If one more of our guys dumps on Bernanke I'm going to scream. Not that the Fed hasn't played a pernicious role, but this is not Bernanke's fault, it's the fault of the dual mandate, which asks the Fed to do two logically contradictory things, with predictably unsatisfactory results. Some of this has been reported but forgotten, and I think it's interesting to hear it from an eyewitness in any event.
First he makes short work of the Fed's role:
The two major causes of the collapse that began in 2007 were, first, the destabilization of the mortgage and financial investment businesses; and second, the Fed’s policy of monetary inflation.The Fed policy caused an explosion in real estate prices and values in the early 2000s which generated a public panic to buy homes at any price. The distortion of the home mortgage industry made many more mortgages available to uncreditworthy borrowers and so made the collapse, when it came, even deeper. No need to say more about the Fed.
Now some necessary background:
There is no more important area for lenders to “underwrite” loans than in home mortgages, because they are large loans and paid off over long time periods. They build up huge liabilities on bank books and restrict further lending, so they must be worthwhile loans for banks to earn profits and stay in business.Lenders normally make a practice of thoroughly checking the creditworthiness of potential borrowers, and they have established criteria that tell them the level of risk that a mortgagee might not pay off the loan. An old and traditional practice of mortgage lenders was called “redlining,” whereby some areas, such as inner cities and decayed urban areas, were considered off-limits for loans. (Too many low income households, plus threats of riot, arson, theft, etc.) The judgment was that in these areas, the risks of default are too high and thus mortgage applications in redlined areas were routinely rejected.
It's at this point that Congress begins to step in, for better or for worse:
Because these areas are overwhelmingly populated by minorities, Congress was under pressure [from ACORN, among others] to treat “redlining” as a form of racial discrimination. In the 1970s, Congress passed the Community Reinvestment Act (CRA) which required certain mortgage banks to abolish redlining and to write mortgages in these areas.
The CRA was not enforced much until the Clinton
Administration in 1993, and again in 1995, issued aggressive new regulations.
Now if a bank wanted any change in its status—a merger, a new location, etc.,—requiring government approval, the FDIC and other agencies would review the bank’s books to see whether it was in fact following CRA by making a good faith effort to write mortgages within these areas. If not, the bank could be denied permission to go ahead with the change.Lenders would now find themselves holding a number of mortgages which, by their ordinary underwriting standards, were at risk of foreclosure. This of course threatened the individual bank and the mortgage banking structure as a whole.
The year before, in 1992, Congress enacted the “Government-SponsoredEnterprises” (GSEs) Act.
This Act organized Fannie Mae and Freddie Mac (FF) as “secondary mortgage markets.” This means that these two entities do not offer mortgages to home buyers, they buy mortgages already held by banks. So a bank gives a mortgage to a borrower and then sells the mortgage to the GSEs.
Understand the effect of this move:
The bank no longer has much reason to worry about the risk of foreclosure. There is no mortgage liability on its books. The bank makes its money from the price paid to it by the GSEs and has nothing more to do with the mortgage except to continue to service it, send out monthly statements, etc., for which it received a fee from the GSEs which are now the true risk holders. The lenders, on the other hand, now have more money available to them so they can offer more mortgages than they could have if they did not have the GSEs as “secondary markets.” This is called “spreading the risk.”
Contained within the GSEs Act was the mandate that the GSEs must include in the mortgages they buy a percentage that come from
“under-served" (or "redlined") communities.
What percentage? "We don't know, ask HUD," was Congress' effective answer, booting the precise meaning of their own law over to Executive Branch regulators:
How many such mortgages they had to buy each year was determined by HUD. When they started out, I think the number was something like 30%, meaning that 3 out of 10 mortgages on the books of the GSEs had to come from these areas. HUD periodically would raise that number, and so it went higher and higher until it was in the range of 55% by 2007, i.e. more than half of FF’s mortgage business was uncreditworthy and normally would not be written by lenders except perhaps at much higher interest rates.
By continuously writing more and more business in these restricted areas, the quality of the mortgages had to decline over time. Think about this. At the start of the program, Fannie Mae & Freddie Mac were underwriting the best of the risky mortgages. But as the years went on, the risks got higher and higher as the banks reached increasingly risky mortagees.(By my personal witness, being in the division that decided on these quotas, I believe the quotas were set in good faith by trustworthy career officials who would have been terrified to tell Congress they could not meet the demands of the law. Bureaucrats always avoid angering the source of their funds, and Congressional "oversight" usually means assuaging Congress that their laws are being obeyed; they don't want to hear it if their laws cause problems.)
The best were written at the beginning obviously. At a certain point, the GSEs began to write mortgages for lenders with no credit history at all (“Alt-A” mortgages). (The amount of total liabilities on the books of FF when it began to unravel was by my estimate about $5 trillion.)
Piecing it all together then:
What happened here is that banks offering mortgages under CRA in redlined communities would immediately sell them to the GSEs, transferring the high risk mortgages, keeping the mortgage price, and of course keeping for their own accounts the quality, low-risk mortgages. Keep the gold, get rid of the dross. This completely changed the incentives for underwriting. Since the bank no longer holds much risk, it has little incentive to be sure that its CRA mortgages go to creditworthy borrowers.In fact, CRA practically required that they NOT restrict their mortgages. Government wanted to see lots of CRA business being written. The result was that these banks kept writing poor mortgages and passing them over to FF [Fannie & Freddie]. FF, in turn, was forced by the GSEs law to take these mortgages without paying attention to their high risk potential since the law said that as much as one-half of their business had to be in “underserved communities.”
Next move. Also in the 1990s, the GSEs began to engage in trading a rarely used financial
investment instrument called Mortgage Backed Securities (MBS), or “mortgage
securitization.”
An MBS is a batch of mortgages bundled together in one investment package and sold to a buyer. In that way the buyer takes on these mortgages as they are being paid off over the years and has paid a selling price to the seller (the GSEs). The seller now holds the money but has disposed of the mortgages and their risks. MBSs come in a wide variety of technically complex forms, for example they might involve only 50% of each mortgage, etc., but the idea is the same as with CRA and the GSEs. The purchase money goes to the GSEs which now have more money to use to buy more mortgages from the original lender. This creates a much larger pool of mortgage money, thereby making it possible for many more home buyers to get mortgages. So the home ownership rate in the US began to grow substantially (70% by 2007) as more and more people found that they could get mortgages on easy terms.
What happened to the MBSs? Here's where Wall Street comes in:
They were sold by FF to large investment houses such as Bear Stearns, Lehman Brothers, AIG, etc. and some European financial houses which were now the holders of these mortgages.Everyone in this process thought it was a terrific deal: the investors get a reliable and predictable stream of mortgage payments for years to come; the GSEs make profits from the sales of these MBSs; the originating banks make similar profit plus commissions for continuing to service the monthly mortgages (without risk); and Congress is happy because the redlined communities are now “greenlined,” and minorities are participating in home ownership. ACORN (which was very involved in pushing this policy) goes away. As long as home values kept rising, everyone involved profited.
So far so good. The big question to me, however, has always been why Wall Street didn't see how toxic these "instruments" were. Was it really just greed? Go for the short-term gain and all else be damned?
Why did final investors such as AIG who were holding these mortgages not see how toxic they were? The answer, I believe, is that these investors did not bother to “underwrite” these MBS securities, that is, they never looked into them to see how risky these mortgages actually were. They are highly technical investments and the financial houses are not mortgage underwriting experts. They were simply depending on the “Government-Sponsored Enterprises” (FF) to do this underwriting for them! This was logical. After all, FF were sponsored by the US government and would not be running a quick-buck mortgage racket…would they?Would anyone really be that foolish?
Before I came to Washington, I worked in the re-insurance business, and I often saw the same idea play out. If some insurer -- let's say State Farm, hypothetically-- wrote a $5 million policy, but could only afford a $1 million pay-out, they'd come to us to find other companies to "spread the risk." All I had to do was get one of the biggest companies to sign on for a portion of the risk. Once they did, smaller companies would sign on too, trusting the leg-work of the larger firm. If it's good enough for Lloyd's of London, it's good enough for me was the attitude.
In the case of the Wall Street lenders, of course it's surmise, but I just believe their attitude was if it’s good enough for the government-sponsored enterprises, it must be good enough for me. They have the mortgage expertise, I have the capital to help them out.
This attitude was naïve and financially imprudent, but it was not in the main “greed” at all. It was an attitude of investor trust in government expertise. And of course, once housing values started declining in 2007, these mortgages had to be foreclosed and the investment houses discovered they were holding worthless toxic assets.
A second question is how such high levels of risk could be supported?
The answer is that they were supported by the government, the American people. Private investors could make great profits by them, but if there were losses, the American people had to bear the cost (in many cases), e.g. covering the FF losses and bailing out some financial houses and banks: private profit, social risk, we call it.
Did no one see this coming?
There were certainly people within government who foresaw, or suspected, that there was something amiss about this artificial scheme.By 2003, the Bush administration was making an effort to tighten oversight of the GSE's and raised red flags with Congress, which ignored them. HUD officials, FF officials, and other agencies also go up to Congress periodically, to the oversight committees that were run by Rep. Barney Frank and Sen. Chris Dodd, to report on what they are doing. The committee chairs wanted only to hear that the “underserved communities” quotas were being filled. They had it fixed in their minds that these programs "helped the poor," and didn't want to hear about financial concerns. Barney Frank was endorsing this program as a success story less than a year and half before Fannie Mae went into conservatorship. [That's where those infamous Barney Frank youtubes come into the picture.]
So greed is not to blame?
Not on Wall Street's part, I don't think. It is true that some officials at Fannie & Freddie made big bucks through salaries and bonuses for tremendous sales numbers in the early 2000s. They were not guiltless in this. However, since their organizations were forced by Congress --which delivered a mandate and then neglected its oversight responsibilities-- to write more and more toxic business, the blame for the collapse cannot be laid at their feet.It may be argued that they should have been courageous enough to tell Frank & Dodd that this scheme was a disaster in the making years earlier. But what would the consequences be of their making that argument while home prices were still rising? They would have been browbeaten, attacked as racists, ridiculed, and fired in disgrace.
Bottom line is this:
The GSEs incidentally, I heard just today, are being revived instead of dissolved. It’s not clear that we have reached the end of this game, by any means.investors were gulled into trusting the government’s knowledge, and in the end went bankrupt or nearly so without bailouts. FF officials were living high making obscene dollars, but from a scheme which they were forced to carry out. The full blame for this disaster rests with Congress itself for inventing this fool’s game—and then becoming indignant when it collapsed and brought down the world economy.
