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Tuesday, October 7, 2008

Countering the Conservative Meme on the Mortgage Crisis

Last night, I attended a Republican function and I had a chance to debate two people on the roots of the mortgage crisis. Neither had much background in mortgages, though one said they used to be a realtor (if you know anything about the business then you know that gives them little or no more knowledge about mortgages than the average person), and both had the exact same description of how this happened. They have this description not because that's what happened but rather because this description fits their world view. Republicans believe that government interference and social engineering, through the Community Reinvestment Act, in the market set the wheels in motion on the crisis. Because Congress and the Clinton Administration, Conservatives will say, demanded that Fannie Mae and Freddie Mac lend more aggressively in low income areas, Fannie Mae/Freddie Mac exploded the market with irresponsible SUB PRIME loans. Since these two were serving in poor areas, the Democrats in Congress then blocked any and all demands by the Republicans to monitor these two. While this is a nice story and it certainly hits each and every erogenous point for Conservatives, it is unfortunately not only not true but obscenely misinformed.

The first problem is the time line. Here is the important timeline. CRA was created in 1977. It was updated in the mid 1990's. Then, in about the end of 2001, the refinancing boom occurred. In mid 2002, Greenspan lowered the Fed Funds Rate below 1%. The sub prime market took off around 2003. The sub prime market tanked at the end of 2006. Alt A tanked in August of 2007. Fannie/Freddie tanked in the summer of 2008.

Now, in order to believe that it was the CRA that caused this, you would have to believe that for whatever reason things that were set in motion in the mid 1990's didn't materialize for nearly a decade later. Meanwhile, things that happened immediately before the boom, and would logically be related (the refinancing boom and the rate cuts) somehow had nothing to do with the crisis. Finally, you would also have to believe that while sub prime as an industry disintegrated at the end of 2006, for some unknown reason the backer of all of this sub prime didn't disintegrate for a year and a half later. In order to believe this, you would have to suspend all logic and reason.

Just think about it. Throughout 2007, sub prime banks like WMC, New Century, First Franklin, Argent, and Freemont alll closed shop. By the end of 2007, Alt A banks like First Magnus and Greenpoint also closed shop. Yet, Fannie and Freddie continued to operate into 2008 without any problems. Who would they buy loans from if they securitized sub prime? All the sub prime banks would have gone out of business and yet Fannie/Freddie continued securitizing. The borrower goes to the bank and the bank sells the loan to Fannie/Freddie. Without the bank, there are no loans to securitize. In order to believe the Conservative meme, one would have to believe that Fannie/Freddie continued to securitize loans for over a year even though there were no banks left to securitize them from.

The biggest problem with this theory though is that it is counter to basic mortgage principles. Fannie/Freddie don't primarily do sub prime. They are primarily securitizers of conforming, or good, loans. To blame Fannie/Freddie for the sub prime mess, is the equivalent of mistaking credits and debits in accounting. Sub prime was securitized by outside forces on Wall Street. Don't believe me. Read this article about about Lew Rainieri from 2004.

The past quarter-century has seen a revolution in finance. It's felt every time a homeowner refinances a mortgage or signs up for a credit card. No one person can claim to have lit the fuse for this revolution -- but Lewis S. Ranieri was holding the match. Joining Salomon Brothers' new mortgage-trading desk in the late 1970s, the college dropout became the father of "securitization," a word he coined for converting home loans into bonds that could be sold anywhere in the world. What Ranieri calls "the alchemy" lifted financial constraints on the American dream, created a template for cutting costs on everything from credit cards to Third World debt -- and launched a multibillion-dollar industry.

Salomon and Bank of America Corp. (BAC ) developed the first private mortgage-backed securities (MBS) -- bonds that pooled thousands of mortgages and passed homeowners' payments through to investors -- in 1977. Not a moment too soon: Skyrocketing interest rates were turning the business of savings and loans -- funding long-term mortgages with short-term deposits -- making it a financial death trap for banks just as the housing demands of maturing baby boomers began to surge.Ranieri's job was to sell those bonds -- at a time when only 15 states recognized MBS as legal investments. With a trader's nerve and a salesman's persuasiveness, he did much more, creating the market to trade MBS and winning Washington lobbying battles to remove legal and tax barriers.

A less likely financial engineer would be hard to imagine. Ranieri, a Brooklyn native, set out to be an Italian chef until asthma ruled out work in smoky kitchens. A part-time job in Salomon's mail room set him on the path to trading. A large, volatile man, Ranieri built the firm's mortgage desk in his own image: "fat guys," as author Michael Lewis described them in Liar's Poker, promoted from the back office, who indulged in feeding frenzies and practical jokes while selling strange new bonds to doubtful investors.

If Fannie/Freddie were securitizing sub prime, what sorts of loans was Ranieri securitizing? Does it really logically make sense that multi trillion Dollar operations like Fannie/Freddie were the ones securitizing bad loans, while Ranieri thought up the good idea of securitizing loans for qualified borrowers. Are we really to believe that securitization for risky loans came before securitization for loans for folks with good credit.

The waters are muddied because Fannie/Freddie claim to do sub prime. Of course, that's because they use these words loosely. Often times, Fannie/Freddie would wind up buying these bonds that were tied to sub prime loans. Except they didn't do this to reach any sort of quota of loans for low income housing. They did this because sub prime was hot and there was money to be made. Furthermore, they eventually loosened their criteria to include borrowers that would normally be considered sub prime. Still, this also wasn't done to reach a quota. They did this after sub prime exploded. Again, they did this also because the market was hot.

The worst thing about the fact that most conservatives have fallen in line with this meme because that's what they hear from the Conservative media and pundits. No mortgage professional would ever make such a claim. The same conservatives that would be weary of any story from the New York Times negative towards a conservative or a conservative position, take as fact this meme coming from the conservative media. It's like conservatives see each and every mistake of the liberal media but accept any story from the conservative media as fact. Demagoguery and propaganda is the same whether it comes from the left or the right, and to blame Fannie/Freddie and government intervention for this mess is nothing short of Conservative demagoguery and propaganda. Fannie/Freddie have plenty of blame, and Democrats definitely blocked efforts to reform them, however pinning the blame on these two in order to satisfy an ideological agenda is wrong, no matter what that agenda.

Here is my opinion of how the other side treats this mess.

For a detailed outline of how we got into this mess check out this link.


Jack McHugh said...

"Now, in order to believe that it was the CRA that caused this, you would have to believe that for whatever reason things that were set in motion in the mid 1990's didn't materialize for nearly a decade later."

Alternatively, you would have to examine the role of later amendments to the act, and the interaction of other factors including Fannie and Freddie's growing like Topsy during the period and creating a market for all those garbage loans.

Here's the bottom line: Congress created a system that changed the incentives for lenders in ways that made them behave as they never had before. Lenders essentially had just one choice to make: Not make all these subprime loans and go out of business (because lower volume raised their relative costs and made them unable to compete with lenders who did make the loans), or play along, make a ton of money in the short-term, and hope for the best in the long-term. Oh, and if you resisted you could also expect political "shakedowns" from thuggish outfits like Operation Push and Acorn.

You are correct that we shouldn't be simplistic in our account of this thing, but that works both ways.

mike volpe said...

As I pointed out in the piece, Fannie/Freddie didn't make a market in sub prime loans because Fannie/Freddie specialize in loans for people with good credit. Fannie has plenty to answer for in this crisis and I have written about it in other pieces however none of it has to do with starting the crisis.

While it is a good story that sub prime was loosened to respond to pressure from the government, it simply didn't happen. I don't know what these mysterious amendments were but clearly neither do you because you don't mention any of them. The fact is there were no amendments of any consequence or you would have pointed them out specifically.

The sub prime mess was created because Greenspan lowered the Fed Funds Rate so much that there was loose money. With loose money banks had more money than loans. As such, new loans were created. This had nothing to do with some sort of government interference to force banks to loan to poor folks.

Anonymous said...

I don't see the CRA as the whole culprit in this mess. It is more of a tool than a cause.

Due to compromises that Phil Gramm had to make to to get the Financial Serivces Modernization Act passed the avaliabilty of these loans greatly increased. in the years following this legislation being passed.

It was not until the American Dream Downpayment Act and the Zero Downpayment Act were passed in 2003-04 did the sub prime bust afew years later. It was to much to fast. That is why there was nothing materializing in the 90's. There was no venue for its distribution until after 1999.

Acorn, Fannie Mae, Freddie Mac, Lehman, etc. they all had hands in it. The Democrats were getting their hand out programs and the Republicans were getting their corporate wealth. Everybody was fat, dumb, and happy until the bottom dropped out.

This was the furthest reaching giveaway program coupled with free market liaseez faire, not a good combination.

mike volpe said...


I was doing no down payment loans for borrowers long before 2003-2004, so I don't know what this act did, but it certainly wasn't the catalyst for no money down loans.