Saturday, December 20, 2008
Now Playing at Reason.tv: Peter Wallison on the Roots of the Financial Crisis
What Got Us Here?
Cause and Effect: Government Policies and the Financial Crisis
...Instead of a direct government subsidy, say, for down-payment assistance for low-income families, the government has used regulatory and political pressure to force banks and other government-controlled or regulated private entities to make loans they would not otherwise make and to reduce lending standards so more applicants would have access to mortgage financing.
The two key examples of this policy are the CRA, adopted in 1977, and the affordable housing "mission" of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. As detailed below, beginning in the late 1980s--but particularly during the Clinton administration--the CRA was used to pressure banks into making loans they would not otherwise have made and to adopt looser lending standards that would make mortgage loans possible for individuals who could not meet the down payment and other standards that had previously been applied routinely by banks and other housing lenders. The same pressures were brought to bear on the GSEs, which adapted their underwriting standards so they could accept the loans made under the CRA and other loans that did not conform to what had previously been considered sound lending practices. Loans to members of underserved groups did not come with labels, and once Fannie and Freddie began accepting loans with low down payments and other liberalized terms, the same unsound practices were extended to borrowers who could have qualified under the traditional underwriting standards. It should not be surprising that borrowers took advantage of these opportunities. It was entirely rational to negotiate for a low-down-payment loan when that permitted the purchase of a larger house in a better neighborhood. ...
...As originally enacted in 1977, the CRA was a vague mandate for regulators to "consider" whether an insured bank was serving the needs of the whole community it was supposed to serve. The "community" itself was not defined, and the act stated only that it was intended to "encourage" banks to meet community needs. It was enforced through the denial of applications for such things as mergers and acquisitions. The act also stated that serving community needs had to be done within the context of safe and sound lending practices, language that Congress probably inserted to ensure that the law would not be seen as a form of credit allocation. Although the act was adopted to prevent "redlining"--the practice of refusing loans to otherwise qualified borrowers in low-income areas--it also contained language that included small business, agriculture, and similar groups among the interests that had to be served. With the vague compliance standard that required banks only to be "encouraged" and their performance to be "considered," the act was invoked relatively infrequently when banks applied for permission to merge or another regulatory approval, until the Clinton administration.[1]
The decisive turn in the act's enforcement occurred in 1993 and was probably induced by the substantial amount of media and political attention that had been paid to the Boston Federal Reserve Bank's 1992 study of discrimination in home mortgage lending.[2] The study concluded that while there was no overt discrimination in the allocation of mortgage funds, more subtle forms of discrimination existed in which whites received better treatment by loan officers than members of minorities. The methodology of the study has since been questioned,[3] but it seems to have been highly influential with regulators and members of the incoming Clinton administration at the time of its publication. In 1993, bank regulators initiated a major effort to reform the CRA regulations. Some of the context in which this was occurring can be gleaned from the following statement by Attorney General Janet Reno in January 1994: "[W]e will tackle lending discrimination wherever and in whatever form it appears. No loan is exempt, no bank is immune. For those who thumb their nose at us, I promise vigorous enforcement."[4]
The regulators' effort culminated in new rules adopted in May 1995 that would be phased in fully by July 1997. The new rules attempted to establish objective criteria for determining whether a bank was meeting the standards of the CRA, taking much of the discretion out of the hands of the examiners. "The emphasis on performance-based evaluation," A. K. M. Rezaul Hossain, an economist at Mount Saint Mary College, writes, "can be thought of as a shift of emphasis from procedural equity to equity in outcome. In that, it is not sufficient for lenders to prove elaborate community lending efforts directed towards borrowers in the community, but an evenhanded distribution of loans across LMI [low and moderate income] and non-LMI areas and borrowers."[5] In other words, it was now necessary for banks to show that they had actually made the requisite loans, not just that they were trying to find qualified borrowers. In this connection, one of the standards in the new regulations required the use of "innovative or flexible" lending practices to address credit needs of LMI borrowers and neighborhoods.[6] Thus, a law that was originally intended to encourage banks to use safe and sound practices in lending now required them to be innovative and flexible--a clear requirement for the relaxation of lending standards. ...
...The important question, however, is not the default rates on the mortgages made under the CRA. Whatever those rates might be, they were not sufficient to cause a worldwide financial crisis. The most important fact associated with the CRA is the effort to reduce underwriting standards so that more low-income people could purchase homes. Once these standards were relaxed--particularly allowing loan-to-value ratios higher than the 80 percent that had previously been the norm--they spread rapidly to the prime market and to subprime markets where loans were made by lenders other than insured banks. The effort to reduce mortgage underwriting standards was led by the Department of Housing and Urban Development (HUD) through the National Homeownership Strategy published in 1994 in response to a request by President Clinton. Among other things, it called for "financing strategies, fueled by the creativity and resources of the private and public sectors to help homeowners that lack cash to buy a home or to make the payments."[9] Many subsequent studies have documented the rise in loan-to-value ratios and other indicators of loosened lending standards.[10]...
...The problem is summed up succinctly by Stan Liebowitz of the University of Texas at Dallas: "From the current handwringing, you'd think that the banks came up with the idea of looser underwriting standards on their own, with regulators just asleep on the job. In fact, it was the regulators who relaxed these standards--at the behest of community groups and ‘progressive' political forces...
...By 2005, it had become clear that Fannie and Freddie were not materially assisting middle-class homebuyers by lowering interest rates.[15] Given the political basis for the existence of the GSEs, this is a significant fact. Both Fannie and Freddie had suffered major accounting scandals in 2003 and 2004, and their political support in a Republican Congress was shaky. Alan Greenspan, then at the height of his reputation for financial sagacity, had begun to campaign against them--particularly against their authority to hold the portfolios of mortgages and MBS that constituted their most profitable activity.
When the history of this era is written, students will want to understand the political economy that allowed Fannie and Freddie to grow without restrictions while producing large profits for shareholders and management but no apparent value for the American people. The answer is the affordable housing mission that was added to their charters in 1992, which--like the CRA--permitted Congress to subsidize LMI housing without appropriating any funds. As long as Fannie and Freddie could credibly contend that they were advancing the interests of LMI homebuyers, they could avoid new regulation by Congress--especially restrictions on the accumulation of mortgage portfolios, totaling approximately $1.5 trillion by 2008, that accounted for most of their profits....
...By 1997, Fannie was offering a 97 percent loan-to-value mortgage, and by 2001, it was offering mortgages with no down payment at all. By 2007, Fannie and Freddie were required to show that 55 percent of their mortgage purchases were LMI loans and, within this goal, that
38 percent of all purchases were from underserved areas (usually inner cities) and 25 percent were purchases of loans to low-income and very-low-income borrowers.[19] Meeting these goals almost certainly required Fannie and Freddie to purchase loans with low down payments and other deficiencies that would mark them as subprime or Alt-A....
...The decline in underwriting standards is clear in the financial disclosures of Fannie and Freddie. From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion in subprime and Alt-A loans, amounting to about 40 percent of their mortgage purchases during that period. Freddie's data show that it acquired 6 percent of its Alt-A loans in 2004; this jumped to 17 percent in 2005, 29 percent in 2006, and 32 percent in 2007. Fannie purchased 73 percent of its Alt-A loans during these three years. Similarly, in 2004, Freddie purchased 10 percent of the loans in its portfolio that had FICO scores of less than 620; it increased these purchases to 14 percent in 2005, 17 percent in 2006, and 30 percent in 2007, while Fannie purchased 57.5 percent of the loans in this category during the same period.[20] For compliance with HUD's affordable-housing regulations, these loans tended to be "goal-rich." However, because they are now defaulting at unprecedented rates, the costs associated with these loans will be borne by U.S. taxpayers...
...Under a 1988 international protocol known as Basel I, the bank regulators in most of the world's developed countries adopted a uniform system of assigning bank assets to different risk categories. ...
...The 50 percent risk weight placed on mortgages under the Basel rules provides an incentive for banks to hold mortgages in preference to commercial loans. Even more important, by purchasing a portfolio of AAA-rated MBS, or converting their portfolios of whole mortgages into an MBS portfolio rated AAA, banks could reduce their capital requirement to 1.6 percent. This amount might have been sufficient if the mortgages were of high quality or if the AAA rating correctly predicted the risk of default, but the gradual decline in underwriting standards meant that the mortgages in any pool of prime mortgages--and this was certainly true of subprime and Alt-A mortgages--often had high loan-to-value ratios, low FICO scores, or other indicators of low quality. In other words, the effect of the Basel bank capital standards, applicable throughout the world's developed economies, has been to encourage commercial banks to hold only a small amount of capital against the risks associated with residential mortgages. As these risks increased because of the decline in lending standards and the ballooning of home prices, the Basel capital requirements became increasingly inadequate for the risks banks were assuming in holding both mortgages and MBS portfolios. Even if it is correct to believe that residential mortgages are less risky than commercial loans--an idea that can certainly be challenged in today's economy--the lack of bank capital behind mortgage assets became blazingly clear when the housing bubble deflated....
