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Wednesday, January 4, 2012

Blowing Bubbles: Getting Ready for the Next Bust

Imagine you are a private in the army. Your sergeant orders you to dig a hole. When you finish, the sergeant is horrified to find that you have dug a hole. He dresses you down and then orders you to dig another hole. Insane? Welcome to today’s world of American banking.

Over the course of several decades politicians—both Democrat and Republican—encouraged banks and mortgage companies to ease lending standards in hopes of making housing more affordable for the poor. They also urged the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae (the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association) to purchase the resulting low-quality loans from lending institutions. This freed up money, enabling banks to make more loans than would have otherwise been possible. These actions, along with low short-term interest rates set by the Federal Reserve and tax advantages for home buyers, sparked a housing boom. Home prices soared and investors flocked to purchase mortgage-backed derivatives. Speculation became rampant, and houses were bought simply to resell, or “flip,” when prices rose.

Eventually, the bubble burst. Housing prices collapsed and thousands of home buyers defaulted on their mortgages, sending derivative prices into a death spiral and sparking a Wall Street sell-off. The rest is history: a history that the government is apparently anxious to repeat. The Fed is still pushing its easy-money policies with a vengeance, down-payment subsidies for low-income home buyers are still available for the taking, and lenders are still being pressured to ease standards for minorities and for low-income home buyers. The thinking appears to be that if housing prices can be driven back up to their pre-bust levels, everything will be fine. Homeowners who are currently “underwater” (meaning they owe more on their homes than the homes are now worth) and all those banking and investment houses that saw the value of their mortgage-based securities plummet will supposedly be back in the black.

There is only one problem with this scenario: The pre-bust price levels are not sustainable. We have the bust to prove it.

In the midst of the attempt to reinflate the bubble, politicians, needing to deflect blame for the collapse, have settled on Wall Street and the mortgage lenders as the most plausible villains. (Which is not to say they are blameless; the State-banking partnership is as old as the republic.) Last September the Federal Housing Finance Agency, which oversees Fannie and Freddie, announced it was suing the nation’s 17 largest banks—some of which the government had recently bailed out—for selling risky mortgages to the two GSEs. Yet just two months before, the Department of Justice “requested” that a number of banks lower lending standards for minorities with poor credit ratings, threatening them with discrimination charges if they failed to comply.

How did banks get into this damned-if-you-do-damned-if-you-don’t nightmare? It started in 1977 with the Community Reinvestment Act (CRA). The act requires “each appropriate Federal financial supervisory agency to use its authority when examining financial institutions, to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions.” As Thomas Sowell wrote in his book The Housing Boom and Bust, the act, though seemingly innocuous, was based on the “implicit assumption that government officials are qualified to tell lenders to whom they should lend money entrusted to them by depositors or investors.” Sowell notes that lawmakers never seriously questioned this assumption.

The CRA Gets Teeth

At first the CRA had little impact but it was given teeth by subsequent legislation. The main impetus for additional regulation came from Federal Reserve studies run in the early 1990s showing differing home loan approval rates for black and white applicants. Largely ignored were the findings by these same studies of no racial differences in default rates among approved borrowers. As Sowell explained in Economic Facts and Fallacies, had minorities been unfairly denied loans, their default rates should have been significantly lower than the rate for whites. Instead, the equal default rates indicate the various groups were being held to the same standards.

Imagine a thoroughly racist loan officer looking for the slightest excuse to deny a loan to a minority home buyer. Minor flaws that he would ignore if the applicant were white are eagerly used as justifications for rejecting a mortgage to a minority applicant. Only black and Hispanic borrowers with stellar credit ratings would have their loans approved. The few loans the officer did make to minority borrowers would have a far lower default rate than those he made to whites. The data, however, showed no such differences.

Regardless, lending institutions were subjected to a firestorm of media abuse. Under pressure from both Congress and the White House, federal regulatory agencies loosened lending rules and imposed penalties on lenders failing to meet politically dictated racial quotas.

In 1993 the Department of Housing and Urban Development (HUD) began legal actions against mortgage bankers who declined “too many” minority loan applications. HUD also pushed Freddie and Fannie to increase their purchases of low- and moderate-income (LMI) mortgages. In 1995 regulators required banks to prove they were making a mandated number of loans to LMI borrowers, directing them to use “innovative or flexible” lending practices to achieve their quotas. Still other ways were found to pressure banks into making risky loans. For example, when Congress repealed legislation prohibiting banks from affiliating with securities and insurance companies, it denied the restored freedom to banks with CRA ratings below “satisfactory.” Similarly, regulatory permission for mergers and for opening branch offices was tied to banks’ CRA community service activities, such as hiring minorities, making donations to approved nonprofit organizations, and earmarking loans for minority-owned businesses.

In 1999 the New York Times reported that Fannie Mae, under increasing pressure from the Clinton administration to buy more LMI loans, encouraged banks “to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.” Clinton’s successor, George W. Bush, contributed to the expanding bubble as well, signing the American Dream Downpayment Act in 2003, which provided, and still provides, down-payment subsidies to low-income home buyers.

The drive to make homes more affordable actually made them less so. Prices soared as hundreds of thousands of first-time home buyers flooded into the market. Still, few people buy a home outright; most take out a mortgage. As long as the monthly payments were affordable, home sales could continue apace. To drive monthly payments down, politicians and lenders only needed to get a bit more creative. With plenty of reserves thanks to the Fed’s easy-money policies, banks were more than eager to step up. No-down-payment loans became commonplace, as did adjustable rate mortgages (ARMs) and even so-called “liar loans” for which borrowers were not even required to show they could pay the money back. It did not matter because, of course, housing prices would continue rising forever. If anyone defaulted on his mortgage, the lender would just foreclose on the house and resell it for a tidy profit.

According to Peter J. Wallison and Edward J. Pinto in Forbes (Feb. 16, 2009), in late 2004:

[The chairmen of Freddie and Fannie] were telling meetings of mortgage originators that the GSEs were eager to purchase subprime and other nonprime loans.

This set off a frenzy of subprime and Alt-A [rated between subprime and prime] mortgage origination, in which—as incredible as it seems—Fannie and Freddie were competing with Wall Street and one another for low-quality loans. Even when they were not the purchasers, the GSEs were Wall Street’s biggest customers, often buying the AAA tranches of subprime and Alt-A pools that Wall Street put together. By 2007 they held $227 billion (one in six loans) in these nonprime pools, and approximately $1.6 trillion in low-quality loans altogether.

From 2005 through 2007, the GSEs purchased over $1 trillion in subprime and Alt-A loans, driving up the housing bubble and driving down mortgage quality.

Critics argue that only 6 percent of the subprime loans made to low-income home buyers were provided by CRA-covered banks. However, CRA loans contributed disproportionately to the defaults. According to Bank of America’s October 2008 quarterly report, CRA loans represented only 7 percent of its total mortgage lending, yet these loans made up 29 percent of its mortgage losses.

CRA Infection

The CRA’s largest impact, however, was that it led to an overall drop in lending standards. As Thomas E. Woods, Jr., reported in Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse, “The push for relaxed lending standards for low- and middle-income borrowers was so pervasive and systematic, persisting for a full decade, that it is no surprise that it should have spilled over into the standards for higher-income borrowers as well.” Low standards did more than just “spill over,” however. HUD pressured mortgage lenders not subject to the CRA to sign “Memoranda of Agreement” stating they would make more loans to minority and low-income borrowers. Countrywide Financial was the first lender to sign and, perhaps not coincidentally, the first lender to go bankrupt when the housing bubble burst. Once hailed as a leader, Countrywide is now reviled as a “predatory lender.”

Speculators, availing themselves of zero-down-payment loans and ARMs, purchased house after house with no intention of actually living in any of them. Instead they resold them as prices continued climbing. In the end, a number of homes were built strictly as investment vehicles. “Flipping” homes in this manner could be very lucrative—right up until the housing market crashed. Many speculators, caught between sales, defaulted on their mortgages. Because they had put little or nothing down, the losses were borne by whichever institutions held the mortgages when the music stopped—or by the taxpayers.

Many homeowners, seeing the value of their houses soar during the boom years, cashed in by refinancing their homes at the higher market values and pocketing the difference. When prices tumbled back down, they were left owing more money on their homes than they were now worth. Some, like the speculators, simply walked away.

Still, critics point out that the dollar value of CRA loans paled in comparison to the leveraged debt that Wall Street investors amassed. Imagine an upside-down pyramid of debt with the pyramid’s apex serving as its base. This apex was made up of home mortgages. Piled on this relatively small base were trillions of dollars in leveraged derivatives such as credit-default swaps (essentially insurance against bond or, in this case, loan failure) and other mortgage-based securities.

As top-heavy as this inverted pyramid was, the fact remains that it could have survived had its base been solid. Instead, its foundation was riddled with bad home loans because the government had coerced banks and other lending institutions into handing out money to people who could not afford to repay it. Further, Congress demanded that Freddie and Fannie buy hundreds of billions of dollars’ worth of these subprime loans, enabling lending institutions eagerly to make even more such loans with no incentive to vet borrowers. Investors were blinded to the risks by triple-A ratings handed out by a government-sanctioned cartel of credit rating agencies evaluating the mortgage-based securities.

Three years after the housing bust, the Federal Reserve is still following easy-credit policies. Last September it doubled down with an announced purchase of $400 billion in longer-term Treasury securities hoping to lower long-term interest rates and thereby boost spending and investment. At the same time the government is continuing to pressure banks to make risky loans and sell them to Freddie and Fannie, which were taken over by the government after they went bankrupt. (Last fall Freddie said it needed to borrow $6 billion more from the Treasury after it lost $4.4 billion in the third quarter of the year.) The new twist is that federal regulators are now suing banks for doing what the government demanded, and is still demanding, that they do. This is not too surprising given Washington’s need to pin the blame on someone, anyone, other than Washington. The politicians and regulators also need to be looking ahead, though, for the villains on whom they can blame the new and bigger bust that they currently have in the works. It is nothing short of breathtaking. But then, blowing bubbles always is.

  • Richard Fulmer is a freelance writer from Humble, Texas, and the winner of the third annual Beth A. Hoffman Memorial Prize for Economic Writing for his article "Cavemen and Middlemen," from the April 2012 Freeman