According to two Minneapolis Federal Reserve economists:
The current crisis is rooted in the poor performance of mortgage loans made between 2005 and 2007. If the CRA did indeed spur the recent expansion of the subprime mortgage market and subsequent turmoil, it would be reasonable to assume that some change in the enforcement regime in 2004 or 2005 triggered a relaxation of underwriting standards by CRA-covered lenders for loans originated in the past few years. However, the CRA rules and enforcement process have not changed substantively since 1995.
Three things. The first is that the same Minneapolis Fed that published the above contradicts the claim that nothing important has changed substantively since 1995.
The second change the Minneapolis Federal Reserve left out is this change in 2005 involving the Community Reinvestment Act:
In early 2005, largely at the behest of the banking sector, the Office of Thrift Supervision implemented new rules that were widely perceived as weakening the CRA. Supervision of banks with under $1 billion in assets was loosened, and larger banks were allowed to voluntarily reduce the amount of regulator scrutiny of their "investment" and "service"-two long-standing categories of assessment under the CRA.
This had two unintended consequences that would later prove to be very costly. In the first place, it increased CRA scrutiny of larger banks, who were now the main focus of regulators. This put even more pressure on the banks to make CRA loans. Secondly, by allowing banks to de-emphasize "investment" and "service," the new regulations created an even greater incentive for banks to meet CRA obligations by making home loans.
Emphasis above mine. Here is a graph illustrating the impact of these changes, courtesy of Investor's Business Daily.
The article concerns a study by the National Bureau of Economic Research and states:
...But a new study by the respected National Bureau of Economic Research finds, "Yes, it did. We find that adherence to that act led to riskier lending by banks."
Added NBER: "There is a clear pattern of increased defaults for loans made by these banks in quarters around the (CRA) exam. Moreover, the effects are larger for loans made within CRA tracts," or predominantly low-income and minority areas.
To satisfy CRA examiners, "flexible" lending by large banks rose an average 5% and those loans defaulted about 15% more often, the 43-page study found.
The strongest link between CRA lending and defaults took place in the runup to the crisis — 2004 to 2006 — when banks rapidly sold CRA mortgages for securitization by Fannie Mae and Freddie Mac and Wall Street....
Differences in CRA performance between large and small banks is discussed below. Despite what you may hear from some about reckless bankers after the crash, before the crash they were condemned for being too cautious:
...As early as 1991, community activist Gale Cincotta, was laying the path for undertaking such an assault in her testimony before the Senate Banking Committee. "Lenders will respond to the most conservative standards unless [Fannie Mae and Freddie Mac] are aggressive and convincing in their efforts to expand historically narrow underwriting," she stressed....
...Also in 1995, the Community Reinvestment Act (CRA) regulations were revised to be more quantitative and outcome based. Banks were now measured on their use of "innovative and flexible" lending standards, and their performance was compared to market competitors. As pointed out by Fed Chairman Bernanke in 2007: "Further attention to CRA was generated by the surge in bank merger and acquisition activities that followed the enactment of the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994." CRA's stick of denying a merger application was now combined with CRA's carrot of announcing a big CRA commitment to flexible lending standards to help assure merger approval. The result was trillions of dollars in CRA commitments, largely "negotiated" by community advocacy groups....
From Free fall: How government policies brought down the housing market:
...Nevertheless, there are plentiful data on commitments by large banks to make CRA-type loans in connection with applications to the Fed for permission to merge with small and medium-sized institutions between 1997 and 2007. In a 2007 report, for example, the National Community Reinvestment Coalition (NCRC) reported that in this ten-year period its member organizations had induced banks that were seeking merger approvals from the Fed and other agencies to commit almost $4.5 trillion in CRA-type lending. Press releases at the time these mergers were approved (available online) backed up this claim. After this report received publicity, it was pulled from NCRC’s website, though it is now available elsewhere on the web. These report loans totaling $1.3 trillion made to fulfill prior commitments, but determining the delinquency rates on these loans is impossible; banks have generally refused to make these data available, and the Financial Crisis Inquiry Commission (FCIC)—established by Congress to investigate the causes of the 2008 financial crisis—did not seriously attempt to investigate this issue....
While I'm saving Fannie Mae and Freddie Mac for later, I wish to bring up one important rule change in 2004 concerning them. From Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and Why It Could Happen Again, By Peter Wallison:
The new goals appear to have been a bridge too far. HUD seemed unaware of, or at least unsympathetic to, the problem of finding creditworthy borrowers in in low-income or minority communities. Not only were the GSEs required to find borrowers there - at the same ratre they were found in the market as a whole - but the borrowers now had to be buyers of homes and not just existing LMI homeowners who were refinancing. Although the purpose of the afffordable-housing goals was to make the GSEs stretch to reach the goals, HUD had both increased the quota and substantially narrowed the kinds of loans that would qualify. Because of this, the quality of the loans acquired by the GSEs deteriorated even further between 2005 and 2007 than they had in the past...
Requiring subgoals that gave credit only for loans that were used to buy new homes - rather than just loans that represented refinancing - was a material new burden, and communications within and outside the GSEs before and after the new requirements were instituted, confirm this....However, the fundamental change in the burden that HUD instituted in 2004 accounts fully for the sharp deteroriation in mortage quality that the authors saw in the GSE's data between 2005 and 2007.
Community Reinvestment Act Lending Totals
You can see the buildup of cumulative CRA lending in the chart below. The source of the data is the National Community Reinvestment Coalition (NCRC).
Why the sharp increase? According to the National Community Reinvestment Coalition: CRA Commitments (PDF) (a document they dropped from their own website):
...Since the passage of CRA in 1977, lenders and community organizations have signed over 446 CRA agreements totaling more than $4.5 trillion in reinvestment dollars flowing to minority and lower income neighborhoods.
Lenders and community groups will often sign these agreements when a lender has submitted an application to merge with another institution or expand its services. Lenders must seek the approval of federal regulators for their plans to merge or change their services. The four federal financial institution regulatory agencies will scrutinize the CRA records of lenders and will assess the likely future community reinvestment performance of lenders. The application process, therefore, provides an incentive for lenders to sign CRA agreements with community groups that will improve their CRA performance. Recognizing the important role of collaboration between lenders and community groups, the federal agencies have established mechanisms in their application procedures that encourage dialogue and cooperation among the parties in preserving and strengthening community reinvestment.
A CRA agreement is often a comprehensive document that covers a wide range of loans, investments, and bank services. This publication first provides a detailed list, by state and year, of the number of CRA agreements, and lists the banks and community groups signing the agreements. It then covers, in depth, the innovative affordable housing, small business, and other products contained in CRA agreements....
...Two major factors contribute to the incredible burst of commitments since 1992. First of all, NCRC members and other community organizations are becoming increasingly sophisticated in terms of being able to articulate community needs as well as providing homeownership counseling and other types of services in partnerships with banks. There has been a strong growth in community organizations in the last few years. NCRC started off with a membership of 16 groups in 1992 and now has over 600 member organizations -- all of who either use CRA in their daily work or at least believe it is important to preserve and improve the law.... (Emphasis mine)
SEC Rule Changes
The third issue this overlooks is SEC rule changes in 2004. According to The World Bank (the link is a PDF):
The SEC rule change in 2004 that changed how the SEC figured the net capital requirements is now seen as a significant mistake. Some journalists have mistakenly called this deregulation. What these journalists fail to note is that this rule change was the antithesis of deregulation; rather it was the imposition of internationally coordinated regulatory standards—rules known as the “Basel Rules.” The Basel Committee rules were the consequence of years of work by the central bankers of the world and are based on the belief that a common set of global banking standards would result in more efficient use of capital and a more stable global financial system. The Basel rules call for banks to have capital reserves of eight percent on a risk weighted basis. Commercial loans had a risk weight of 100, so had to be backed by 8 percent capital in reserve. But AAA rated securities (like the securitized mortgage pools), had a substantially lower risk weight of 20 percent, so banks only had to have 1.6 percent capital in reserve to back investments in AAA rated securities....The SEC rule change was one of the regulatory failures that contributed to the financial crisis. But rather than a deregulation problem, this is a cautionary tale against agreement to internationally coordinated regulatory standards. If they substitute for prudential regulation, they could be a lot worse.
Another SEC rule change in 2004 replaced explict rules with SEC micromanaging. While the stated goal was to check the activity of investment banks in detail, the end result (given that the government did not know any more about what was going on than the bankers did) was that the government simply used the banker's models. Investments in mortgage backed securities were one of the reasons for the change:
But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.
They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.
Arnold Kling (who was an economist on the staff of the Federal Reserve Board in the 1980s and an economist with Freddie Mac) explains further:
To foster homeownership, policymakers promoted mortgage lending that was subsidized and lenient. Requirements for down payments were relaxed, as were requirements for borrowers to prove they had the ability to repay their loans....
Washington also was responsible for creating and supporting the process of mortgage securitization. At the time, this was viewed as a way to lower the cost of mortgage credit and stabilize the mortgage lending industry.
Finally, it was bank capital requirements designed by regulators that induced bankers to weave the crazy quilt of collateralized debt obligations, credit default swaps on mortgage securities and off-balance-sheet financing....
John A. Allison explains in The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope:
...When a bank makes a mortgage loan, it fundamentally has two options. It can sell the mortgage (and keep or not keep the right to service the mortgage), typically to Freddie or Fannie. The other option is to retain the mortgage on its books and fund it with deposits. The accounting system treats these fundamentally similar economic decisions materially differently. If the bank sells the mortgage, it records a substantially larger profit on the front end. If it holds the mortgage, its front-end profit will be less.
Why did an accounting system that treats such similar transactions so differently and creates a strong incentive for banks to securitize instead of portfolio (hold on its books) home mortgages get created? Was this decision based on deep arguments about the relationship of accounting to economic value? Unfortunately, while there may have been some intellectual discussion, the fundamental motivation for this accounting change was politics, not economic theory. The primary force behind the accounting change was Countrywide (the big subprime leader that was Freddie and Fannie’s close partner, and that ultimately failed). At the time, Countrywide, while it had a small deposit base, was mainly a mortgage broker. It primarily originated mortgages for sale instead of putting the mortgages on its own balance sheet. The change in the accounting system provided a very material increase in current earnings for Countrywide, especially in relation to bank competitors that were portfolioing a meaningful part of their home loan production. In fact, this change created a “permanent” improvement in Countrywide’s earnings as long as production continued to increase, as the “new” accounting model constantly pulled earnings forward. It also created a major incentive for Countrywide to always increase its mortgage production, even if it had to take more risk. If Countrywide had slowed its production, the accounting system would effectively have double-counted negatively on earnings. Countrywide was supported in its efforts by Freddie Mac and Fannie Mae, who realized that the new model would be a major incentive (human action) for banks to securitize and sell their mortgage production to the two government-sponsored enterprises (GSEs) instead of holding the mortgages on the bank’s books. This shift would increase Freddie and Fannie’s market share and raise their earnings. Both Countrywide and Freddie and Fannie were very politically connected. They asked their congressional supporters to put pressure on the SEC and FASB (the accounting rule-making body) to make these accounting changes. The changes were in the context of the general movement toward fair-value accounting, so it was easy for FASB to support and/ or rationalize the changes....
The following is from Fed Chairman Ben S. Bernanke on March 6, 2007:
...Broadly speaking, Fannie Mae and Freddie Mac each run two lines of business. Their first line of business involves purchasing mortgages from primary mortgage originators, such as community bankers; packaging them into securities known as mortgage-backed securities (MBS); enhancing these MBS with credit guarantees; and then selling the guaranteed securities. Through this process, securities that trade readily in public debt markets are created. This activity, known as securitization, increases the liquidity of the residential mortgage market. In particular, the securitization of mortgages extended to low- and middle-income home purchasers likely has made mortgage credit more widely available.
The GSEs’ second line of business is the main focus of my remarks today. It involves the purchase of mortgage-backed securities and other types of assets for their own investment portfolios. This line of business has raised public concern because its fundamental source of profitability is the widespread perception by investors that the U.S. government would not allow a GSE to fail, notwithstanding the fact that--as numerous government officials have asserted--the government has given no such guarantees. The perception of government backing allows Fannie and Freddie to borrow in open capital markets at an interest rate only slightly above that paid by the U.S. Treasury and below that paid by other private participants in mortgage markets. By borrowing at this preferential rate and purchasing assets (including MBS) that pay returns considerably greater than the Treasury rate, the GSEs can enjoy profits of an effectively unlimited scale. Consequently, the GSEs’ ability to borrow at a preferential rate provides them with strong incentives both to expand the range of assets that they acquire and to increase the size of their portfolios to the greatest extent possible....
...In most situations, policymakers can rely on market forces to constrain the risk-taking behavior of privately owned financial organizations. Market discipline is effective because, normally, the creditors of private firms have powerful incentives to monitor the risk-taking and risk-management activities conducted by these organizations. In particular, if creditors believe that an organization is taking on increased risk, they will reduce their exposure to the organization or demand greater compensation for bearing the additional risk. These market responses act as a brake on an organization’s risk-taking behavior and consequently reduce the likelihood that the company will fail.
Unlike other private firms, however, the GSEs face little or no market discipline from their senior debt holders because of the belief among market participants that the U.S. government will back these institutions under almost any circumstances. As a result, increased risk-taking by the GSEs does not significantly increase their cost of funding or reduce their access to credit, as it would for other private firms. Indeed, as I have already noted, GSE debt trades at a narrow spread over U.S. Treasury debt and at spreads below those of other highly rated financial institutions, including the largest U.S. bank holding companies. Moreover, the spread of GSE debt over Treasuries has been remarkably unresponsive to the recent problems of the GSEs (including the turnover of senior management and the inability of either company to provide current financial statements), suggesting that investors’ faith in an implicit government guarantee remains unshaken.
As I have also noted, their low cost of borrowing gives GSEs an advantage over market participants in profitably financing the acquisition of just about any market-priced asset (other than U.S. Treasuries), and it creates a strong incentive for these companies to look for new types of assets to acquire and to find new lines of business to enter. These ingredients--the large presence of the GSEs in financial markets, the lack of market discipline exercised by investors in GSE senior debt, and the incentives for continued portfolio growth--led the Federal Reserve Board to conclude that while the GSEs do not seem to pose an immediate risk of financial difficulty, their portfolios continue to represent a potentially significant source of systemic risk....
Reduced Down Payments
To expand on Kling's reference to reduced down payments, Peter J. Wallison and Edward J. Pinto write:
...In 1995, expanding the idea in the Best Practices Initiative, HUD issued a policy statement titled "The National Homeownership Strategy: Partners in the American Dream." The first paragraph of chapter 1 leaves no doubt about what HUD had set out to do: "The purpose of the National Homeownership Strategy is to achieve an all-time high level of homeownership in America within the next 6 years through an unprecedented collaboration of public and private housing industry organizations." The paper then made clear that reducing down payments would increase homeownership: "Lending institutions, secondary market investors, mortgage insurers, and other members of the partnership should work collaboratively to reduce homebuyer downpayment requirements. Mortgage financing with high loan-to-value ratios should generally be associated with enhanced homebuyer counseling and, where available, supplemental sources of downpayment assistance."
HUD’s policy was successful. In 1989, only 1 in 230 homebuyers bought a home with a down payment of 3 percent or less, but by 2003, 1 in 7 buyers was providing a down payment at that level and by 2007, the number was less than 1 in 3.10 The program’s contribution to the reduction in home equity and the subsequent increase in leverage is obvious....
Here is more background on getting down payment requirements reduced in the context of the government's "affordable housing" initiatives:
...The first was the ironically named "Federal Housing Enterprises Financial Safety and Soundness Act of 1992." At the behest of ACORN and other community advocacy groups and with the support of Fannie Mae, Congress imposed affordable housing (AH) mandates on Fannie and Freddie. HUD was established as their AH mission regulator. Within 18 months after passage of the 1992 Act, Jim Johnson. Fannie's chairman committed the company to "transforming the housing finance system" and vowed to "provide $1 trillion in targeted lending."
This was followed in 1995 by President Clinton's National Homeownership Strategy in which HUD formalized and greatly expanded a long-standing policy goal: the reduction of down payments. It asked "[l]ending institutions, secondary market investors, mortgage insurers, and other members of the partnership [to] work collaboratively to reduce homebuyer down payment requirements." ...
Elsewhere, John Carney writes:
...The regulators charged with enforcing the CRA praised the lowering of down payments and even their elimination. They told banks that lending standards that exceeded that of regulators would be considered evidence of unfair lending. This effectively meant that no money down mortgages were required. A Treasury Department study published in 2000 found that the CRA had successfully lowered down payments not just for CRA loans, but for all mortgages. ...
Here is a graph of down payment (or loan to value) to deliquency to show why this matters:
Community Reinvestment Act Performance, Large Institutions vs. Small Ones
The problem here is that large institutions tended to perform much more poorly under the CRA than smaller ones (and large programs performed worse than small ones). This is made even more serious by how much a factor the large banks were; 94% of the $6 trillion in CRA commitments made between 1992 and 2008 "were made by banks and thrifts that were or ended up being owned by just four banks: Wells Fargo, JP Morgan Chase, Citibank, and Bank of America". These four banks, in addition to Fannie Mae and Freddie Mac, are responsible for "an estimated 70% or more of outstanding CRA loans". More on Bank of America's CRA performance below. Remember this the next time someone tries to defend government "affordable housing" initiatives by pointing to small programs from small lenders with good statistics, usually studied during the housing boom when rising prices prevented foreclosures (people sold homes they couldn't afford for a profit instead of letting the banks take them back). No statistic from any small program or small lender from before the crash proves these programs innocent of anything.
Another thing impacting the evaluation of any small program is the Hawthorne Effect. It basically states that the evaluation or experiment itself improves performance. Megan McArdle at The Atlantic continues:
...With pilot programs, you always have to be on the lookout for the Hawthorne effect: people being studied often change their behavior in response to the fact of being studied, not to any particular intervention. The effect gets its name from a factory where researchers were studying the effect of lighting on worker productivity. What they found was that both raising and lowering the light level caused productivity to increase--the workers were responding to the researchers, not the lights....
When programs are rolled out on large scale, they suffer from a number of problems. They cannot all be staffed with top-notch, motivated staff.... The permanent staff will not hew as rigorously to procedures and methods as people doing a temporary experiment. And of course, there is no Hawthorne effect....
Small banks were treated differently in an additional way (note yet another change in the law in 1999):
...when CRA was enacted in 1977, federal regulators had to evaluate most of the banks under their oversight every two years. In 1999, as part of the Gramm-Leach-Billey Act, the review cycle for smaller banks - those with less than $250 million in assets - was extended from two to five years....
From the same source, large banks performed worse, CRA loans performed worse, and this was all particularly ugly in the 2004-2006 period:
Our empirical strategy compares lending behavior of banks undergoing CRA exams within a given census tract in a given month to the behavior of banks operating in the same census tractmonth that do not face these exams. We find that adherence to the act led to riskier lending by banks: in the six quarters surrounding the CRA exams lending is elevated on average by about 5 percent every quarter and loans in these quarters default by about 15 percent more often. These patterns are accentuated in CRA-eligible census tracts and are concentrated among large banks. The effects are strongest during the time period when the market for private securitization was booming.
...we find that large lending institutions drive our main findings on the impact of CRA exams on the quantity and quality of extended loans. This is to be expected: federal regulatory agencies consider depository institutions’ CRA scores when considering applications for deposit facilities, including branch openings as well as mergers and acquisitions. To the extent that larger banks are more heavily engaged in mergers and acquisitions activity and expansion through branch openings, they will have a greater incentive...
...We find evidence of elevated lending by treatment group banks around the CRA exam during the 2004-2006 period. Moreover, our results show that the differential performance of loans originated by treatment and control group banks around CRA exams is particularly strong during the 2004-2006 period. This coincides with the time period when private securitization boomed and might therefore reflect an unexplored channel through which the private securitization market induced risky lending in the economy....
...It is important to note that our empirical strategy does not provide an assessment of the full impact of the CRA on the origination of risky loans. This is because the analysis examines the effect of CRA evaluations relative to a baseline of banks not undergoing a CRA exam. To the extent that there are adjustment costs in changing lending behavior, the baseline level of lending behavior itself may be shifted toward catering to CRA compliance. That is, banks may have responded to the CRA in periods outside of CRA exams. Because the empirical strategy nets out the baseline effect, our estimates of the effect of CRA evaluations provide a lower bound to the actual impact of the CRA. If adjustment costs in lending behavior are large and banks can’t easily tilt their loan portfolio toward greater CRA compliance, the full impact of the CRA is potentially greater than that estimated by the change in lending behavior around CRA exams.
In The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope, John A. Allison writes:
...Initially the loss ratios in CRA (subprime) lending were acceptable. This was because of a combination of good economic times and the fact that it takes time for a loan portfolio to mature, particularly when it is growing rapidly. Once a high-risk loan portfolio starts to experience slower growth, its loss ratios rise rapidly. The early positive losses that were experienced, partly made possible by Greenspan’s constantly printing money to keep the economy from correcting, led many bankers to believe that low-income (subprime) lending was far less risky that it is. This early loan loss experience also distorted some of the models used by rating agencies to rate bonds,...
Or, as stated elsewhere:
...HUD’s loosened underwriting standards succeeded in increasing homeownership: between 1995 and 2004, the US homeownership rate rose from 64 percent—where it had been for thirty years—to more than 69 percent. That added substantial demand to the market, which gave the bubble a bigger boost than simple speculation might have accomplished on its own. In a normal speculative or bubble market, financial sources add funds as the bubble grows but eventually sell out and withdraw as they perceive the risks to have increased.
This is probably the mechanism that naturally limits the size of housing and other asset bubbles in markets not substantially affected by government objectives. But the 1997 to 2007 bubble was different because it was ultimately fed by a government social policy, not the normal profit-making goals of investors and speculators. Unlike private speculators, the government does not fear losses when it is pursuing an objective like increasing homeownership, and it persisted in feeding money into the market long after the risks would have driven private sources out....
...In a market where prices are rising quickly, homeowners who cannot meet their mortgage obligations can often refinance or sell their homes without a loss. In the midst of a housing bubble, therefore, subprime loans can look like excellent risk-adjusted investments. For this reason, by 2004, private investors had become interested in PMBS backed by subprime loans; these securities were offering high yields but not showing losses commensurate with their risk. This phenomenon was helped along by the fact that the low interest rates in the early 2000s had produced a vast number of refinanced and unseasoned mortgages, which in their early years characteristically have low rates of delinquency and default. Finally, the rating agencies seemed to see things the same way and were putting triple-A ratings on pools of subprime loans. Thus, in early 2007, for example, Austan Goolsbee—later head of President Obama’s Council of Economic Advisers—noted: “the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.”...
...Underlying the giant housing bubble that drew them in was a government investment that in 2008 consisted of 20.4 million subprime and other risky loans—about three times the size of the PMBS market. If the government had not created a ten-year bubble by making massive investments in subprime and other low-quality mortgages, the private sector would never have been drawn into the subprime market in such a significant way. The weakening of financial institutions in the mortgage meltdown—and the resulting financial crisis—would never have occurred....
Bank of America Community Reinvestment Act Performance
In the same study, Minneapolis Fed also claimed:
In total, of all the higher-priced loans, only 6 percent were extended by CRA-regulated lenders (and their affiliates) to either lower-income borrowers or neighborhoods in the lenders' CRA assessment areas, which are the local geographies that are the primary focus for CRA evaluation purposes. The small share of subprime lending in 2005 and 2006 that can be linked to the CRA suggests it is very unlikely the CRA could have played a substantial role in the subprime crisis.
The first part is consistent with Bank of America's claim that in 3Q 2008 its CRA loans constituted 7% of its owned residential-mortgage portfolio. Unfortunately for the Fed (and for BoA), that 7% represented 29 percent of that portfolio's net losses (the numbers for first quarter 2009 were about 7% of the residential book, but about 24% of the losses). More bad news from BoA:
...in its 10-K annual report to the Securities and Exchange Commission for 2009, Bank of America made one of the few bank references to CRA loan quality: "At December 31, 2009, our CRA portfolio comprised six percent of the total residential mortgage balances, but comprised 17 percent of nonperforming residential mortgage loans. This portfolio also comprised 20 percent of residential net charge-offs during 2009."...
Furthermore, this 6 percent statistic leaves something out:
...it doesn't include subprime loans — or securities — bought by CRA-covered banks. Mortgages originated by independent mortgage companies can be bought by banks to get CRA credit. Nor does the study include the billions in public commitments big banks made to lend to low-income and minority households to buy off Acorn and other CRA lobbyists.
Community Reinvestment Act Estimated Default Rates
CRA default rates can be estimated. According to
Peter J. Wallison, writing for Cato (PDF):
...Recent research by Edward Pinto (2008a, 2008b)—an expert in this field—has shown that, largely due to the banks’ commitments, over $3.5 trillion in single-family CRA loans were originated from 1993 to 2007. About half of these loans went to Fannie and Freddie, to meet their affordable housing requirements; about 10 percent were insured by the Federal Housing Administration; about 10 percent were sold as private mortgage-backed securities (PMBSs), and most of the rest remained on the balance sheets of the four largest U.S. banks. While it’s difficult to find data on how these CRA loans have performed, the few bank reports that break out these loans show much higher default rates than prime loans. Pinto’s research indicates that Fannie and Freddie’s affordable housing loans are a good proxy for CRA loans performance. For example, Fannie’s delinquency rate on its $900 billion in high-risk loans, 85 percent of which are affordable housing loans, was 11.36 percent at September 30, 2009—about 6.5 times the 1.8 percent delinquency rate on the GSEs’ traditionally underwritten loans....
Overall (warning, the link is a PDF):
While both CRA- and non-CRA lenders have increased the number of loans to low-income borrowers, the financial soundness of CRA covered institutions decreases the better they conform to the CRA. Gunther compares certain institutions’ CRA ratings to their CAMELS rating—a formula used by bank regulators to assign safety and soundness ratings that takes into account capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risks. He found that the better a lender was rated by CRA standards, the worse was its CAMELS rating....
Fannie and Freddie Ramp Up For Political Cover After Scandals
Large banks weren't the only institutions buying CRA loans (and securities based on those loans). Approximately 50% of CRA originations since the mid-1990s were acquired by Fannie Mae and Freddie (the GSEs) to help them meet HUD-mandated affordable housing (AH) goals. Investor's Business Daily quotes Fannie Vice Chair Jamie Gorelick (and others):
...CRA regulations are at the core of Fannie's and Freddie's so-called affordable housing mission. In the early 1990s, a Democrat Congress gave HUD the authority to set and enforce (through fines) CRA-grade loan quotas at Fannie and Freddie.
It passed a law requiring the government-backed agencies to "assist insured depository institutions to meet their obligations under the (CRA)." The goal was to help banks meet lending quotas by buying their CRA loans....
..."We want your CRA loans because they help us meet our housing goals," Fannie Vice Chair Jamie Gorelick beseeched lenders gathered at a banking conference in 2000, just after HUD hiked the mortgage giant's affordable housing quotas to 50% and pressed it to buy more CRA-eligible loans to help meet those new targets. "We will buy them from your portfolios or package them into securities."
She described "CRA-friendly products" as mortgages with less than "3% down" and "flexible underwriting."
From 2001-2007, Fannie and Freddie bought roughly half of all CRA home loans, most carrying subprime features.
Lenders not subject to the CRA, such as subprime giant Countrywide Financial, still fell under its spell. Regulated by HUD, Countrywide and other lenders agreed to sign contracts with the government supporting such lending under threat of being brought under CRA rules.
"Countrywide can potentially help you meet your CRA goals by offering both whole loan and mortgage-backed securities that are eligible for CRA credit," the lender advertised to banks....
At the same time as CRA enforcement was hitting large institutions hard, Fannie and Freddie were ramping up:
It appears that this aggressive expansion of Fannie Mae and Freddie Mac into subprime lending was a political strategy adopted by their leaders in response to heightened congressional scrutiny and criticism in the wake of the accounting scandals at the agencies that emerged during 2003 to 2004 and which threatened to lead to a revocation of their favored status as government-sponsored enterprises. Fannie and Freddie aggressively restyled their lending operations as the promotion of affordable housing and actively encouraged retail lenders to generate mortgages with those characteristics. As a result, not only did the number of subprime loans explode in the 2005 to 2007 period, but a disproportionate number of these loans were made to the riskiest borrowers or had extremely high risk characteristics, such as negative amortization, interest-only, high-LTV, or very low FICO scores.
And what were the Fannie/Freddie/GSE accounting scandals? According to the Washington Post:
When James A. Johnson walked out of his office as chief executive at Fannie Mae for the last time, in December 1998, the longtime Democratic Party operative and investment banker could look back at his nearly decade-long tenure at the helm knowing the company had lived up to his promises of double-digit earnings growth. The value of its assets had also tripled, and its share price had risen sevenfold.
"Without good numbers, nothing else can get done," he told The Post in 1998.
Good numbers kept Wall Street happy. They paid the light bills for more than 50 partnership offices that represented Fannie Mae around the country. And they made top executives multimillionaires. Johnson received $21 million in his last year as chief executive and a consulting contract worth $600,000 a year.
But when good numbers -- and the bonuses that came with them -- weren't possible anymore, the executives who came after Johnson allegedly rearranged the math and, even after accounting problems were found, used the company's political clout to fend off closer regulation. That was the conclusion of Fannie Mae's chief regulator, the Office of Federal Housing Enterprise Oversight, in a 340-page report that determined the company's $10.6 billion accounting scandal was rooted in a corporate culture that dates back 20 years....
Investigators found that Fannie Mae's reported earnings per share closely tracked the targets set for executives to receive their maximum bonus payouts.
SOURCE: OFHEO Report of the Special Examination of Fannie Mae | The Washington Post - May 24, 2006
The Report of the Special Examination of Fannie Mae (PDF) agrees:
...During the period covered by this report—1998 to mid-2004—Fannie Mae reported extremely smooth profit growth and hit announced targets for earnings per share precisely each quarter. Those achievements were illusions deliberately and systematically created by the Enterprise’s senior management with the aid of inappropriate accounting and improper earnings management.
A large number of Fannie Mae’s accounting policies and practices did not comply with Generally Accepted Accounting Principles (GAAP). The Enterprise also had serious problems of internal control, financial reporting, and corporate governance. Those errors resulted in Fannie Mae overstating reported income and capital by a currently estimated $10.6 billion.
By deliberately and intentionally manipulating accounting to hit earnings targets, senior management maximized the bonuses and other executive compensation they received, at the expense of shareholders. Earnings management made a significant contribution to the compensation of Fannie Mae Chairman and CEO Franklin Raines, which totaled over $90 million from 1998 through 2003. Of that total, over $52 million was directly tied to achieving earnings per share targets....
Before joining Fannie, Franklin Raines was Clinton's White House budget director. Jim Johnson vetted VP candidates for Walter Mondale and John Kerry during their presidential campaigns, and was tapped for the same role with the Obama campaign before being forced out. After leaving Fannie, Johnson joined the board of Goldman Sachs (he headed the compensation committee) where an "internal Fannie probe in 2006 led by former U.S. Senator Warren Rudman identified several accounting violations that occurred on Johnson’s watch". It was Goldman Sachs who
...designed a mortgage-backed security that it said in a Nov. 19 presentation would allow Fannie to "better manage the recognition of income" for accounting purposes, according to the OFHEO report. The security allowed Fannie to push $107 million in income to future years, when the company expected a rise in interest rates would depress its earnings. Goldman received $625,000 in fees for one of the two transactions, which OFHEO said "had no significant purpose other than to achieve desired accounting results."...
Rahm Emanuel, formerly White House Chief of Staff to President Barack Obama, senior advisor to President Bill Clinton from 1993 to 1998, and a Democratic member of the United States House of Representatives served on Fannie Mae’s board for a mere 14 months and raked in a cool $320,000.
In The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope, John A. Allison explains further:
...Banks had been pushed into the low-income high-risk housing market by the Community Reinvestment Act, but Freddie and Fannie largely avoided the low-income market for years. They did this through powerful political connections. They were big contributors to both political parties, and they enlisted the support of the politically powerful Home Builders Association, which viewed Freddie and Fannie as vital to the residential construction industry. Their balancing act of avoiding as much of the low-income market as they could started coming apart with Clinton’s 1999 goal for them to have half their loan portfolio in affordable-housing/ subprime loans. However, they really lost control over an unrelated issue. In 2002, because of the accounting failures at WorldCom and Enron, the accountants at Freddie and Fannie took a far deeper look at the institutions’ accounting systems. Based on this examination, both organizations ultimately had to execute major accounting restatements of their earnings. Issues of fraud by the executive management to maximize their bonuses were raised. It was a very visible "scandal."
...Whether or not Fannie and/ or Freddie were guilty of anything more than honest misinterpretations of complex accounting rules, the impact of the accounting problems was very significant for both organizations. Their political cover was blown. The balancing act was undone. If Freddie and Fannie wanted to keep the U.S. government guarantee of their debt, they had to focus on what Congress wanted, and Congress wanted Freddie and Fannie to become very serious about achieving Clinton’s (and now Bush’s) affordable-housing goals. This is when they cranked up their low-income lending business and ultimately became the primary driver of the subprime lending markets. The irony is that the internal staff at Freddie and Fannie did not want to go after this market. They knew that with their organizations’ very high financial leverage, this subprime strategy was incredibly risky. Both companies had survived by making only lower-risk loans and had low loan loss ratios. Their operating formula was not designed for high-risk affordable-housing lending. However, Congress was not going to continue to guarantee their debts unless they met the subprime goals, and if it did not do so, they would be out of business. They had no choice but to cooperate....
...Several economists pointed out that the legitimate affordable-housing market was not big enough to equal 50 percent of the giant loan portfolios of Freddie Mac and Fannie Mae. In order to meet this political goal of the Clinton administration, Freddie and Fannie would have to consistently lower their lending standards. In fact, one economist noted that this high level of risk taking could jeopardize the financial viability of Freddie and Fannie, and that these institutions were so big that if they failed, it could have a dramatic impact of the U.S. economy, and it could happen in ten years. Nine years later, it happened.
...By the way, one of the arguments heard from a few economists is that Freddie and Fannie cannot be the cause of the subprime problems because they were not major subprime lenders. This argument is based on false information. Freddie and Fannie never reported large subprime portfolios before they failed. However, they had very large portfolios that they classified as Alt-A. This is a class of loans that is supposed to be somewhat more risky than prime, but less risky than subprime. Unfortunately, it turns out that their Alt-A portfolios were in fact largely subprime portfolios. A careful examination of the actual credit characteristics of these supposed Alt-As indicates that they had the same risk profiles as subprime loans. This should not be surprising, given the political mandate to serve the low-income market that the GSEs were under. Economists at the American Enterprise Institute (AEI) have estimated that Freddie and Fannie’s subprime portfolio was in excess of $ 2 trillion. This is huge. The reporting error itself materially distorted the market. If you are buying subprime mortgage bonds, or if you are a rating agency trying to rate these bonds, the size of the market is extremely important in your decision process.
Freddie and Fannie’s failure to report $ 2 trillion in subprime loans misled all the market participants, including the rating agencies. ...
......Freddie and Fannie chose to expand their relationships with those originators that were already at least partially in the subprime business, such as Countrywide and Washington Mutual, and encourage their traditional originators to develop subprime expertise. They also made it significantly easier for nontraditional mortgage brokers to bypass the mortgage consolidators and sell loans directly to the GSEs. This was an earnings-driven strategy by Freddie and Fannie, as they wanted to capture the consolidators’ profit. It was a completely off-mission concept, as Freddie and Fannie had originally been created to support the mortgage industry’s loan origination business (primarily S& Ls), not to bypass the industry. This decision turned into a significant quality control problem for Freddie and Fannie, as the bank industry consolidators had played an important role in managing quality, especially in reducing fraud. To meet the affordable-housing loan goals established by Congress, the GSEs opened the floodgates by constantly lowering standards and working with their friends at Countrywide, Washington Mutual, and the others to drive greater subprime volume by constantly taking more and more risk....
This is from Hoover's The Mortgage Crisis: Some Inside Views:
...The turning point was the spring and summer of 2004. Fannie and Freddie had kept their exposures low to loans made with little or no documentation (no-doc and low-doc loans), owing to their internal risk-management guidelines that limited such lending. In early 2004, however, senior management realized that the only way to meet the political mandates was to massively cut underwriting standards.
The risk managers complained, especially at Freddie Mac, as their emails to senior management show. They refused to endorse the move to no-docs and battled unsuccessfully against the reduced underwriting standards from April to September 2004....
...Politics—not shortsightedness or incompetent risk managers—drove Freddie Mac to eliminate its previous limits on no-doc lending. Commenting on what others referred to as the "push to do more affordable [lending] business," Senior Vice President Robert Tsien wrote to Dick Syron on July 14, 2004: "Tipping the scale in favor of no cap [on no-doc lending] at this time was the pragmatic consideration that, under the current circumstances, a cap would be interpreted by external critics as additional proof we are not really committed to affordable lending."...
...In a painstaking forensic analysis of the sources of increased mortgage risk during the 2000s, "The Failure of Models that Predict Failure," Uday Rajan of the University of Michigan, Amit Seru of the University of Chicago and Vikrant Vig of London Business School show that more than half of the mortgage losses that occurred in excess of the rosy forecasts of expected loss at the time of mortgage origination reflected the predictable consequences of low-doc and no-doc lending. In other words, if the mortgage-underwriting standards at Fannie and Freddie circa 2003 had remained in place, nothing like the magnitude of the subprime crisis would have occurred....
(it is claimed) that the GSEs bought large numbers of subprime mortgages for market share or because these loans were highly profitable. If that were true, Fannie and Freddie would have exceeded the goals by wide margins. That they cleared these hurdles with little to spare in most years - and missed them occasionally - is strong evidence that they were dragged along by HUD's remoseless pressure.
According to Cato's Mark Calabria, by "2005, one out of every four loans purchased by Fannie Mae was from Countrywide" and "one of out every 10 for Freddie Mac was also from Countrywide", the end result being that "close to 90 percent of Countrywide’s loan originations were bought or guaranteed by some arm of the federal government". How was this achieved? (warning, link is a PDF)
...In 1999, Fannie Mae CEO Jim Johnson and Countrywide CEO Angelo Mozilo reached a strategic agreement giving Fannie Mae exclusive access to many of the loans originated by Countrywide in exchange for a discount on fees Fannie charged when buying loans. The agreement linked the growth and success of Countrywide to Fannie Mae’s continued desire to acquire a large volume of loans....
...Because the growth and success of Countrywide was tied directly to Fannie Mae’s continued hunger for acquiring and holding loans and Wall Street’s continued investment in mortgage-backed securities composed of subprime mortgages, Countrywide CEO Angelo Mozilo offered a key group of VIPs preferential treatment through a special loan division. Countrywide gave preferential treatment to legislators, Congressional staff, cabinet members, Fannie Mae executives, lobbyists, and others well connected in Washington. Countrywide also gave preferential treatment to business partners, local politicians, homebuilders, entertainers and law enforcement officials....
...Countrywide’s VIP loan program was a tool with which Countrywide built its relationship with Congress and protected its relationship with Fannie Mae. Senior Countrywide officials and lobbyists openly and explicitly weighed the value of relationships with potentially influential borrowers against the cost to Countrywide in terms of forfeited fees and payments....
Senator Christopher Dodd, Member of the Committee on Banking, Housing and Urban Affairs (elevated to Committee Chairman in 2007), who saved approximately $75,000 by refinancing his home at a reduced rate;
James “Jim” Johnson, former Fannie Mae CEO and adviser to the presidential campaigns of John Kerry and Barack Obama, whose loans were priced personally by Mozilo at discounted rates.
Franklin D. Raines, CEO of Fannie Mae, for whom Countrywide’s VIP loan division applied a discount of “1 point off, no junk” to a $1 million refinance in response to a phone call from his secretary stating “per Angelo, Frank needs to refi.”...
The Wall Street Journal has created this helpful graph:
Despite earning "$21 million in his last year as chief executive and a consulting contract worth $600,000 a year" (above), Johnson evidently needed the financial help:
...Jim Johnson, chief executive officer of Fannie Mae from 1991 to 1998, earned $100 million during his time at the company. Nonetheless, Countrywide employees expressed concern about giving him a loan because he didn’t pay his bills regularly and had a low credit score, according to e-mails published in Issa’s report.
Because of Johnson’s credit report, “I’m concerned about signing on these loans,” Countrywide underwriter Gene Soda said in a 2005 e-mail to another Countrywide employee, according to the report.
Countrywide’s chief executive officer, Angelo Mozilo, who had a close relationship with Johnson, wrote back, instructing his employees to give Johnson a loan “1/2 below prime.”
“Don’t worry about” the credit score, Mozilo wrote. “He is constantly on the road and therefore pays his bills on an irregular basis but he ultimately pays them.” In another e-mail, Mozilo wrote, “Jim Johnson continues to be a source of many loans for our company and this is just a small token of appreciation for the business that he sends to us.”...
This was not limited to a handful of insiders, it went further:
...The number of loans to borrowers who worked at Fannie Mae spiked at two points during the lifetime of Countryside’s VIP program. The first spike came in 1998, as Countrywide was negotiating a volume discount with Fannie Mae, the second spike came in 2001-03, on the leading edge of a “mortgage boom that occurred from late 2002 through 2004" and an expansion of the VIP loan unit....
...While negotiating the volume discount,“Countrywide CEO Angelo Mozilo leveraged his company’s position as the nation’s largest residential housing lender to extract a lower “guarantee fee” from Fannie Mae CEO Jim Jonson, who himself receive several Countrywide VIP loans.” (More than $10 Million worth of loans)...
Goldman, Fannie, and Countrywide had a good little thing going:
...Countrywide abandoned standards altogether, even doctoring loans to make applicants look creditworthy, while generating a fortune for its co-founder, Angelo R. Mozilo. Meanwhile, Wall Street banks received fat fees underwriting securities issued by Fannie and Freddie, and even more money providing lenders like Countrywide with lines of credit to expand their risky lending and then bundling the mortgages into securities they peddled to their clients. The Street, Morgenson and Rosner say, knew lending standards were declining but maintained the charade because it was so profitable. Goldman Sachs even used its own money to bet against the bundles — making huge profits off the losses of its clients on the very securities it had marketed to them....
Sen Dodd was an important Fannie Mae defender. Keep the above in mind next time someone says lenders like Countrywide weren't covered by the CRA, and so therefore government housing programs, and the government, are innocent. Does the above demonstrate a lack of government involvement? Even so, Countrywide was still involved with the CRA:
...Countrywide marketed its loans directly to banks as a way for them to meet CRA obligations. "The result of these efforts is an enormous pipeline of mortgages to low- and moderate-income buyers. With this pipeline, Countrywide Securities Corporation (CSC) can potentially help you meet your Community Reinvestment Act (CRA) goals by offering both whole loan and mortgage-backed securities that are eligible for CRA credit,” a Countrywide advertisement on its website read....
Other "Affordable Housing" Initiatives
Peter J. Wallison, a commissioner of the Financial Crisis Commission, continues:
...The 1992 affordable housing goals required that, of all mortgages Fannie and Freddie bought in any year, at least 30 percent had to be loans made to borrowers who were at or below the median income in the places where they lived. Over succeeding years, the Department of Housing and Urban Development (HUD) increased this requirement, first to 42 percent in 1995, to 50 percent in 2000, and finally to 55 percent in 2007. It is important to note, accordingly, that this occurred during both Democratic and Republican administrations....
...[According to] Fannie's 2006 10-K report...
[W]e have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD's increased housing goals and new subgoals. These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions. We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD's goals and subgoals, which could increase our credit losses.
Government arm twisting encouraged this lending:
...Rewind to 1994. That year, the federal government declared war on an enemy — the racist lender — who officials claimed was to blame for differences in homeownership rate, and launched what would prove the costliest social crusade in U.S. history.At President Clinton's direction, no fewer than 10 federal agencies issued a chilling ultimatum to banks and mortgage lenders to ease credit for lower-income minorities or face investigations for lending discrimination and suffer the related adverse publicity. They also were threatened with denial of access to the all-important secondary mortgage market and stiff fines, along with other penalties.
The threat was codified in a 20-page "Policy Statement on Discrimination in Lending" and entered into the Federal Register on April 15, 1994, by the Interagency Task Force on Fair Lending. Clinton set up the little-known body to coordinate an unprecedented crackdown on alleged bank redlining....
...For the first time, Washington's bank regulators put racial lending at the top of their checklist. Banks that failed to throw open their lending windows to credit-poor minorities were denied expansion plans by the Fed in an era of frenzied financial mergers and acquisitions. HUD threatened to deny them access to Fannie Mae and Freddie Mac, which it controlled. And the Justice Department sued them for lending discrimination and branded them as racists in the press....
...Confronted with the combined force of 10 federal regulators, lenders naturally toed the line, and were soon aggressively marketing subprime mortgages in urban areas. The marching orders threw such a scare into the industry that the American Bankers Association issued a "fair-lending tool kit" to every member. The Mortgage Bankers Association of America signed a "fair-lending" contract with HUD. So did Countrywide....
You can see this GSE activity in this chart from Mark A. Calabria of Cato.org. According to Calabria, "during the bubble years, Fannie and Freddie were the largest single source of liquidity for the subprime market. And the chart doesn’t even take into account all the subprime whole loans being purchased by the GSEs." The vertical axis values are USD billions (bars) and market share (line).
GSE growth can be seen in the following chart (PDF):
...At the end of 1981, when the [President’s Commission on Housing] was starting its work, Fannie and Freddie represented just 7.1% of the residential mortgage market, and held $64.8 billion worth of mortgages in their portfolios and guaranteed an additional $20.6 billion. A decade later, their market share had grown to an extraordinary 28.4%, with corresponding portfolio holdings of $153.4 billion and guarantees of $714.5 billion. And by 2002, they held $1.21 trillion and guaranteed $1.52 trillion, equivalent to a 44.7% share of the residential mortgage market. This growth of Fannie and Freddie is depicted in [the figure] below. The left-hand side provides the total dollar value of Fannie and Freddie’s commitments to the mortgage market through their portfolios and their net MBS issuances, while the righthand side represents their share of the mortgage market....
Freddie and Fannie ramped up their mortgage backed security activities:
...HUD not only encouraged no down payments but also adopted affordable housing mandates for the government-sponsored enterprises that issue mortgage securities, Fannie Mae and Freddie Mac. Beginning in 1996, the GSEs had to make 40% of new loans they financed to borrowers with incomes below the national median.
With lower underwriting standards and a mandate to fulfill, Fannie and Freddie's MBS issuance began to take off. It surged more than 116%, from $342 billion in 1997 to $741 billion in 1998.
It was a recipe for disaster as Fannie and Freddie had an implicit guarantee (since made explicit) that the government would cover any losses that they suffered. With that backing, investors were all too willing to gobble up the GSEs' MBS offerings, even if they included subprime loans....
In response to the Minneapolis Federal Reserve's defense of the CRA loans themselves, the statistics say otherwise:
...the epicenters of the mortgage crisis are inner-city urban areas--precisely those areas where the CRA was most applicable. As the Boston Federal Reserve put it in a massive 2008 study, "In the current housing crisis foreclosures are highly concentrated in [urban] minority neighborhoods." The study found that borrowers in these areas were seven times more likely to be foreclosed on than the general population. Analysis by the Pew Research Center and another by The New York Times found that mortgage holders in these areas had foreclosure rates four times higher than the national average.
One additional question. If Fannie and Freddie were lying about their profits from this activity, and that 'profitability' encouraged private entities to get into the business, are Fannie and Freddie absolved of any guilt concerning the results? Also, as the chart from Cato shows, the GSEs made MBS purchases from private entities. Private entities issuing an increasing amount of those securities doesn't get either GSE off the hook for them or their consequences, particularly when agents of Fannie claimed credit for that market when doing so suited their purposes.
Government Ownership of Mortgages
The data shows that the principal buyers [of almost 25 million subprime and other nonprime mortgages—almost half of all U.S. mortgages] were insured banks, government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and the FHA—all government agencies or private companies forced to comply with government mandates about mortgage lending. When Fannie and Freddie were finally taken over by the government in 2008, more than 10 million subprime and other weak loans were either on their books or were in mortgage-backed securities they had guaranteed. An additional 4.5 million were guaranteed by the FHA and sold through Ginnie Mae before 2008, and a further 2.5 million loans were made under the rubric of the Community Reinvestment Act (CRA), which required insured banks to provide mortgage credit to home buyers who were at or below 80% of median income. Thus, almost two-thirds of all the bad mortgages in our financial system, many of which are now defaulting at unprecedented rates, were bought by government agencies or required by government regulations.
In his January 2011 Financial Crisis Inquiry Commission Dissent, Peter J. Wallison of the American Enterprise Institute writes:
...The fact that the credit risk of two-thirds of all the NTMs in the financial system was held by the government or by entities acting under government control demonstrates the central role of the government’s policies in the development of the 1997-2007 housing bubble, the mortgage meltdown that occurred when the bubble deflated, and the financial crisis and recession that ensued. Similarly, the fact that only 7.8 million NTMs [non-traditional mortgages] were held by investors and financial institutions in the form of PMBS shows that this group of NTMs were less important as a cause of the financial crisis than the government’s role. The Commission majority’s report focuses almost entirely on the 7.8 million PMBS, and is thus an example of its determination to ignore the government’s role in the financial crisis....
...In the Triggers memo, based on his research, Pinto estimated that Fannie and Freddie purchased about 50 percent of all CRA loans over the period from 2001 to 2007...
The following table is included:
|Entity||No. of Subprime and Alt-A Loans||Unpaid Principal Amount|
|Fannie Mae and Freddie Mac||12 million||$1.8 trillion|
|FHA and other Federal||5 million||$0.6 trillion|
|CRA and HUD Programs||2.2 million||$0.3 trillion|
|Total Federal Government||19.2 million||$2.7 trillion|
|Other (including subprime and Alt-A PMBS issued by Countrywide, Wall Street and others)||7.8 million||$1.9 trillion|
|Total||27 million||$4.6 trillion|
Also included is this helpful graph:
According to Michael Cembalest, the Chief Investment Officer of JP Morgan Private Bank, "What emerges from new research is something quite different: government agencies now look to have guaranteed, originated or underwritten 60% of all “non-traditional” mortgages, which totaled $4.6 trillion in June 2008. What’s more, this research asserts that housing policies instituted in the early 1990s were explicitly designed to require US Agencies to make much riskier loans, with the ultimate goal of pushing private sector banks to adopt the same standards."
Another chart (below), from Edward Pinto, has the government accounting for 71% of 'risky' loans, with the attached article saying "based on the number of toxic loans in the system in 2008, the government was responsible for not just a simple majority, but more than two-thirds. It's quantifiable — 71% to be exact.... and the remaining 29% of private-label junk was mostly attributable to Countrywide Financial, which was under the heel of HUD and its "fair-lending" edicts".
CRA push + GSE pull + regulation changes = mortgage crisis.
For more information, check out The Community Reinvestment Act, Evaluated
Appendix I, Was Deregulation to Blame?
No, it wasn't, because it didn't happen:
...regulation as a whole has thrived under President George W. Bush. Between 2001 and fiscal year 2009, the federal regulatory budget increased 65 percent in real terms, to about $17.2 billion....
John A. Allison, in The Financial Crisis and the Free Market Cure: Why Pure Capitalism is the World Economy’s Only Hope, states:
ONE OF THE FUNDAMENTAL MYTHS BEING PROMULGATED IS THAT the banking industry was deregulated during the Bush administration, and that this was a major cause of the financial crisis. Nothing could be further from the truth. The regulatory burden was increased significantly during the Bush years. In fact, regulatory cost was at an all-time high (until the current period) during the peak of the bubble (2005– 2007). Banks’ operating statements reflect this cost increase, as does the multithousand-page increase in various government regulatory documents. Government spending alone (excluding costs that the industry incurred and that must be paid by the companies being regulated) on financial regulations (not company bailouts) increased, in adjusted dollars, from $ 725 million in 1980 to $ 2.07 billion in 2007. The financial industry was not deregulated, it was misregulated. During the Bush administration, three major new financial regulatory acts were passed: the Privacy Act, Sarbanes-Oxley, and the Patriot Act.
Continuing on that theme in other sections of Allison's book:
...Contrary to popular opinion, the banking industry has not been deregulated. It has been grossly misregulated, from Sarbanes-Oxley to the Patriot Act, to regulatory interference in the real estate lending process, to the Dodd-Frank legislation. The regulators were too liberal in good times and too conservative in bad times. There is absolutely no reason to believe that they will not make these same mistakes in the future. The regulators are driven by incentives like everyone else. Unfortunately, their incentives are political, not economic....
...One factor that undoubtedly influenced the rating agencies was the way they were compensated. For years, the agencies had charged the buyers of the bonds for rating the bonds, a system encouraged by S& P, Moody’s, and Fitch and that led them to be more conservative because their clients were the bond buyers. When John Moody founded his now-famous firm in 1909, he charged bond investors for the research and ratings. Tragically, in the early 1970s, the SEC, seeking to expand market access to ratings, forced Moody’s and the other rating firms to fundamentally change their compensation model in a way that created serious conflicts of interest. Under the new method, the agencies were paid by issuers— bond sellers, not bond buyers. The SEC was influenced by union and government pension plans that did not want to pay the cost of the ratings.
Under government-mandated “issuer pays” rules, the rating firms were motivated to lower their standards, fearing that issuers who were displeased with their ratings would yank their business and move it to a competitor rating firm.
The change in the compensation system created very different incentives for the rating agencies. Their client was now the seller (issuer) instead of the buyer (investor). This change obviously endangered investors. Of course, the sellers always want the highest rating possible, as a higher rating allows them to borrow at a lower rate....
...Critics of the rating agencies who deride free markets and greed have a false focus: the change in the compensation method (from “investor pays” to “issuer pays”), which so eroded the objectivity of the rating firms, was mandated by the SEC and motivated by its favoritism toward union and government pension plans....
And Gramm-Leach-Bliley won't work as a scapegoat either:
...The Glass-Steagall Act of 1933 prohibited investment banks from acting as commercial banks, and vice versa. Signed by Bill Clinton (who continues to defend the legislation), the Gramm-Leach-Bliley Act of 1999 repealed those aspects of the law. Many on the left blame at least part of our current woes on that move. With the repeal, Barack Obama said in a March economic address, “we have deregulated the financial services sector, and we face another crisis.”
In fact, multiple exemptions to Glass-Steagall had been granted for years before Gramm-Leach-Bliley was signed into law. Most European financial markets, not normally known as more “deregulated” than the U.S., never separated commercial and investment banks in the first place. And there is no correspondence between institutions that benefited from the repeal and those that recently collapsed. Institutions that didn’t take advantage of the Glass-Steagall repeal, such as Lehman Brothers and Bear Stearns, were the ones that failed most spectacularly, in part because they lacked the stability provided by commercial banking deposits.
If anything, Gramm-Leach-Bliley may have softened the blow. The George Mason economist Tyler Cowen argues that Gramm-Leach-Bliley made way for more diversity in the financial sector, and “so far in the crisis times the diversification has done considerably more good than harm.” Under the Glass-Steagall rules, Bank of America and J.P. Morgan Chase would not have been able to acquire Merrill Lynch and Bear Stearns. Nor would Goldman Sachs and Citibank have their current unified form, which may have helped them survive....
From The New York Times, Reinstating an Old Rule Is Not a Cure for Crisis:
...The first domino to nearly topple over in the financial crisis was Bear Stearns, an investment bank that had nothing to do with commercial banking. Glass-Steagall would have been irrelevant. Then came Lehman Brothers; it too was an investment bank with no commercial banking business and therefore wouldn’t have been covered by Glass-Steagall either. After them, Merrill Lynch was next — and yep, it too was an investment bank that had nothing to do with Glass-Steagall.
Next in line was the American International Group, an insurance company that was also unrelated to Glass-Steagall. While we’re at it, we should probably throw in Fannie Mae and Freddie Mac, which similarly, had nothing to do with Glass-Steagall.
Now let’s look at the major commercial banks that ran into trouble.
Let’s first take Bank of America. Its biggest problems stemmed not from investment banking or trading — though there were some losses — but from its acquisition of Countrywide Financial, the subprime lender, which made a lot of bad loans — completely permissible under Glass-Steagall....
Appendix II, More Fannie and Freddie History
The GSEs have been at the center of accounting games from their inception (PDF):
...By far, the most important legislation affecting Fannie Mae was its conversion into a private company in 1968. It was primarily for accounting purposes. The Johnson administration wanted Fannie Mae privatized, so as to remove its debt from the federal government's books, thereby reducing the size of the national debt. In addition, a change in federal budgeting procedures at the time would have counted Fannie Mae's net purchases of mortgages as current government expenditures, which would have meant that those net purchases would have added to recorded federal budget deficits—something that any presidential administration would want to avoid doing during its own term.
The privatization meant that Fannie Mae was spun off to the private sector and became a publicly traded company, with its shares listed on the New York Stock Exchange (NYSE). However, Fannie Mae retained its federal charter and the special status and privileges that went with the charter. Fannie Mae also had its own special regulator: the Department of Housing and Urban Development (HUD), which had been created as a cabinet-level department in 1965 and retained some regulatory powers over Fannie Mae. Another prominent indicator of the specialness of Fannie Mae, despite its apparent structure as just another private (publicly traded) company, was the power of the President of the United States to appoint five board members to the Fannie Mae board of directors. No other company that was listed on the NYSE had presidential appointees on its board....
To their bailout (same PDF):
...The real accounting trick in keeping GSE securities on the Fed balance-sheet is the same as the one that underlay why Fannie Mae was privatized in 1968 in the first place: to keep its assets and liabilities unfunded from the current presidential administration’s standpoint. Each administration grows the GSE guarantees, passing on ever more risks to the next one and to future taxpayers, without having to discipline current spending and without having to raise taxes in its own term of office to reduce fiscal imbalance. This policy creates fictional housing wealth that allows households to consume beyond their true borrowing capacity. Indeed, U.S. mortgage equity withdrawals were the engine of world economic growth between 2000 and 2007, but they could not be sustained once the housing bubble burst...
The GSEs were kept off the Treasury's books for PR reasons:
...For Fannie Mae and Freddie Mac, the figure to remember is 79.9 -- the percent ownership that the U.S. Treasury took in each when it seized control in 2008. If the stakes were 80 percent, the mortgage companies would land on the federal budget, as we’re reminded in “Guaranteed to Fail,” a valuable book on how two quasi-public companies became “the world’s largest and most leveraged hedge funds.”
Kiss all the political posturing about the U.S. public debt ceiling goodbye: With Fannie Mae and Freddie Mac’s debts tacked on, the total would lurch to $15.84 trillion, well over the current limit of $14.29 trillion, the authors say....
Isn't that the same sort of off-the-books game playing that got Enron into trouble?
For those of you still insisting that Fannie had no subprime activity, they admitted they did. According to an article in the Washington Post titled Fannie's Perilous Pursuit of Subprime Loans
...Discussing the company's successes, [Fannie Mae chief executive Daniel H.] Mudd said one of Fannie Mae's achievements in 2006 was expanding its involvement in the market for subprime and other nontraditional mortgages. He called it a step "toward optimizing our business." ...
...Fannie Mae aimed to benefit from subprime loans and expand the market for them -- and hoped to pass much of the risk on to others, documents show. Along with subprime loans, which were typically issued to borrowers with blemished credit, the company targeted so-called Alt-A loans, which were often made with no verification of the borrower's income.
"By entering new markets -- especially Alt-A and subprime -- and guaranteeing more of our customers' products at market prices, we met our goal of increasing market share from 22 to 25 percent," Mudd wrote in a 2006 year-end report to the Fannie Mae board dated Jan. 3, 2007.
In other internal documents, there was a common refrain: One of Fannie Mae's objectives for 2006 was to "increase our penetration into subprime."...
...In 2006 and 2007, Fannie Mae "carefully broadened our entry into the subprime market," [Fannie Mae spokesman Brian] Faith said in a statement. At the time, it wasn't clear how severe the problems in the housing market would become, he said....
...Fannie Mae sought to reap the rewards and protect itself from the downside of the investments through a feat of financial engineering it called its "Risk Transformation Facility," which was meant to transfer the riskiest elements to other investors.... (Emphasis mine)
The SEC has since charged Mudd with fraud:
...As recently as 2008, New York Times columnist Paul Krugman stated: "Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income."
Now, the government's own market watchdog, the Securities and Exchange Commission, says that's false. They're going after former Fannie CEO Daniel Mudd and former Freddie CEO Richard Syron to prove it.
"Fannie Mae and Freddie Mac executives told the world that their subprime exposure was substantially smaller than it really was," was how Robert Khuzami, director of SEC enforcement, described it Friday.
But that's an understatement.
From 2007 to 2008, according to SEC documents, executives at Freddie and Fannie together estimated their total exposure to subprime loans at about $10 billion.
The real amount? Nearly $300 billion total.
In short, Fannie and Freddie are frauds. They systematically hid their exposure to potential losses from investors, taxpayers and regulators....
Peter J. Wallison and Edward Pinto continue (emphasis mine):
...The SEC findings add $219 billion and 1.43 million loans to our original Fannie and Freddie subprime and Alt-A totals, bringing the combined subprime and Alt-A total to $2.041 trillion and 13.37 million loans.
The SEC findings add $219 billion and 1.43 million loans to our original Fannie and Freddie subprime and Alt-A totals, bringing the combined subprime and Alt-A total to $2.041 trillion and 13.37 million loans.
All told, after adding the SEC’s new data to our original estimates, there were approximately 28 million subprime and Alt-A loans outstanding on June 30, 2008, before the financial crisis, with a value of approximately $4.8 trillion. This was half of all mortgages in the United States. Of these loans, over 74 percent were on the books of U.S. government agencies and firms subject to government housing finance policies. This shows where the demand for these low quality loans came from. Fannie and Freddie were themselves exposed to more than 13 million subprime or Alt-A loans, or 65 percent of the government total.
The table below shows the values of the subprime and Alt-A loans originally included in Pinto’s Forensic Study and Wallison’s Dissent, supplemented by the data included in the SEC’s complaints and the non-prosecution agreements....
Peter Wallison states elsewhere:
Let's consider what Min is saying here. He's arguing that Pinto's definitions of subprime and Alt-A loans are not consistent with the definitions others have used for data collection and analysis. In other words, Pinto has used his own definitions to analyze the data in a new way. What Pinto did, that no one had done before, is show that loans made to people with FICO credit scores lower than 660 (which he called "subprime") had substantially higher rates of delinquency and default than loans to people with credit scores above 660 (which he called "prime"). In addition, Pinto found that loans with various deficiencies such as interest only, no documentation, no or low downpayments, or were investment properties (not owner occupied) -- which Pinto called, collectively, "Alt-A" -- also had much higher rates of default than loans that were not subject to these deficiencies. Pinto then found that these kinds of loans began to increase substantially after 1992, when affordable housing requirements were imposed on Fannie Mae and Freddie Mac, and began to default in unprecedented numbers when the 1997-2007 housing bubble started to deflate. In my dissent from the majority report of the Financial Crisis Inquiry Commission, using data from Fannie Mae (Table 5, p.61), I show that both subprime and Alt-A mortgages were necessary for meeting the affordable housing goals.
In reality, then, Min is simply complaining that Pinto discovered the sources of the huge mortgage losses that caused the financial crisis. The way the data had been looked at before -- and the way Fannie and Freddie reported that data -- obscured the fact that half of all outstanding mortgages were either subprime or Alt-A just before the bubble deflated and the financial crisis began. ...
The GSEs were trying, explicitly, to erase the line between prime and subprime loans. Can you blame private businesses for taking 'stupid' risks when the government was hiding just how much risk was out there? From Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and Why It Could Happen Again, By Peter Wallison, p. 166 (the last quote coming from Federal Register / Vol. 65, No. 211 / Tuesday, October 31, 2000 / Rules and Regulations - PDF):
When the new affordable-housing goals were finally announced, just before the 2000 election, they contained dramatic increases and drove Fannie and Freddie into a new and far more challenging era. As Barry Zigas, then a senior vice president at Fannie, told a housing group, “Our mission goals are really like CRA on steroids.”
...In a December 2000 memorandum, a Fannie staffer noted that the line between prime and subprime was disappearing. "[A]s Fannie Mae and Freddie Mac are expanding approvals through automated underwriting, the distinction between prime and subprime is increasingly difficult to articulate". This objservation recalls the HUD statement, made in connection with the 2000 afffordable-housing goal increase, that "[a]s the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan vers a prime loan will likely deteroriate, making expansion by the GSEs look like an increase in the prime market."
HUD recognizes that, to lead the mortgage industry over time, the GSEs will have to stretch to reach certain goals and close the gap between the secondary mortgage market and the primary mortgage market [that is, reach parity in loan purchases between the LMI market and the regular market].
From the New York Times, Airing the depth of troubles at Fannie Mae:
In 2004, before Fannie Mae pushed into riskier loans, the Department of Housing and Urban Development suggested the definitions were becoming fuzzy.
"As the GSE's become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSE's look more like an increase in the prime market," the housing department said in a November 2004 report.
From the American Enterprise Institute for Public Policy Research, GSE Affordable Housing Goals: Politicized Credit Allocation (PDF):
As flexible lending expands the volume and risk characteristics increases markedly, yet these loans were still called prime. HUD acknowledged as much in a 2000 rule making.
As the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market. Since . . . one could define a prime loan as one that the GSEs will purchase, the difference between the prime and subprime markets will become less clear. This melding of markets could occur even if many of the underlying characteristics of subprime borrowers and the market's (i.e., non-GSE participants) evaluation of the risks posed by these borrowers remain unchanged.
Or, from Free fall: How government policies brought down the housing market:
As HUD observed when raising the AH goals to 50 percent in 2000:
Because the GSEs have a funding advantage over other market participants, they have the ability to under price their competitors and increase their market share. This advantage, as has been the case in the prime market, could allow the GSEs to eventually play a significant role in the subprime market. As the GSEs become more comfortable with subprime lending, the line between what today is considered a subprime loan versus a prime loan will likely deteriorate, making expansion by the GSEs look more like an increase in the prime market.
Even the GSEs knew these loans were problematic:
...Since Fannie and Freddie guarantee 90% of US mortgages, private lenders will match their weaker standards. Many of these weak loans will, in turn, be securitized and traded on Wall Street....
...Starting in 2000, HUD announced it was jacking up the quotas for low-income borrowers to 50% in the interest of diversity, meaning Fannie and Freddie had to find a non-prime loan for every prime loan it acquired. HUD explained it wanted Fannie and Freddie to “become more comfortable with subprime lending.”...
...In 1992, neither Fannie nor Freddie had any loans with down payments under 5%, Wallison notes. But by 2007, on the eve of the crisis, 26% of Fannie’s loans and 19% of Freddie’s had down payments that low....
...From 1997-2007, Fannie and Freddie acquired a combined $1.5 trillion in loans with subprime credit scores, and another $2.2 trillion in subprime securities....
...A 2006 Fannie staff memo is eye-opening. “Everybody understood that we were now buying loans that we would have previously rejected but our mandate was to serve low-income borrowers,” it said. “So that’s what we did.”...
From THE FINANCIAL CRISIS INQUIRY REPORT, FINAL REPORT OF THE NATIONAL COMMISSION ON THE CAUSES OF THE FINANCIAL AND ECONOMIC CRISIS IN THE UNITED STATES:
...In March 2003, as Fannie prepared for new increases in the AH goals, its staff prepared a presentation, perhaps for HUD or for policy defense in public forums. The apparent purpose was to show that the goals should not be increased significantly in 2004. Slide 5 stated:
In 2002, Fannie Mae exceeded all our goals for the 9th straight year. But it was probably the most challenging environment we’ve ever faced. Meeting the goals required heroic 4th quarter efforts on the part of many across the company. Vacations were cancelled. The midnight oil burned. Moreover, the challenge freaked out the business side of the house. Especially because the tenseness around meeting the goals meant that we considered not doing deals—not fulfilling our liquidity function—and did deals at risks and prices we would not have otherwise done.
By September 2004, it was becoming clear that continuing increases in the AH goals were having a major adverse effect on Fannie’s profitability. In a memorandum to Brian Graham (another Fannie official), Paul Weech, Director of Market Research and Policy Development, wrote: “Meeting the goals in difficult markets imposes significant costs on the Company and potentially causes market distorting behaviors. In 1998, 2002, and 2003 especially, the Company has had to pursue certain transactions as much for housing goals attainment as for the economics of the transaction.”...
Finally, in a December 21, 2007, letter to Brian Montgomery, Assistant Secretary of Housing, Fannie CEO Daniel Mudd asked that, in light of the financial and economic conditions then prevailing in the country—particularly the absence of a PMBS market and the increasing number of mortgage delinquencies and defaults— HUD’s AH goals for 2007 be declared “infeasible.” He noted that HUD also has an obligation to “consider the financial condition of the enterprise when determining the feasibility of goals.” Then he continued: “Fannie Mae submits that the company took all reasonable actions to meet the subgoals that were both financially prudent and likely to contribute to the achievement of the subgoals….In 2006, Fannie Mae relaxed certain underwriting standards and purchased some higher risk mortgage loan products in an effort to meet the housing goals. The company continued to purchase higher risk loans into 2007, and believes these efforts to acquire goals-rich loans are partially responsible for increasing credit losses.”
...Our argument is and has been that the financial crisis would not have occurred but for government housing policy implemented principally through Fannie and Freddie and the Department of Housing and Urban Development (HUD). Although there were a number of such policies, the most important were the affordable housing requirements first imposed on Fannie and Freddie in 1992 and expanded and tightened by HUD through 2007.
...Of particular interest are Fannie and Freddie’s non-prosecution agreements with the SEC, in which they agree with facts that confirm—and in many cases go beyond—our original research concerning the scope of the GSEs’ subprime and Alt-A exposure. These are facts, and Nocera and others who might wish it otherwise should become familiar with them.
For example, in its non-prosecution agreement Freddie agreed that as of June 30, 2008, it had $244 billion in subprime loans, comprising 14 percent of its credit guaranty portfolio, rather than the $6 billion it had previously disclosed. Freddie also agreed that it had $541 billion in reduced documentation loans alone, vastly more than the $190 billion in previously disclosed Alt-A loans which Freddie had said included loans with reduced documentation.
While the SEC documents about $1.03 trillion in previously undisclosed subprime and Alt-A loans in Fannie and Freddie’s credit guaranty portfolios, an estimated $812.8 billion, or about 80 percent, were already accounted for in the totals of Fannie and Freddie subprime and Alt-A exposures included in Pinto’s Forensic Study and Wallison’s Dissent from the majority report of the Financial Crisis Inquiry Commission.
The SEC findings add $219 billion and 1.43 million loans to our original Fannie and Freddie subprime and Alt-A totals, bringing the combined subprime and Alt-A total to $2.041 trillion and 13.37 million loans....
Even with that, home ownership rates remain static:
Despite decades of federal intervention in the housing market, home ownership rates are virtually the same today as they were in 1968, according to an brief released by the Heritage Foundation on Monday....
...The pace of government intervention was especially frenetic in the 1990s, the report says, such that, “from 1990 to 2003, Fannie [Mae] and Freddie [Mac] went from holding 5 percent of the nation’s mortgages ($136 billion) to more than 20 percent ($1.6 trillion),” all with implicit government backing....
Prior to 1968, “government-backed mortgages never accounted for more than 6 percent of the market in any given year.” However, “the homeownership rate was 64 percent in 1968, virtually identical to what it is now.”