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Tuesday, July 7, 2009

Revisiting Fannie/Freddie and the CRA in the Mortgage Crisis

The Republicans have again chosen their favorite boogey men for blame in the mortgage crisis, Fannie Mae, Freddie Mac and the Community Reinvestment Act. The Republicans House Committee on Oversight and Government Reform lead by Congressman Darrell Issa has released this white paper today on all three entity's roles in the mortgage crisis. In my opinion, the Republicans have once again inflated the role of all three in the crisis.

The committee traces the roots of the crisis back to 1993 when Congress intially toughened their mandate on Fannie/Freddie to increase lending in low income neighborhoods. This caused Fannie to create quotas and it lead to loosening of standards on their loans.

This was perpetuated by the Clinton administration when HUD Secretary Henry Cisneros created the National Homeownership Strategy. The NHS directed Fannie/Freddie and other banks to create strategies to create underwriting guidelines that would lower down payment requirements, loosen standards, and in any other way make it easier for the poor to qualify for loans.

Inherently, the Committee realizes that blaming CRA for the crisis is absurd. In the report, the Committee states

Although, CRA lending increased by 250% between 1996-2008, CRA never accounted for more than 3% of total lending

Think about that. Even at its most prevalent, CRA was never more than 3% of the overall market. We are lead to believe that a program that accounted for no more than 1% of the overall market throughout the 1990's somehow had so much scope that it influenced lending on a systemic basis. Even the committee itself knows this is absurd. That's why the Committee includes the NHS in its list of deviants of the mortgage crisis. The problem is that NHS was no more in scope than CRA. The committee would have us believe that two obscure programs, two programs no one had heard of prior to 2008, created such a ripple that the entire industry was affected? Does this seem logical?

The Committee makes several leaps that would only seem reasonable to a layman. It doesn't account for significant gaps between events that they blame for the crisis and the crisis itself. Worse than that, the Committee simply mischaracterizes the nature of the mortgage market then and now.

For instance, here is one conclusion that the committee makes.

Fannie Mae and Freddie Mac were leaders in risky mortgage lending. According to an analysis presented to the Committee, between 2002 and 2007, Fannie and Freddie purchased $1.9 trillion of mortgages made to borrowers with credit scores below 660, one of the definitions of “subprime” used by federal banking regulators. This represents over 54% of all such mortgages purchased during those years. (p.24)

To say that loans below 660 are necessarily "sub prime" is just nonsense. There is absolutely no context there. I once did a loan for two borrowers both below 600. Their loan to value, however, was about 50% and their debt to income was below 30%. This loan qualified for Fannie Mae and no one would consider it sub prime. In fact, mortgage professionals would have classified "sub prime" as any loan not bought by Fannie/Freddie or FHA. The report never does say just how much of the market loans under the "NHS" program became but I doubt it was any more than CRA.

Then, the report says this.

Once government-sponsored efforts to decrease down payments spread to the wider market, home prices became increasingly untethered from any kind of demand limited by borrowers’ ability to pay. Instead, borrowers could just make smaller down payments and take on higher debt, allowing home prices to continue their unrestrained rise. Some statistics help illustrate how this occurred. Between 2001 and 2006, median home prices increased by an inflation-adjusted 50 percent, yet at the same time Americans’ income failed to keep up.

This is also a dubious claim. One of the characteristics of sub prime was always to offer borrowers the opportunity to purchase a property with little or no money down. Besides that, Fannie/Freddie didn't begin to relax their standards on no money down loans in earnest until 2004-2005-2006. Before the crisis occurred, it was very rare to find a Fannie/Freddie loan that could be done with no money down. That became a lot more prevalent once the real estate boom began.

To hear the Committee say it, Fannie/Freddie expanded their portfolio of no money down loans and this caused sub prime to do it. This flies in the face of logic. Sub prime was by nature the basket of loans that were more aggressive. They didn't need to wait for Fannie/Freddie to create more aggressive loans. Their loans were already more aggressive.

The Committee also doesn't answer the most obvious question. If the roots of all of this happened in the 1990's, why did the crisis start in earnest in 2003. Sub prime had grown since the early 1990's. Yet, it was the loans that were created starting in 2004 that turned growth into crisis. So, how exactly were events in the 1990's responsible for loan decisions in 2004?

I have long pointed out that the problem wasn't merely no money down loans. Rather, it was the layering of risks. It was no money down loans for borrowers with poor credit scores who were also not verifying their incomes. In 2002, there was no such thing as a no money down stated loan. In fact, in 2002, sub prime was careful about offering stated in only selected situations. (for self employed borrowers, commissioned borrwers, and other borrowers with uneven income) By 2006, the industry standard was a loan for a 620 credit score borrower, stating income and stating assets to a full 100% of the value of the property.

So, what causes such an explosive decrease in underwriting standards? How about an explosion in competition? In 2003, sub prime was still dominated by a select few players.

The top 25 lenders made nearly 90% of loans in 2002, nearly double their 1990 market share, according to the Harvard Joint Center for Housing Studies. Ameriquest, New Century Mortgage and National City are among industry leaders. Mainstream lenders are entering the market, but the vast majority of business is done by mortgage firms, thrifts and other entities.

Between 2003, 2007, there was an exponential growth in the number of banks and mortgage companies that provided sub prime loans. There was a financial event much closer to all of this that could much more easily explain this explosion. That was the Fed's loose money policy between 2001-2003 in which the Fed Funds Rate fell eventually below 1%. That gave banks far more access to money. The rub, if you will, of sub prime is that was always more easily vulnerable to the characteristics of a speculative market. Prime loans were for borrowers of good credit quality. There is a natural end to the underwriting levels of such borrowers. Sub prime was for borrowers of dubious credit quality. That's a universe with no end. You can always extend credit to more and more dubious borrowers. Once banks gained access to more money, they naturally gravitated to sub prime because that universe always had frontiers still unexplored.

None of this has anything to do with CRA and NHS. In reality, these two programs were rather inconsequential. (don't believe me, just look at the figures provided by the committee. neither program accounted for very much of the basket of loans) They are now being demonized for political purposes. Don't get me wrong, it's an awful idea to set quotas so that borrowers of dubious credit profiles get loans they shouldn't. That's the nature of both CRA and NHS. I just believe that reckless monetary policy has a much greater effect on our economy than some obscure misguided social engineering program.

Both Fannie and Freddie are and were terribly corrupt, and both have a lot to answer for in this crisis. I believe both added fuel to the fire. They jumped into sub prime lending after seeing how hot it was in earnest in 2005. They were both created in order to facilitate lending to borrowers of good credit. Their charter was never meant for them to speculate in markets for borrowers of dubious credit. They did this not to help expand the market. It didn't need any help. It was booming without them. They did it because everyone in the market was making tons of money and they wanted their piece. That is outrageously scandalous. People should be held responsible.

What people shouldn't do is use them, or the CRA, as boogey men to try and score political points. Both Fannie/Freddie are much more tied to Democrats than Republicans. The CRA is an example of the kind of social engineering program that Democrats love. That's why Republicans are desperate to blame all of these entities for the crisis. We can't make the narrative for this crisis what we want. We must tell the story as it happened, not as we want it to happen. This latest white paper is an example of the former.


Because I expect conservative readers to attack my thesis, I am including my own white paper on this crisis.

To try and understand the current crisis, we first need to understand how we got here. First, we must go all the way back to the end of 1999. That’s when Alan Greenspan, then head of the Federal Reserve, first began raising the Prime Interest Rate. This move surprised most everyone, and Wall Street included. This lead directly to the popping of the so called Internet bubble. This bubble popping cost roughly $3 trillion in paper losses in stocks between March and December of 2000. This lead directly to the recession that awaited George Bush when he entered office in Januray of 2001.

The economic malaise that was materializing in late 2000 was only exacerbated by two other events, 9/11 and the revelations of Enron et al. As such, by the end of 2001, we were in a full blown recession. While President Bush was enacting tax cuts, Alan Greenspan was furiously reducing interest rates just as quickly as he raised them in 1999-2000.

By the end of 2002, Greenspan had lowered interest rates so aggressively that the Fed Funds Rate, the rate that banks borrow from each other at, stood at .75%. The Fed Funds Rate is an overnight rate. This is important to understand because there are only two reasons why a bank would borrow overnight 1) they’d done something reckless and needed the money or 2) they were about to do something reckless and need the money. Greenspan lowered the Fed Funds Rate below 1% for well over a year and kept it there.

What this did was create so called loose money. Banks had access to far too much easily available cash. The recession had depressed almost all industries at the time except one, real estate. That’s because the recession had also lead directly to record low mortgage rates. We were at the time in the middle of what was dubbed the refi boom. Because interest rates work in relation to relative inflation, the recession was great for rates because at the time the only fear was deflation. The record low rates didn’t only create a lot of refinancing but also lead to more buying. At the time, we were just seeing the beginning of the real estate boom.

Because real estate was the only good sector, all this extra available bank capital went into one place, mortgages. The ‘problem” if you will at the time was that banks had more money than available loans. The solution was the birth of the sub prime explosion. Because folks with good credit (prime borrowers) were limited, banks began looking to more non traditional places for their money.

Mortgage Backed Securities, which bundled these sub prime loans and turned them into bonds, were the brainchild originally of Lew Ranieri at Lehman Brothers in the 1980’s. The financial vehicle had its glory days in the late 1980’s and early 1990’s, but since then the vehicle had lost some favor. It was, however, ready for a resurgence. Banks came to hedge funds, insurance companies, private equity firms and other financial conglomerates with ideas for new and aggressive loans. Because real estate was starting to move, these securitizers (those that package these loans together and turn them into bond) were all to willing to create newMortgage Backed Securities out of these more aggressive ideas.

For the first couple years, the industry moved aggressively to loosen guidelines, but these moves were still relatively tempered. That all changed in 2005 when a new sub prime player entered the market. That player was Argent Mortgage, the sister company of Ameriquest. Argent would be able to walk into just about any mortgage company and offer more aggressive loans than anyone else. This caused panic and frustration in all their competitors as they saw their market share rapidly deteriorate. In response, the entire competitive landscape was trying to one up each other. So, what was a meticulous loosening of guidelines, turned into a free for all. Banks were in a constant war with each other to offer new and more aggressive programs.

What was lost was any semblance of reason. Whereas at the beginning, even sub prime frowned on such things as prior bankruptcies, foreclosures, and mortgage lates, by the end, nearly everything was dismissed. Furthermore, the revolution of so called “stated loans” became the fruit of future disaster. Stated started out only for borrowers with uneven or sophisticated incomes: commissioned borrowers, self employed borrowers, or borrowers with multiple investment properties. By 2005, nearly everyone could get a stated loan. As such, folks on salary like teachers, secretaries, and even janitors could get a loan by stating their income without actually providing any income documentation.

By the end of 2006, the industry’s recklessness had reached its limit. The industry had standardized the so called 620 stated/stated no money down loan. This was a loan for a borrower with a credit score of 620 (which is in the bottom third of all credit scores) and this borrower could state but not verify their income, their liquid assets (meaning how much they had in the bank) and do all of this with no money down.

Meanwhile, several things were happening on the securitization side of the business. In 1999, Congress and then President Bill Clinton passed landmark deregulation legislation of banks and financial services companies. What this bill allowed was for investment banks and commercial banks to perform each other’s functions. This had many different effects. For instance, brokerage firms like Merrill Lynch could offer checking accounts, and banks could offer investments. More pertinent to this discussion, it allowed more financial services firms to both package loans together and turn them into bonds, and to buy the buyers of said bonds. So, as the real estate market got hotter and hotter, more and more financial services firms began taking bigger positions in these bonds. Even more troubling was the availability of leverage to buy these bonds. Financial services firms were using margin, and very leveraged margin, to take massive positions in these bonds.

At the beginning of 2007, with no more new loans to create, the real estate market finally took a breather. With the real estate market taking a breather, all of the excesses that were masked by the hot market began to come to light. The entire industry was now discovering that billions of Dollars worth financial vehicles were being held with underlying borrowers with no ability to pay for their mortgage. These excesses were masked by the hot real estate market in several ways. Often these borrowers were able to refinance out of their loans before they got into trouble. Other times, these borrowers were even able to sell and buy new properties. Now that neither option was possible, the industry discovered that billions of Dollars worth of assets were attached to “toxic borrowers”. This of course lead to toxic assets. The beginning of 2007 was the end of sub prime.

The first part of 2007, it looked as though the toxicity would be limited to sub prime. By August, the industry realized that toxicity was wide spread. The next domino to fall was so called Alt A. This is the sub set of loans between prime and sub prime. At about this time, both Fannie and Freddie both asked for massive bailouts as well. These two giants both got themselves far too involved in aggressive loans. When these loans were money makers, they piled on to take massive positions. Now that they went bad, both held billions of worthless assets.

The next major event was in September of 2007 when FASB rule 157, mark to market, took effect. This forced banks to put a current market value on all assets, including billions worth of MBS’. While this rule may seem reasonable, what it did was force a so called write down of billions worth illiquid MBS. Because the market for Mortgage Backed Securities was no longer liquid, these banks couldn’t sell their assets, and each month their balance sheets got progressively worse as they had to apply ever lessening values on their MBS holdings. With shrinking assets, banks needed to raise capital in other places just to meet minimum capital requirements.

The next major event was the near downfall of Bear Stearns. In one weekend, the Federal Reserve orchestrated a multi billion Dollar buyout and essentially brokered a merger between JP Morgan/Chase and Bear Stearns. Of course, this consolidation of power was met with controversy and skepticism, but we were all told that it was necessary to avoid a financial meltdown. As it turns out, it only masked this meltdown for another six months. The meltdown came when the Fed couldn’t do the same for Lehman Brothers that it did for Bear Stearns in September of 2008. Since, we have seen a quick deterioration of wealth, jobs, and Gross Domestic Product. We have been told that there is a credit freeze while financial institutions clean their balance sheets of these so called “toxic assets”.


Steve W. said...

Mike is essentially correct. I used to also blame CRA,etc. until I looked at the numbers. While CRA is morally wrong, its effect was too small to be significant. The Fed's numbers on sub-prime and Alt A mortgages backs up Mikes analysis and can be seen at the following links.

Burke said...

While there is no one cause of the mortgage crisis, the conduits opened by Freddie and Fannie were major enablers. If interest rates had not gone so low, these conduits would probably not have been abused. The low rates left banks scrambling to make a return. That ramped originations and sales of loans to Freddie and Fannie.

Greenspan did what he had to do in lowering the rates, but he left them there too long. The Fed's lack of response to the housing bubble didn't help much either.

The market's respect for Greenspan was too great. The complexity of the economy is too much for any man or committee. The trust placed in Greenspan provided a false sense of security for the financial industry. Everyone seemed to think that his assurances were good as gold and continued about their business of leveraging their bets.

Anonymous said...

Steve W., how is it morally wrong to ban redlining?

mike volpe said...

I don't think that's what Steve said. He said the CRA is morally wrong. It has nothing to do with redlining. There is a big difference between banning the practice of a bank avoiding certain areas and telling a bank it has to do a certain number of loans in certain areas.

Anonymous said...

The CRA in itself didn't sink enough money to blow the markets. But the CRA changed the methods behind mortgage guarantees and the resale market that spread way beyond the CRA target and into the entire market where insanely risky mortgages became normalized.

The CRA made bad decisions defensible and in fact, required for continuation of the business.

The good intentions behind CRA led to idiot statements like this one from GW Bush who claimed that "the downpayment is the greatest threat to home ownership", when in fact, the downpayment is the best tool to ensure that mortgages are really going to be paid.

mike volpe said...

Why and how did the CRA do this? Do you think the CRA was the vehicle that introduced no money down loans? It wasn't. Sub prime was always a vehicle for no money down loans.

It's a conspiracy theory to claim that an inconsequential program somehow sent shockwaves through the industry despite itself having almost no effect.

Bill Smith said...

What you guys don't understand is that banks were basically told by regulators to loan anything to anybody, not just through CRA, but all types and sizes of loans. Because fanny and freddy where buying anything and everything on the secondary and the fed was handing out money like it was candy, it wasn't just people that never should have gotten a mortgage at all getting loans, but also people getting an awful lot more money than they should have. This artificially inflated house prices because everyone could buy a house now, supply did not meet demand and prices artificially went up. Then after everyone rushed to buy a house and the amount of buyers went down and foreclosures started coming on the market like crazy, home prices dropped through the hardwood floor.
So the major cause of this entire mess is the CRA, Fanny and Freddy, and the fed, that is a fact.
As far as it being morally wrong not to lend to peopl living in the red lined districts? Why don't you take a ride through one of those areas and tell us if you'd personally lend over $10,000 to anybody to buy a house in those areas? No? then why should a bank be forced to do it?