It’s a good 20 pages long, but do yourself a favor and read this transcript from NPR about “The Giant Pool of Money.” It is an excellent primer on the convoluted and volatile consequences we made by creating a commodity-trading system with housing loans. You will learn how this went from being just a housing bubble to a full blown credit crisis.
Here’s a part from an irrationally exuberant mortgage broker who fell hard once the bottom fell out, not that one feels sorry for him:
Glen Pizzolorusso: This sounds obscene, but it was first month I got a $25,000 paycheck. That didn’t even cover my expenses.” So you’re sitting here and you’re like I made 25,000 this month, which is more than most people make in six months and that doesn’t cover my expenses. Now what do I do? The next couple months I made 30 or 40 grand, then it went down to 10. You could just feel it winding down. The good old days were over. It was scary.
While traders like Pizzolorusso weren’t directly tied to the Fannie/Freddie system, people are mistaken (or just spinning) in attempting to point out that the CRA (Community-Reinvestment Act of 1977 and reform in 1995) criticisms aren’t valid to this situation.
Here’s one such empty defense of CRA:
University of Michigan law professor Michael Barr testified back in February before the House Committee on Financial Services that 50% of subprime loans were made by mortgage service companies not subject comprehensive federal supervision and another 30% were made by affiliates of banks or thrifts which are not subject to routine supervision or examinations.
The above statistics are alone meaningless. What matters is not what percent of subprime loans were made by whom, but rather what percent of defaulted subprime loans were made by whom. The above statistic leads the reader to assume something not proven: that just because 50-80% of loans weren’t directly tied to CRA the CRA isn’t equally culpable, or that those 50-80% were somehow a greater risk or that they had a greater default rate.
To better retort any CRA defense, start with economist and author Thomas DiLorenzo in, “The CRA scam and its defenders.”
Gordon cites Fed bureaucrat Janet Yellen as the source of a “killer statistic” that absolves the government of all guilt: “Independent mortgage companies” which are not covered by the CRA made many more “high-priced loans” to borrowers with bad credit than did CRA-regulated banks, she says. Well, so what? Even if Yellen is correct, that does not mean that CRA-regulated loans have not caused tens of billions of dollars in defaults.
Moreover, Yellen and Gordon don’t seem to understand what an “independent mortgage company” is. Many of these companies are like the one in which my next-door neighbor is employed [or like Mr. Pizzolorusso from the NPR transcript]: they are middlemen who arrange mortgage loans for borrowers — including “subprime” borrowers — with banks, including CRA-regulated banks. Some killer statistic.
By ignoring the role of the Fed in creating the whole housing-market mess, Gordon’s pronouncement that it is entirely a result of “market failure” is laughable on its face. He also flatly denies that CRA lending has had anything to do with why so many uncreditworthy borrowers have defaulted now that the Fed-generated housing bubble has burst. This, too, is an untenable position.
When the CRA was created during the Carter administration, the administration also funded with tax dollars numerous “community groups” that have helped the Fed, the Comptroller of the Currency, and other federal regulatory agencies to enforce the act. Under the CRA, if a bank wants to make virtually any change in its business operations — merging, opening up a new branch, getting into a new line of business — it must first prove to regulators that it has made “enough” loans to the government’s preferred borrowers. The (partially) tax-funded “community groups” like ACORN (Association of Community Organizations for Reform Now) can file petitions with regulators that stop the bank’s activities in their tracks, perhaps defeating them altogether. The banks routinely buy off ACORN and other “community groups” by giving them millions of dollars as well as promising to make even more dubious loans.
In order to try to diversify the risk of these loans, the Federal Home Loan Mortgage Company (“Freddie Mac”) pioneered the “securitization” of bundles of these high-risk loans so that they could be sold on secondary markets. Such “securitization” exploded during the 1990s as a result of government regulation. … The government also “streamlined” the regulatory requirements for CRA loans in 1995, allowing — and indeed pressuring — banks to make such loans without the benefit of many traditional credit-worthiness criteria, such as the size of the mortgage payment relative to income, savings history, and even income verification! Instead, the Fed told banks that participation in a credit-counseling program, many of which are federally funded, could be used as “proof” of a low-income applicant’s ability to make his mortgage payments. In other words, federal bank regulators required banks to make bad loans based on nonexistent credit standards.
As DiLorenzo clearly lays out, the CRA set up this system. It didn’t just spontaneously appear in the free market.
[The Australian] 1995: The Community Reinvestment Act is revised so that banks and thrifts are forced to give home loans to low and moderate-income households as well. In return they are allowed to repackage and sell those sub-prime risks to others, which Bear Stearns pioneers in 1997…. Mae and Mac ran leverage ratios that exceeded 60 to one (cheered on by the Democrats) to keep giving loans to people who could not really afford it. It only took more traditional interest rates for the bubble to burst. The independent investment banks that did not have access to bank deposits collapsed and almost brought the whole system down. All those who now think that the solution is to give more powers to politicians, authorities and central banks should look at what they did with the powers they already had.
Again, with no CRA revision, there is no reason to create a market for bundling risky loans and slicing them up for resale.
And, if you didn’t know, according to the Washington Post, “Fannie and Freddie finance about 40 percent of all U.S. mortgages, with $5.3 trillion in outstanding debt.”
The agency [HUD] neglected to examine whether borrowers could make the payments on the loans that Freddie and Fannie classified as affordable. From 2004 to 2006, the two purchased $434 billion in securities backed by subprime loans, creating a market for more such lending. Subprime loans are targeted toward borrowers with poor credit, and they generally carry higher interest rates than conventional loans.
Today, 3 million to 4 million families are expected to lose their homes to foreclosure because they cannot afford their high-interest subprime loans. Lower-income and minority home buyers — those who were supposed to benefit from HUD’s actions — are falling into default at a rate at least three times that of other borrowers.
This matters greatly, as explained by Russell Roberts of George Mason U, because this giant pair of institutions was basically ordered by the federal government to lower their credit and background standards in order to provide the poor with more access to purchase a home. While the intentions may have been proper, the result was disaster:
Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target — 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.
For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be “special affordable” loans, typically to borrowers with income less than 60% of their area’s median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.
Fannie and Freddie also purchased hundreds of billions of subprime securities for their own portfolios to make money and to help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities.
As a result, the federal government artificially created a housing bubble, whereby supply slowly but surely overtook demand.
In other words, it’s not just the defaulted loans. So long as housing prices rose there would be no crisis. But the government helps artificially inflate supply with CRA by pressuring banks to make loans they would have otherwise not made. The CRA helped create a trading market for housing. Once supply surpassed demand the housing prices fell, compounding the problem of both CRA and non-CRA subprime loans.
Is the CRA solely responsible for the mess? Of course not. But neither is “the free market,” the private middleman mortgage firms who simply followed the lead of Fannie and Freddie, the agencies that had an artificial competitive advantage courtesy of the federal government’s misguided cries of racially-sensitive loan access.
It is kinetic energy: the CRA was the first large domino to start the turmoil.
