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September 12, 2007
The Subprime Meltdown and SRI: Engage, Avoid, Predict
    by Bill Baue

Shareowner activists engaged banks on predatory lending long before the subprime crisis climaxed, and SRI research predicted the meltdown in time to avoid some impacts.


The subprime market meltdown: you could see it coming for miles--if you were wearing the right colored glasses. Socially responsible investing (SRI) is one such set of lenses. Shareowner activists began engaging banks on “predatory lending” years before regulators started noticing (but not acting on) red flags in the subprime market in late 2003--the beginning of “chronology of neglect” according to Senate Banking, Housing, and Urban Affairs Committee Chair Chris Dodd (D-CT).

Some SRI funds avoided the worst impacts of the meltdown by excluding mortgage-backed securities containing predatory loans. And in October 2006, when Fitch, Moody’s, and S&P still rated the subprime market as essentially secure, SRI researchers predicted the meltdown--before the proverbial scat hit the fan.

In theory (and sometimes in practice), subprime lending benefits low-income borrowers with marred credit histories that disqualify them for prime rate loans, as it gives them access to credit--albeit at higher interest rates (to offset the risk linked to their histories.) Unfortunately, the rise of the subprime market was fueled in large part by the profitability of loans with abusive terms, such as “exploding ARMs” (adjustable rate mortgages) that offer a barely-affordable “teaser” rate which mushrooms to an unaffordable rate a few years later. In short, lenders preyed on borrowers with poor financial literacy.

Shareowner activists took note of this trend as early as 1999 after a keynote speech at SRI in the Rockies by Martin Eakes, founding CEO of Self-Help, a North-Carolina-based community development financial institution (CDFI.) Thereafter, SRI firms such as Trillium Asset Management, Christian Brothers Investment Services (CBIS), Pax World, and Neuberger Berman joined Responsible Wealth (a project of United for a Fair Economy) to engage companies on predatory lending. For example, they filed a shareowner resolution at Wells Fargo, one of the largest subprime lenders in the US, that asked the company to link executive compensation to fighting predatory lending.

Shareowner engagement with Citi over a number of years prompted the company to discontinue multiple abusive practices in its subprime lending. For example, Citi quit offering single premium credit life insurance, which adds an upfront charge for insurance to cover mortgage payments in case of death or sickness, with interest lasting the life of the mortgage while insurance coverage typically lasted only three to five years. The practice, labeled “the nations worst insurance rip-off” by the Consumer Federation of America, “basically stripped thousands of dollars of equity out of homeowners’ financial situation,” according to Deborah Momsen-Hudson of Self-Help. Shareowner activists such as CBIS ended their engagement with Citi in 2006 after achieving their objectives.

Social concerns were the driving force behind the shareowner engagement, but the investors also recognized that socially responsible practices often link to financial performance. Irresponsible practice creates reputational, as well as legal and market, risks that can be avoided. On the opportunity side, through more responsible practices, which can further enhance reputation, as well as create more stable market positioning. SRI criteria based on environmental, social, and governance (ESG) considerations are increasingly viewed as perceptive radar readings for flagging broader problems, including financial strengths and weaknesses.

Take, for example, the Community Reinvestment Act CRA Qualified Investment Fund, or CRAFund (ticker: CRAIX), a SRI fixed income fund that borrows its name from the 1977 law supporting investment in community economic development, such as low-income housing. Since its early stages, the fund has spurned adjustable rate mortgages, and its portfolio of single-family mortgage-backed securities issued by Fannie Mae and Freddie Mac consists exclusively of 30-year, fixed-rate conventional loans. According to Lipper, the fund ranks in the 39th percentile of US mortgage funds on a five-year basis with returns of 3.51 percent as of August 31, 2007--meaning that it outperformed 61 percent of its peers.

While social investors engaged proactively on predatory lending and may have shielded themselves somewhat from the fallout, the subprime meltdown impacted the entire economy, necessarily hitting SRI. SRI portfolios tend to hold a slightly higher percentage of financial institutions than mainstream portfolios, according to Momsen-Hudson of Self-Help--perhaps exposing SRI funds slightly more to the subprime meltdown.

However, certain SRI strategies may have helped investors avoid some of the fallout. While conducting research for their Global Banking Report on Retail Lending report, which was issued in October 2006, analysts at SRI research firm Innovest Strategic Value Advisors predicted the subprime meltdown. Innovest forecasted that the impacts “will not be limited to the retail banking sector” because mortgage backed securities are sold off to capital markets, so a “spike in foreclosures will therefore reverberate in capital markets.”

Innovest analysts reached these conclusions almost by accident, simply by asking questions about the underlying social impacts of subprime lending that mainstream rating firms seemed to ignore. For example, Innovest noticed the rise in the subprime market from 6 percent of residential mortgage originations to 40 percent in 2006--how were so many poor people suddenly able to buy houses when real wages had been stagnant for the past 6 years?  And more fundamentally, are sub-prime borrowers better or worse off because of this new market?

“The answer we came up with was no,” said Greg Larkin, a senior analyst with Innovest. “The mainstream rating agencies, who were locked into a bull market at the end of its peak, were asking is there still money to be made in the sub-prime sector?  The answer they came up with was a qualified yes.”

“They were looking at the trees, not the storm clouds gathering over the forest--in the form of high risk loans to a demographic marked by overstretched personal finances and stagnant real wages,” Larkin told SocialFunds.com. “Ironically, there was more money to be made from our analysis,” which recommended caution, than from the mainstream rating firms, which maintained bullish recommendations until it was too late.

Going forward, social investors are advocating for regulatory relief in the form of loan modifications, which have already been called for by Congress, as well as federal, state, and local regulators. Momsen-Hudson of Self-Help points out that lenders and their investors typically lose $40,000 on a foreclosed $100,000 loan (due to lost interest as well as expenses for fixing up and reselling the house).

“What we and a lot of folks in the economic justice community are advocating is that the investors should allow those loans to be modified so the investor only loses $20,000 and the family will stay in their house with a lower payment,” Momsen-Hudson said. “It’s good for the families and it’s good for the institutions--sort of like reverse engineering the problem into what should have been the solution to begin with, making the loan sustainable instead of abusive and predatory.”

 

 
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