Wednesday, March 18, 2009

What Went Wrong

What Went Wrong

My father used to keep old newspapers (truly enormous numbers of them) because he said that, "Newspapers are the first draft of history." It's true. Regular readers of my blog have seen a number of items over the last year or so about the economic disaster that we are now suffering. I had occasion to write up a summary of the disaster for a relative.

Think of this as the second draft of history.

What caused the economic disaster that we are now facing? While there are a number of factors, the core of the disaster was the expansion of the subprime mortgage market. Lenders, left to their own devices, tend not to make highly risky loans. These highly risky loans are called subprime mortgages (because the borrowers are below what the lender considers optimum credit rating). These loans are to people with poor or no credit history, or who cannot document their earnings (you know, like with paycheck stubs or statements from their business's accountant).

In 1977, something called the Community Reinvestment Act was passed by Congress to deal with the claim of "redlining"--that lenders were reluctant to lend money in minority neighborhoods. It wasn't that the lenders were racists; they looked at the value of homes in the poorest neighborhoods and were reluctant to take risks. The CRA, however, had little in the way of teeth.

In 1992, the Federal Reserve Bank of Boston released a study that claimed that there was lending discrimination against blacks going on
, because they compared lending rates for whites and blacks with equivalent incomes, and found that blacks were less likely to get loans. But other economists have since pointed out that whites and blacks with equivalent incomes have very different net worths. Whites with the same income tend to have much higher net worth than blacks at that level.

Throughout the 1990s, ACORN pressured banks throughout the Chicago area to get more lending to subprime borrowers. As Stanley Kurtz's October 7, 2008 National Review Online article explains:
Critics of the notion that CRA had a major impact on the subprime crisis ask how a law passed in 1977 could have caused a crisis in 2008? The answer has a lot to do with ACORN — and the critical years of 1990-1995. While the 1977 Community Reinvestment Act did call on banks to increase lending in poor and minority neighborhoods, its exact requirements were vague, and therefore open to a good deal of regulatory interpretation. Banks merger or expansion plans were rarely held up under CRA until the late 1980s, when ACORN perfected its technique of filing CRA complaints in tandem with the sort of intimidation tactics perfected by that original “community organizer” (and Obama idol), Saul Alinsky.

At first, ACORN’s anti-bank actions were relatively few in number. However, under a provision of the 1989 savings and loan bailout pushed by liberal Democratic legislators, like Massachusetts Congressman Joseph P. Kennedy, lenders were required to compile public records of mortgage applicants by race, gender, and income. Although the statistics produced by these studies were presented in highly misleading ways, groups like ACORN were able to use them to embarrass banks into lowering credit standards. At the same time, a wave of banking mergers in the early 1990's provided an opening for ACORN to use CRA to force lending changes. Any merger could be blocked under CRA, and once ACORN began systematically filing protests over minority lending, a formerly toothless set of regulations began to bite.

ACORN’s efforts to undermine credit standards in the late 1980s taught it a valuable lesson. However much pressure ACORN put on banks to lower credit standards, tough requirements in the “secondary market” run by Fannie Mae and Freddie Mac served as a barrier to change. Fannie Mae and Freddie Mac buy up mortgages en masse, bundle them, and sell them to investors on the world market. Back then, Fannie and Freddie refused to buy loans that failed to meet high credit standards. If, for example, a local bank buckled to ACORN pressure and agreed to offer poor or minority applicants a 5-percent down-payment rate, instead of the normal 10-20 percent, Fannie and Freddie would refuse to buy up those mortgages. That would leave all the risk of these shaky loans with the local bank. So again and again, local banks would tell ACORN that, because of standards imposed by Fannie and Freddie, they could lower their credit standards by only a little.
The Clinton Administration's efforts to expand lending to blacks and Hispanics, while well intentioned, required more subprime mortgage lending. The most effective way to do this was to change Fannie Mae and Freddie Mac's underwriting rules. This September 22, 2008 Investor's Business Daily editorial explains:
It all started, innocently enough, in 1994 with President Clinton's rewrite of the Carter-era Community Reinvestment Act.

Ostensibly intended to help deserving minority families afford homes — a noble idea — it instead led to a reckless surge in mortgage lending that has pushed our financial system to the brink of chaos.

With all the old rules out the window, Fannie and Freddie gobbled up the market. Using extraordinary leverage, they eventually controlled 90% of the secondary market mortgages. Their total portfolio of loans topped $5.4 trillion — half of all U.S. mortgage lending. They borrowed $1.5 trillion from U.S. capital markets with — wink, wink — an "implicit" government guarantee of the debts.
These two GSEs (government sponsored enterprises), because they buy a big chunk of privately originated mortgages, are in a position to substantially change the risk equation. If Bank of America knows that a $720,000 mortgage to a guy making $14,000 a year is so risky that Fannie Mae isn't going to buy this mortgage, then they have to carry the risk on this paper--and they won't do very many such mortgages. If they know that Fannie Mae likely will buy it, why not? They make some money on the loan origination, they earn interest as long as they carry the paper--and then they can sell it to Fannie Mae. And the change in underwriting rules did change the equation--dramatically.

There were warnings at the time. This September 30, 1999 New York Times article about the Clinton Administration's leaning on Fannie Mae tells us what happened, and included a very prescient warning:
In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.


''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''
So now, all sorts of people were able to get mortgages that could not do so before. Some estimates are that five million illegal aliens obtained mortgages. This January 12, 2006 KSFN-TV report discusses how illegal aliens were now getting mortgages--and lenders were jumping at the chance. And how likely is that you will make your payments if you get arrested and deported--or even just the economy slows down, and your job disappears? Even lawful residents can get hit by this, but an illegal alien is even more likely to flake out on a  mortgage under those conditions.

What happens when you dramatically expand the number of people buying homes? It drives up prices. What happens prices of houses start rising? Why, people start speculating--and not millionaires who can afford to make six mortgages while a house sits vacant, but people who were told that they could buy a house, wait three months, and resell it for $40,000 more. Some did, at the start of this tulip bulb mania. And those at the end discovered what happens when the boom slows even a little--you end up a with a house you paid too much for, and that you can't sell for what you paid, and you can't rent it for enough to cover the mortgage.

The separation of loan origination from long-term loan servicing created an incentive to make a lot of loans--then sell them to someone else while the potato was still hot. Golden West S&L, for example, was sold by Herbert and Marion Sandler to Wachovia for $24.2 billion just as the bubble was hitting its peak. (The details are in this May 9, 2006 San Francisco Chronicle article.) They then took their $2.4 billion that they personal received, and used it to fund Democratic activities.

There were some other things going on here as well. Back about 2000, a clever Chinese grad student named David X. Li came up with a brilliant equation for calculating the risk relationship between a group of mortgages. You see, when mortgages get bought and sold on Wall Street, they don't buy and sell one mortgage. They bundle up a bunch of them in order to spread the risk around. What you end up with are called collateralized mortgage obligations (CMOs). This clever equation provided this wonderful method of figuring out the risk that if one of the mortgages failed to perform, what was the risk of others failing? Beautiful formula--based on a limited set of data. So naturally, everyone in the CMO business started using this formula as a way of making the risk acceptable. You can read a lot more about it in the February 23, 2009 Wired.

But that limited set of data didn't include any housing market downturns. Whoops! Guess what happened when the housing market started to cool off? The equation didn't work, especially if many of the houses that those involved were in the same overheated--now supercooled--housing market (such as Los Angeles, Atlanta, or DC). And a lot of those CMOs were suddenly worth a fraction of what some idiot paid for them.

There's plenty of mistakes that were made here, but the core problem was the rapid expansion of the subprime housing mortgage market. And that's got a straightforward cause: the desire to make housing available to people with lousy or non-existent credit histories. After foreclosure, those people have much worse credit histories.

We're all on the hook now. The bad news, we were warned. As I mentioned, that first warning was the September 30, 1999 New York Times article. Second warning: September 11, 2003, again in the New York Times, detailing how Freddie Mac and Fannie Mae had manipulated accounting and taken risks. Treasury Secretary Snow said that more supervision was necessary. And who argued against? Reps. Barney Frank (D-MA) and Melvin L. Watt (D-NC). Republicans were for regulation and Democrats were against. Surprised?

Third warning: a November 11, 2003 Wall Street Journal editorial about the housing finance market. White House chief economist N. Gregory Mankiw argued for stronger regulation of Fannie Mae, because of the risks to taxpayers. And who argued against? “Congressman Barney Frank criticized Mr. Mankiw because he is worried about the tiny little matter of safety and soundness rather than ‘concern about housing.’ But as Mr. Mankiw pointed out, most of the federal subsidy for the companies goes to enrich private investors and executives, not poor home-owners.”

The following sentence from that 2003 editorial is especially prescient: “One weakness of democracy is that it tends to ignore problems before they erupt into crises. The risk portfolios of Fannie Mae and Freddie Mac are a classic example.”

We must understand what went wrong so that we don’t repeat those mistakes. It was not Republican laissez faire that caused this. A Democratic President imposed regulation that ballooned the subprime mortgage market in the interests of making housing affordable. When Bush Administration officials said that more supervision was needed because of the risk, the most liberal Democrats in Congress defended the status quo.

Senator McCain (R-AZ) sponsored corrective legislation in 2005 and 2007—which went nowhere. A bipartisan group of Congressmen, mostly Democrats but with just enough Republicans to prevent a Republican-controlled Congress from passing it, blocked the bill when the alarm bells were ringing, but before the fire was out of control.

We were warned. And those who foolishly defended these policies now control Congress and the White House.