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AN IMPERFECT STORM
The real thrust to the actions that resulted in one of the biggest economic collapses in the history of the country began in 1993, with the reform of the 1977 Community Reinvestment Act. Going forward from then, a cast of politicians, agencies, regulators, and market players took actions that resulted in the creation of an asset bubble that nearly collapsed our economy. They didn’t do it in concert - these were mostly disparate policy actions.
Major new policies, or policy changes, often bring unintended consequences. There shouldn’t be, but the scale to which the government and economy has grown, and the sophistication of its mechanisms, it appears, exceeds policymakers' comprehension. Ideology and political ego/greed-induced myopia parry any considerations to any possible negative dynamics.
The major participants and their contribution to the ultimate result are listed below. Timing, or the order of succession of certain policies or actions weren’t that critical. It’s just that they all occurred within the right time-frame. It was truly an Imperfect Storm. The unconsciousness of it all is astounding. So, there’s no order of any sort to the participants. After reading how all were involved, a time-line of how one may have been affected or compounded by another will be evident.
House Banking Committee
In 1993, bank regulators began a major effort to reform the 1977 Community Reinvestment Act. Their thrust was to increase home ownership by low-to-middle income borrowers. Required by the new regulation was the use of “innovative and flexible” lending practices to promote qualification of LMI borrowers and neighborhoods.
“I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing.”—Rep. Barney Frank, September 25, 2003, House Financial Services Committee hearing.
“These two entities, Fannie Mae and Freddie Mac, are not facing any kind of financial crisis,” Frank said. He added, “The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.” —Rep. Barney Frank, 2003, House Financial Services Committee hearing.
Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data. Fannie doesn’t make loans, it buys them. It kept some, and sold off most to investors, charging an additional fee to cover them should they fail.
As far back as 1992, provisions of the Community Reinvestment Act, and an affordable housing mission added to the charter of Fannie Mae, required Fannie to lower its standards in order to meet new mandates. But, referring back to the first sentence of this section, the magnitude of growth in risky loans became exponential in the few years prior to the bubble bursting. This is because for Fannie to purchase mandated larger numbers of Low-to-Middle-Income loans, lenders had to make loans to more LMI borrowers.
Lenders became “imaginative”, as they were prompted to do by the 1977 CRA reform act – and regardless of the lengths to which their imagination took them, virtually no responsible government authority made a move to throttle them back. Additional flexibility to expand loan purchases had been provided earlier through the 1968 Charter Act, which authorized Fannie Mae to issue Mortgage-Backed securities.
Additional Fannie and Freddie notes:
Per the WSJ April 29,2010 – “Former Fannie Mae Chief Credit Officer Edward Pinto calculates that as of June 2008, the toxic twins and other government entities were responsible for more than $2.7 trillion in subprime and Alt-A mortgage exposure.”
In May 2010, Freddie said it lost $8 bil in the first quarter, and requested $10.6 billion from Uncle Sam. In addition, it said it would need more in the future. The total already lost by Fannie and Freddie through the end of 2009 was 126.9 billion.
Gramm-Leach-Bliley Act (GLBA), aka, the Financial Services Modernization Act of 1999 - . . .repealed part of the Glass-Steagall Act of 1933 - specifically, the section which prohibited banks from being involved in any combination of Investment Banking, Commercial Banking, or Insurance. The primary justification was that individuals put money into investments when the economy was doing well, and into savings accounts when it wasn’t. The combined entities would be able to do well in both good and bad economic times. Today, this is known as the Financial Services Sector. Congress may have been unconsciously prescient by passing this legislation. It allowed for the structure necessary to successfully compete in the growing global banking market. Unfortunately, the regulations were less than appropriate and precise to ultimately prevent the catastrophe that would follow. Politicians lack the understanding of the depth and dynamics of financial mechanics and complexities, and so are unable to conceive proper safeguards. Too many of them can only contemplate capitalism from an academic perspective. This is the miasma from which unintended consequences emerge.
The Federal Reserve began its wild rate swinging in 1999, by raising rates to combat “incipient” inflation and a perceived bubble in prices for companies in the technology sector. But, raising rates is a macro action. The whole market sank as a result of the increased cost of money. To bring the economy out of the resultant slow-down, the Fed started an easing cycle in mid-2000. That easing cycle lasted until late 2002, going to as low as .75 points. The availability of low-interest mortgages, propelled by congress mandating higher participation by Fannie Mae in Low and Moderate Income borrower-based loans, fueled the housing boom. As the fed rate increased over the next 3 ½ years, ultimately rising to 6 points, the bubble began to materialize. Some of the lending market’s “innovative” mortgage products, that were a result of the prompting by the Community Redevelopment Act, were beginning to trip conditions that increased already-risky borrowers’ loan payments. This effect would continue to grow.
At the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010, Ben Bernanke stated that the Fed’s policy of ultra-low interest rates did not cause the housing bubble. He can rest comfortably there, as he is, literally, correct. But, unlike all the other agencies, legislators, and regulators mentioned here, the Fed wasn’t just another abettor – the Fed was a major abettor. Without the prolonged low Fed rates, rising house values would never have become ballistic, and the mortgage products conceived to include all comers might still be unimagined.
Alan Greenspan on April 7th, 2010: "If the Fed as a regulator had tried to thwart what everyone perceived as a fairly broad consensus that the trend was in the right direction, homeownership was rising and that was an unmitigated good, then Congress would have clamped down on us," he told a questioner at a congressionally appointed commission investigating the financial crisis. "There's a presumption that the Federal Reserve's an independent agency, and it is up to a point, but we are a creature of the Congress and if ... we had said we're running into a bubble and we need to retrench, the Congress would say 'we haven't a clue what you're talking about'," Greenspan said.
What Mr. Greenspan fails to make clear is whether or not the Fed actually did discern a looming bubble. But, beyond that, his statements are a self-indictment, in that even if they were aware of it, they didn’t bother taking action because dealing with the congress would have been futile!
The Financial Accounting Standards Board, is a private, not-for-profit organization designated by the SEC as the financial accounting organization responsible for setting accounting standards for public companies in the U.S. The five permanent members, and their staff comprise a considerable background knowledge of economics and accounting. FAS 157 - effective for entities with fiscal years beginning after November 15, 2007, is better known as the Mark-To-Market accounting standard. Previous to FAS 157, values of assets “held to maturity” were estimated by a method known as Mark-To-Model, where a hypothetical value was used to determine the value of assets that would mature at a future date. Mark-To-Market required that the value of these “held to maturity” financial instrument be determined as if it were to be sold at current fair market price.
The FASB explanation for implementing Mark-To-Market was for greater transparency as required by Sarbanes-Oxley. In a perfect world, the change to MTM would probably have made little difference to financial reporting. That perfect world would have been one where every financial instrument was solidly underwritten. The FASB was probably too far removed from what was happening with regard to contemporary market product complexities and imaginative investing strategies. That they didn’t hesitate at all to implement MTM, showed that they had no idea that U.S. financial institutions were holding billions of dollars of assets with inflated ratings. Overnight, the reserves held by many banks – as balanced against their liabilities per Mark-To-Model accounting, were insufficient. Also overnight, the underlying value of much of the instruments they held was being questioned. So, it was double trouble for financial institutions. They had to quickly re-build their reserves. But, to do that they would now have to sell assets . . .that effectively could not be priced.
Credit Rating Agencies (CRA’s and their regulators)
“Lax lending standards employed by lightly regulated non-bank mortgage originators initiated a downward competitive spiral which led to pervasive issuance of unsustainable mortgages. Ratings agencies freely assigned AAA credit ratings to the senior tranches of mortgage securitizations without doing fundamental analysis of underlying loan quality.” –Sheila Bair, Chairwoman FDIC
Currently, there are 10 Nationally Recognized Statistical Rating Organizations (NRSRO’s). There are others that can provide ratings, but the government (specifically the SEC) imprimatur is the result of a determination that these CRA’s publish ratings that the market considers accurate and reliable. The reliability of these CRA’s was not examined closely enough during the period where evermore creative security instruments, in volume, were being produced. The CRA’s earn their money by providing ratings for their client’s bonds, etc. The conflict here is just too obvious.
Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the 1992 GSE Act)
. . . established HUD-imposed housing goals for financing of affordable housing and housing in central cities and other rural and underserved areas. This is the action that put in place the authority for HUD’s Office of Federal Housing Enterprise Oversight (Fannie and Freddie’s Regulator) to establish housing goals for the financing of low-to middle income homebuyers. Through 2008 these imposed goals generated 26 million sub-prime and other non-prime mortgages. During this time “Sub-Prime” was not yet a pejorative. These mortgages were on the balance sheets of the FHA, Fannie and Freddie, and the four largest banks. In order to gain approval from the Fed and other regulators, banks were required to make loans to less than qualified borrowers, for whom they had to accommodate with “imaginative mortgage” products.
MBSs, CDOs, SIVs and Credit Default Swaps
A Mortgage Backed Security is a bond created by bundling mortgages into a package. Some of those financial institutions packaging and selling these MBSs weren’t too careful about the overall quality of the underlying mortgages, or how they were characterized. SIVs, or Structured Investment Vehicles, were off-balance-sheet entities for banks that had less regulation oversight which allowed them to make more highly leveraged investments. Many of these investments were in MBSs. CDOs (Collateralized Debt Obligations) and Credit Default Swaps are insurance purchases, made as hedges, by buyers of these instruments – AIG being one of the larger providers of this type of insurance.
As the housing market grew, so did the market for these structured investments – as well as the hedging insurance against their failure. The amount of money eventually tied up into these kind of investments was astounding. This is similar to every house in the Los Angeles basin having earthquake insurance. Should an earthquake happen, causing damage to all insureds, the issuer(s) would not have enough reserves to cover all the claims.
The Fed’s rate actions from 2002 through most of 2005 made money excessively cheap. Hud’s low-income homeowner-imposed goals made Fannie and Freddie willing mortgage buyers. Lenders, who were overwhelmed with potential borrowers, found themselves in the sweet middle with a cheap source for money on one end, and a willing buyer for the mortgages they produced, on the other. Without some agency authority calling the industry out for its drift towards looser underwriting requirements, the lenders proceeded with less and less restraint. They rationalized that if they didn’t make the loan, the questionable applicant would just go down the street to the next lender, who would. There were mortgage products with favorable enough initial terms to allow low-quality borrowers to qualify. The gambit being promoted was that the borrowers would refinance the loan just short of the first re-set.
As perpetuated by media portrayals, buyers who got into mortgage difficulty are not all victims of greedy lenders pulling fast ones over on them. Fostered by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 (the 1992 GSE Act), low Loan-To-Value (as well as No-Docs and Stated Income) mortgages, provided the opportunity for a whole new range of buyers to participate in home ownership. Home buyers in the Low- and Middle-income ranges had been specifically targeted through mandated government goals. These were “artificial” home buyers. The misguided moral obligation on the government’s part to make home ownership available to everyone, meant an outreach to those who did not possess sufficient fiscal wherewithal and/or practical financial experience, required by such an obligation. When the collapse began, these were the first to have their (minimal) equity turn negative. Subsequently, this was compounded for many of them by loan-rate re-sets that caused house payments to increase. For those who could still manage to hang on through that, there were (and will be) those who lost their jobs as the real estate market collapse spread to the financial institutions, and ultimately, to the economy as a whole.
These buyers definitely had enablers, though. On one end were Government agencies, with mandates for the GSE’s to increase their share of mortgage purchases from marginal borrowers. And on the other, were the lenders who, in the absence of explicit caution by regulators, successively relaxed underwriting standards with each new borrower-qualifying scheme. In the middle, were the Secondary Markets, who seeing cheap money, compliments of the Fed, and a willing Mortgage-Backed Securities buyer in the form of the GSE’s, ramped up volume to take advantage of the opportunity to make bundles of easy money.
It was all so organically unconscious on the part of all the above participants. Yet, with a bit more mental engagement as they exercised their responsibilities, they may have been able to see the potential unintended consequences that the dynamics of their decision making could create.