Wednesday, October 01, 2008

The housing collapse: How we got here

I was going to write today about my take on how we wound up in the current mess but instead will quote from a few superb columns on the topic that I found today. Let me begin with Richard Rahn, who provides a nice overview:
First, a few basic facts: It is universally understood that the present financial meltdown began with the problems of two enormous government-sponsored enterprises (GSEs) -- Fannie Mae and Freddie Mac. These two enterprises purchased mortgages from banks to allow banks to issue larger and riskier mortgages with the explicit goal of increasing homeownership.

Fannie and Freddie were allowed to have a lower percentage of capital reserves, needed in case of losses, than other purely private banks were required to keep. Fannie and Freddie both engaged in accounting practices that the courts have ruled to be improper and fraudulent. Fannie and Freddie have contributed millions of dollars to political candidates, including most members of Congress.

During the Carter administration, the Democratic Congress passed the Community Reinvestment Act (CRA), which gave federal regulators the power to pressure banks into issuing loans to high-risk households and small businesses. During the Clinton administration, the CRA was given more power to force banks to issue even riskier loans to poor households. Officials of the Bush administration and members of Congress, who tried to rein in the CRA because they saw a train wreck coming, were accused of racism by some congressional Democrats and left-wing activist groups.
This totally belies the notion, currently being advanced by many on the political left, that what occurred was a failure to sufficiently regulate. Rather, government interference in the marketplace played a central role by encouraging lending to those least capable of managing their financial affairs. While Democrats may have been the instigators, a number of Republicans also bought into this. Recall that President George W. Bush in the 2002 State of the Union address called for "...broader home ownership, especially among minorities..."

It wasn't just minorities though that were effected, as Steven Malaga explains:
Quoting from a study which declared that “underwriting guidelines…may be unintentionally racially biased,” the Boston Fed then called for what amounted to undermining many of the lending criteria that banks had used for decades. It told banks they should consider junking the industry’s traditional debt-to-income ratio, which lenders used to determine whether an applicant’s income was sufficient to cover housing costs plus loan payments. It instructed banks that an applicant’s “lack of credit history should not be seen as a negative factor” in obtaining a mortgage, even though a mortgage is the biggest financial obligation most individuals will undertake in life. In cases where applicants had bad credit (as opposed to no credit), the Boston Fed told banks to “consider extenuating circumstances” that might still make the borrower creditworthy. When applicants didn’t have enough savings to make a down payment, the Boston Fed urged banks to allow loans from nonprofits or government assistance agencies to count toward a down payment, even though banks had traditionally disallowed such sources because applicants who have little of their own savings invested in a home are more likely to walk away from a loan when they have trouble paying.

Of course, the new federal standards couldn’t just apply to minorities. If they could pay back loans under these terms, then so could the majority of loan applicants. Quickly, in other words, these became the new standards in the industry. In 1999, the New York Times reported that Fannie Mae and Freddie Mac were easing credit requirements for mortgages it purchased from lenders, and as the housing market boomed, banks embraced these new standards with a vengeance. Between 2004 and 2007, Fannie Mae and Freddie Mac became the biggest purchasers of subprime mortgages from all kinds of applicants, white and minority, and most of these loans were based on the lending standards promoted by the government.

Meanwhile, those who raced to make these mortgages were lionized. Harvard University’s Joint Center for Housing Studies even invited Angelo Mozilo, CEO of the lender which made more loans purchased by Fannie and Freddie than anyone else, Countrywide Financial, to give its prestigious 2003 Dunlop Lecture on the subject of "The American Dream of Homeownership: From Cliché to Mission.” A brief, innocuous description of the event still exists online here.

Many defenders of the government’s efforts to prompt banks to lend more to minorities have claimed that this effort had little to do with the present mortgage mess. Specifically they point out that many institutions that made subprime mortgages during the market bubble weren’t even banks subject to the Community Reinvestment Act, the main vehicle that the feds used to cajole banks to loosen their lending.

But this defense misses the point. In order to push banks to lend more to minority borrowers, advocates like the Boston Fed put forward an entire new set of lending standards and explained to the industry just why loans based on these slacker standards were somehow safer than the industry previously thought. These justifications became the basis for a whole new set of values (or lack of values), as no-down payment loans and loans to people with poor credit history or to those who were already loaded up with debt became more common throughout the entire industry.
Steven Horwitz of St. Lawrence University then picks up the baton and adds this part:
The final chapter of the story is that in 2004 and 2005, following the accounting scandals at Freddie, both Freddie and Fannie paid penance to Congress by agreeing to expand their lending to low-income customers. Both agreed to acquire greater amounts of subprime and Alt-A loans, sending the green light to banks to originate them. From 2004 to 2006, the percentage of loans in those riskier categories grew from 8% to 20% of all US mortgage originations. And the quality of these loans were dropping too: downpayments were getting progressively smaller and more and more loans carried low starter interest rates that would adjust upward later on. The banks were taking on riskier borrowers, but knew they had a guaranteed buyer for those loans in Fannie and Freddie, back, of course, by us taxpayers. Yes, banks were "greedy" for new customers and riskier loans, but they were responding to incentives created by well-intentioned but misguided government interventions. It is these interventions that are ultimately responsible for the risky loans gone bad that are at the center of the current crisis, not the "free market."
Another factor he highlights, perhaps missed by most observers, is the role of land-use regulations:
At the same time, home prices were rising making those who had taken on large mortgages with small down payments feel as though they could handle them and inspiring a whole variety of new mortagage instruments. What's interesting is that the rise in prices affected most strongly cities with stricter land-use regulations, which also explains the fact that not every city was affected to the same degree by the rising home values. These regulations prevented certain kinds of land from being used for homes, pushing the rising demand for housing (fueled by the considerations above) into a slowly responding supply of land. The result was rapidly rising prices. In those areas with less stringent land-use regulations, the housing price boom's effect was much smaller. Again, it was regulation, not free markets, that drove the search for profits and was a key contributor to the rising home prices that fueled the lending spree.
All of these factors provided the spark for the housing boom. The Federal Reserve, meanwhile, supplied the gasoline, as Rahn notes:
The Federal Reserve engaged in a policy of excessively easy money, cutting the federal funds rate to only 1 percent in June 2003, a rate lower than inflation. Thus, banks were encouraged to provide many very low-rate adjustable mortgages that they, in turn, could offload on the GSEs. Everyone knew interest rates would eventually rise and many borrowers would then be unable to pay the mortgages. But each party in the chain thought it could pass off the bad paper to the next sucker. The result, the taxpayer becomes the ultimate sucker.
To summarize, we have politically correct government policies put in place to expand minority readership, abetted by the government-backed institutions of Freddie Mac and Fannie Mae and fueled by a Federal Reserve desperate to stoke the American economy in the wake of the tech bubble collapse and 9/11. Land-use regulations that drive up the cost of housing and put it even further out of reach of buyers, increasing the need to borrow more and engage in more risky lending schemes, served to fan the flames.

And yet many somehow think that a lack of regulation is to blame, including one individual that stands on the verge of being elected president.

Update: All of this explains chiefly how the housing bubble occurred. How this led to the destruction of the current financial crisis can best be explained here.

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