lenders could charge. As banks rushed to relocate their credit card subsidiaries to those states, others followed.
From the consumer's standpoint, the move was a mixed bag. The good news was that people who hadn't previously qualified for credit cards could enter the market. If they managed their cards well, they could qualify for car loans and mortgages. If they didn't, however, they could expect to pay not the state-mandated 9 or 10 percent in interest, but 15, 20, or sometimes even 30 percent in interest. (Minnesota caps interest at a relatively business-friendly 18 percent.)
As the market opened up, lenders were pleased to discover that when they encouraged people to take on more debt, they made more money. First credit card issuers discovered that people spent more when lenders raised credit limits and lowered minimum monthly payments. That led to the realization that the customers who pay their bill in full every month might be the best risk, but not the most profitable mark; better are the so-called revolvers, the 35 million Americans who, according to an investigation by PBS's Frontline, make only minimum payments. In 1996, another Supreme Court decision eliminated many restrictions on the fees lenders can charge. Before long, many credit card issuers were making more money on late fees and overage penalties than on interest.
Today 144 million Americans have credit cards, which they use to charge $1.5 trillion a year. Between 1990 and 2003, household debt, adjusted for inflation, rose more than 80 percent, according to the Federal Reserve. From 1945 to 2003, it rose 30-fold.
The credit card industry's discovery of profit in debt did not go unnoticed by other sectors of the financial services industry, and in the mid-'90s lenders began loosening the terms on mortgages and home equity loans. In 1996 alone, for instance, the number of home equity loans made rose by 22 percent, according to American Banker. While the loans had long been used for new roofs and remodeling, lenders began to urge consumers to use home equity loans to deal with their burgeoning credit card debt. Why pay 12 or 15 percent interest on a credit card when you can pay 8 percent and, because it's a second mortgage, write off interest paid on your taxes?
Mortgage terms were changing, too. Home ownership rates soared as the down payments required to finance the purchase of a house fell from 20 to 10 percent, and then to 5 percent, and finally to zero. For those who still found buying a house too expensive, the adjustable rate mortgage offered lower-than-normal interest rates for a few years--usually three--after which, consumers were counseled, they could simply refinance. And with each transaction, of course, the mortgage broker made a tidy commission and the lender raked in fat fees.
The bursting of the tech bubble a few years ago left a lot of investment dollars looking for a new home and accelerated the explosion in housing prices, which in turn stimulated more interest from Wall Street investors. Vast amounts of capital became available to companies specializing in giving mortgages to people with no credit, bad credit, or tarnished credit. These so-called subprime lenders charge interest rates and fees far higher than those offered to more desirable "prime" customers. The loans are then packaged in big pools and sold as securities to investors.
A growing pool of people like the Marolts, with blemished credit and a well-founded fear of getting priced out of the housing market, has meant boom times for subprime mortgagors. Subprime loans made up 5 percent of mortgages issued in 2000 and 28 percent of the total so far this year. In the three years ending in June 2004, revenue at New Century grew 651 percent, from $180 million to $1.4 billion, according to the Orange County Business Journal. During that same time period, Ameriquest's mortgage production grew more than 12-fold to $82.7 billion, according to American Banker magazine.
As housing prices rose, subprime lenders proved inventive at finding new ways to qualify buyers for ever-larger loans. There's the brand-new (to Minnesota) 40-year mortgage. There's the stated-income loan, once reserved for wealthy customers whose businesses provided high but unsteady income. With this loan, the buyer simply declares an income and submits no documentation. There's the interest-only loan, in which the customer pays no principal for a specified period, usually three or five years, and gets hit with a balloon payment at the end. (The balloon payment is particularly popular with lenders because it's often difficult for the buyer to figure out how much they are paying in fees.)
And, possibly the riskiest of all, there's the so-called option-ARM, or negative amortization loan, in which the buyer pays only a portion of the interest while the balance is quietly tacked onto the principal. Lenders often tell borrowers willing to contemplate this last financing package that the value of their house will most likely outstrip their mounting debt levels. Even if that turns out to be true, it doesn't begin to address the sticker shock that will set in when the mortgage payment goes up--as much as 30 percent on a two-point hike in the rate--in a couple of years. (For examples, see sidebar on page 22.)
As Ameriquest and its competitors have grown more profitable, and years of low interest rates have dried up the market for mortgage refinances, "prime" lenders have begun offering many of the same risky mortgages. In July the St. Paul Pioneer Press reported that 36 percent of all nonconforming mortgage loans (those not meeting guidelines of federal mortgage agencies) made in the Twin Cities this year were interest-only. In 2003, they made up just 8 percent locally. Nationally, the number of such loans doubled during the same time to 27 percent.
Big surprise: There's a distinct correlation between high-risk loans and eventual foreclosures. A study done last year by Macalester College geography professor Laura Smith and her students found a disproportionate number of subprime loans among foreclosures in Ramsey County in 2002. Three-fourths of the foreclosed loans were made by unregulated lenders: 99 by Ameriquest, 35 by its parent company, Town & Country Credit, and 48 by New Century. One third of the 353 foreclosures were of adjustable-rate loans.
"Almost 63 percent of the foreclosed mortgages had originated three or fewer years before the foreclosure," the study notes. "This means that most of these mortgages were foreclosed upon very quickly. Sometimes a fast foreclosure may indicate that the borrower was not prepared to make their payments from the beginning, indicating possible abusive lending practices."
In Hennepin County, according to sheriff's office statistics, the number of foreclosures has risen steadily over the last four years from 473 to 766. It's not just here: The foreclosure rate rose last spring in 47 states, even as the percentage of mortgages that were interest-only or adjustable-rate soared to 63. Eight percent of American homeowners now pay at least half their income on their mortgage.
A recent study showed that 40 percent of people seeking foreclosure prevention assistance in Philadelphia cited medical costs as the source of their problems. In 2000, that city's sheriff auctioned 300 to 400 foreclosed properties a month, according to the Washington Post. This year, the number is more than 1,000.
"Why are bankers making such risky loans?" asks Doug Henwood in the most recent issue of his Left Business Observer newsletter. "One reason is that they're a little desperate; profitability is down sharply in the industry, and there's tremendous overcapacity. Another reason is that banks themselves rarely hold onto the loans; they're packaged into bonds and sold in large chunks to institutional investors. And the investors may assume that Alan Greenspan will save them should things go sour. Why not? He's done it many times in the past.
"When risk can be passed along like that, there's an incentive to overlook it," Henwood continues. "It used to be said of Soviet-style economies that they were systems of 'generalized irresponsibility.' We've got the capitalist version going in the USA."
The Marolts bought the little white house at 26275 Seventh St. W. in 1991 for $51,000, shortly after they were married. Built in 1981, it had three bedrooms and a good-sized yard. John and Rosalie were high school sweethearts reunited after decades of separate lives. Both had nearly grown kids. The house was a great place to get them all together for barbecues and Thanksgiving dinners. One of their sons built a fire pit out back, carefully rounding up stones from places that were special to the family or that had a story associated with them.
John Marolt bought the house with a VA loan with great terms but an interest rate of 8.5 percent. When rates came down a few years later, they refinanced. Their original payments were only $650; they figured they could afford a little more. So while they were at it, they took out a few thousand extra to buy new carpeting and appliances and to pay off some credit cards.
They don't have the paperwork from that loan, but the documents from the next one tell a story of things starting to go wrong. In 2000, they took out a home equity loan to catch up on $11,000 in bills and overdue property taxes. To get the loan, however, the Marolts had to pay $5,000 in fees, all of which the lender conveniently rolled into the loan. A year later, when they got a call from a telemarketer who swore they could lower their monthly bills by refinancing one more time, they bit.
The new mortgage was through Centex, a subprime company. The appraisal Centex ordered valued the Marolts' house at $134,000. They ended up with a mortgage of $123,000, including thousands of dollars in fees. Worse, neither John nor Rosalie realized that their monthly payment of $1,098 didn't include nearly $150 a month in property taxes.
They had been falling behind on the taxes for a year and a half when another telemarketer, this one working for Ameriquest, the nation's largest subprime lender, called and again promised that refinancing would save them money. This time, they never even met the broker who took their application over the phone, or received any explanation for the sheaf of documents delivered by FedEx, only instructions to sign and return them.
When they got everything back at the end, the Marolts were shocked to learn that they had borrowed $158,000. On top of paying off their last mortgage, the documents revealed that Ameriquest loaned the Marolts an additional $35,000: Nearly $10,000 went to pay off John's car, something the couple says they didn't ask for and didn't want to do; $2,400 went to back taxes; $6,000 was to cover a prepayment penalty (a rarity outside of the subprime market) on their old loan. The final paperwork arrived with a check for $6,000. When Rosalie asked what it was for, she was told she could use it to pay credit cards or other loans, or take a vacation. She paid the credit cards.
Worse, more than $9,000 went right back to Ameriquest, $5,000 of it listed as a "discount" fee charged for a lower interest rate. At a time when people with solid credit were paying little more than 5 percent, the Marolts' "points" got them an adjustable rate mortgage with a starting interest rate of 9.75 percent. The rate would begin to go up in two years and, according to the final paperwork, could then go up every six months until it topped 15 percent.
The Marolts made the $1,500 payment a few times before concluding they were in over their heads and would be better off selling the house. They called Ameriquest and asked for a copy of the appraisal that had been done when the loan was made. John says he got the runaround for more than five months. When he finally got a copy of the appraisal, he could see why.
The little white house had been valued at a laughable $186,000. The appraisal wrongly stated that the house had a new roof, new siding, new kitchen and bath, central air, a finished basement, blacktop driveway--all kinds of nonexistent improvements. The Marolts called a couple of real estate agents who said they'd be lucky to get $130,000. (It's currently for sale for $139,000.) They made a couple more payments but then, early last summer, Rosalie had gastric bypass surgery. She couldn't work, costing them more than $900 a month in lost wages; when she went back to her job, her hours had been cut. John wasn't getting the overtime he was used to. (Much later, the Marolts realized in reviewing their loan papers that Ameriquest had qualified them for such a large loan by using pay stubs from a month in which John earned more than $700 in overtime, they contend.)
They missed the June mortgage payment, and then July. Rosalie cashed in her 401k and wired the balance, $3,300 after paying a $600 penalty, to Ameriquest. As soon as she handed the money to Western Union, Rosalie says she realized they had made still another mistake: The money covered the June and July payments, but it was crystal clear they weren't going to be able to make August, or September, or for that matter any more mortgage payments at all. When Ameriquest reported the missed payments to the credit bureaus, the Marolts started getting notices that everything from their credit card rate to their car insurance was going up. The Marolts eventually complained to Minnesota Attorney General Mike Hatch, whose office is part of a multi-state effort to intervene with Ameriquest on behalf of disgruntled consumers.
"The whole process has been so stressful, so emotional," says Rosalie. "We never told the kids a whole lot about it. They just assumed we weren't making the payments and they said, 'If you want that house so bad, why didn't you make the payments?' Your kids are supposed to look up to you and when you have this happen, they don't. Besides losing respect for yourself, you lose the respect of your family."
When the Marolts finally found a landlord willing to rent to them, a local woman who thought their honesty counted for something, they abandoned the little white house. Their rent was almost $400 lower than their mortgage payment, so they could start catching up on their other bills. When the Sherburne County sheriff finally foreclosed, on November 11, 2004, it was a relief. Collectors stopped calling them at home and on the job. They were finally, officially, a bad risk.
Marquette vs. First Omaha wasn't the end of the tension between the federal government and the states over regulation of the financial services industries. Indeed, as the rules on banks have steadily loosened, consumer train wrecks such as the Marolts' prompted periodic action by state and local governments. Ameriquest, for instance, is currently the target of predatory lending investigations by the attorney general's office in more than two dozen states, including Minnesota. Connecticut may simply ban the lender from doing business there.
According to documents Ameriquest filed with federal regulators, the complaints include allegations that Ameriquest inflated appraisals, misstated borrowers' incomes, deceived borrowers about its fees and loan terms, and applied inappropriate policies regarding loans for properties on Indian reservations. Based on past settlements by other predatory lenders and on the amount Ameriquest has agreed to pay to settle a class-action lawsuit in four states, American Banker magazine estimates the company has set aside up to $500 million in anticipation of paying refunds and damages.
In March, the U.S. House of Representatives began considering a bill that would further curtail state officials' power. The measure would create nationwide standards for the subprime mortgage industry, but would also require that federal law trump state rules.
Founded in 1979 as Long Beach Savings and Loan, Ameriquest is owned by billionaire financier Roland E. Arnall. Last month, Bush nominated Arnall to be U.S. Ambassador to the Netherlands. According to the campaign finance watchdog group the Center for Responsive Politics, Arnall and his wife Dawn contributed nearly $943,000 to Democrats and more than $1.1 million to Republicans between 1999 and 2004.
The Arnalls and their employees have been particularly generous to George W. Bush. According to Roll Call, last year they contributed $5 million to Progress for America, a group that paid for ads supporting Bush. They donated an additional $1 million to his inaugural committee, $1.8 million to Laura Bush's library fund, and earned the status of Bush-Cheney campaign "rangers" by soliciting more than $200,000 from others. Ameriquest employees, meanwhile, gave $150,000 to Bush. (The Arnalls seem to be more opportunistic than ideological: During the 2004 election cycle, they contributed $360,000 to the Democratic National Committee and $1,000 each to John Kerry and Hillary Rodham Clinton.)
In May, federal bank regulators issued "guidance" warning against the newer, riskier mortgages. In July, however, the New York Times reported that the cautionary words had virtually no impact because the agencies wouldn't take action. "We don't want to stifle financial innovation," was one explanation quoted by the paper. "We have the most vibrant housing and housing-finance market in the world, and there is a lot of innovation."
"We're not trying to set off alarms that we see broad issues," another regulator assured the Times. "We are seeing examples of practices that need to be tightened down a bit."
One more reason why lenders aren't likely to suffer too many ill consequences from irresponsible lending: Economists note that banks learned a great deal from the savings and loan crisis of the '90s. Consumers' willingness to embrace adjustable rate mortgages means much of the risk for banks of rising interest rates has been shifted onto borrowers. Similarly, because so many of the mortgages are now sold as securities, much of the negative effect of rising foreclosure rates will fall on investors.
Unless elected officials suddenly take as much interest in people like the Marolts as they do the Arnalls, credit guru Dahlheimer doesn't see much changing. "The profit margin on a grocery store is about 1 percent," he says. "You have to sell a lot of lettuce. If you can make 29 percent by moving money around, that's 28 times more profitable. If you have 100 clients, and 50 of them go into bankruptcy, you're still making 14 percent.
"Unregulated free market capitalism is a race to the bottom in terms of ethics. That's why we have regulations. Regulated capitalism is a thing of beauty," he continues. "When you break those rules you set people up for failure. You take away their seatbelt and say, 'Drive happy.'"
As for the Marolts, having very little credit seems to be what ultimately works. They're both working part-time at the supermarket. Now, they pay off their credit cards every month. There's a year of payments left on Rosalie's car, a 2002 Saturn, "and then that's it for the debt."
City Pages intern Peter Madsen contributed research for this story.