Hidden in Plain Sight

What Really Caused the World's Worst Financial Crisis—and Why It Could Happen Again

Peter J. Wallison

• Editorial: Encounter Books
• Año: 2016
• ISBN:
  9781594038662
• Categoría: Business
• Categoría: Governo e imprese

The 2008 financial crisis—like the Great Depression—was a world-historical event. What caused it will be debated for years, if not generations. The conventional narrative is that the financial crisis was caused by Wall Street greed and insufficient regulation of the financial system. That narrative produced the Dodd-Frank Act, the most
comprehensive financial-system regulation since the New Deal. There is evidence, however, that the Dodd-Frank Act has slowed the recovery from the recession. If insufficient regulation caused the financial crisis, then the Dodd-Frank Act will never be modified or repealed; proponents will argue that doing so will cause another crisis.A competing narrative about what caused the financial crisis has received little attention. This view, which is accepted by almost all Republicans in Congress and most conservatives, contends that the crisis was caused by government housing policies. This book extensively documents this view. For example, it shows that in June 2008, before the crisis, 58 percent of all US mortgages were subprime or other low-quality mortgages. Of these, 76 percent were on the books of government agencies such as Fannie Mae and Freddie Mac. When these mortgages defaulted in 2007 and 2008, they drove down housing prices and weakened banks and other mortgage holders, causing the crisis.After this book is published, no one will be able to claim that the financial crisis was caused by insufficient regulation, or defend Dodd-Frank, without coming to terms with the data this book contains.

PART I

The Basics

A summary of the argument, important distinctions among mortgages, other explanations for the financial crisis, and a short history of government housing policies

1

Introduction

What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again

Who controls the past controls the future.

GEORGE ORWELL, 1984

The 2008 financial crisis was a major event, equivalent in its initial scope—if not its duration—to the Great Depression of the 1930s. Government officials who participated in efforts to mitigate its effects claim that their actions prevented a complete meltdown of the world’s financial system, an idea that has found many adherents among academic and other commentators. We will never know, of course, what would have happened if these emergency actions had not been taken, but it is possible to gain an understanding of why they were considered necessary—that is, the likely causes of the crisis. The history of events leading up to the crisis forms a coherent story, but one that is quite different from the narrative underlying the Dodd-Frank Act.

Why is it important at this point to examine the causes of the crisis? After all, the crisis is six years in the past, and Congress and financial regulators have acted, or are acting, to prevent a recurrence. Even if we can’t pinpoint the exact cause of the crisis, some will argue that the new regulations now being put in place will make a repetition unlikely. Perhaps. But these new regulations—specifically those authorized in the Dodd-Frank Act adopted by Congress in 2010—have slowed and will continue to slow economic growth in the future, reducing the quality of life for most Americans. If these regulations were really necessary to prevent a recurrence of the financial crisis, then there might be a legitimate trade-off in which we are obliged to sacrifice economic freedom for the sake of financial stability. But if the crisis did not stem from a lack of regulation, we have needlessly restricted future economic growth.

In the wake of the crisis, many commentators saw it as a “crisis of capitalism,” an inevitable consequence of the inherent instability—as they see it—of a free-market or capitalist system.¹ The implication was that crises of this kind will be repeated unless we gain control of the financial and economic institutions that influence the direction of our economy. That was the unspoken impulse behind the Dodd-Frank Act and the underlying assumption of those who imposed it.

But it is not at all clear that what happened in 2008 was the result of insufficient regulation, deregulation, or an economic system that is inherently unstable. On the contrary, there is compelling evidence that the financial crisis was the result of the government’s own housing policies. These policies, as we will see, were based on an idea—still popular on the left—that underwriting standards in housing finance are excessively conservative, discriminatory, and unnecessary. If it is true that the crisis was the result of government policies, then the supposed instability of the financial system is a myth, and the regulations put in place to prevent a recurrence at such great cost to economic growth were a serious policy mistake. Indeed, if we look back over the last hundred years, it is difficult to see instability in the financial system that was not caused by the government’s own policies. The Great Depression, now more than eighty years ago, probably doesn’t qualify as a financial crisis; although financial firms were affected, it was a broadly based economic recession, made worse and prolonged by the Federal Reserve’s mistaken monetary policies. One would have to go back to the Panic of 1907 to find something comparable to what happened in 2008, and few would claim that a financial system is inherently unstable if its major convulsions occur only once every hundred years.

How, then, did government housing policies cause the 2008 financial crisis? Actually, “cause” is too strong a word. Many factors were involved in the crisis, but the way to think about the relationship between the government’s housing policies and the financial crisis, as I will discuss in this book, is that the crisis would not have occurred without those policies; they were, one might say, the sine qua non of the crisis—the element without which there would not have been a widespread financial breakdown in 2008. In this sense, throughout this book, I will say that the U.S. government’s housing policies caused the crisis.

The seeds of the crisis were planted in 1992 when Congress enacted “affordable-housing” goals for two giant government-sponsored enterprises (GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Before 1992, these two firms dominated the housing finance market, especially after the savings and loan (S&L) industry—another government mistake—had collapsed. The role of the GSEs, as initially envisioned and as it developed until 1992, was to conduct what were called secondary market operations. They were prohibited from making loans themselves, but they were authorized to buy mortgages from banks, S&Ls, and other lenders. Their purchases provided cash for lenders and thus encouraged homeownership by making more funds available for additional mortgages.

Other government agencies were involved in housing finance, notably the Federal Housing Administration (FHA), the Veterans Administration (VA), and the Department of Agriculture’s Rural Housing Service (RHS), but the GSEs were by far the most important. By the mid-1980s, they were acting as conduits by packaging mortgages into pools and selling securities backed by these pools to investors in the United States and around the world. For a fee, they guaranteed that investors would receive the principal and interest on these securities that they had been promised. The increasing dominance of the housing market by the GSEs and the government is well illustrated in Figure 1.1, which covers both the mortgage pools they guaranteed and their portfolios of mortgages and mortgage-backed securities (MBS).

Although Fannie and Freddie, as they were called, were owned by public shareholders, they were chartered by Congress and carried out a government mission by maintaining a liquid secondary market in mortgages. As a result, market participants believed that the two GSEs were government-backed and would be rescued by the government if they ever encountered financial difficulties. This widely assumed government support enabled them to borrow at rates only slightly higher than the U.S. Treasury itself; with these low-cost funds they were able to drive all competition out of the secondary mortgage market for middle-class mortgages. Between 1991 and 2003, the GSEs’ share of the U.S. housing market increased from 28.5 percent to 46.3 percent.² From this dominant position, they were able to set the underwriting standards for the market as a whole; few mortgage lenders would make middle-class mortgages—by far the predominant market—that could not be sold to Fannie or Freddie.

Source: U.S. Flow of Funds, Federal Reserve, 1980–2009. Adapted from Tobias Adrian and Hyun Song Shin, “The Changing Nature of Financial Intermediation and the Financial Crisis of 2008–09,” Federal Reserve Bank of New York, Staff Report no. 439, revised April 2010, p. 2.

FIG. 1.1. Total holdings of U.S. home mortgages by type of financial institution

THE DEVELOPMENT OF UNDERWRITING STANDARDS

Over time, the GSEs had learned from experience what underwriting standards kept delinquencies and defaults low. These standards required down payments of 10 to 20 percent, good borrower credit histories, and low debt-to-income (DTI) ratios after the mortgage was closed. These were the foundational elements of what was called a prime loan or a traditional mortgage, discussed more fully in chapter 2. Mortgages that did not meet these standards were called “subprime” if the weakness in the loan was caused by the borrower’s credit standing, and were called “Alt-A”^aa if the problem was the quality of the loan itself. Among other defects, Alt-A loans might involve reduced documentation; negative amortization; a borrower’s obligation to pay interest only; a low down payment; a second mortgage; cash-out refinancing; or loans made to an investor who intends to rent out the home. In this book, subprime and Alt-A mortgages are together called nontraditional mortgages, or NTMs, because they differ substantially in default risk from the mortgages that Fannie and Freddie had made traditional in the U.S. housing finance market. Many observers of this market believe that tight underwriting standards—occasionally called a “tight credit box”—adversely affect the homeownership rate in the United States; however, even though the GSEs insisted on tight underwriting standards before 1992, the homeownership rate in the United States remained relatively high, at 64 percent, for the thirty years between 1965 and 1995.

The term Alt-A is said to derive from the market practice of referring to the GSEs as “Agencies.” Alt-A mortgages were said to be “Alternative to Agencies” or mortgages that the GSEs wouldn’t buy. Ironically, in order to meet the affordable-housing goals, the GSEs eventually became the biggest buyers of Alt-A loans.

The GSEs were subject to some statutory restrictions on their activities. In addition to the prohibition on direct lending to homebuyers, they could not acquire mortgages that were larger than a certain size (this was known as the “conforming loan limit,” a statutory formula that allowed loan size to grow as housing prices rose), and after 1992 they were subject to prudential regulation by the Office of Federal Housing Enterprise Oversight (OFHEO), an agency of the Department of Housing and Urban Development (HUD). HUD was also their “mission regulator,” with power to ensure that they were performing the role that the government had assigned to them. Most important, as mission regulator, HUD was given authority under the 1992 legislation to administer the affordable-housing goals, which are discussed at much greater length in later chapters of this book.

THE AFFORDABLE-HOUSING GOALS AND THE DECLINE IN UNDERWRITING STANDARDS

In a sense, the ability of the GSEs to dominate the housing finance market and set their own strict underwriting standards was their undoing. Community activists had had the two firms in their sights for many years, arguing that their underwriting standards were so tight that they were keeping many low- and moderate-income families from buying homes. Finally, as housing legislation was moving through Congress in 1992, the House and Senate acted, directing the GSEs to meet a quota of loans to low- and moderate-income borrowers when they acquired mortgages. At first, the low- and moderate-income (LMI) quota was 30 percent: in any year, at least 30 percent of the loans Fannie and Freddie acquired must have been made to LMI borrowers—defined as borrowers at or below the median income in their communities.

Thirty percent was not a difficult goal. It was probably true at the time the affordable-housing goals were enacted that 30 percent of the loans Fannie and Freddie bought had been made to LMI borrowers. But in giving HUD authority to increase the goals, Congress cleared the way for far more ambitious requirements—suggesting in the legislation, for example, that down payments could be reduced below 5 percent without seriously impairing mortgage quality. HUD received the signal. In succeeding years, HUD raised the LMI goal in steps to 42 percent in 1997, 50 percent in 2001, and 56 percent in 2008. Congress also required additional “base goals” that encompassed low- and very-low-income borrowers and residents of minority areas described as “underserved.” HUD increased these base goals between 1996 and 2008, and at a faster rate than the LMI goals. Finally, in 2004, HUD added subgoals that provided affordable-housing goals credit only when the loans were used to purchase a home (known as a home purchase mortgage), as distinguished from a refinancing. As discussed later, it was much more difficult to find high-quality home-purchase mortgages than loans that were simply refinancing an existing mortgage.

As HUD increased the goals after 1992, it became considerably more difficult for the GSEs to find creditworthy borrowers, especially when the quota reached and then exceeded 50 percent. To do so, Fannie and Freddie had to reduce their underwriting standards. In fact, as we will see, that was explicitly HUD’s purpose. As early as 1995, the GSEs were buying mortgages with 3-percent down payments, and by 2000 Fannie and Freddie were accepting loans with zero down payments. At the same time, they were compromising other underwriting standards, such as borrower credit standing and debt-to-income ratios (DTIs), in order to find the NTMs they needed to meet the affordable-housing goals.

New, easy credit terms brought many new buyers into the market, but the effect spread far beyond the LMI borrowers whom the reduced underwriting standards were intended to help. Mortgage lending is a competitive business; once Fannie and Freddie started to loosen their underwriting standards, many borrowers who could have afforded prime mortgages sought the easier terms now available so they could buy larger homes with smaller down payments. As early as 1995, Fannie’s staff recognized that it was subsidizing homebuyers who were above the median income, noting that “average pricing of risk characteristics provides insufficient targeting of the subsidy. The majority of high LTV [loan-to-value] loans go to borrowers with incomes above 100% of the area median.”³ Thus, homebuyers above the median income were gaining leverage, and loans to them were decreasing in quality. In many cases, they were withdrawing cash from the equity in their homes through cash-out refinancing, further weakening the quality of the mortgages. Although the initial objective had been to reduce underwriting standards for low-income borrowers, the advantages of buying or refinancing a home with a low down payment were also flowing to high-income borrowers. Fannie never cured this problem. By 2007, 37 percent of loans with down payments of 3 percent or less went to borrowers with incomes above the median.⁴

Because of the gradual deterioration in loan quality after 1992, by 2008 more than half of all mortgages in the United States—31 million loans—were subprime or Alt-A. Of these 31 million, 76 percent were on the books of government agencies or institutions like the GSEs that were controlled by government policies.^bb This shows incontrovertibly where the demand for these mortgages originated. Table 1.1 shows where these 31 million loans were held on June 30, 2008.

Throughout this book, for ease of reference, I refer to institutions that were compelled to acquire NTMs by government regulations as “government agencies.” Many of them, such as FDIC-insured banks and even Fannie Mae and Freddie Mac, are not government agencies in t...