Tuesday, July 26, 2011

How the Gov't. Promoted A Systematic Loosening of Underwriting Standards and Caused the Crisis

In a new article by AEI Resident Fellow Ed Pinto (former executive vice president and chief credit officer for Fannie Mae), he reviews how government policies promoted a systematic loosening of underwriting standards in an effort to promote affordable housing, which then contributed to the housing bubble, mortgage meltdown and financial crisis. Here are six facts about the government's role in the crisis:

1. "In the late-1980s and early-1990s ACORN and other community groups claimed that Fannie and Freddie were standing in the way of their efforts to replace traditional underwriting with flexible underwriting. They lobbied Congress to force the Government Sponsored Enterprises (GSEs) to abandon their traditional underwriting standards. The goal was to force the GSEs to replace their conservative underwriting standards with flexible ones, knowing that this would spur the rest of the market to do the same.

2. These community groups were successful in convincing Congress to impose affordable housing (AH) mandates on Fannie and Freddie. This set in motion 14 years of ever looser loan standards.

3. Fannie embraced AH mandates in order to buy the political protection it would use to defeat any unwelcome changes to its lucrative charter benefits. To this purpose, it vows to “transform” the housing finance system. The strategy worked–Fannie was politically unassailable until 2008.

4. The government implements the National Homeownership Strategy with the goal of replacing traditional underwriting with flexible standards.

5. Dissenting voices (AEI's Peter Wallison among them) predicted that these efforts to transform housing finance would end in disaster.

6. As flexible lending expands, the volume and risk characteristics of so-called prime loans increases markedly, yet these loans were still called prime. For example, loans with no downpayment acquired by Fannie are called prime merely because Fannie is now willing to acquire them. The same logic applies to loans with impaired credit. HUD acknowledges this in a 2000 rule making.

7. The United States, alone among developed countries, turned its prudential regulation of underwriting standards over to a social welfare agency, namely HUD. In 2004, HUD extols its “revolution in affordable lending.”

8. The National Homeownership Strategy resulted in the substantial elimination of downpayments.  The proportion of loans with down payments of 3 percent or less steadily increased from 0.5 percent of home purchases in 1990 to 40 percent by 2007 (see graph above).  (MP: The bottom graph above shows how the increase in no- and low-downpayment mortgages was associated with an increase in the homeownership rate between 1995-2005.)

Conclusion: The major cause of the financial crisis in the United States was the collapse of housing and mortgage markets resulting from an accumulation of an unprecedented number of weak and risky Non-Traditional Mortgages (NTMs). These NTMs began to default en masse beginning in 2006, triggering the collapse of the worldwide market for mortgage-backed securities and in turn triggering the instability and insolvency of financial institutions that we call the financial crisis. Government policies forced a systematic industry-wide loosening of underwriting standards in an effort to promote affordable housing, compounded by moral hazard spread by Fannie and Freddie."

17 Comments:

At 7/27/2011 8:08 AM, Blogger Paul said...

1. "In the late-1980s and early-1990s ACORN and other community groups claimed that Fannie and Freddie were standing in the way of their efforts to replace traditional underwriting with flexible underwriting.."

They did this with the help of community organizer and lawyer Barack Obama who sued Citibank on behalf of Acorn to force the bank to make loans to people who couldn't pay them back. To my knowledge, no reporter has ever asked him about this.

 
At 7/27/2011 8:37 AM, Blogger Jon said...

Paul Krugman is touting this rebuttal to the Wallison/Pinto argument. Worth a read.

 
At 7/27/2011 9:30 AM, Blogger morganovich said...

this seems like common sense 101 to me.

take the the marginal 5% of americans who could not get/afford a mortgage before and give them new ones with looser underwriting standards with 300%+ as much leverage and any fool could see you are playing with fire.

a 3% mortgage is 33:1 leverage. that's a stunning amount. not only will the sudden availability of such leverage almost always cause a bubble, but it will wreck people when it bursts.

 
At 7/27/2011 10:28 AM, Blogger Jon said...

The argument does make sense. The question is, are the facts consistent with the free market theory?

According to David Min the answer is no. In fact Freddie and Fannie had lower rates of default than the private sector. The AEI is forced to erroneously classify mortgages as sub prime in order to make Freddie and Fannie look bad.

Wallison is forced to write a lonely dissent from the Financial Crisis Inquiry Commission because it does not come to the approved, corporate backed AEI preferred conclusions.

 
At 7/27/2011 11:14 AM, Blogger Benjamin said...

And that is how those urban darkies torpedoed the global financial system, according to AEI.

As hardcore right-wing authors Redleaf and Vigilante point out in their book "Panic,", there aren't enough poor people in the USA to collapse global capital markets.

The key words in the AEI "study" are these: "The goal was to force the GSEs to replace their conservative underwriting standards with flexible ones, knowing that this would spur the rest of the market to do the same."

Oh? You mean private-sector lenders reduced their underwriting standards just because the GSE's did? And that makes it ACORN's fault? Is that what free markets are about? They copy government models?

This "study" is weaker than Prohibition-era beer gone flat.

 
At 7/27/2011 11:23 AM, Blogger cruiser said...

It's interesting that they decoupled in 2004. I wonder what caused that.

 
At 7/27/2011 11:25 AM, Blogger Larry G said...

so... if we took away govt involvement in mortgages including the mortgage deduction and let the free market be "free"... we'd not have these problems?

the Acorn blather is GRADE A right-wing propaganda - the vast, vast majority of failed mortgages were in "hot" housing markets with heavy speculation on fast accelerating prices.

A very low percent of the failed mortgages were in formerly 'red-lined" areas. The vast majority were in lily white suburbs and condos.

so.. it's the govt's fault for letting these mortgage companies issue "no doc" loans on speculative housing?

ha ha ha...

I LOVE the way these things get SPUN.

 
At 7/27/2011 11:39 AM, Blogger Che is dead said...

"The AEI is forced to erroneously classify mortgages as sub prime in order to make Freddie and Fannie look bad."

Given the performance of Alt-A loans, Pinto's arguments about loan categorization have proven out. Pinto looked at a loan's underlying characteristics in order to determine it's real risk and argued that many loans which were not categorized as subprime were in fact high risk loans with subprime characteristics:

The catch-all Alt-A category includes many of the innovative products that helped fuel the housing boom, such as mortgages that carry little, if any, documentation of income or assets, and so-called option adjustable-rate mortgages, which give borrowers multiple payment choices but can lead to a rising loan balance. Loans taken by investors buying homes they don't plan to occupy themselves can also fall into the Alt-A category ... Data from UBS AG show that the default rate for Alt-A mortgages has doubled in the past 14 months. "The credit deterioration has been almost parallel to what's been happening in the subprime market," says UBS mortgage analyst David Liu.

WSJ

Even those who are purported to be financial experts still miss the bigger picture. That is, they fail to understand that the category of Alt-A loans covers the vast majority of option ARMs and Alt-A is basically a category assigned to loans that were no-doc or low doc, had weaker credit scores, and low to zero down payment. In other words, mortgages that make Medusa look like the next Miss USA.

DoctorHousingBubble

"Wallison is forced to write a lonely dissent ... because it does not come to the approved, corporate backed AEI preferred conclusions."

David Min is a leftist hack who works for the Center for American Progress, a "progressive" think tank. When you cannot even get a New York Times reporter to defend the financial cancer that is the GSE's, regardless of their importance to the Democrat Party political machine, you know the rot is deep.

 
At 7/27/2011 11:41 AM, Blogger Che is dead said...

"You mean private-sector lenders reduced their underwriting standards just because the GSE's did? And that makes it ACORN's fault? Is that what free markets are about? They copy government models?"

They were required to lower them by law. Douche bag.

 
At 7/27/2011 11:43 AM, Blogger morganovich said...

"Oh? You mean private-sector lenders reduced their underwriting standards just because the GSE's did? "

bunny-

you are just racking up the stupid this week. private lenders sell the loans on to freddy and fannie or get guarantees from them.

if you know they will buy it, you originate it and sell to them. so yes, that's exactly what caused it.

the private guys knew they could just sell them on.

if some idiot walked into mcdonalds and said "i'll pay $5 for every burger you can make no matter how crappy it tastes" you'd get a ton of really bad burgers made. that would be the fault of the idiot, not mcdonalds.

what freddy and fannie did was even worse, they ASKED for bad burgers. the feds REQUIRED bad burgers (through CRA).

is it any shock we got such crap?

 
At 7/27/2011 11:54 AM, Blogger Che is dead said...

People inside the mortgage and investment world have two different perspectives on Fannie and Freddie’s role. The first view is that Fannie and Freddie were followers, not leaders. They put up with the affordable-housing mandates because they were already involved in loans to low-income borrowers. They loosened credit standards between 1998 and 2003 to keep market share. They got involved in Alt-A and subprime loans in 2005 and 2006 for the same reason. They were just victims of the crisis.

The second view is best summarized by a hedge fund manager who told me that Fannie and Freddie “made their own weather.” Fannie and Freddie were such a large part of the market’s liquidity that they were the underlying cause of what went wrong. They created the originate-and-sell market. They steered the mortgage-lending business with the dominance of their automated underwriting systems. Encouraged by the U.S. Department of Housing and Urban Development (HUD), they poured hundreds of billions of dollars into home purchases made by borrowers with low incomes. And ultimately, through their purchases of subprime securities (purchases they used to help satisfy their HUD affordable housing goals), they helped create the market for subprime ...

Fannie and Freddie .... played a significant part in the expansion of mortgage credit to low-income borrowers, an expansion that presumably pushed up housing prices in low-income neighborhoods, making subprime securitization more attractive ...

After 2003, Fannie and Freddie didn’t exactly stand on the sidelines. They didn’t fade away or pull back sharply. Between 2004 and 2006, they still purchased almost a million home loans each year made to borrowers with incomes below the median. They still purchased 268,000 loans with less than 5 percent down in 2004, almost 400,000 such loans in 2006, and over 600,000 such loans in 2007. They purchased hundreds of billions of subprime mortgage-backed securities and were a significant part of the demand for those securities.

[...]

Fannie and Freddie bought 25.2% of the record $272.81 billion in subprime MBS [mortgage-backed securities] sold in the first half of 2006, according to Inside Mortgage Finance Publications, a Bethesda, MD-based publisher that covers the home loan industry.

In 2005, Fannie and Freddie purchased 35.3% of all subprime MBS, the publication estimated. The year before, the two purchased almost 44% of all subprime MBS sold.

-- Russell Roberts is the J. Fish and Lillian F. Smith Distinguished Scholar at the Mercatus Center and a professor of Economics at George Mason University.

Gambling with Other People's Money"

 
At 7/27/2011 12:12 PM, Blogger Che is dead said...

"Fannie Mae co-opted relevant activist groups, handing out money to Acorn, the Congressional Black Caucus, the Congressional Hispanic Caucus and other groups that it might need on its side ..."

"Fannie lavished campaign contributions on members of Congress. Time and again experts would go before some Congressional committee to warn that Fannie was lowering borrowing standards and posing an enormous risk to taxpayers. Phalanxes of congressmen would be mobilized to bludgeon the experts and kill unfriendly legislation."

-- “Reckless Endangerment”

In "Reckless Endangerment," Morgenson and Rosner offer considerable censure for reckless bankers, lax rating agencies, captured regulators and unscrupulous businessmen. But the greatest responsibility for the collapse of the housing market and the near "Armageddon" of the American economy belongs to Fannie Mae and Freddie Mac and to the politicians who created and protected them. With a couple of prominent exceptions, the politicians were Democrats claiming to do good for the poor. Along the way, they enriched themselves and their friends, stuffed their campaign coffers, and resisted all attempts to enforce market discipline. When the inevitable collapse arrived, the entire economy suffered, but no one more than the poor.

Jim Johnson, adviser to Walter Mondale and John Kerry, amassed a personal fortune estimated at $100 million during his nine years as CEO of Fannie Mae. "Under Johnson," Morgenson and Rosner write, "Fannie Mae led the way in encouraging loose lending practices among the banks whose loans the company bought. A Pied Piper of the financial sector, Johnson led both the private and public sectors down a path that led directly to the credit crisis of 2008."

Fannie Mae lied about its profits, intimidated adversaries, bought off members of Congress with lavish contributions, hired (and thereby co-opted) academics, purchased political ads (through its foundation) and stacked congressional hearings with friendly bankers, community activists and advocacy groups (including ACORN). Fannie Mae also hired the friends and relations of key members of Congress (including Rep. Barney Frank's partner).

"How the Democrats Nearly Destroyed the Economy"

 
At 7/27/2011 12:31 PM, Blogger juandos said...

'marginal' Min (and Krugman for that matter) needs a little tutoring by Veronique de Rugy...

 
At 7/27/2011 3:03 PM, Blogger Ron H. said...

"so.. it's the govt's fault for letting these mortgage companies issue "no doc" loans on speculative housing?"

As always, you fail to understand incentives.

There are a number of factors that contributed to the financial crisis, and loosened lending standards is only one of them.

In addition, your obsession with categorizing things into convenient, homogenous boxes like 'republican' or 'right wing', a term you don't appear to understand by the way, interferes with your already limited ability to understand what you read.

For anyone who might be interested in an excellent treatment of the entire subject, not including Larry who I know can't be bothered to read, I highly recommend Meltdown by Thomas E. Woods Jr.

 
At 7/27/2011 3:16 PM, Blogger Ron H. said...

Che is dead

Thanks for the excellent links. Much appreciated.

 
At 7/27/2011 3:42 PM, Blogger juandos said...

"A very low percent of the failed mortgages were in formerly 'red-lined" areas. The vast majority were in lily white suburbs and condos"...

Hey Larry G, what are you consuming and in what quantities to come up with these rather bizzare statements?

 
At 7/27/2011 7:59 PM, Blogger Larry G said...

"They were required to lower them by law."

not true. They were required to show they did not turn down qualified borrows by "redlining".

The facts are that the vast majority of failed mortgages were NOT in redlined areas...

 

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