The Financial Crisis:Who’s at Fault? Mike Bray February 2, 2010
I hold the view that many parties contributed to the housing boom, bust and the ensuing financial crisis.Recent blame has focused on Wall Street and large banks, and singled out the largest financial institutions as lead contributors to the economic mess of 2008.Along with the populist ire directed toward the largest financial institutions is the parallel view that more government regulation was needed to rein in the excesses of the banks and brokers.These narrow viewpoints ignore the contributing role to the financial crisis of the government, mortgage brokers, speculators, over-indebted homeowners, the Federal Reserve, the rating agencies, hedge funds and investors.The banks and brokers share blame for the meltdown also, but they certainly do not stand alone in creating the mess.
It can be argued that it was not the absence of regulation that created the economic crisis, but unwise regulation that laid the foundation of the crisis.Destructive legislation started with the “Community Reinvestment Act” passed under the Carter Administration in 1977.The intent of this law was to encourage commercial banks and savings and loan associations to lend in low-income neighborhoods.Sanctions for compliance gave regulating authorities power over the approval process for new bank branches and mergers.Regulating agencies included the Federal Reserve Board, F.D.I.C., Office of the Comptroller of Currency, and Office of Thrift Supervision.The CRA became a coercive tool under the Clinton administration.In the late 1990’s, banks were required to prove statistically that they were lending to poorer neighborhoods and lower-income families.“Banks, engaged in a frenzy of mergers and acquisitions, soon learned that outstanding CRA ratings were the coin of the realm for obtaining regulators’ permission for such deals.Further, nonprofit advocacy groups-including the now famous Acorn and the Neighborhood Assistance Corporation of America (NACA)-demanded, successfully, that banks seeking regulatory approvals commit large pools of mortgage money to them, effectively outsourcing the underwriting function to groups that viewed such loans as a matter of social justice rather than due diligence...sizeable pools of capital came to be allocated in an entirely new way…in sharp contrast to the old regulatory emphasis on safety and soundness, regulators now judged banks not on how their loans performed, but on how many loans they made and to whom.” [1] Other laws and regulations contributed to the lending mess.In 1982 Congress passed the Alternative Mortgage Transactions Parity Act (AMTPA).This law allowed non-federally funded or chartered housing creditors to write adjustable-rate mortgages, but did nothing to provide regulation or oversight of the new loan originators.AMTPA gave license to all kinds of new and exotic mortgage products that got so many borrowers into financial trouble today.These products include adjustable rate mortgages, in which the interest rate “floats” after a number of years, balloon-payment mortgages, interest-only mortgages, and the option-ARM, which allows borrowers to underpay by as much as they want during the first few years and adds unpaid interest to the balance of the loan.(By enlarging the loan balance, many borrows quickly slip into a negative equity position.)Regulations passed by Congress creating AMTPA clearly led to what has subsequently been called “predatory lending,” leaving many borrowers locked into mortgage contracts they did not understand and with higher loan payment resets they could not afford. “By 2007, about one-fourth of all adjustable-rate mortgage loans, interest only loans and payment option loans were at least 60 days late on their mortgage payments.This was more than double the rate of payment delinquencies on conventional 30-year fixed rate mortgages.”[2] Other acts by Congress and administration officials also contributed to an unsustainable housing bubble and mortgage crisis.To encourage home ownership, the 1992 Enterprise Act required FNMA and FMAC to dedicate a sizeable portion of loans they purchase every year to “affordable housing goals.” “In 1996, HUD set a goal for Fannie Mae and Freddie Mac that at least 42% of the mortgages they purchase be issued to borrowers whose household income was below the median in their area.This target was increased to 50% in 2000 and 52% in 2005.” [3] The Government Sponsored Entities like FNMA started receiving government tax incentives for purchasing mortgage backed securities containing mortgages made to low-income borrowers.At the end of 2008 there were 26 million sub prime and other non-prime loans outstanding; about 60% were on the books of FNMA, FMAC, or FHA.Finally, the government played a role in aiding the rapid rise in housing prices and dramatic increase in mortgage lending through the prolonged low interest rate policies of the Federal Reserve Bank from 2000 through 2004. While the role of government laid the foundation for the financial crisis by spurring the housing bubble and facilitating hyper-growth in the mortgage industry and subprime credit markets, others are also guilty of contributing to the crisis.The role of unregulated mortgage brokers played a large role in placing homeowners in loans they should not have qualified to borrow, loans with onerous terms many applicants did not understand, and enticed many homeowners into drawing money out of equity they had in their homes.Mortgage brokers were customarily paid on the “yield spread premium” which gave incentive to brokers to put borrowers into higher cost mortgages to increase their own commissions. Adding to the risk of mortgage default were weakened underwriting standards.20% of loan originations in 2006 were subprime quality, up from 5% of originations in 1994.In 2005 the median down payment was 2% for first time homebuyers.43% of new mortgages in 2005 made no down payment at all.One third of adjustable rate mortgages created in 2004-2006 had initial “teaser rates” below 4% with substantially higher resets to be applied at a later date.In this environment, lending standards continued getting looser.These easier applicant standards were given acronyms; “SIVA” for stated income, verified assets to “NIVA” for no proof of employment or income and only funds in a bank account being verified.Finally, there was “NINA” which omitted proof of employment, income and assets and went solely on credit scores.Somehow, nobody in authority thought to regulate the mortgage industry and the lax underwriting standards.Naturally, mortgage fraud by lenders and borrowers increased dramatically and the housing price bubble grew ever larger.Between 1997 and 2006, the price of a typical American home increased 124%. [4] Homeowners saw their paper wealth increase with home values consistently rising.This rise in real estate values spurred homeowners to increase speculative borrowing.Many owners refinanced their mortgages with cash-out refinancing; this enabled borrowers to increase the size of loan against their home and get cash back in the bargain, all due to the increase in valuation of their residence.“Over $300 billion of such loans were taken out in 2006 and represented 86% of all home refinances in that year.” [5]This “wealth effect” and air of consumer confidence led to overindulgence with credit card debt, too.“During 2008, the typical household in the U.S. owned 13 credit cards, with 40% of cardholders carrying a balance, up from 6% in 1970.”[6]Homeowner irresponsibility with household debt and over-confidence in the inevitable rise in housing values had catastrophic consequences for many who found themselves overextended.Several television shows, such as “Flip that House,” contributed to public overconfidence by showcasing the ease with which homes needing improvements could be purchased, fixed up, and resold at a profit. Many commercial entities aided or facilitated the explosive growth in mortgages, especially of the subprime variety.Mortgages of all different types were bundled into investment products (such as mortgage pools, unit trusts, and mutual funds) by investment banks.These “securitized” products were generally referred to as mortgage backed securities (MBS).After the leading role of the government sponsored entities-GNMA, FNMA, and FMAC-the leading investment bank underwriters of MBS securities in 2006 were Lehman Brothers and Bear Stearns, followed by some of the largest commercial and investment banks in the United States.By creating asset-backed, diversified mortgage pools, marketing of these securities became a matter of convincing investors of the inherent safety of the product.Successful distribution of nearly all types of mortgage backed products, including subprime mortgage pools, was greatly aided by “AAA” ratings assigned by the three primary rating agencies, Moody’s, Standard and Poors, and Fitch. In retrospect, these ratings were overstated for the collateral and risk of the MBS pools and contributed to the rapid growth of the underlying mortgages and facilitated fraudulent practices among mortgage originators.Investment and commercial bankers should have known better, too, but contributed to their own financial free-fall by investing in the very same troubled MBS pools they were selling to their customers. Investment banks contributed further to the financial crisis by seeking greater leverageontheir balance sheets.Following similar legislation granted European bank competitors in the Basel Accords, the SEC in 2004 liberalized the “net capital” rule for the five largest investment banks and allowed debt to equity leverage to reach levels as high as 30 to 1, a doubling from previous levels.When the housing bubble finally broke, the excess leverage caused the fire sale of Bear Stearns (which was sold to JP Morgan for $2 per share; a year earlier the shares of Bear had traded as high as $170 per share), the bankruptcy of Lehman Brothers, the merger of Merrill Lynch into B of A, and the conversion of Morgan Stanley and Goldman Sachs into commercial banks.Federal government TARP funds totaling 700 billion were infused into the banking system to stem the “run on the banks” and the prospect of systemic risk to the global economic system.The government’s cash infusion into the financial sector accomplished its main goal of averting a credit crisis.Additionally, all the largest major banks repaid their TARP loans by the end of 2009 and greatly improved their capital ratios. Rising interest rates brought an end to rising house prices. Residential home values started to decline in mid-2006 and declined 20% from their peak by September 2008.By May 2008, delinquencies and foreclosures on subprime mortgages hit 25%.By August 2008, over 9% of all U.S. mortgages outstanding were either delinquent or in foreclosure. [7] While sustained low interest rate policies contributed to the housing bubble and enabled rapid growth in the mortgage market, the Federal Reserve Bank’s inevitable shift to higher interest rate policies triggered the housing price drop and related increase in mortgage delinquencies and foreclosures. Other factors weighed in on the destabilization of financial institutions.These included “short selling” of stocks in the major banks by hedge funds at the height of the crisis in the fall of 2008.Around the same time the “mark to market” accounting rule forced banks to write down inventories of asset-backed securities to fire sale prices causing an even greater need for capital.Hedge funds were not regulated by the Security and Exchange Commission (SEC).Also escaping the eye of regulators were credit default swaps, which could have been considered securities.Mortgage backed securities covered by credit default swaps were in the 40 trillion dollar range by November 2008.Insurance giant AIG’s exposure of 440 billion dollars to credit default swaps prompted a TARP bailout of 150 billion dollars in October 2008. I.R.S. laws allow individuals to deduct interest paid for mortgages; Taxpayers were given incentive toward home ownership when the Tax Reform Act of 1986 retained the individual income tax deduction for mortgage interest on first and second homes.Deductions for all other types of personal interest such as car loans or credit card interest were eliminated under the provisions of the Act.Tax deductibility made mortgage interest more desirable than other types of consumer interest, prompting some homeowners to pay off credit card balances and other types of consumer debt by taking out second mortgages, home equity lines of credit, or by refinancing first mortgage obligations with a cash back option.This, too, added to the mortgage bubble. In summary, there were many contributing factors to the overall financial crisis.The role of the government in promoting home ownership through legislation like the CRA, AMTPA and Enterprise Act, their enabling of FNMA and FMAC to grow unchecked with loose lending standards, and the low interest rate policies of the Federal Reserve from 2001 to 2004 set the table for the financial crisis that followed. [1] “The Financial Crisis and the CRA, Howard Husock, City Journal, 10/30/08
[2] “The Housing Boom and Bust,” Thomas Sowell, Basic Books, 2009, page 63
[6]Ibid [7] “Subprime_Mortgage_Crisis, Wikopedia.org, 12/29/2009 Thomas Sowell, in his excellent book “The Housing Boom and Bust” put it this way; “The current economic crisis itself grew out of politicians intervening in business and markets, making decisions for which they have neither experience nor expertise, much less a stake.”[8]
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