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Government policies and the subprime

mortgage crisis

The U.S. subprime mortgage crisis was a set of events and government regulation.
and conditions that led to a financial crisis and subse-
quent recession that began in 2005. It was characterized
by a rise in subprime mortgage delinquencies and fore-
closures, and the resulting decline of securities backed by
1 Legislative and regulatory
said mortgages. Several major financial institutions col- overview
lapsed in September 2008, with significant disruption in
the flow of credit to businesses and consumers and the Deregulation, excess regulation, and failed regulation by
onset of a severe global recession. the federal government have all been blamed for the late-
Government housing policies, over-regulation, failed reg- 2000s (decade) subprime mortgage crisis in the United
ulation and deregulation have all been claimed as causes States.[8]
of the crisis, along with many others. While the modern In general, conservatives have claimed that the finan-
financial system evolved, regulation did not keep pace and cial crisis was caused by too much regulation aimed
became mismatched with the risks building in the econ- at increasing home ownership rates for lower income
omy. The Financial Crisis Inquiry Commission (FCIC) people.[9] They have pointed to two policies in particu-
tasked with investigating the causes of the crisis reported lar: the Community Reinvestment Act (CRA) of 1977
in January 2011 that: “We had a 21st-century financial (particularly as modified in the 1990s), which they claim
system with 19th-century safeguards.”[1] pressured private banks to make risky loans, and HUD
Increasing home ownership has been the goal of several affordable housing goals for the government-sponsored
presidents, including Roosevelt, Reagan, Clinton, and enterprises (“GSEs”) — Fannie Mae and Freddie Mac
George W. Bush.[2] However, the FCIC wrote that Fan- — which they claim caused the GSEs to purchase risky
nie Mae and Freddie Mac, government affordable hous- loans,[9] and led to a general breakdown in underwriting
ing policies, and the Community Reinvestment Act were standards for all lending.[10]
not primary causes of the crisis.[1][3] Liberals present data that suggest GSE loans were less
Failure to regulate the non-depository banking system risky and performed better than loans securitized by
(also called the shadow banking system) has also been more lightly regulated Wall Street banks.[9] They also
blamed.[1][4] The non-depository system grew to exceed suggest that CRA loans mandated by the government
the size of the regulated depository banking system,[5] but performed better than subprime loans that were purely
the investment banks, insurers, hedge funds, and money market-driven.[8][9] They also present data which sug-
market funds were not subject to the same regulations. gests that financial firms that lobbied the government
Many of these institutions suffered the equivalent of a most aggressively also had the riskiest lending practices,
bank run,[6] with the notable collapses of Lehman Broth- and lobbied for relief from regulations that were limiting
ers and AIG during September 2008 precipitating a fi- their ability to take greater risks.[9] In testimony before
nancial crisis and subsequent recession.[7] Congress both the Securities and Exchange Commission
(SEC) and Alan Greenspan claimed failure in allowing
The government also repealed or implemented several
the self-regulation of investment banks.[11][12]
laws that limited the regulation of the banking industry,
such as the repeal of the Glass-Steagall Act and imple- The Financial Crisis Inquiry Commission issued three
mentation of the Commodity Futures Modernization Act concluding documents in January 2011: 1) The FCIC
of 2000. The former allowed depository and investment “conclusions” or report from the six Democratic Com-
banks to merge while the latter limited the regulation of missioners; 2) a “dissenting statement” from the three
financial derivatives. Republican Commissioners; and 3) a second “dissenting
statement” from Commissioner Peter Wallison. Both the
Note: A general discussion of the causes of the subprime
Democratic majority conclusions and Republican minor-
mortgage crisis is included in Subprime mortgage crisis,
ity dissenting statement, representing the views of nine of
Causes and Causes of the 2007–2012 global financial cri-
the ten commissioners, concluded that government hous-
sis. This article focuses on a subset of causes related to af-
ing policies had little to do with the crisis. The major-
fordable housing policies, Fannie Mae and Freddie Mac
ity report stated that Fannie Mae and Freddie Mac “were

1
2 3 MORTGAGE AND BANKING REGULATION

not a primary cause of the crisis” and that the Com- helped avoid catastrophe. This approach had opened up
munity Reinvestment Act “was not a significant factor gaps in oversight of critical areas with trillions of dollars
in subprime lending or the crisis.”[1] The three Repub- at risk, such as the shadow banking system and over-the-
lican authors of their dissenting statement wrote: “Credit counter derivatives markets. In addition, the government
spreads declined not just for housing, but also for other permitted financial firms to pick their preferred regulators
asset classes like commercial real estate. This tells us to in what became a race to the weakest supervisor.”[1]
look to the credit bubble as an essential cause of the U.S.
housing bubble. It also tells us that problems with U.S.
housing policy or markets do not by themselves explain 3 Mortgage and banking regula-
the U.S. housing bubble.”[1]
However, Commissioner Wallison’s dissenting statement
tion
did place the blame squarely on government housing poli-
cies, which in his view contributed to an excessive num- 3.1 Alternative Mortgage Transaction
ber of high-risk mortgages: "...I believe that the sine qua Parity Act of 1982
non of the financial crisis was U.S. government hous-
ing policy, which led to the creation of 27 million sub- In 1982, Congress passed the Alternative Mortgage
prime and other risky loans—half of all mortgages in the Transactions Parity Act (AMTPA), which allowed non-
United States—which were ready to default as soon as the federally chartered housing creditors to write adjustable-
massive 1997–2007 housing bubble began to deflate. If rate mortgages. Among the new mortgage loan types cre-
the U.S. government had not chosen this policy path— ated and gaining in popularity in the early 1980s were
fostering the growth of a bubble of unprecedented size adjustable-rate, option adjustable-rate, balloon-payment
and an equally unprecedented number of weak and high and interest-only mortgages. These new loan types are
risk residential mortgages—the great financial crisis of credited with replacing the long-standing practice of
2008 would never have occurred.”[1] banks making conventional fixed-rate, amortizing mort-
In a working paper released in late 2012, the National gages. Among the criticisms of banking industry dereg-
Bureau of Economic Research (NBER), the arbiters of ulation that contributed to the savings and loan crisis
the Business Cycle, presented “Did the Community Rein- was that Congress failed to enact regulations that would
vestment Act Lead to Risky Lending?" The economists have prevented exploitations by these loan types. Subse-
compared “the lending behavior of banks undergoing quent widespread abuses of predatory lending occurred
CRA exams within a given census tract in a given month with the use of adjustable-rate mortgages.[14][15] Approx-
(the treatment group) to the behavior of banks operat- imately 90% of subprime mortgages issued in 2006 were
ing in the same census tract-month that did not face these adjustable-rate mortgages.[16]
exams (the control group). This comparison clearly in-
dicates that adherence to the CRA led to riskier lending
by banks.” They concluded: “The evidence shows that 3.2 The Housing and Community Devel-
around CRA examinations, when incentives to conform opment Act of 1992
to CRA standards are particularly high, banks not only
increase lending rates but also appear to originate loans This legislation established an “affordable housing” loan
that are markedly riskier.[13] purchase mandate for Fannie Mae and Freddie Mac,
and that mandate was to be regulated by HUD. Initially,
the 1992 legislation required that 30% or more of Fan-
nie’s and Freddie’s loan purchases be related to “afford-
2 Deregulation able housing” (borrowers who were below normal lend-
ing standards). However, HUD was given the power to
The FCIC placed significant blame for the crisis on set future requirements, and HUD soon increased the
deregulation, reporting: “We conclude widespread fail- mandates. This encouraged “subprime” mortgages. (See
ures in financial regulation and supervision proved dev- HUD Mandates, below.)
astating to the stability of the nation’s financial markets.
The sentries were not at their posts, in no small part
due to the widely accepted faith in the self-correcting 3.3 Repeal of the Glass Steagall Act
nature of the markets and the ability of financial insti-
tutions to effectively police themselves. More than 30 The Glass–Steagall Act was enacted after the Great De-
years of deregulation and reliance on self-regulation by pression. It separated commercial banks and investment
financial institutions, championed by former Federal Re- banks, in part to avoid potential conflicts of interest be-
serve chairman Alan Greenspan and others, supported tween the lending activities of the former and rating activ-
by successive administrations and Congresses, and ac- ities of the latter. In 1999, President Bill Clinton signed
tively pushed by the powerful financial industry at every into law Gramm-Leach-Bliley Act, which repealed por-
turn, had stripped away key safeguards, which could have tions of the Glass-Steagall Act. Economist Joseph Stiglitz
3

criticized the repeal of the Act. He called its repeal the vestment banks at the center of the crisis in September
“culmination of a $300 million lobbying effort by the 2008, such as Lehman Brothers and Merrill Lynch, were
banking and financial services industries...” He believes it not subject to the same capital requirements as depository
contributed to this crisis because the risk-taking culture banks (see the section on the shadow banking system be-
of investment banking dominated the more risk-averse low for more information). The ratio of debt to equity (a
commercial banking culture, leading to increased levels measure of the risk taken) rose significantly from 2003
of risk-taking and leverage during the boom period.[17] to 2007 for the largest five investment banks, which had
[25][26]
"Alice M. Rivlin, who served as a deputy director of the $4.1 trillion in debt by the end of 2007.
Office of Management and Budget under Bill Clinton, FDIC Chair Sheila Bair cautioned during 2007 against
said that GLB was a necessary piece of legislation be- the more flexible risk management standards of the Basel
cause the separation of investment and commercial bank- II accord and lowering bank capital requirements gener-
ing 'wasn't working very well.'" Bill Clinton stated (in ally: “There are strong reasons for believing that banks
2008): “I don't see that signing that bill had anything to left to their own devices would maintain less capital—
do with the current crisis.”[18] Luigi Zingales argues that not more—than would be prudent. The fact is, banks do
the repeal had an indirect effect. It aligned the formerly benefit from implicit and explicit government safety nets.
competing investment and commercial banking sectors to Investing in a bank is perceived as a safe bet. Without
lobby in common cause for laws, regulations and reforms proper capital regulation, banks can operate in the mar-
favoring the credit industry.[19] ketplace with little or no capital. And governments and
Economists Robert Kuttner and Paul Krugman have sup- deposit insurers end up holding the bag, bearing much of
ported the contention that the repeal of the Glass–Steagall the risk and cost of failure. History shows this problem is
Act contributing to the subprime meltdown.[20][21] very real … as we saw with the U.S. banking and S & L
Andrew Ross Sorkin believes the repeal was not the crisis in the late 1980s and 1990s. The final bill for inad-
problem. The vast majority of failures were either due equate capital regulation can be very heavy. In short, reg-
to poorly performing mortgage loans, permissible under ulators can't leave capital decisions totally to the banks.
Glass-Steagall, or losses by institutions who did not en- We wouldn't be doing [27]
our jobs or serving the public in-
gage in commercial banking and thus were never covered terest if we did.”
by the act.[22]

3.4 Capital requirements and risk classifi- 4 Boom and collapse of the shadow
cation banking system
Capital requirements refer to the amount of financial The non-depository banking system grew to exceed the
cushion that banks must maintain in the event their invest- size of the regulated depository banking system. How-
ments suffer losses. Depository banks will take deposits ever, the investment banks, insurers, hedge funds, and
and purchase assets with them, assuming not all deposits money market funds within the non-depository system
will be called back by depositors. The riskier the assets
were not subject to the same regulations as the depository
the bank selects, the higher the capital requirements to system, such as depositor insurance and bank capital re-
offset the risk. Depository banks were subject to exten-
strictions. Many of these institutions suffered the equiv-
sive regulation and oversight prior to the crisis. Deposits alent of a bank run with the notable collapses of Lehman
are also guaranteed by the FDIC up to specific limits.
Brothers and AIG during September 2008 precipitating
However, depository banks had moved sizable amounts a financial crisis and subsequent recession.[7]
of assets and liabilities off-balance sheet, via complex le- The FCIC report explained how this evolving system
gal entities called special purpose vehicles. This allowed remained ineffectively regulated: “In the early part of
the banks to remove these amounts from the capital re- the 20th century, we erected a series of protections—
quirements computation, allowing them to take on more the Federal Reserve as a lender of last resort, federal
risk, but make higher profits during the pre-crisis boom deposit insurance, ample regulations—to provide a bul-
period. When these off-balance sheet vehicles encoun- wark against the panics that had regularly plagued Amer-
tered difficulties beginning in 2007, many depository ica’s banking system in the 19th century. Yet, over
banks were required to cover their losses.[23] Martin Wolf the past 30-plus years, we permitted the growth of a
wrote in June 2009: "...an enormous part of what banks shadow banking system—opaque and laden with short-
did in the early part of this decade – the off-balance-sheet term debt—that rivaled the size of the traditional bank-
vehicles, the derivatives and the 'shadow banking system' ing system. Key components of the market—for ex-
itself – was to find a way round regulation.”[24] ample, the multitrillion-dollar repo lending market, off-
Unlike depository banks, investment banks borrow balance-sheet entities, and the use of over-the-counter
money from investors and invest it; they are not subject derivatives—were hidden from view, without the protec-
to the same oversight or capital requirements. Large in- tions we had constructed to prevent financial meltdowns.
4 5 FANNIE MAE AND FREDDIE MAC

We had a 21st-century financial system with 19th-century to cause the crisis. “As the shadow banking system
safeguards.”[1] expanded to rival or even surpass conventional bank-
ing in importance, politicians and government officials
should have realized that they were re-creating the kind
4.1 Significance of the parallel banking of financial vulnerability that made the Great Depression
system possible—and they should have responded by extending
regulations and the financial safety net to cover these new
institutions. Influential figures should have proclaimed a
simple rule: anything that does what a bank does, any-
thing that has to be rescued in crises the way banks are,
should be regulated like a bank.” He referred to this lack
of controls as “malign neglect.”[7] Some researchers have
suggested that competition between GSEs and the shadow
banking system led to a deterioration in underwriting
standards.[9]
For example, investment bank Bear Stearns was required
to replenish much of its funding in overnight markets,
making the firm vulnerable to credit market disruptions.
When concerns arose regarding its financial strength, its
ability to secure funds in these short-term markets was
compromised, leading to the equivalent of a bank run.
Securitization markets were impaired during the crisis Over four days, its available cash declined from $18 bil-
lion to $3 billion as investors pulled funding from the firm.
In a June 2008 speech, U.S. Treasury Secretary Timothy It collapsed and was sold at a fire-sale price to bank JP
Geithner, then President and CEO of the NY Federal Re- Morgan Chase March 16, 2008.[28][29][30]
serve Bank, placed significant blame for the freezing of
American homeowners, consumers, and corporations
credit markets on a “run” on the entities in the “paral-
owed roughly $25 trillion during 2008. American banks
lel” banking system, also called the shadow banking sys-
retained about $8 trillion of that total directly as tradi-
tem. These entities became critical to the credit markets
tional mortgage loans. Bondholders and other traditional
underpinning the financial system, but were not subject
lenders provided another $7 trillion. The remaining $10
to the same regulatory controls. Further, these entities
trillion came from the securitization markets, meaning
were vulnerable because they borrowed short-term in liq-
the parallel banking system. The securitization markets
uid markets to purchase long-term, illiquid and risky as-
started to close down in the spring of 2007 and nearly
sets.
shut-down in the fall of 2008. More than a third of
This meant that disruptions in credit markets would make the private credit markets thus became unavailable as a
them subject to rapid deleveraging, selling their long-term source of funds.[31][32] In February 2009, Ben Bernanke
assets at depressed prices. He described the significance stated that securitization markets remained effectively
of these entities: “In early 2007, asset-backed commer- shut, with the exception of conforming mortgages, which
cial paper conduits, in structured investment vehicles, in could be sold to Fannie Mae and Freddie Mac.[33]
auction-rate preferred securities, tender option bonds and
The Economist reported in March 2010: “Bear Stearns
variable rate demand notes, had a combined asset size of
and Lehman Brothers were non-banks that were crip-
roughly $2.2 trillion. Assets financed overnight in tri-
pled by a silent run among panicky overnight "repo"
party repo grew to $2.5 trillion. Assets held in hedge
lenders, many of them money market funds uncertain
funds grew to roughly $1.8 trillion. The combined bal-
about the quality of securitized collateral they were hold-
ance sheets of the then five major investment banks to-
ing. Mass redemptions from these funds after Lehman’s
taled $4 trillion. In comparison, the total assets of the
failure froze short-term funding for big firms.”[6]
top five bank holding companies in the United States at
that point were just over $6 trillion, and total assets of the
entire banking system were about $10 trillion.” He stated
that the “combined effect of these factors was a finan-
cial system vulnerable to self-reinforcing asset price and 5 Fannie Mae and Freddie Mac
credit cycles.”[5]

Fannie Mae and Freddie Mac (also called FNMA and


4.2 Run on the shadow banking system FHLMC) are government sponsored enterprises (GSEs)
that purchase mortgages, buy and sell mortgage-backed
Economist Paul Krugman described the run on the securities (MBS), and guarantee a large fraction of the
shadow banking system as the “core of what happened” mortgages in the U.S.
5.1 Financial Crisis Inquiry Commission 5

5.1 Financial Crisis Inquiry Commission


The Financial Crisis Inquiry Commission (FCIC) re-
ported in 2011 that Fannie Mae & Freddie Mac “con-
tributed to the crisis, but were not a primary cause.”[1]
The FCIC reported that:

• “all but two of the dozens of current and former


Fannie Mae employees and regulators interviewed
on the subject told the FCIC that reaching the goals
was not the primary driver of the GSEs’ purchases
of riskier mortgages"; that
* GSE refers to loans either purchased or guaranteed by govern-
• until 2005, the homeownership goals for GSEs — ment sponsored entities Fannie Mae (FNMA) and Freddie Mac
50% of mortgage purchases were to be made up of (FHLMC)
low- or moderate-income families — were so un- *SUB refers to loans that were sold into private label securities
challenging as to be satisfied by the “normal course labeled subprime by issuers
of business”, although in 2005 the goal was raised *ALT refers to loans sold into private label Alt-a securitizations
and reached 55% in 2007; (not as risky as subprime loans)
*FHA refers to loans guaranteed by the Federal Housing Admin-
• most Alt-A loans — which are included in riskier istration or Veterans Administration
mortgages for which the GSEs are criticized for buy- (source: Final Report of the National Commission on the Causes
ing — “were high-income-oriented”, purchased to of the Financial and Economic Crisis in the United States, p. 218,
increase profits, not with an eye towards meeting figure 11.3)
low- and moderate-income homeownership goals;
that The Commission found that GSE mortgage securities
• much of the GSEs’ efforts to boost homeownership
were marketing and promotional efforts — housing essentially maintained their value through-
fairs, and outreach programs — that had nothing out the crisis and did not contribute to the sig-
to do with reducing or loosening lending standards; nificant financial firm losses that were central
that to the financial crisis. The GSEs participated
in the expansion of subprime and other risky
• the law mandating lending to increase homeowner- mortgages, but they followed rather than led
ship allowed both Fannie and Freddie “to fall short Wall Street and other lenders
of meeting housing goals that were `infeasible` or
that would affect the companies’ safety and sound- into subprime lending.[1]
ness”, and that the GSE’s availed themselves of that Writing in January 2011, three of the four Republicans on
loophole when they felt the need to; and that the FCIC Commission[37] though dissenting from other
• in the end, examination of the loans found only a conclusions of the majority, found that U.S. housing pol-
small number (for example 4% of all loans pur- icy was, at[38] the most, only one of the causes of the crisis.
chased by Freddie between 2005 and 2008) were The three wrote:
purchased “specifically because they contributed to
the [homeownership] goals”.[34] “Credit spreads declined not just for hous-
ing, but also for other asset classes like com-
mercial real estate. This tells us to look to
The Commission found GSE loans had a delinquency rate
the credit bubble as an essential cause of the
of 6.2% in 2008 versus 28.3% for non-GSE or private
U.S. housing bubble. It also tells us that prob-
label loans.[35] Taking the roughly 25 million mortgages
lems with U.S. housing policy or markets do
outstanding at the end of each year from 2006 through
not by themselves explain the U.S. housing
2009 and subdividing them into 500+ subgroups accord-
bubble.”[39]
ing to characteristics like credit scores, down payment
and mortgage size, mortgage purchaser/guaranteer, etc.,
the Commission found the average rate of serious delin- 5.1.1 Wallison’s Dissent
quencies much lower among loans purchased or guaran-
teed by government sponsored organizations such as the In his lone dissent to the majority and minority opin-
FHA, Fannie Mae and Freddie Mac, than among non- ions of the FCIC, Commissioner Peter J. Wallison of the
prime loans sold into “private label” securitization.[36] American Enterprise Institute (AEI) blamed U.S. hous-
(see “Loan Performance in Various Mortgage-Market ing policy, including the actions of Fannie & Freddie, pri-
Segments” chart) marily for the crisis, writing: “When the bubble began to
6 5 FANNIE MAE AND FREDDIE MAC

deflate in mid-2007, the low quality and high risk loans Aggressive promotion of easy collateral appraisal sys-
engendered by government policies failed in unprece- tems In the mid-1990s Fannie and Freddie also pro-
dented numbers. The effect of these defaults was exac- moted Automated Valuation Systems (AVMs).[45] Be-
erbated by the fact that few if any investors—including fore long the two GSEs decided that, in many cases,
housing market analysts—understood at the time that on-site physical inspections were not needed.[46] Rather,
Fannie Mae and Freddie Mac had been acquiring large the AVM, which relied mostly on comparable sales data,
numbers of subprime and other high risk loans in order to would suffice. Some analysts believe that the use of
meet HUD’s affordable housing goals.” His dissent relied AVMs, especially for properties in distressed neighbor-
heavily on the research of fellow AEI member Edward hoods, led to overvaluation of the collateral backing mort-
Pinto, the former Chief Credit Officer of Fannie Mae. gage loans.[47]
Pinto estimated that by early 2008 there were 27 million
higher-risk, “non-traditional” mortgages (defined as sub-
prime and Alt-A) outstanding valued at $4.6 trillion. Of Promotion of thousands of small mortgage brokers
these, Fannie & Freddie held or guaranteed 12 million In 2001 some mainstream banks told the Wall Street
mortgages valued at $1.8 trillion. Government entities Journal that Fannie and Freddie were promoting small,
held or guaranteed 19.2 million or $2.7 trillion of such thinly capitalized mortgage brokers over regulated com-
mortgages total.[40] As of January 2008, the total value munity banks,[48] by providing these brokers with au-
of U.S. mortgage debt outstanding was $10.7 trillion.[41] tomated underwriting systems. The Wall Street Jour-
nal reported that the underwriting software was “made
Wallsion publicized his dissent and responded to critics available to thousands of mortgage brokers” and made
in a number of articles and op-ed pieces, and New York these “brokers and other small players a threat to larger
Times Columnist Joe Nocera accuses him of “almost banks.” [48] The theory was that “brokers armed with
single-handedly” creating “the myth that Fannie Mae and automated-underwriting software” could sell loans di-
Freddie Mac caused the financial crisis”.[42] rectly to F&F, thereby “cutting banks out of the loan-
making business.” [48] At the peak of the housing boom
there were about 75,000 small mortgage brokers across
the United States,[49] and it is believed that many of these
5.2 Other debate about the role (if any) of accounted for the slip-shod and predatory loan practices
Fannie and Freddie in creating the fi- that led to the subprime mortgage crisis.[50]
nancial crisis
Creation of the low-quality loan products offered by
5.2.1 Critics of Fannie Mae and Freddie Mac
private lenders Many of the loan products sold by
mortgage lenders, and criticized for their weak standards,
Critics contend that Fannie Mae and Freddie Mac af- were designed by Fannie or Freddie. For example, the
fected lending standards in many ways - ways that often “Affordable Gold 100” line of loans, designed by Fred-
had nothing to do with their direct loan purchases: die, required no down payment and no closing costs from
the borrower. The closing costs could come from “a va-
riety of sources, including a grant from a qualified insti-
[51]
Aggressive promotion of easy automated underwrit- tution, gift from a relative or an unsecured loan.”
ing standards In 1995 Fannie and Freddie introduced
automated underwriting systems, designed to speed-up Close relationship to loan aggregators Countrywide,
the underwriting process. These systems, which soon set a company reported to have financed 20 percent of all
underwriting standards for most of the industry (whether United States mortgages in 2006, had a close business
or not the loans were purchased by the GSEs) greatly re- relationship with Fannie Mae. This relationship is de-
laxed the underwriting approval process. An independent scribed in Chain of Blame by Muolo and Padilla: “Over
study of about 1000 loans found that the same loans were the next 15 years [starting in 1991] Countrywide and
65 percent more likely to be approved by the automated Fannie Mae – Mozilo and Johnson and then Mozilo and
processes versus the traditional processes.[43] The GSE Franklin Raines, Johnson’s successor – would be linked at
were aggressive in promoting the new, liberalized sys- the hip.” [52] “Depending on the year, up to 30 percent of
tems, and even required lenders to use them. In a paper Fannie’s loans came from Countrywide, and Fannie was
written in January 2004, OFHEO described the process: so grateful that it rewarded Countrywide with sweetheart
“Once Fannie Mae and Freddie Mac began to use scoring purchase terms – better than those offered to real (solid
and automated underwriting in their internal business op- and reputable) banks.”[53]
erations, it was not long before each Enterprise required
the single-family lenders with which it does business to
use such tools. The Enterprises did so by including the False reporting of subprime purchases Estimates of
use of those technologies in the conforming guidelines subprime loan purchases by Fannie and Freddie have
for their seller/servicers.” [44] ranged from zero to trillions of dollars. For example, in
5.2 Other debate about the role (if any) of Fannie and Freddie in creating the financial crisis 7

2008 Economist Paul Krugman erroneously claimed that The estimates of Wallison, Calomiris, and Pinto are
Fannie and Freddie “didn't do any subprime lending, be- based upon analysis of the specific characteristics of the
cause they can't; the definition of a subprime loan is pre- loans. For example, Wallison and Calomiris used 5
cisely a loan that doesn't meet the requirement, imposed factors which, they believe, indicate subprime lending.
by law, that Fannie and Freddie buy only mortgages is- Those factors are negative loan amortization, interest-
sued to borrowers who made substantial down payments only payments, down-payments under 10 percent, low-
and carefully documented their income.” [54] documentation, and low FICO (credit) scores.[59]
Economist Russell Roberts[55] cited a June 2008 Wash-
ington Post article which stated that "[f]rom 2004 to
2006, the two [GSEs] purchased $434 billion in secu-
rities backed by subprime loans, creating a market for
more such lending.”[56] Furthermore, a 2004 HUD report
admitted that while trading securities that were backed Cheerleading for subprime When Fannie or Freddie
by subprime mortgages was something that the GSEs of- bought subprime loans they were taking a chance because,
ficially disavowed, they nevertheless participated in the as noted by Paul Krugman, “a subprime loan is precisely
market.[57] Both Fannie and Freddie reported some of a loan that doesn't meet the requirement, imposed by law,
their subprime purchases in their annual reports for 2004, that Fannie and Freddie buy only mortgages issued to bor-
2005, 2006, and 2007.[58] However, the full extent of rowers who made substantial down payments and care-
GSE subprime purchases was not known until after the fully documented their income.” [54] As noted, the SEC
financial crisis of 2007/08. In December 2011 the Secu- has alleged that Fannie and Freddie both ignored the law
rities and Exchange Commission charged 6 ex-executives with regard to the purchase of subprime loans. However,
of Fannie and Freddie with Securities Fraud, and the SEC some loans were so clearly lacking in quality that Fannie
alleged that their companies held, in reality, over $2 tril- and Freddie wouldn't take a chance on buying them. Nev-
lion in subprime loans as of June 2008 (a month before ertheless, the two GSEs promoted the subprime loans that
Krugman made his exonerating statement). they could not buy. For example: “In 1997, Matt Miller, a
Director of Single-Family Affordable Lending at Freddie
Mac, addressed private lenders at an Affordable Housing
Estimates of the subprime loan and securities pur- Symposium. He said that Freddie could usually find a
chases of Fannie and Freddie Critics claim that the way to buy and securitize their affordable housing loans
amount of subprime loans reported by the two GSEs are 'through the use of Loan Prospector research and creative
wildly understated. In an early estimate of GSE subprime credit enhancements … .' Then, Mr. Miller added: 'But
purchases, Peter J. Wallison of the American Enterprise what can you do if after all this analysis the product you
Institute and Calomiris estimated that the two GSEs held are holding is not up to the standards of the conventional
about $1 trillion of subprime as of August 2008.[59] A secondary market?' Matt Miller had a solution: Freddie
subsequent estimate by Edward Pinto, a former Fannie would work with “several firms” in an effort to find buyers
Mae Executive, was about $1.8 trillion, spread among for these [subprime] loans.” .[63]
12 million mortgages.[60] That would be, by number, The GSEs had a pioneering role in expanding the use of
nearly half of all subprime loans outstanding in the United subprime loans: In 1999, Franklin Raines first put Fan-
States. The highest estimate was produced by Wallison nie Mae into subprimes, following up on earlier Fannie
and Edward Pinto, based on amounts reported by the Se- Mae efforts in the 1990s, which reduced mortgage down
curities and Exchange Commission in conjunction with payment requirements. At this time, subprimes repre-
its securities fraud case against former executives of Fan- sented a tiny fraction of the overall mortgage market.[64]
nie and Freddie. Using the SEC information, Wallison In 2003, after the use of subprimes had been greatly ex-
and Pinto estimated that the two GSEs held over $2 tril- panded, and numerous private lenders had begun issuing
lion in substandard loans in 2008.[61] subprime loans as a competitive response to Fannie and
The discrepancies can be attributed to the estimate Freddie, the GSE’s still controlled nearly 50% of all sub-
sources and methods. The lowest estimate (Krugman’s) is prime lending. From 2003 forward, private lenders in-
simply based on what is legally allowable, without regard creased their share of subprime lending, and later issued
to what was actually done. Other low estimates are simply many of the riskiest loans. However, attempts to defend
based on the amounts reported by Fannie and Freddie in Fannie Mae and Freddie Mac for their role in the crisis,
their financial statements and other reporting. As noted by citing their declining market share in subprimes after
by Alan Greenspan, the subprime reporting by the GSEs 2003, ignore the fact that the GSE’s had largely created
was understated, and this fact was not widely known un- this market, and even worked closely with some of the
til 2009: “The enormous size of purchases by the GSEs worst private lending offenders, such as Countrywide. In
[Fannie and Freddie] in 2003–2004 was not revealed un- 2005, one out of every four loans purchased by Fannie
til Fannie Mae in September 2009 reclassified a large Mae came from Countrywide.[65] Fannie Mae and Fred-
part of its securities portfolio of prime mortgages as sub- die Mac essentially paved the subprime highway, down
prime.” [62] which many others later followed.
8 5 FANNIE MAE AND FREDDIE MAC

5.2.2 Defenders of Fannie Mae and Freddie Mac why this was happening: the subprime mort-
gage originators were starting to dominate the
Economist Paul Krugman and Attorney David Min have market. They didn't need Fannie and Freddie
argued that Fannie Mae, Freddie Mac, and the Commu- to guarantee their loans ... As Fannie’s market
nity Reinvestment Act (CRA) could not have been pri- share dropped, the company’s investors grew
mary causes of the bubble/bust in residential real estate restless ...
because there was a bubble of similar magnitude in com- Citigroup had been hired to look at what
mercial real estate in America[66] — the market for ho- Citi called `strategic alternatives to maximize
tels, shopping malls and office parks scarcely affected by long term ... shareholder value` [at Fannie
affordable housing policies.[67][68] Their assumption, im- Mae]. Among its key recommendations for
plicitly, is that the financial crisis was caused by the burst- increasing ... market capitalization: ... be-
ing of a real estate “bubble.” gin guaranteeing `non-conforming residential
mortgages`"[74]
“Members of the Right tried to blame the seeming mar-
ket failures on government; in their mind the government
“Non-conforming” loans meaning not conforming to
effort to push people with low incomes into home own-
prime lending standards.
ership was the source of the problem. Widespread as this
belief has become in conservative circles, virtually all se- In a 2008 article on Fannie Mae, the New York Times de-
rious attempts to evaluate the evidence have concluded scribes the company as responding to pressure rather than
that there is little merit in this view.” setting the pace in lending. By 2004, “competitors were
[69] snatching lucrative parts of its business. Congress was
Joseph Stiglitz
demanding that [it] help steer more loans to low-income
Countering Krugman’s analysis, Peter Wallison argues borrowers. Lenders were threatening to sell directly to
that the crisis was caused by the bursting of a real es- Wall Street unless Fannie bought a bigger chunk of their
tate bubble that was supported largely by low or no- riskiest loans”[75]
down-payment loans, which was uniquely the case for
Federal Reserve data found more than 84% of the sub-
U.S. residential housing loans.[70] Also, after research-
prime mortgages in 2006 coming from private-label in-
ing the default of commercial loans during the financial
stitutions rather than Fannie and Freddie, and the share
crisis, Xudong An and Anthony B. Sanders reported (in
of subprime loans insured by Fannie Mae and Fred-
December 2010): “We find limited evidence that sub-
die Mac decreasing as the bubble got bigger (from
stantial deterioration in CMBS [commercial mortgage-
a high of insuring 48% to insuring 24% of all sub-
backed securities] loan underwriting occurred prior to
prime loans in 2006).[76] According to economists Jeff
the crisis.”[71] Other analysts support the contention that
Madrick and Frank Partnoy, unlike Wall Street, the GSEs
the crisis in commercial real estate and related lending
“never bought the far riskier collateralized debt obliga-
took place after the crisis in residential real estate. Busi-
tions (CDOs) that were also rated triple-A and were the
ness journalist Kimberly Amadeo reports: “The first signs
main source of the financial crisis.”[77] A 2011 study by
of decline in residential real estate occurred in 2006.
the Fed using statistical comparisons of geographic re-
Three years later, commercial real estate started feeling
[72] gions which were and were not subject to GSE regula-
the effects. Denice A. Gierach, a real estate attorney
tions, found “little evidence” that GSEs played a signifi-
and CPA, wrote:
cant role in the subprime crisis.[78][79]
Another argument against Wallison’s thesis is that the
...most of the commercial real estate loans numbers for subprime mortgages provided for him by
were good loans destroyed by a really bad Pinto are inflated and “don’t hold up”.[80] Krugman cited
economy. In other words, the borrowers did the work of economist Mike Konczal: “As Konczal says,
not cause the loans to go bad, it was the all of this stuff relies on a form of three-card monte: you
economy.[73] talk about “subprime and other high-risk” loans, lump-
ing subprime with other loans that are not, it turns out,
In their book on the crisis, journalists McLean and No- anywhere near as risky as actual subprime; then use this
cera argue that the GSEs (Fannie and Freddie) followed essentially fake aggregate to make it seem as if Fan-
rather than led the private sector into subprime lending. nie/Freddie were actually at the core of the problem.”[81]
In Pinto’s analysis, “non-traditional mortgages” include
“In 2003, Fannie Mae’s estimated market Alt-A mortgages, which are not used by low and moder-
share for bonds backed by single-family hous- ate income borrowers and have nothing to do with meet-
ing was 45%. Just one year later, it dropped ing affordable housing goals.
to 23.5%. As a 2005 internal presentation at According to Journalist McLean, “the theory that the
Fannie Mae noted, with some alarm, `Private GSEs are to blame for the crisis” is a “canard”, that “has
label volume surpassed Fannie Mae volume for been thoroughly discredited, again and again.”[80] The
the first time.` ... There was no question about Commission met with Pinto to analyze his figures and, ac-
5.3 Federal takeover of Fannie Mae and Freddie Mac 9

cording to McLean, “Pinto’s numbers don’t hold up”.[80] alleges the executives bought the subprime mortgages (in
The Government Accountability Office estimated a far the words of Nocera) “belatedly ... to reclaim lost market
smaller number for subprime loans outstanding than share, and thus maximize their bonuses.” [42] According
Pinto. Pinto stated that, at the time the market collapsed, to Jeff Madrick and Frank Partnoy, what put Fannie and
half of all U.S. mortgages — 27 million loans — were Freddie into conservatorship in September 2008[86] “had
subprime. The GAO estimated (in 2010) that only 4.59 little to do with pursuit of the original goals of `affordable
million such loans were outstanding by the end of 2009, lending`. The GSEs were far more concerned to max-
and that from 2000 to 2007 only 14.5 million total non- imize their profits than to meet these goals; they were
borrowing at low rates to buy high-paying mortgage se-
prime loans were originated.[80]
curities once their accounting irregularities were behind
Pinto’s data, included in Wallison’s FCIC dissenting re- them. ... Most disturbing about the GSEs, they refused
port estimated Fannie and Freddie purchased $1.8 tril- to maintain adequate capital as a cushion against losses,
lion in subprime mortgages, spread among 12 million despite demands from their own regulators that they do
mortgages. However, according to journalist Joe Nocera, so.”[77]
Pinto’s mortgage numbers are “inflated”, by classifying
“just about anything that is not a 30-year-fixed mortgage Nocera’s contention notwithstanding, at least one exec-
as `subprime.`"[82] utive at Fannie Mae had an entirely different viewpoint,
stating in an interview:
It must be noted that the judgments made above (by Kon-
czal, Krugman, McLean, the GAO, and the Federal Re-
serve) were made prior to the SEC charging, in Decem- Everybody understood that we were now
ber 2011, Fannie Mae and Freddie Mac executives with buying loans that we would have previously
securities fraud. Significantly, the SEC alleged (and still rejected, and that the models were telling us
maintains) that Fannie Mae and Freddie Mac reported as that we were charging way too little, but our
subprime and substandard less than 10 percent of their ac- mandate was to stay relevant and to serve low-
tual subprime and substandard loans.[83] In other words, income borrowers. So that’s what we did.”[75]
the substandard loans held in the GSE portfolios may Fannie and Freddie were both under political
have been 10 times greater than originally reported. Ac- pressure to expand purchases of higher-risk af-
cording to Wallison, that would make the SEC’s estimate fordable housing mortgage types, and under
of GSE substandard loans higher than Edward Pinto’s significant competitive pressure from large in-
estimate.[84] vestment banks and mortgage lenders.[75]

According to David Min, a critic of Wallison at the Center


for American Progress, Wallison has cited New York Times columnist Gretchen
Morgenson and her book Reckless Endangerment as
demonstrating that “the Democratic political operative”
as of the second quarter of 2010, the delin- Jim Johnson turned Fannie Mae “into a political machine
quency rate on all Fannie and Freddie guaran- that created and exploited the government housing poli-
teed loans was 5.9 percent. By contrast, the cies that were central to the financial crisis and led the
national average was 9.11 percent. The Fan- way for Wall Street”.[87] However, in a review of Mor-
nie and Freddie Alt-A default rate is similarly genson’s book, two economist critics of Wallison (Jeff
much lower than the national default rate. The Madrick and Frank Partnoy) point out Morgenson does
only possible explanation for this is that many not defend Wall Street as misled by Fannie, but states “of
of the loans being characterized by the S.E.C. all the partners in the homeownership push, no industry
and Wallison/Pinto as “subprime” are not, in contributed more to the corruption of the lending process
fact, true subprime mortgages.[82][85] than Wall Street.”[77]

Still another criticism of Wallison is that insofar as Fannie


and Freddie contributed to the crisis, its own profit seek- 5.3 Federal takeover of Fannie Mae and
ing and not government mandates for expanded home- Freddie Mac
ownership are the cause. In December 2011, after
the Securities and Exchange Commission charged 6 ex- By 2008, the GSE owned, either directly or through mort-
executives of Fannie and Freddie with Securities Fraud, gage pools they sponsored, $5.1 trillion in residential
Wallison stated, as did the SEC, that the full extent of mortgages, about half the amount outstanding.[88] The
GSE subprime purchases was hidden during the crisis. GSE have always been highly leveraged, their net worth
Based upon the SEC charges, Wallison estimated that as of 30 June 2008 being a mere US$114 billion.[89]
Fannie and Freddie held, in reality, over $2 trillion in sub- When concerns arose regarding the ability of the GSE
prime loans as of June 2008.[84] However, journalist Joe to make good on their nearly $5 trillion in guaran-
Nocera contends that the “SEC complaint makes almost tee and other obligations in September 2008, the U.S.
no mention of affordable housing mandates” and instead government was forced to place the companies into a
10 6 COMMUNITY REINVESTMENT ACT

conservatorship, effectively nationalizing them at the tax- which they were required to lend were half as likely to
payers expense.[90][91] Paul Krugman noted that an im- default as similar loans made in the same neighborhoods
plicit guarantee of government support meant that “prof- by independent mortgage originators not subject to the
its are privatized but losses are socialized,” meaning that law.”[1]
investors and management profited during the boom- The three Republican authors of a dissenting report to
period while taxpayers would take on the losses during the FCIC majority opinion wrote in January 2011: “Nei-
a bailout.[92] ther the Community Reinvestment Act nor removal of the
Announcing the conservatorship on 7 September 2008, Glass-Steagall firewall was a significant cause. The crisis
GSE regulator Jim Lockhart stated: “To promote stabil- can be explained without resorting to these factors.” The
ity in the secondary mortgage market and lower the cost three authors further explained: “Credit spreads declined
of funding, the GSEs will modestly increase their MBS not just for housing, but also for other asset classes like
portfolios through the end of 2009. Then, to address sys- commercial real estate. This tells us to look to the credit
temic risk, in 2010 their portfolios will begin to be grad- bubble as an essential cause of the U.S. housing bubble.
ually reduced at the rate of 10 percent per year, largely It also tells us that problems with U.S. housing policy or
through natural run off, eventually stabilizing at a lower, markets do not by themselves explain the U.S. housing
less risky size.”[93] bubble.”[102]
According to Jeff Madrick and Frank Partnoy, the GSEs
ended up in conservatorship because of the sharpness 6.2 Debate about the role of CRA in the
of the drop in housing prices, and despite the fact that
crisis
they “never took nearly the risks that the private market
took.” Jason Thomas and Robert Van Order argue that the
Detractors assert that the early years of the CRA were rel-
downfall of the GSEs “was quick, primarily due to mort-
atively innocuous; however, amendments to CRA, made
gages originated in 2006 and 2007. It … was mostly as-
in the mid-1990s, increased the amount of home loans to
sociated with purchases of risky-but-not-subprime mort-
unqualified low-income borrowers and, for the first time,
gages and insufficient capital to cover the decline in prop-
allowed the securitization of CRA-regulated loans con-
erty values.” In their paper on the GSEs they did “not find
taining subprime mortgages.[103][104] In the view of some
evidence that their crash was due much to government
critics, the weakened lending standards of CRA and other
housing policy or that they had an essential role in the de-
affordable housing programs, coupled with the Federal
velopment of the subprime mortgage - backed securities
Reserve’s low interest-rate policies after 2001, was a ma-
market”.[94]
jor cause of the financial crisis of 2007/08.[105]
CPA Joseph Fried wrote that there is a paucity of CRA
loan performance data, based on a response by only 34
6 Community Reinvestment Act of 500 banks surveyed.[106] Nevertheless, estimates have
been attempted. Edward Pinto, former Chief Credit Of-
Main article: Community Reinvestment Act ficer of Fannie Mae (1987–89) and Fellow at the Ameri-
can Enterprise Institute, estimated that, at June 30, 2008,
there were $1.56 trillion of outstanding CRA loans (or the
The CRA was originally enacted under President Jimmy
equivalent). Of this amount, about $940 billion (about
Carter in 1977. The Act was set in place to encour-
6.7 million loans) was, according to Pinto, subprime.[107]
age banks to halt the practice of lending discrimination.
There is debate among economists regarding the effect Economist Paul Krugman notes the subprime boom “was
of the CRA, with detractors claiming it encourages lend- overwhelmingly driven” by loan originators who were not
ing to uncreditworthy consumers[95][96][97] and defend- subject to the Community Reinvestment Act.[108] One
ers claiming a thirty-year history of lending without in- study, by a legal firm which counsels financial services
creased risk.[98][99][100][101] entities on Community Reinvestment Act compliance,
found that CRA-covered institutions were less likely to
make subprime loans (only 20–25% of all subprime
6.1 Conclusions of the Financial Crisis In- loans), and when they did the interest rates were lower.
quiry Commission The banks were half as likely to resell the loans to other
parties.[109]
The Financial Crisis Inquiry Commission (majority re- Federal Reserve Governor Randall Kroszner and Federal
port) concluded in January 2011 that: "...the CRA was Deposit Insurance Corporation Chairman Sheila Bair
not a significant factor in subprime lending or the crisis. have stated that the CRA was not to blame for the
Many subprime lenders were not subject to the CRA. Re- crisis.[110][111] In a 2008 speech delivered to The New
search indicates only 6% of high-cost loans—a proxy for America Foundation conference, Bair remarked, “Let me
subprime loans—had any connection to the law. Loans ask you: where in the CRA does it say: make loans to
made by CRA-regulated lenders in the neighborhoods in people who can't afford to repay? No-where! And the
11

fact is, the lending practices that are causing problems to- approval for a merger was “good citizenship” exhibited
day were driven by a desire for market share and revenue by lending to under-serviced markets.[122]
growth ... pure and simple.”[112] Bair is literally correct:
During the Clinton administration, the CRA was reinvig-
The CRA doesn't tell banks to make loans to those who orated and used to control mergers. President Clinton
can't pay. However, research suggests that many banks said the CRA “was pretty well moribund until we took
felt heavily pressured. For example, Bostic and Robin- office. Over 95 percent of the community investment …
son found that lenders seem to view CRA agreements “as made in the 22 years of that law have been made in the
a form of insurance against the potentially large and un- six and a half years that I’ve been in office.”[123] The CRA
known costs...” of lending violations.[113]
became an important tool in Clinton’s “third way” as an
Federal Reserve Governor Randall Kroszner says the alternative to both laissez-faire and government transfer
CRA is not to blame for the subprime mess, “First, only payments to directly construct housing.[122]
a small portion of subprime mortgage originations are re- CRA ratings, however, and not CRA loans, were the main
lated to the CRA. Second, CRA-related loans appear to tools of altering banking practices. A poor rating pre-
perform comparably to other types of subprime loans. vented mergers. Community activist groups became an
Taken together… we believe that the available evidence important part of the merger process. Their support was
runs counter to the contention that the CRA contributed crucial to most mergers and in return the banks supported
in any substantive way to the current mortgage crisis,” their organizations. By 2000 banks gave $9.5 billion of
Kroszner said: “Only 6%of all the higher-priced loans support to activist groups and in return these groups tes-
were extended by CRA-covered lenders to lower-income tified in favor of select mergers. The creation by mergers
borrowers or neighborhoods in their CRA assessment ar- of the mega-bank WaMu in 1999 came with a ten-year
eas, the local geographies that are the primary focus for CRA $120 billion agreement to fund housing activist ef-
CRA evaluation purposes.”[114] forts. In return CRA activists back the merger of one
According to American Enterprise Institute fellow Ed- of “worst-run banks and among the largest and earliest
ward Pinto, Bank of America reported in 2008 that its banks to fail in the 2007–09 subprime crisis.”[122]
CRA portfolio, which constituted 7% of its owned res- Banks that refused to abandon traditional credit practices
idential mortgages, was responsible for 29 percent of its
remained small. By controlling mergers, CRA ratings
losses. He also charged that “approximately 50 percent of created “believer banks” that not only originated loans
CRA loans for single-family residences ... [had] charac-
labeled CRA-loans but extended easy credit across the
teristics that indicated high credit risk,” yet, per the stan- board. By controlling the merger process the government
dards used by the various government agencies to eval- was able to breed easy-credit banks by a process of arti-
uate CRA performance at the time, were not counted ficial selection.[122]
as “subprime” because borrower credit worthiness was
not considered.[115][116][117][118] However, economist Paul Steven D. Gjerstad and Vernon L. Smith, reviewing the
Krugman argues that Pinto’s category of “other high- research on the role of the CRA, find that CRA loans
risk mortgages” incorrectly includes loans that were not were not significant in the crisis but CRA scoring (bank
high-risk, that instead were like traditional conforming ratings) played an important role. They conclude “the
mortgages.[119] Additionally, another CRA critic con- CRA is neither absolved of playing a role in the crisis nor
cedes that “some of this CRA subprime lending might faulted as a root cause.” It justified easy credit to those of
have taken place, even in the absence of CRA. For that modest means and indirectly affected all lending to the
reason, the direct impact of CRA on the volume of sub- borrowers it targeted. It was, however, part of an emerg-
prime lending is not certain.”[120] ing consensus among lenders, government and the public
for easy credit.[124]
James Kourlas points out that ”industry participants …
were convinced that they could handle the new lending
standards and make a profit. They were convinced that
they could safely fund the massive expansion of housing 7 Government “affordable home-
credit. That they were wrong is not proof in and of itself
that they were willing to sacrifice profits for altruistic ide- ownership” policies
als. That government started the ball rolling doesn’t fully
explain why the industry took the ball and ran with it.”[121] 7.1 Overview
The CRA was revived in the 1990s, during the merger
fever among banks. The fragmented banking system The Financial Crisis Inquiry Commission (FCIC),
was a legacy of state-level anti-branching laws. Without Federal Reserve economists, business journalists Bethany
branches and national diversification, banks were subject McLean and Joe Nocera, and several academic re-
to local economic downturns. In the aftermath of the searchers have argued that government affordable hous-
Savings and loan crisis a decade of mergers consolidated ing policies were not the major cause of the financial
[125][126]
the banking industry. One of the criteria for government crisis. They also argue that Community Rein-
vestment Act loans outperformed other “subprime” mort-
12 7 GOVERNMENT “AFFORDABLE HOMEOWNERSHIP” POLICIES

gages, and GSE mortgages performed better than private occurred in 2006. Three years later, commercial real es-
label securitizations. tate started feeling the effects.[72] Denice A. Gierach, a
According to the Financial Crisis Inquiry Commission, real estate attorney and CPA, wrote:
“based on the evidence and interviews with dozens of
individuals involved” in HUD’s (Department of Hous- ...most of the commercial real estate loans
ing and Urban Development) “affordable housing goals” were good loans destroyed by a really bad
for the GSEs, “we determined these goals only con- economy. In other words, the borrowers did
tributed marginally to Fannie’s and Freddie’s participa- not cause the loans to go bad, it was the
tion in “risky mortgages”. [127] economy.[73]
Economists Paul Krugman and David Min point out that
the simultaneous growth of the residential, commercial Critics of U.S. affordable housing policies have cited
real estate—and also consumer credit—pricing bubbles three aspects of governmental affordable housing policy
in the US and general financial crisis outside it, under- as having contributed to the financial crisis: the Commu-
mines the case that Fannie Mae, Freddie Mac, CRA, or nity Reinvestment Act, HUD-regulated affordable hous-
predatory lending were primary causes of the crisis, since ing mandates imposed upon Fannie Mae and Freddie
affordable housing policies did not effect either US com- Mac, and HUD’s direct efforts to promote affordable
mercial real estate or non-US real estate.[85][128] housing through state and local entities. Economist
Thomas Sowell wrote in 2009: “Lax lending standards
[T]here was no federal act driving banks used to meet 'affordable housing' quotas were the key to
to lend money for office parks and shopping the American mortgage crisis.” Sowell described multiple
malls; Fannie and Freddie weren’t in the CRE instances of regulatory and executive pressure to expand
[commercial real estate] loan business; yet 55 home ownership through lower lending standards during
percent — 55 percent! — of commercial the 1990s and 2000s.[130]
mortgages that will come due before 2014 are
underwater.[129]
7.2 Department of Housing and Urban
Writing in January 2011, three of the four Republicans on Development (HUD)
the FCIC Commission[37] also agreed that the concurrent
commercial real estate boom showed that U.S. housing 7.2.1 HUD mandates for affordable housing
policies were not the sole cause of the real estate bubble:
The Department of Housing and Urban Development
(HUD) loosened mortgage restrictions in the mid-1990s
“Credit spreads declined not just for hous- so first-time buyers could qualify for loans that they could
ing, but also for other asset classes like com- never get before.[131] In 1995, the GSE began receiv-
mercial real estate. This tells us to look to ing affordable housing credit for purchasing mortgage
the credit bubble as an essential cause of the backed securities which included loans to low income
U.S. housing bubble. It also tells us that prob- borrowers. This resulted in the agencies purchasing sub-
lems with U.S. housing policy or markets do prime securities.[132]
not by themselves explain the U.S. housing
bubble.”[39] The Housing and Community Development Act of 1992
established an affordable housing loan purchase mandate
for Fannie Mae and Freddie Mac, and that mandate was
Countering the analysis of Krugman and members of the to be regulated by HUD. Initially, the 1992 legislation re-
FCIC, Peter Wallison argues that the crisis was caused quired that 30 percent or more of Fannie’s and Freddie’s
by the bursting of a real estate bubble that was supported loan purchases be related to affordable housing. How-
largely by low or no-down-payment loans, which was ever, HUD was given the power to set future require-
uniquely the case for U.S. residential housing loans.[70] ments. In 1995 HUD mandated that 40 percent of Fan-
Krugman’s analysis is also challenged by other analy- nie and Freddie’s loan purchases would have to support
sis. After researching the default of commercial loans affordable housing. In 1996, HUD directed Freddie and
during the financial crisis, Xudong An and Anthony B. Fannie to provide at least 42% of their mortgage financ-
Sanders reported (in December 2010): “We find limited ing to borrowers with income below the median in their
evidence that substantial deterioration in CMBS [com- area. This target was increased to 50% in 2000 and 52%
mercial mortgage-backed securities] loan underwriting in 2005. Under the Bush Administration HUD contin-
occurred prior to the crisis.”[71] Other analysts support ued to pressure Fannie and Freddie to increase affordable
the contention that the crisis in commercial real estate housing purchases – to as high as 56 percent by the year
and related lending took place after the crisis in residen- 2008.[133] In addition, HUD required Freddie and Fannie
tial real estate. Business journalist Kimberly Amadeo re- to provide 12% of their portfolio to “special affordable”
ports: “The first signs of decline in residential real estate loans. Those are loans to borrowers with less than 60%
7.2 Department of Housing and Urban Development (HUD) 13

of their area’s median income. These targets increased ment loans and undisclosed second, unsecured loans to
over the years, with a 2008 target of 28%.[134] the borrower to pay their down payments (if any) and
[141]
To satisfy these mandates, Fannie and Freddie announced closing costs. This idea manifested itself in “silent
low-income and minority loan commitments. In 1994 second” loans that became extremely popular in several
Fannie pledged $1 trillion of such loans, a pledge it ful- states such as California, and in scores of cities such as
[142]
filled in 2000. In that year Fannie pledged to buy (from San Francisco. Using federal funds and their own
private lenders) an additional $2 trillion in low-income funds, these states and cities offered borrowers loans
and minority loans, and Freddie matched that commit- that would defray the cost of the down payment. The
loans were called “silent” because the primary lender was
ment with its own $2 trillion pledge. Thus, these gov-
ernment sponsored entities pledged to buy, from the pri- not supposed to know about them. A Neighborhood
Reinvestment Corporation (affiliated with HUD) public-
vate market, a total of $5 trillion in affordable housing
loans. [135] ity sheet explicitly described the desired secrecy: “[The
NRC affiliates] hold the second mortgages. Instead of go-
Until relatively recently, “subprime” was praised by at ing to the family, the monthly voucher is paid to [the NRC
least some members of the U.S. government. In a 2002 affiliates]. In this way the voucher is “invisible” to the tra-
speech in the Housing Bureau for Senior’s Conference, ditional lender and the family (emphasis added).[143]
Edward Gramlich, a former Governor of the Federal Re-
serve Board, distinguished predatory lending from sub- HUD also praised Fannie and Freddie for their efforts to
prime lending: “In understanding the problem, it is par- promote lending flexibility: “In recent years many mort-
ticularly important to distinguish predatory lending from gagees have increased underwriting flexibility. This in-
generally beneficial subprime lending… Subprime lend- creased flexibility is due, at least in part to … liberal-
ing … refers to entirely appropriate and legal lending to ized affordable housing underwriting criteria established
borrowers who do not qualify for prime rates….”[136] Mr. by secondary market [144]
investors such as Fannie Mae and
Gramlich also cited the importance of subprime lending Freddie Mac.” To illustrate the desirable flexibility
to the government’s afforable housing efforts: " Much the Strategy cited a Connecticut program that “allows for
of this increased [affordable housing] lending can be at- nontraditional employment histories, employment histo-
tributed to the development of the subprime mortgage ries with gaps, short-term employment, and frequent job
[145]
market….” [137] changes.”
Criticism of the HUD strategy and the resultant relax-
Joseph Fried, author of “Who Really Drove the Economy
Into the Ditch?" believes it was inevitable that the looser ation of standards was criticized by at least one research
lending standards would become widespread: "…it was company years prior to the subprime mortgage crisis. In
impossible to loosen underwriting standards for people 2001, the independent research company, Graham Fisher
with marginal credit while maintaining rigorous standards & Company, stated: “While the underlying initiatives
for people with good credit histories. Affordable housing of the [strategy] were broad in content, the[146] main theme
policies led to a degrading of underwriting standards for … was the relaxation of credit standards.” Graham
loans of all sizes.” [10] Fisher cited these specifics:

• “The requirement that homebuyers make significant


7.2.2 HUD’s “National Homeownership Strategy” down payments was eliminated in the 1990s. The
[strategy] urged and approved increasingly larger re-
“The National Homeownership Strategy: Partners in the ductions in requirements. Down payment require-
American Dream”, was compiled in 1995 by Henry Cis- ments have dropped to record low levels.” [147]
neros, President Clinton’s HUD Secretary. This 100-
page document represented the viewpoints of HUD, Fan- • “Over the past decade Fannie Mae and Freddie Mac
nie Mae, Freddie Mac, leaders of the housing industry, have reduced required down payments on loans that
various banks, numerous activist organizations such as they purchase in the secondary market. Those re-
ACORN and La Raza, and representatives from several quirements have declined from 10% to 5% to 3%
state and local governments.”[138] The strategy was not and in the past few months Fannie Mae announced
limited to the loan purchases of Fannie and Freddie, or to that it would follow Freddie Mac’s recent move into
Community Reinvestment Act loans. “This was a broad, the 0% down payment mortgage market.” [148]
governmental plan for the entire lending industry, com-
prising '100 proposed action items,' ostensibly designed • “Private mortgage insurance requirements were re-
to 'generate up to 8 million additional homeowners’ in laxed.” [148]
America.[139] • New, automated underwriting software, developed
As part of the 1995 National Homeownership Strategy, by Fannie and Freddie, allows reduced loan doc-
HUD advocated greater involvement of state and local or- umentation and “higher debt to income levels
ganizations in the promotion of affordable housing.[140] than does traditional underwriting.” The under-
In addition, it promoted the use of low or no-down pay- writing systems were approved “even though they
14 7 GOVERNMENT “AFFORDABLE HOMEOWNERSHIP” POLICIES

were stress-tested using only a limited number and 7.5 Policies of the Bush Administration
breadth of economic scenarios.” [149]
• The house appraisal process “is being compro- President Bush advocated the "Ownership society.” Ac-
mised. We have spoken with real estate apprais- cording to a New York Times article published in 2008,
ers, fraud appraisers and national appraisal organi- “he pushed hard to expand home ownership, especially
zations and have been told, almost unanimously, that among minorities, an initiative that dovetailed with his
the changes in the appraisal process, over the past ambition to expand the Republican tent — and with the
decade, have jeopardized the soundness of the pro- business interests of some of his biggest donors. But his
cess and skewed real estate prices.” [150] housing policies and hands-off approach to regulation en-
couraged lax lending standards.” .[155]
Government housing policies guaranteed home mort- There appears to be ample evidence that the Bush ad-
gages and/or promoting low or no down payment have ministration recognized both the risk of subprimes, and
been criticized by economist Henry Hazlitt as “inevitably” specifically the risks posed by the GSE’s who had an im-
meaning “more bad loans than otherwise”, wasting tax- plicit guarantee of government backing. For example, in
payer money, " leading to “an oversupply of houses” 2003, the Bush administration, recognizing that the cur-
bidding up[ the cost of housing. In “the long run, rent regulators for Fannie and Freddie were inadequate,
they do not increase national production but encour- proposed that a new agency be created to regulate the
age malinvestment.”[151] These risks were realized as the GSE’s. This new agency would have been tasked specifi-
housing bubble peaked in 2005–2006 and deflated there- cally with setting capital reserve requirements, (removing
after, contributing to the crisis. that authority from Congress), approving new lines busi-
ness for the GSE’s, and most importantly, evaluating the
risk in their ballooning portfolios. It was in specific re-
7.3 Role of the Federal Home Loan Banks sponse to this regulatory effort that Barney Frank made
his now infamous statement “These two entities -- Fannie
The Federal Home Loan Banks (FHLB) are less under- Mae and Freddie Mac -- are not facing any kind of finan-
stood and discussed in the media. The FHLB provides cial crisis, the more people exaggerate these problems,
loans to banks that are in turn backed by mortgages. the more pressure there is on these companies, the less
Although they are one step removed from direct mort- we will see in terms of affordable housing.” [156] Had this
gage lending, some of the broader policy issues are sim- new regulatory agency been put in place in 2003, it likely
ilar between the FHLB and the other GSEs. Accord- would have uncovered the accounting fraud regarding ex-
ing to Bloomberg, the FLHB is the largest U.S. bor- ecutive bonuses which was occurring at that time at Fan-
rower after the federal government.[152] On January 8, nie Mae. This accounting scandal would later force the
2009, Moody’s said that only 4 of the 12 FHLBs may resignation of Franklin Raines and others executives.[157]
be able to maintain minimum required capital levels and This new agency may also have slowed or stopped the fur-
the U.S. government may need to put some of them into ther movement of the entire mortgage industry into sub-
conservatorship.[152] prime loans by exposing the full extent of the risks then
taken by Fannie and Freddie, who at this time, controlled
nearly half of all subprime loans being issued.
7.4 Policies of the Clinton Administration
Republican Mike Oxley, the former chairman of the
As noted, the National Homeownership Strategy, which House Financial Services Committee, has pointed out
advocated a general loosening of lending standards, at that the House of Representatives did in fact pass a law
least with regard to affordable housing, was devised in strengthening regulation of the GSEs (the Federal Hous-
1995 by HUD under the Clinton Administration. During ing Finance Reform Act of 2005) but the Bush White
the rest of the Clinton Administration HUD set increas- House scuttled it. In Oxley’s words, “All the hand wring-
ingly rigorous affordable housing loan requirements for ing and bedwetting is going on without remembering how
Fannie and Freddie. the House stepped up on this. What did we get from the
[158]
In 1995 the Clinton Administration made changes to the White House? We got a one-finger salute.”
CRA. The changes were extensive and, in the opinion Efforts to control GSE were thwarted by intense lobby-
of critics, very destructive. Under the new rules, banks ing by Fannie Mae and Freddie Mac.[159] In April 2005,
and thrifts were to be evaluated “based on the number Secretary of the Treasury John Snow repeated call for
and amount of loans issued within their assessment areas, GSE reform, saying “Events that have transpired since
the geographical distribution of those loans, the distribu- I testified before this Committee in 2003 reinforce con-
tion of loans based on borrower characteristics, the num- cerns over the systemic risks posed by the GSEs and fur-
ber and amount of community development loans, and ther highlight the need for real GSE reform to ensure that
the amount of innovation and flexibility they used when our housing finance system remains a strong and vibrant
approving loans.”[153] Some analysts maintain that these source of funding for expanding homeownership oppor-
new rules pressured banks to make weak loans.[154] tunities in America … Half-measures will only exacer-
15

bate the risks to our financial system.” Then Senate Mi- able monetary stimulation.[166]
nority Leader Harry Reid rejected legislation saying " we
cannot pass legislation that could limit Americans from
owning homes and potentially harm our economy in the 9 Enforcement of laws and regula-
process.” [160] A 2005 Republican effort for comprehen-
sive GSE reform was threatened with filibuster by Senator tions
[161]
Chris Dodd (D-CT).
Many existing laws and regulations were not effectively
enforced prior to the crisis. The SEC was criticized for
8 Role of the Federal Reserve Bank relaxing investment bank oversight and requiring inad-
equate risk disclosures by banks. The FDIC allowed
banks to shift large amounts of liabilities off-balance
Further information: Criticism of the Federal Reserve sheet, thereby circumventing depository banking capital
requirements. The Federal Reserve was criticized for not
Some economists, such as John Taylor, [162]
have asserted properly monitoring the quality of mortgage originations.
that the Fed was responsible, or at least partially responsi- Once the crisis hit its critical stage in September 2008, the
ble, for the United States housing bubble which occurred regulators did not consistently apply remedies available to
prior to the 2007 recession. They claim that the Fed kept them, thereby increasing uncertainty. A primary exam-
interest rates too low following the 2001 recession,[163] ple was allowing the demise of investment bank Lehman
The housing bubble then led to the credit crunch. Then- Brothers in September 2008, despite the Fed and Trea-
Chairman Alan Greenspan disputes this interpretation. sury Department facilitating a rescue/merger for Bear-
He points out that the Fed’s control over the long-term Stearns in March 2008 and the Merrill-Lynch merger
[1]
interest rates critics have in mind is only indirect. The with Bank of America in September 2008.
Fed did raise the short-term interest rate over which it Journalist Gretchen Morgenson cites the Financial Crisis
has control (i.e. the federal funds rate), but the long-term Inquiry Commission as noting with disapproval that dur-
interest rate (which usually follows the former) did not ing the course of the housing boom from 2000 to 2006,
increase.[164] the Federal Reserve “referred a grand total of three insti-
The Federal Reserve’s role as a supervisor and regula- tutions to prosecutors for possible fair-lending violations
tor has been criticized as being ineffective. Former U.S. in mortgages.” The report also quotes a former fraud in-
Senator Chris Dodd, then-chairman of the United States vestigator in the savings-and-loan crisis — William K.
Senate Committee on Banking, Housing, and Urban Af- Black — lamenting as “terrible” that the “FBI got virtu-
fairs, remarked about the Fed’s role in the present eco- ally no assistance from the regulators, the banking regu-
nomic crisis, “We saw over the last number of years when lators and the thrift regulators.”[167]
they took on consumer protection responsibilities and the
regulation of bank holding companies, it was an abysmal
failure.” 9.1 SEC and the net capital rule
According to Bethany McLean and Joe Nocera, Federal
Reserve chairman Alan Greenspan's ideologically oppo-
sition to government regulation was unmoved either by
complaints by grassroots “housing advocates” about the
damage to low income communities by predatory mort-
gage lending in the early 1990s, by the failure of market
forces to prevent an early, smaller subprime bubble and
bust in the late 1990s, or by appeals by Reserve board
governor Edward Gramlich to take a more active role in
policing the subprime business.[165]
A related criticism is made by economist Raghuram Ra-
jan (Governor of Reserve Bank of India) who in a book
on the financial crisis also argues that the low interest rate
policy of the Greenspan Fed both allowed and motivated Leverage ratios of investment banks increased significantly be-
investors to seek out risk investments offering higher re- tween 2003 and 2007.
turns, leading to the subprime crisis (as well as the Dot-
com bubble). The underlying cause for the American During the investment banking crisis in 2008, some an-
economy’s tendency to go “from bubble to bubble”, ac- alysts blamed the Securities and Exchange Commission
cording to Rajan, was the “economy’s weak safety nets” (SEC) for its 2004 decision that, they claimed, allowed
for the unemployed, which made “the US political system greater leverage. This leverage enabled investment banks
... acutely sensitive to job growth” and prone to unsustain- to substantially increase the level of debt they were taking
16 10 REGULATION OF DERIVATIVES

on, fueling the growth in mortgage-backed securities sup- had ratios equal to or greater than 28-to-1 at fiscal year-
porting subprime mortgages.[168][169] Subsequent analysis end 1998, which was higher than their ratios at fiscal year-
brings these claims into question.[170][171] end 2006 before the crisis began.”[172]
The critics note that the top five US investment banks Erik Sirri, then Director of the SEC’s Division of Trad-
each significantly increased their financial leverage dur- ing and Markets, concluded: “Since August 2008, com-
ing the 2004–2007 time period (see diagram), which in- menters in the press and elsewhere have suggested that the
creased their vulnerability to the MBS losses. These five 2004 amendments … allowed these firms to increase their
institutions reported over $4.1 trillion in debt for fiscal debt-to-capital ratios to unsafe levels well-above 12-to1,
year 2007, a figure roughly 30% the size of the U.S. econ- indeed to 33-to-1…. While this theme has been repeated
omy. Three of the five either went bankrupt (Lehman often in the press and elsewhere, it lacks foundation in
Brothers) or were sold at fire-sale prices to other banks fact.”[170]
(Bear Stearns and Merrill Lynch) during 2008, creating The SEC is also responsible for establishing financial
instability in the global financial system. The remain- disclosure rules. Critics have argued that disclosure
ing two converted to commercial bank models in or- throughout the crisis was ineffective, particularly regard-
der to qualify for Troubled Asset Relief Program funds ing the health of financial institutions and the valuation of
(Goldman Sachs and Morgan Stanley).[169] mortgage-backed securities.[173] The SEC is investigating
While the nominal 8% capital requirements (i.e., 12.5 these claims.[174]
to 1 leverage ratio) had not been changed by the reg-
ulatory authorities, risk-based weighing allowed capital
requirements to be reduced for A rated securities and 10 Regulation of derivatives
higher. This change, still more stringent than the in-
ternational Basel accords, was motivated by the goal
The Commodity Futures Modernization Act of 2000 ex-
of keeping American banks competitive with European
empted derivatives from regulation, supervision, trading
banks. The reduced capital requirements encouraged
on established exchanges, and capital reserve require-
banks to hold the less risky A rated securities (accord-
ments for major participants. Concerns that counter-
ing to rating agency standards) rather than the more
parties to derivative deals would be unable to pay their
risky higher-leveraged (i.e. embedded leverage) first-
obligations caused pervasive uncertainty during the cri-
loss tranches. The reduction in capital reserves (and in-
sis. Particularly relevant to the crisis are credit default
creased explicit leveraged) was accompanied by the re-
swaps (CDS), a derivative in which Party A pays Party
duction of risky lower rated securities that had higher in-
[171] B what is essentially an insurance premium, in exchange
ternal leverage.
for payment should Party C default on its obligations.
At least one prominent official within the SEC has re- Warren Buffett famously referred to derivatives as “finan-
jected the notion that the 2004 SEC changes caused the cial weapons of mass destruction” in early 2003.[175][176]
banks to reduce their capital reserves. In an April 9, 2009
Like all swaps and other derivatives, CDS may either
speech, Erik Sirri, then Director of the SEC’s Division of
be used to hedge risks (specifically, to insure creditors
Trading and Markets, stated "[t]he Commission did not
against default) or to profit from speculation. Derivatives
undo any leverage restrictions in 2004,” nor did it intend
[170] usage grew dramatically in the years preceding the crisis.
to make a substantial reduction. Although the SEC
The volume of CDS outstanding increased 100-fold from
rule changes provided flexibility that could be used by
1998 to 2008, with estimates of the debt covered by CDS
banks to minimize their capital balances, Sirri explained
contracts, as of November 2008, ranging from US$33
that this was not applicable in the case of the 5 banks
to $47 trillion. Total over-the-counter (OTC) deriva-
in the Consolidated Supervised Entity (CSE) program.
tive notional value rose to $683 trillion by June 2008, of
Those 5 entities used an alternative standard, and had
which about 8% were CDS.[177]
done so for decades. Specifically, they calculated capi-
tal requirements as a percentage of customer receivables CDS are lightly regulated. As of 2008, there was no cen-
(and not on the basis of the investments they held). Under tral clearing house to honor CDS in the event a party to
the standard in use, the emphasis was on their ability to a CDS proved unable to perform his obligations under
meet customer-related obligations - not on overall bank the CDS contract. Required disclosure of CDS-related
financial stability.”[170] obligations has been criticized as inadequate. Insurance
companies such as American International Group (AIG),
Some argue that leverage ratios did not change as dramat-
MBIA, and Ambac faced ratings downgrades because
ically as claimed by critics.[170] Consider, for example,
widespread mortgage defaults increased their potential
this statement made by the Government Accountability
exposure to CDS losses. These firms had to obtain addi-
Office (GAO): “In our prior work on Long-Term Capi-
tional funds (capital) to offset this exposure. AIG’s hav-
tal Management (a hedge fund), we analyzed the assets-
ing CDSs insuring $440 billion of MBS resulted in its
to-equity ratios of four of the five broker-dealer holding
seeking and obtaining a Federal government bailout.[178]
companies that later became CSEs and found that three
Like all swaps and other pure wagers, what one party
17

loses under a CDS, the other party gains; CDSs merely 11 Regulation of credit rating
reallocate existing wealth [that is, provided that the pay-
ing party can perform]. Hence the question is which
agencies
side of the CDS will have to pay and will it be able to
do so. When investment bank Lehman Brothers went Further information: Credit rating agencies and the
bankrupt in September 2008, there was much uncer- subprime crisis
tainty as to which financial firms would be required to
honor the CDS contracts on its $600 billion of bonds Rating agencies such as Moody’s and Standard and Poor’s
outstanding.[179][180] provide risk ratings for securities such as bonds and
Economist Joseph Stiglitz summarized how credit default the mortgage-backed securities at the heart of the cri-
swaps contributed to the systemic meltdown: “With this sis. They are paid by the company issuing the bonds,
complicated intertwining of bets of great magnitude, no which presents an independence issue. The rating agen-
one could be sure of the financial position of anyone else- cies grossly erred in their assessment of risky mortgage-
or even of one’s own position. Not surprisingly, the credit backed securities, providing the highest safety rating to
markets froze.”[181] securities that later became worthless.
Former President Bill Clinton and former Federal Re- The Financial Crisis Inquiry Commission reported in Jan-
serve Chairman Alan Greenspan indicated they did not uary 2011 that: “The three credit rating agencies were
properly regulate derivatives, including credit default key enablers of the financial meltdown. The mortgage-
swaps (CDS).[182][183] A bill (the “Derivatives Markets related securities at the heart of the crisis could not have
Transparency and Accountability Act of 2009”) (H.R. been marketed and sold without their seal of approval.
977) was unsuccessfully introduced[184] to further regu- Investors relied on them, often blindly. In some cases,
late the CDS market and establish a clearinghouse. This they were obligated to use them, or regulatory capi-
bill would provide the authority to suspend CDS trading tal standards were hinged on them. This crisis could
under certain conditions.[185] not have happened without the rating agencies. Their
ratings helped the market soar and their downgrades
Author Michael Lewis wrote that CDS and synthetic through 2007 and 2008 wreaked havoc across markets
CDO derivatives enabled speculators to stack bets on the and firms.”[1]
same mortgage bonds and CDO’s. This is analogous
to allowing many persons to buy insurance on the same
house. Speculators that bought CDS insurance were bet-
ting that significant defaults would occur, while the sell-
12 Other topics
ers (such as AIG) bet they would not. A theoretically
infinite amount could be wagered on the same housing- 12.1 Federal regulatory influence of states
related securities, provided buyers and sellers of the CDS
could be found.[186] He referred to this as a “Doomsday Some have argued that, despite attempts by various U.S.
Machine.”[187] states to prevent the growth of a secondary market in
repackaged predatory loans, the Treasury Department’s
NY Insurance Superintendent Eric Dinallo argued in
Office of the Comptroller of the Currency, at the insis-
April 2009 for the regulation of CDS and capital require-
tence of national banks, struck down such attempts as vi-
ments sufficient to support financial commitments made
olations of Federal banking laws.[190]
by institutions. “Credit default swaps are the rocket fuel
that turned the subprime mortgage fire into a conflagra-
tion. They were the major cause of AIG’s – and by exten- 12.2 Conservative criticism before
sion the banks’ – problems...In sum, if you offer a guar-
Congress
antee – no matter whether you call it a banking deposit,
an insurance policy, or a bet – regulation should ensure
During March 1995 congressional hearings William A.
you have the capital to deliver.” He also wrote that banks
Niskanen, chair of the Cato Institute, criticized the pro-
bought CDS to enable them to reduce the amount of capi-
posals for political favoritism in allocating credit and mi-
tal they were required to hold against investments, thereby
cromanagement by regulators, and that there was no as-
avoiding capital regulations.[188] U.S. Treasury Secretary
surance that banks would not be expected to operate at a
Timothy Geithner has proposed a framework for legisla-
loss. He predicted they would be very costly to the econ-
tion to regulate derivatives.[189]
omy and banking system, and that the primary long-term
effect would be to contract the banking system. He rec-
ommended Congress repeal CRA.[191]
Gerald P. O'Driscoll, former vice president at the Federal
Reserve Bank of Dallas, stated that Fannie Mae and Fred-
die Mac had become classic examples of crony capital-
ism. Government backing let Fannie and Freddie dom-
18 12 OTHER TOPICS

inate the mortgage underwriting. “The politicians cre- These programs generally worked as follows: “Let’s say
ated the mortgage giants, which then returned some of someone wanted to buy a $100,000 house but didn't have
the profits to the pols - sometimes directly, as cam- the required down payment and closing costs, which we
paign funds; sometimes as “contributions” to favored will say totaled $6,000. A nonprofit 'affordable hous-
constituents.”[192] ing' organization would provide the required $6000 to
Some lawmakers received favorable treatment from fi- the homebuyer as a 'gift' and, simultaneously, collect the
nancial institutions involved in the subprime industry. same amount — plus a tidy fee (usually 1% or a flat
(See Countrywide financial political loan scandal). In fee) — from the seller. The amount collected from the
seller was called a 'donation' but, in reality, it was sim-
June 2008 Conde Nast Portfolio reported that numer-
ous Washington, DC politicians over recent years had ply money laundering, conducted by pious organizations
that talked about the poor and needy while raking in mil-
received mortgage financing at noncompetitive rates at
Countrywide Financial because the corporation consid- lions in revenues.[199] Although HUD’s Inspector Gen-
eral urged, in 2000, that seller-funded gift programs be
ered the officeholders under a program called “FOA’s”—
"Friends of Angelo”. Angelo being Countrywide’s Chief banned, HUD resisted until 2008, well after the begin-
ning of the subprime mortgage crisis.[200] Seller-funded
Executive Angelo Mozilo.[193] On 18 June 2008, a Con-
gressional ethics panel started examining allegations that down payments were finally banned by an act of Congress
chairman of the Senate Banking Committee, Christopher in 2008.
Dodd (D-CT), and the chairman of the Senate Budget
Committee, Kent Conrad (D-ND) received preferential
loans by troubled mortgage lender Countrywide Finan- 12.4 Importance of home equity extraction
cial Corp.[194] Two former CEOs of Fannie Mae Franklin to economic growth
Raines and James A. Johnson also received preferential
loans from the troubled mortgage lender. Fannie Mae was A significant driver of economic growth during the Bush
the biggest buyer of Countrywide’s mortgages.[195] administration was home equity extraction, in essence
On September 10, 2003, U.S. Congressman Ron Paul borrowing against the value of the home to finance per-
gave a speech to Congress in which he argued that the sonal consumption. Free cash used by consumers from
then-current government policies encouraged lending to equity extraction doubled from $627 billion in 2001 to
people who couldn't afford to pay the money back, and $1,428 billion in 2005 as the housing bubble built, a
he predicted that this would lead to a bailout, and he in- total of nearly $5 trillion dollars over the period. Us-
troduced a bill to abolish these policies.[196] ing the home as a source of funds also reduced the
net savings rate significantly.[201][202][203] By comparison,
GDP grew by approximately $2.3 trillion during the same
12.3 State and local governmental pro- 2001–2005 period in current dollars, from $10.1 to $12.4
trillion.[204]
grams
Economist Paul Krugman wrote in 2009: “The prosperity
As part of the 1995 National Homeownership Strategy, of a few years ago, such as it was — profits were terrific,
HUD advocated greater involvement of state and local or- wages not so much — depended on a huge bubble in hous-
ganizations in the promotion of affordable housing.[197] ing, which replaced an earlier huge bubble in stocks. And
In addition, it promoted the use of low or no-down pay- since the housing bubble isn't coming back, the spending
ment loans and second, unsecured loans to the borrower that sustained the economy in the pre-crisis years isn't
to pay their down payments (if any) and closing costs.[141] coming back either.”[205] Niall Ferguson stated that ex-
This idea manifested itself in “silent second” loans that cluding the effect of home equity extraction, the U.S.
became popular in several states such as California, and in economy grew at a 1% rate during the Bush years.[206]
scores of cities such as San Francisco.[142] Using federal Since GDP growth is a significant indicator of the success
funds and their own funds, these states and cities offered of economic policy, the government had a vested interest
borrowers loans that would defray the cost of the down in not fully explaining the role of home equity extraction
payment. The loans were called “silent” because the pri- (borrowing) in driving the GDP measure pre-crisis.
mary lender was not supposed to know about them. A
Neighborhood Reinvestment Corporation (affiliated with
HUD) publicity sheet explicitly described the desired se- 12.5 Moral hazard from other bailouts
crecy: "[The NRC affiliates] hold the second mortgages.
Instead of going to the family, the monthly voucher is paid Further information: Moral hazard
to [the NRC affiliates]. In this way the voucher is “invis-
ible” to the traditional lender and the family (emphasisA taxpayer-funded government bailout of financial in-
added).[198] stitutions during the savings and loan crisis may have
In addition to the use of “silent seconds” HUD condoned created a moral hazard and acted as encouragement to
and promoted the use of down payment gifting programs. lenders to make similar higher risk loans.[207][208]
19

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25

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