July 8, 2009

A surprisingly sophisticated GOP report on the Mortgage Meltdown

Republican staffers on the Committee on Oversight and Government Reform (Darrell Issa (CA-49), Ranking Member) have penned a lengthy report on The Role of Government Affordable Housing Policy in Creating the Global Financial Crisis of 2008. Despite the inevitable partisan tendentiousness -- no mention of George W. Bush's White House Conference on Increasing Minority Homeownership, too much blame on Fannie and Freddie, not enough blame on businesses and deregulation -- it turns out to be better than you'd expect.

Here's the first paragraph:
The housing bubble that burst in 2007 and led to a financial crisis can be traced back to federal government intervention in the U.S. housing market intended to help provide homeownership opportunities for more Americans. This intervention began with two government-backed corporations, Fannie Mae and Freddie Mac, which privatized their profits but socialized their risks, creating powerful incentives for them to act recklessly and exposing taxpayers to tremendous losses. Government intervention also created “affordable” but dangerous lending policies which encouraged lower down payments, looser underwriting standards and higher leverage. Finally, government intervention created a nexus of vested interests – politicians, lenders and lobbyists – who profited from the “affordable” housing market and acted to kill reforms. In the short run, this government intervention was successful in its stated goal – raising the national homeownership rate. However, the ultimate effect was to create a mortgage tsunami that wrought devastation on the American people and economy. While government intervention was not the sole cause of the financial crisis, its role was significant and has received too little attention.

This report resembles a better documented, better informed but more coy version of my June 2008 Taki article The Diversity Recession. It underplays how much the politicians were pushing on an open door among lenders, more than a few of whom thought handing out zero down liar loans was a great moneymaking idea.

Some highlights:
In the early 1990s, Fannie and Freddie began to come under considerable pressure to lower their underwriting standards, particularly on the size of down payments and the credit quality of borrowers. A deeply flawed 1992 study published by the Federal Reserve Bank of Boston, purporting that minorities faced discrimination in mortgage lending, was particularly influential at the time. ...

Yet the damage had been done and Congress seized on the study as part of a major legislative reorganization of the GSEs’ function. In 1992, Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act, which created an “affordable housing mission” for Fannie Mae and Freddie Mac. This legislation directed HUD to establish three separate quotas requiring the GSEs to set aside a certain percentage of their yearly mortgage purchases to loans with affordable characteristics. These quotas were expressed as the minimum share of mortgages that Fannie and Freddie purchased every year which had to be made to “low and moderate-income families … low-income families in low-income areas and very low-income families,” as well as borrowers in “central cities, rural areas, and other underserved areas.” Congress granted HUD the authority to adjust these three affordable housing quotas for the GSEs over time, allowing both Democratic and Republican Administrations to consistently make campaign promises to boost homeownership through government intervention in the market. Consequently, under both the Clinton and Bush Administrations, HUD dramatically increased these quotas, which reached their zenith when the Bush Administration raised them to 56 percent, 27 percent and 39 percent, respectively.

HUD’s affordable housing quotas represented major departures from the GSEs’ prior commitment to underwriting only sustainable mortgages. Fannie Mae’s original congressional charter acknowledged the risks involved in low down payment loans because it allowed Fannie to purchase loans with less than a 20 percent down payment only in concert with certain mitigating factors such as private mortgage insurance or a repurchase agreement with the mortgage originator. The establishment of the HUD quotas broke this convention and set the stage for the dramatic politicization of mortgage lending.

In 1994, Fannie Mae CEO Jim Johnson announced the company’s first affordable housing initiative, the $1 trillion “Opening the Doors to Affordable Housing” program. Johnson, a long-time friend of both President Clinton and Treasury Secretary Robert Rubin, took the helm of Fannie in 1991 after a stint at Lehman Brothers. ...

In 1995, Johnson seeded the Fannie Mae Foundation with $350 million of Fannie stock. The company used this foundation to spread millions of dollars around to politically connected organizations like the Congressional Hispanic Caucus Institute. It also hired well-known academics to write papers that gave an aura of academic rigor to policy positions favorable to Fannie Mae. For example, one paper coauthored by now-Director of the Office of Management and Budget Peter Orszag, concluded that the chance was minimal that the GSEs were not holding sufficient capital to cover their losses in the event of a severe economic shock. The authors suggested that “the risk to the government from a potential default on GSE debt is effectively zero,” and that “the expected cost to the government of providing an explicit government guarantee on $1 trillion in GSE debt is just $2 million." As of May 14, 2009, the taxpayers had already been exposed to $700 billion of GSE bailouts. ...

While CRA [Community Reinvestment Act] cannot be directly blamed for the huge volumes of risky nonprime mortgages that were eventually purchased by Fannie, Freddie and Wall Street investment houses, CRA continued a pattern of behavior of lowering mortgage underwriting standards in order to drive up the national homeownership rate.

The other important event of 1995 was the release of the Clinton Administration’s National Homeownership Strategy. The document’s foreword, penned by HUD Secretary Henry Cisneros, cited President Clinton’s directive to “lift America’s homeownership rate to an all-time high by the end of the century.” Among the methods the Strategy proposed to achieve this bump in the homeownership rate was lower down payments.

In retrospect, President Clinton’s rebranding of prudent down payments of 10 to 20 percent as “barrier[s] to home purchase” takes on great significance. As with the 1995 CRA reform and the Clinton Administration’s decision to allow the GSEs to count subprime loans toward their affordable housing goals, this represented a shift in government policy from one that emphasized equity of procedure to equity of outcome. This emphasis on equity of outcome inevitably created tremendous pressure on regulated institutions to make more loans to low-income borrowers. It also created pressure for secondary market investors such as Fannie Mae and Freddie Mac to buy these loans. The correspondingly lower emphasis on how the loans were being made inevitably meant less attention would be paid to their quality and sustainability.

Let me interrupt to discuss the general question of Deep Roots for Recent Problems. Every political viewpoint has its favorite Deep Roots theories and scoffs at the other sides Deep Roots. For example, liberals denounce the idea that the 1977 CRA had anything to do with the housing crash 30 years later, while simultaneously proclaiming that the 1978 Proposition 13 is the main cause of California's current budget problems. The difficulties that minority firemen in New Haven in the 21st Century have understanding the intricacies of water pressure stem from slavery, Jim Crow, and discrimination up through the early 1970s.

So, let's take a look at, say, the failure of the three ratings agencies in this decade to properly alert investors to the riskiness of complex mortgage-backed securities. The roots go back to 1970s when the rating agencies switched from getting paid by buyers of bonds to getting paid by issuers of bonds. Along with the government making the Big 3 ratings agencies into a de facto cartel in 1975, that wrecked the incentives for honest behavior. And yet, the ratings firms didn't completely whore themselves out for decades. Why? Because that would be wrong. The problem is that years of virtuous behavior resisting bad incentives just make the blow-up when the players finally embrace the Dark Side all that much worse because others built in expectations of continued goodness.

Eventually, greedier owners, such as Warren Buffett, who bought 20% of Moody's, inclined the firms to prostitute themselves more. The firms could get away with it for a number of years because they had spent a long time not prostituting themselves, so the bad incentive structure didn't seem as relevant. Still, note that they screwed up worst of all in mortgage-backed securities. That was for a variety of reasons, such as less experience in a down market and, importantly, the general government and social pressure in favor of DiversityLending and the recurrent Anti-HateFact Awareness campaigns.

As Henry Canaday has pointed out, it's not a coincidence that the financial system blew a gasket at exactly the place where the most political and cultural pressure was exerted: mortgages for minority and lower income households.
Risky mortgage lending, particularly loans with very low down payments, contributed directly to the rise of a housing bubble. Had this risky lending been contained within the low-income segment of the market targeted by politicians advocating more “innovation” in “affordable lending,” the damage to the wider economy might have been minimal. ...

Although the erosion of mortgage underwriting standards began in Washington with initiatives like the CRA as a way to reduce “barriers to homeownership,” this trend inevitably spread to the wider mortgage market. One observer noted:
Bank regulators, who were in charge of enforcing CRA standards, could hardly disapprove of similar loans made to better qualified borrowers. This is exactly what occurred.

Borrowers – regardless of income level – took advantage of the erosion of underwriting standards that started with government affordable housing policy. As one study observed,“[o]ver the past decade, most, if not all, the products offered to subprime borrowers have also been offered to prime borrowers.” For example, Alt-A and adjustable-rate mortgages became incredibly popular with borrowers – who were generally not low-income – engaging in housing speculation. ...

Once government-sponsored efforts to decrease down payments spread to the wider market, home prices became increasingly untethered from any kind of demand limited by borrowers’ ability to pay.

Government actions distorted the housing market, yet advocates of affordable housing policies, such as Congressman Barney Frank (D-MA), have asserted that those who criticize these policies seek to place blame for the financial crisis solely on borrowers of modest means. This misses the mark entirely. In fact, responsibility for the erosion of mortgage lending standards, which began with government affordable housing policy, rests squarely on the policy makers who advocated these ill-conceived policies in the first place. Borrowers quite naturally responded to the incentives they were given, irrespective of their socioeconomic status, and risky lending spread to the wider mortgage market.

Well, I think financial buccaneers like Angelo Mozilo, Roland Arnall, and Kerry Killinger who pocketed hundreds of millions from lending to deadbeats deserve some share of the blame, too. But that's just my personal opinion.

The report goes on to discuss "Special Interests: The Rise of the 'Affordable' Housing Coalition:"
Fannie Mae and Freddie Mac would ultimately announce over $5 trillion in affordable housing initiatives. Many of these loans came increasingly from large non-bank mortgage lenders like Countrywide Financial Corporation, the country’s largest mortgage lender and a major innovator in pushing subprime loans. These non-bank lenders rose to fill the void in mortgage lending left in the wake of the savings and loan crisis, and they grew rapidly in response to government policies that encouraged lower lending standards. A symbiotic relationship developed between these non-bank lenders and the GSEs. For example, Fannie Mae under CEO Jim Johnson reached a “strategic agreement” with Countrywide CEO Angelo Mozilo, under which “Countrywide agreed to deliver a large portion of Fannie’s annual loan volume in exchange for special financing terms." In fact, Countrywide regularly accounted for 10 to 30 percent of all the loans purchased by Fannie Mae in a given year. In the words of Mozilo: “If Fannie and Freddie catch a cold, I catch the f***** flu."

Unlike here at iSteve, the GOP report doesn't use asterisks.

All this raises the usual problems of disentangling cause-and-effect in history. A Fannie-centric view of what went wrong runs into the problem that Fannie and Freddie were hamstrung in 2003 and 2004 by exposure of their giant stock manipulation scandals. As the GOP report explains:
In 2003, Fannie Mae and Freddie Mac were at the height of their power. They dominated the secondary mortgage market, including a combined exposure of $372 billion to subprime mortgages made to borrowers with FICO scores below 660, 81 percent of the total market. Wall Street firms were responsible for a mere 19 percent of this market. However, accounting scandals were about to hammer the GSEs’ share prices, threaten their market share, and create an urgent need for a pro-active political influence strategy to blunt calls for reform.

During those years, Wall Street firms rushed into take over the traditional role of the GSEs. They were egged on by the Bush Administration's October 15, 2002 White House Conference on Increasing Home Ownership, where Bush called for adding 5.5 million more minority homeowners through, in effect, zero downpayment liar loans.

The GOP report doesn't mention that, but it puts forward an interesting argument its blame Fannie/Freddie quest:
Similarly, Wall Street investment houses like Lehman Brothers, Bear Stearns, and Merrill Lynch, which came to specialize in packaging and investing in the lowest-quality tranches of mortgage-backed securities, profited hugely from the increased volume that government affordable lending policies sparked. Private-label securitization of subprime mortgages grew from $60 billion-a-year in 1997 to nearly $500 billion-a-year by 2006. These firms could not compete in any segment of the market Fannie and Freddie chose to close off to them because the GSEs could always undercut Wall Street’s costs by virtue of their government-granted competitive advantages. However, as with the GSEs’ relationship to non-bank lenders such as Countrywide, Wall Street formed its own symbiotic relationship with Fannie and Freddie. Wall Street firms profited from buying and selling GSE mortgage-backed securities, which because of the government backing were deemed to be as safe as Treasury bonds – but with a higher yield. For their part, the GSEs became the largest purchasers of the “AAA”-rated tranches of Wall Street’s private-label securities, while Wall Street invested in the lower-quality portions. However, without the GSEs’ participation, it is unlikely that Wall Street could have
formed these pools of toxic mortgages, making Fannie and Freddie the indispensable actors in the subprime market. This resulted in consistent downward pressure on down payments and on the credit quality of borrowers, fueling the housing bubble.

But it would be more persuasive if it at least mentioned the Bush Push.

Then, in 2005-2006, the most idiotic years for lending, the revitalized GSE's fought back against their declining market shares and poured zillions into bad mortgages. The report notes:
In response, Fannie Mae and Freddie Mac sought protection from their strongest political protectors, the advocates of high-risk affordable lending. The GSEs essentially doubled down on risky low down payment lending to shore up support on Capitol Hill and fend off attempted regulation. GSE congressional supporters, many of whom sat on key committees charged with oversight of the housing and mortgage industries, made repeated public statements in support of the push to reduce the quality of underwriting at the GSEs and to block congressional efforts at better regulation.

For example, at a hearing of the House Financial Services Committee on the GSE accounting scandals, Congresswoman Maxine Waters (D-CA) publicly praised the GSEs for implementing their “affordable housing mission, a mission that has seen innovation flourish, from desktop underwriting to 100 percent [zero-down payment] loans.”

And in a speech delivered at the swearing-in ceremony of the Congressional Black Caucus in 2005, Franklin Raines’ successor, Fannie Mae CEO Daniel Mudd, sent a clear signal to congressional advocates of loosened lending standards that his company sought political cover in order to blunt efforts to address the serious structural problems posed by the GSEs. Mudd told the assembled Members that he was “humbled…to reaffirm the friendship and the partnership between Fannie Mae and the Congressional Black Caucus,” and noted that “[s]o many of you have been good friends to Fannie Mae and our [affordable housing] mission…You’ve been friends through thick and thin.” In reference to the accounting scandal, Mudd noted:
We have indeed come upon a difficult time for Fannie Mae. There is much to be done inside my company and I humbly ask you to help us and to help me. If there are areas where we are missing, if there are areas where we could do better, we’d like to hear it from our friends and I’d be so bold as to say, our family first.

He noted pointedly that “Fannie Mae has lent more money to more minorities and more underserved individuals than any single company in history,” and reassured Members that “you will see Fannie Mae reaching out and listening to the [Congressional Black] Caucus” and opined that “you are also the conscience of Fannie Mae, keeping us on course to serve those who need serving most.”

This speech by Fannie Mae’s CEO reveals much about the unique relationship between the GSEs and congressional advocates of lower mortgage lending standards. The company was desperate to maintain its unfair competitive advantages granted by Congress in the wake of the accounting scandals and increased calls to strip it of some of those privileges. Its leadership clearly decided that the best strategy was to play up the politically popular albeit short-sighted goal of lowering their standards in order to increase the national homeownership rate and please their political benefactors. That the effect of this strategy was to trap Americans in unsustainable mortgages and feed the growth of a housing bubble merely heaped insult upon injury.

So, whose fault was this pattern of political and private interests leapfrogging each other to doom?

The usual categories of conventional thinking -- Republican vs. Democrat, business vs. government, libertarian vs. regulatory, etc. -- aren't very useful here because it was a total systemic screw-up. And those occur precisely when the culture's approved divisions of thought are inadequate, when what All-Right Thinking People think about the Sacred Verities are wrong, and only a few people who have been marginalized for their Evil Thoughts are right.

Ultimately, the most reasonable attribution of blame falls foremost on our culture's most sacred mindset: anti-skepticism about minorities. Decades of demonizing realistic thought about race came back to bite us.

From a purely theoretical point of view, where else would we be most likely to get ripped off other than from a direction we are not allowed to worry about?

Strikingly, the GOP report does tiptoe up to the edge of reporting HateStats:
Indeed, according to the U.S. Census Bureau, Latino homeownership increased by 47 percent during the housing bubble, from 4.1 million to 6.1 million between 2000 and 2007. This was an astonishing rate of increase at a time when the national homeownership rate rose by just 8 percent.

The report concludes with some big numbers:
During the House Oversight and Government Reform Committee’s investigation starting, in the fall of 2008, it became clear that Fannie Mae and Freddie Mac were in fact leaders in risky mortgage lending. According to an analysis presented to the Committee, between 2002 and 2007, Fannie and Freddie purchased $1.9 trillion of mortgages made to borrowers with credit scores below 660, one of the definitions of “subprime” used by federal banking regulators. This represents over 54% of all such mortgages purchased during those years. If one factors in Alt-A and adjustable-rate mortgages, this analysis found that, at the end of 2008, Fannie and Freddie were still exposed to $1.6 trillion of risky default-prone loans. Thus, at year-end 2008, Fannie Mae and Freddie Mac were responsible for 34 percent of all outstanding subprime mortgages and 60 percent of all outstanding Alt-A mortgages in the United States.

... nonprime loans, which accounted for only 34% of the GSEs’ risk exposure at the end of 2008, were suffering a 6% delinquency rate, accounting for 90% of the GSEs’ losses. Put another way, the GSEs’nonprime loans were 14 times more likely to be in serious delinquency than their prime loans. In the end, failures on nonprime GSE mortgages may account for the failure of roughly 1 in 6 home mortgages in the U.S., or 8.8 million foreclosures. ...

These statistics are alarming enough on their own, but the real tragedy of the
government’s affordable housing policy is the impact on average Americans, particularly those of modest means. Millions of these borrowers, who were supposed to have been helped by federal affordable housing policy, have now been forced into delinquency and foreclosure, destroying their asset base, their credit, and in some cases their families. For example, Latino homeowners, who once appeared to be among the most frequent beneficiaries of affordable housing policies, are now the victims of the policies that their political representatives in Washington once championed. According to the Pew Hispanic Center, nearly one-in-ten Latino homeowners said they had missed a mortgage payment or were unable to make a full payment, while 3 percent said they have received a foreclosure notice in the past year. At the same time, 62 percent of Latino homeowners said there have been foreclosures in their neighborhoods and 36 percent say they are worried about their own homes going into foreclosure.

My published articles are archived at iSteve.com -- Steve Sailer


Anonymous said...

There is nobody good in this story: knaves, frauds, thieves, fools, opportunists, shakedown artists, race hustlers, sociopaths, egomaniacs, and political wirepullers. I am reminded of the title of Hunter Thompson's book, "Generation of Swine."

A phony sympathy for minorities covers the whole mix in the same way that an oil spill coats the detritus on a beach with gooey slime.

Like Diogenes, we search in vain for an honest man.

RKU said...

Well, since I notoriously have a one-track mind, what jumped out at me was something in the last quoted paragraph of Steve's very long excerpt from the Republican report, which he praised so highly:

"...nearly one-in-ten Latino homeowners said they had missed a mortgage payment or were unable to make a full payment, while 3 percent said they have received a foreclosure notice in the past year..."

Now 30 seconds with Google allowed me to find the overall national figures based on data from the Bankers' Association:

"Apparently 7.88% of all home mortgages nationally are delinquent, and 3.30% are currently in foreclosure."

Offhand, wouldn't this seem to indicate that the Latino deliquency/foreclosure figures are roughly comparable to the national average, maybe somewhat higher, but not enormously so?

Furthermore, we must remember---as Steve endlessly emphasizes---that Latino home-buying was very heavily concentrated in the "Sand States" such as CA, AZ, NV, and FL, which have delinquency/foreclosure levels enormously higher than the national average. Wouldn't this tend to indicate that Latino homeowners generally have *lower* delinquency/foreclosure rates than their non-Latino neighbors?

I think Steve and the Republicans may have just blown up the "Diversity Mortgage Meltdown" theory without realizing it...

I'm not some king of fanatic pro-Latino lunatic...just someone who likes to follow a Reality-Based model.

CJ said...

Long read Steve. I'm still digesting it, but I think you forgot to paste in a quote from the report that you intended to include. It's after the colon in this section.

During those years, Wall Street firms rushed into take over the traditional role of the GSEs. They were egged on by the Bush Administration's October 15, 2002 White House Conference on Increasing Home Ownership, where Bush called for adding 5.5 million more minority homeowners through, in effect, zero downpayment liar loans. The GOP report argues:

The GOP report doesn't go that far ...

John Anello said...

The role of the ratings agencies in the debacle is grossly underestimated. S&P, Moody’s, and Fitch were rating mortgage backed securities with the same amount of discrepancy used by Chicago meat packing inspectors in 1906.

These rating agencies remain in business despite their reckless behavior because SEC regulations require that institutions receive their ratings from a nationally recognized statistical rating organization. Becoming an NRSRO is very difficult, again because of SEC regulation.

So the ratings agencies are basically government sponsored monopolies immune from free market consequences for their mistakes. Anyone still think it was the free market that failed?

Xtra Laj said...

"I'm not some king of fanatic pro-Latino lunatic...just someone who likes to follow a Reality-Based model."

Good point raised. Would like to hear Steve respond, but I think that the numbers you are citing are very compatible with the Hispanic population being a sizable part of national foreclosures and driving the national statistics. But whether that is the case would require us to see how the data you are using and the data Steve is using overlap.

read it said...

"I'm not some king of fanatic pro-Latino lunatic...just someone who likes to follow a Reality-Based model."


I think the main difference is the percent of total dollars of default which does not necessarily mirror the exact percent of defaults. This hard data presented by Steve shows the impact of minority defaults. Also, when the lending institutions report numbers, they are based on actually counting the defaults and counting the total mortgages. These are not random phone surveys where people can lie.

Anonymous said...

Republicans are intelligent when they're out of power. They're idiots when they're in power.

Democrats are idiots in and out of power.

There's your choice, America.

John Seiler said...

The GOP report also neglects:

1) The debasement of the currency by Greenspan-Bush, causing gold to triple in price after 9/11.

2) The role of state and local governments in advancing shaky mortgages to minorities. In the mid-2000s, Republican Gov. Schwarzenegger signed a bill advancing such easy loans. What other states did so? Somebody should research this.

Eric said...

Apparently 7.88% of all home mortgages nationally are delinquent, and 3.30% are currently in foreclosure.

I think "missed a mortgage payment" and "delinquent" aren't exactly the same thing. If I don't make a payment in March and then use my tax return in April to make my account current I have missed a payment but I'm not delinquent (at least as of April).

Toadal said...

Gainer and Sturm said "Supreme Court's 5-to4 decision... perpetuates profound misconceptions about the capacity of paper-and-pencil tests to gauge a person’s potential on the job."

How else to access how quickly and accurately a candidate can grasp firefighting efficiency while making life and death decisions, besides a paper-and-pencil test? How do we qualify a bookkeeper, a programmer, or an anesthesiologist?
We use Civil Service paper-and-pencil tests to select the most highly qualified candidates; to do otherwise would lead to a weaker, poorer, and more corrupt nation.

Maybe I'm laughing my way to disaster
Maybe my race has been run
Maybe I'm blind to the fate of mankind
But what can be done?

So God bless the goods we was given
And God bless the U. S. of A.
And God bless our standard of livin'
Let's keep it that way

Paul Simon - Have a Good Time

Anonymous said...

"Congress granted HUD the authority to adjust these three affordable housing quotas for the GSEs over time, allowing both Democratic and Republican Administrations to consistently make campaign promises to boost homeownership through government intervention in the market. Consequently, under both the Clinton and Bush Administrations, HUD dramatically increased these quotas, which reached their zenith when the Bush Administration raised them to 56 percent, 27 percent and 39 percent, respectively."

But 56%+27%+39%=122%...Can anyone explain how the three HUD quotas managed that?