What follows is largely remarks from my spy in the housing industry, government sector. It's lengthy for a blog post, but I offer it because as foolish and tedious as the "blame Wall Street" folks are (Wall Street, as we shall see, is more victim than villain in this set piece), it's equally foolish and tedious to go through all the GOP debates and not have
a single one of our candidates able to place the blame for our troubles squarely where it belongs:
with Congress & its abdication of "oversight."
If one more of our guys dumps on Bernanke I'm going to scream. Not that the Fed hasn't played a pernicious role, but this is not Bernanke's fault, it's the fault of the dual mandate, which asks the Fed to do two logically contradictory things, with predictably unsatisfactory results. Some of this has been reported but forgotten, and I think it's interesting to hear it from an eyewitness in any event.
First he makes short work of the Fed's role:
The two major causes of the
collapse that began in 2007 were, first, the destabilization of the mortgage
and financial investment businesses; and second, the Fed’s policy of monetary
inflation.
The Fed policy caused an explosion in real estate prices and values
in the early 2000s which generated a public panic to buy homes at any
price. The distortion of the home mortgage industry made many more
mortgages available to uncreditworthy borrowers and so made the collapse, when
it came, even deeper. No need to say more about the Fed.
Now some necessary background:
There is no more important area for lenders to “underwrite” loans than in home
mortgages, because they are large loans and paid off over long time
periods. They build up huge liabilities on bank books and restrict
further lending, so they must be worthwhile loans for banks to earn profits and
stay in business.
Lenders normally make a practice of thoroughly checking
the creditworthiness of potential borrowers, and they have established criteria
that tell them the level of risk that a mortgagee might not pay off the
loan. An old and traditional practice of mortgage lenders was called
“redlining,” whereby some areas, such as inner cities and decayed urban areas,
were considered off-limits for loans. (Too many low income households, plus
threats of riot, arson, theft, etc.) The judgment was that in these areas,
the risks of default are too high and thus mortgage applications in redlined
areas were routinely rejected.
It's at this point that Congress begins to step in, for better or for worse:
Because these areas are overwhelmingly populated by minorities, Congress was
under pressure [from ACORN, among others] to treat “redlining” as a form of racial discrimination.
In the 1970s, Congress passed the
Community Reinvestment Act (CRA) which
required certain mortgage banks to abolish redlining and to write mortgages in
these areas.
The CRA was not enforced much until the Clinton
Administration in 1993, and again in 1995, issued aggressive new regulations.
Now if
a bank wanted any change in its status—a merger, a new location, etc.,—requiring
government approval, the FDIC and other agencies would review the bank’s books
to see whether it was in fact following CRA by making a good faith effort to
write mortgages within these areas. If not, the bank could be denied
permission to go ahead with the change.
Lenders would now find
themselves holding a number of mortgages which, by their ordinary underwriting
standards, were at risk of foreclosure. This of course threatened the
individual bank and the mortgage banking structure as a whole.
This Act organized Fannie Mae and Freddie Mac
(FF) as “secondary mortgage markets.” This means that these two entities
do not offer mortgages to home buyers, they buy mortgages already held by
banks. So a bank gives a mortgage to a borrower and then sells the
mortgage to the GSEs.
Understand the effect of this move:
The bank
no longer has much reason to worry about the risk of foreclosure. There
is no mortgage liability on its books. The bank makes its money from the
price paid to it by the GSEs and has nothing more to do with the mortgage
except to continue to service it, send out monthly statements, etc., for which
it received a fee from the GSEs which are now the true risk holders. The
lenders, on the other hand, now have more money available to them so they can
offer more mortgages than they could have if they did not have the GSEs as
“secondary markets.” This is called “spreading the risk.”
Contained within the GSEs Act was the mandate that the GSEs must include in the mortgages they buy a percentage that come from
“under-served" (or "redlined") communities.
What percentage? "We don't know, ask HUD," was Congress' effective answer, booting the precise meaning of their own law over to Executive Branch regulators:
How many
such mortgages they had to buy each year was determined by HUD. When they
started out, I think the number was something like 30%, meaning that 3 out of
10 mortgages on the books of the GSEs had to come from these areas. HUD
periodically would raise that number, and so it went higher and higher until it
was in the range of 55% by 2007, i.e. more than half of FF’s mortgage business
was uncreditworthy and normally would not be written by lenders except perhaps
at much higher interest rates.
(By my personal witness, being in the
division that decided on these quotas, I believe the quotas were set in good
faith by trustworthy career officials who would have been terrified to tell
Congress they could not meet the demands of the law. Bureaucrats always
avoid angering the source of their funds, and Congressional "oversight" usually means assuaging Congress that their laws are being obeyed; they don't want to hear it if their laws cause problems.)
By continuously writing more
and more business in these restricted areas, the quality of the mortgages had
to decline over time. Think about this. At the start of the program, Fannie Mae & Freddie Mac were underwriting the best of the risky mortgages. But as the years went on, the risks got higher and higher as the banks reached increasingly risky mortagees.
The best were written at the beginning
obviously. At a certain point, the GSEs began to write mortgages for
lenders with no credit history at all (“Alt-A” mortgages). (The amount of
total liabilities on the books of FF when it began to unravel was by my
estimate about $5 trillion.)
Piecing it all together then:
What happened here is that banks offering mortgages under CRA in redlined
communities would immediately sell them to the GSEs, transferring the high risk
mortgages, keeping the mortgage price, and of course keeping for their own
accounts the quality, low-risk mortgages. Keep the gold, get rid of the
dross. This completely changed the incentives for underwriting. Since the bank no longer holds much risk, it has little incentive to be sure
that its CRA mortgages go to creditworthy borrowers.
In fact, CRA practically
required that they NOT restrict their mortgages. Government wanted to see
lots of CRA business being written. The result was that these banks kept
writing poor mortgages and passing them over to FF [Fannie & Freddie]. FF, in turn, was
forced by the GSEs law to take these mortgages without paying attention to
their high risk potential since the law said that as much as one-half of their
business had to be in “underserved communities.”
Next move. Also in the 1990s, the GSEs began to engage in trading a rarely used financial
investment instrument called Mortgage Backed Securities (MBS), or “mortgage
securitization.”
An MBS is a batch of mortgages bundled together in one
investment package and sold to a buyer. In that way the buyer takes on
these mortgages as they are being paid off over the years and has paid a
selling price to the seller (the GSEs). The seller now holds the money
but has disposed of the mortgages and their risks. MBSs come in a wide
variety of technically complex forms, for example they might involve only 50%
of each mortgage, etc., but the idea is the same as with CRA and the
GSEs. The purchase money goes to the GSEs which now have more money to
use to buy more mortgages from the original lender. This creates a much
larger pool of mortgage money, thereby making it possible for many more home
buyers to get mortgages. So the home ownership rate in the US began to
grow substantially (70% by 2007) as more and more people found that they could get
mortgages on easy terms.
What happened to the MBSs? Here's where Wall Street comes in:
They were sold by FF to large investment
houses such as Bear Stearns, Lehman Brothers, AIG, etc. and some European
financial houses which were now the holders of these mortgages.
Everyone
in this process thought it was a terrific deal: the investors get a reliable
and predictable stream of mortgage payments for years to come; the GSEs make
profits from the sales of these MBSs; the originating banks make similar profit
plus commissions for continuing to service the monthly mortgages (without
risk); and Congress is happy because the redlined communities are now
“greenlined,” and minorities are participating in home ownership. ACORN
(which was very involved in pushing this policy) goes away. As long as home values kept rising, everyone involved profited.
So far so good. The big question to me, however, has always been why Wall Street didn't see how toxic these "instruments" were. Was it really just greed? Go for the short-term gain and all else be damned?
Why did final investors such as AIG who were
holding these mortgages not see how toxic they were? The answer, I
believe, is that these investors did not bother to “underwrite” these MBS
securities, that is, they never looked into them to see how risky these
mortgages actually were. They are highly technical investments and the
financial houses are not mortgage underwriting experts. They were simply
depending on the “Government-Sponsored Enterprises” (FF) to do this
underwriting for them! This was logical. After all, FF were
sponsored by the US government and would not be running a quick-buck mortgage
racket…would they?
Would anyone really be that foolish?
Before I came to Washington, I worked in the re-insurance business, and I often saw the same idea play out. If some insurer -- let's say State Farm, hypothetically-- wrote a $5 million policy, but could only afford a $1 million pay-out, they'd come to us to find other companies to "spread the risk." All I had to do was get one of the biggest companies to sign on for a portion of the risk. Once they did, smaller companies would sign on too, trusting the leg-work of the larger firm. If it's good enough for Lloyd's of London, it's good enough for me was the attitude.
In the case of the Wall Street lenders, of course it's surmise, but I just believe their attitude was if it’s good enough for the
government-sponsored enterprises, it must be good enough for me. They
have the mortgage expertise, I have the capital to help them out.
This
attitude was naïve and financially imprudent, but it was not in the main
“greed” at all. It was an attitude of investor trust in government expertise.
And of course, once housing values started declining in 2007, these mortgages
had to be foreclosed and the investment houses discovered they were holding
worthless toxic assets.
A second question is how such high levels of risk could be supported?
The
answer is that they were supported by the government, the American
people. Private investors could make great profits by them, but if there
were losses, the American people had to bear the cost (in many cases), e.g.
covering the FF losses and bailing out some financial houses and banks: private
profit, social risk, we call it.
Did no one see this coming?
There were certainly people within government who foresaw, or suspected, that
there was something amiss about this artificial scheme.
By 2003, the Bush administration was making
an effort to tighten oversight of the GSE's and raised red flags with Congress, which ignored them. HUD officials, FF officials, and other agencies also go up to
Congress periodically, to the oversight committees that were run by Rep. Barney
Frank and Sen. Chris Dodd, to report on what they are doing. The
committee chairs wanted only to hear that the “underserved communities” quotas
were being filled. They had it fixed in their minds that these programs "helped the poor," and didn't want to hear about financial concerns. Barney Frank
was endorsing this program as a success story less than a year and half before
Fannie Mae went into conservatorship. [That's where
those infamous Barney Frank youtubes come into the picture.]
So greed is not to blame?
Not on Wall Street's part, I don't think. It is true that some officials at Fannie & Freddie made big bucks through salaries and
bonuses for tremendous sales numbers in the early 2000s. They were not
guiltless in this. However, since their organizations were forced by
Congress --which delivered a mandate and then neglected its oversight responsibilities-- to write more and more toxic business, the blame for the collapse
cannot be laid at their feet.
It may be argued that they should have been
courageous enough to tell Frank & Dodd that this scheme was a disaster in
the making years earlier. But what would the consequences be of their making that argument
while home prices were still rising? They would have been browbeaten,
attacked as racists, ridiculed, and fired in disgrace.
Bottom line is this:
investors were gulled into trusting the government’s
knowledge, and in the end went bankrupt or nearly so without bailouts. FF
officials were living high making obscene dollars, but from a scheme which they
were forced to carry out. The full blame for this disaster rests with
Congress itself for inventing this fool’s game—and then becoming indignant
when it collapsed and brought down the world economy.
The GSEs incidentally, I heard just today, are being revived instead of dissolved. It’s not
clear that we have reached the end of this game, by any means.
