Tuesday, October 7, 2008

Hurricane Subprime - Part I (1977 to 2000)

The left claims that the subprime crisis is a failure of capitalism and a consequence of "deregulation" pushed by Republicans. How accurate are those claims?

The short answer to the above question - ridiculous. Yes, other things have combined with the subprime crisis to worsen the mess we are in financially. But to point to those things while claiming that the subprime crisis itself is anything other than the alpha and omega of this fiscal catastrophe is pure prevarication.

One way to analogize the financial crisis is to a hurricane, with the left's push of subprime lending as a tool of social engineering being the hurricane gaining strength over the ocean. The deregulation of which the left complains did nothing to cause or strengthen the hurricane. What it did was effect some the levees on land designed to protect the markets.

During the period 1977-2000, most of the elements of our current fiscal crisis were put in place. President Clinton turned a little known law from the Carter-era, the Community Reinvestment Act, into a tool of massive socialist engineering. Color-blind lending standards were eviscerated and new standards were enforced by the police powers of the government and through the enlistment of community organizers and their ilk. Fannie Mae and Freddie Mac were made the engines of the new social engineering, creating an ever-expanding market for mortgages founded upon the new "innovative" lending standards. All attempts by Republicans to attack this cancer failed. The left deliegitimized and beat back every attempt to reform the CRA by recasting such efforts as racist.

As to the levees designed to protect our economy against such hurricane, some were important, others were meaningless. Possibly the most important but as of yet underreported aspect of the crisis, is how rating agencies of the era vastly underrated the risk of the toxic mortgage backed securities coming out of Fannie Mae. The repeal of Glass-Steagall actually strengthened some of the levees. Credit Default Swaps, which developed unregulated during the Clinton era, have proven to be a failed levee unable to withstand the widescale failure of the underlying mortgages.

As a side note before beginning this, understand that the goal of "affordable housing" was laudable. Looking at this in retrospect, there were and are two ways to approach this issue - one from a capitalist and market based approach and one from a socialist and redistributionist approach. The former would have been a series of programs to repair credit and to assist individuals with amassing savings for a downpayment. The latter, well, that was what the left was able to enact.

1977 – A Tropical Depression Forms Under President Jimmy Carter:

The Community Reinvestment Act (CRA) of 1977 was a well intentioned law pushed by then President Jimmy Carter. In defense of President Carter (and those words pass my lips for the first, and I suspect, last time) this law did nothing more than make "red-lining" illegal. Red-lining was a practice whereby banks would simply refuse to extend credit into the poorer sections in their communities. This grossly unfair practice hit minorities the hardest and it did so without reference to credit history or an individualized assessment of likelihood of repayment. The CRA of 1977 did not mandate any lessening of race and gender neutral lending standards. To the contrary, as the NYT summed up the original intent of the CRA, "the Community Reinvestment Act [was] supposed to be about geography, not race or gender." Looking back in 1994, one Fed boardmember described the law as, up to then, having done "little harm and some good." It waited for the left to turn this law into a cancer by stamping it with identity politics.

As we headed into the brave new world of the 1990’s, mortgage lending standards were well established based on decades of experience. These standards included a credit history with a qualifying score, a verifiable and long-term income stream, and based on that income stream, a 28/36 ratio to gross or net as the cap on the share of monthly income that could be devoted to mortgage payments. Further, a down payment in the range of 20% was the industry standard. Years of experience had shown that individuals with that sizeable a stake in their home were far less likely to go into default.

1992 - The Tropical Depression Becomes A Category I Hurricane

William Jefferson Clinton was elected President in 1992, the same year the Boston Fed published an atrocious study alleging wide-spread racism in mortgage lending. According to the report, "Blacks and Hispanics remained trapped in a lending gap when they tried to buy homes last year in Greater Boston, denied mortgages more than twice as often as whites regardless of income."

The report did not accurately adjust data for credit scores, income steams, etc., which, when later done, showed no racism in lending practices. Nonetheless, this single report was embraced by the left as proof positive of wide spread racism in lending. No further – and surely to be conflicting reports – were deemed necessary before taking action on a national scale. The left used the report as justification not to level what was in reality an already level playing field, nor to justify market based government programs to help raise lower-income minority borrowers to the point that they could meet the lending standards and save for a down payment. Rather, they used the report to entirely gut lending standards on a nationwide scale, forcing lending institutions to take part in a massive redistribution of wealth as part of the most costly bit of social engineering ever undertaken.

The Boston Fed led the way, publishing "Closing the Gap: A Guide to Equal Opportunity Lending" in 1992. The central thesis of this guide was that "[u]nintentional discrimination may be observed when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower–income minority applicants" (emphasis added).

The "arbitrary and outdated criteria" the Boston Fed had in mind amounted to an attack across the panoply of lending standards. Racially neutral fiscal standards and reality fell to the politics of race (quotes from the Fed publication appear in italics):

Gone were “outdated” debt limits, as obligation ratios were now deemed arbitrary and racist when applied to lower income households:

“Obligation Ratios: . . . Many lower–income households are accustomed to allocating a large percentage of their income toward rent. While it is important to ensure that the borrower is not assuming an unreasonable level of debt, it should be noted that the secondary market is willing to consider ratios above the standard 28/36.”

Gone were credit history and credit scores. And indeed, in what can be called the ACORN Full Employment Act, credit counseling and buyer education programs run by community organizations could ameliorate bad credit history.

“Credit History: Policies regarding applicants with no credit history or problem credit history should be reviewed. Lack of credit history should not be seen as a negative factor. . . For lower–income applicants in particular, unforeseen expenses can have a disproportionate effect on an otherwise positive credit record. In these instances, paying off past bad debts or establishing a regular repayment schedule with creditors may demonstrate a willingness and ability to resolve debts.

Successful participation in credit counseling or buyer education programs is another way that applicants can demonstrate an ability to manage their debts responsibly.

Gone was the requirement for a permanent income source. Now, even temporary sources of income, such as welfare and unemployment benefits, were to be considered without regard to the fact that, while the mortgage would take 30 years, the income streams now being counted were of very limited duration.

“Sources of Income: In addition to primary employment income, Fannie Mae and Freddie Mac will accept the following as valid income sources: overtime and part–time work, second jobs (including seasonal work), retirement and Social Security income, alimony, child support, Veterans Administration (VA) benefits, welfare payments, and unemployment benefits.”

And in perhaps what has turned out to be the biggest mistake, gone were requirements that the individual borrower personally produce a down payment. Long experience had shown that a significant downpayment made personally by the borrower was perhaps the most significant indicie of stability of mortgages:

Down Payment and Closing Costs: Accumulating enough savings to cover the various costs associated with a mortgage loan is often a significant barrier to homeownership by lower–income applicants. Lenders may wish to allow gifts, grants, or loans from relatives, nonprofit organizations, or municipal agencies to cover part of these costs. Cash–on–hand could also be an acceptable means of payment if borrowers can document its source and demonstrate that they normally pay their bills in cash.

Even appraisal standards were changed for lending in low-income areas - and accompanied by a clear warning that failure to follow these new standards could lead to liability for racism.

Management should be aware that Fannie Mae and Freddie Mac have issued statements to the effect that they understand urban areas require different appraisal methods. Accordingly, it may be advantageous to use the services of appraisers with experience in conducting appraisals in minority and lower–income neighborhoods. Management should consider having all appraisal reports that would cause an application to be denied reviewed by another experienced appraiser. This can help protect the financial institution as well, as it may be held liable if an appraisal is found to be discriminatory.

Lastly, if the financial institutions did not understand the downside of still using “outdated and arbitrary” lending procedures, then the Boston Fed provided a helpful reminder on the last page.

The federal agencies that regulate financial institutions have authority to enforce Regulation B administratively. Civil suits for unlawful credit discrimination may be brought within two years of the date of the occurrence of the alleged violation. Damages include actual damages and punitive damages of up to $10,000 in individual actions. Punitive damages are limited to the lesser of $500,000 or 1 percent of the creditor’s net worth in class actions.

The damage done by this massive bit of social engineering and protected by the left bled throughout the entire mortgage industry. It, more than anything else, is where responsibiity for the subprime crisis - a crisis that in reality goes far beyond subprime loans - actually lies.

1993 – 2000: The Hurricane Gains Strength To Category II

There were five parts to the Clinton Administration’s single-minded push to drive America’s into the subprime swamp. The first three were directed at forcing financial institutions to dispense with the “outdated and arbitrary” lending criteria. The fourth leg was to create a huge market for these loans. The fifth and last leg was the meme used to forward and defend these “innovations” by Clinton and Democrats. Any challenge to this new plan was invariably recast as racism and race cards were played with wild abandon.

To force these new lending standards on America. Clinton promulgated new regulations under the CRA, turning it from a purely geographical law aimed at red-lining into the nation’s largest affirmative action program. These regulations were enforced by the Justice Dept. and bank regulators on one end, while provisions in the CRA allowed “community groups” on the other end to bring private law suits – something out of which ACORN and other progressive organizations have made a highly profitable cottage industry.

By 1993, Clinton proposed a vast expansion of regulation under the CRA. He did this not through Congress, but through regulators. Once Congress has voted on enabling legislation for regulators, they are empowered, within limits, to craft regulation that passes into law without vote by Congress. This from the NYT in December, 1993:


The Clinton Administration proposed tough new tests today that are intended to insure that banks end discrimination in their lending to members of minority groups and to people with low and moderate incomes.

The changes are the latest effort by the Administration to broaden access to credit, financial services and investments. Officials predicted that people and businesses in these groups would gain access that they might not otherwise get to billions of dollars in credit once the proposals take effect in 1995.

The regulations, which set higher standards for banks, for the first time apply objective measurements on three levels. Banks would be tested in several ways to determine if their overall pattern of lending in specific neighborhoods was biased, when compared to their overall lending and those of competitors. They would also be judged on whether they were making investments in a community's growth, like grants for economic redevelopment, and whether they were providing a full array of customer services.

. . . [B]anks could for the first time face sanctions like binding orders or fines to change their practices.

That would give regulators additional power. Now, a bank's poor record in this area can affect whether the Government will permit bank acquisitions or mergers, and institutions that fall short have been sued by community groups or regulators. Lately, Federal regulators have blocked bank acquisitions when they regarded a lending pattern unfavorably.

The proposal is the most important modification of equal-lending enforcement since 1977, when Congress passed the Community Reinvestment Act. That law was intended to force banks to make loans to individuals, businesses and groups in neighborhoods that many large financial institutions had shunned. . . .

There were a few brave souls who unafraid of charges of racisim, spoke out against this change. One group was at the Fed. This from a NYT article in December, 1993:

Members of the Federal Reserve Board today sharply criticized the Clinton Administration's new plan for insuring that banks open branches and make loans in poor and minority neighborhoods. . . . [M]ost of its members expressed reservations about the plan as drafted. . . .

. . . Its reservations about the fair lending plan, which is part of a broad effort by the Administration to spur lending in poorer communities, had been expected. But some members strongly denounced the plan, revealing the depth of the board's opposition for the first time.

. . . The Administration's plan would toughen the tests used to insure that banks comply with the Community Reinvestment Act. For the first time, banks would be tested based on data about their loans and other operations.

And ironically, one of the other vocal and staunch opponents of this new push into subprime lending were minority owned banks that served large urban areas. This from the NYT in September, 1993:

The black bankers said they were concerned about heightened enforcement of the Community Reinvestment Act of 1977, which mandates lending in underserved areas, . . .

Indeed, many black-owned banks have tended to aim at the wealthiest and most creditworthy black customers while turning away poorer applicants for fear of losing money on risky loans.

If that does not tell you how devoid of substance charges of racism were against conservatives and Republicans who challenged Clinton's changes to the CRA, nothing will. Yet that did not stop the left from playing the race cards with abandon in response to any and all efforts to legislatively reign in the CRA. In 1995, House Republicans made a major push to fundamentally change the CRA from the world’s largest affirmative action program into one that assured a level playing field for all.

As reported in the NYT, the proposed legislation would have barred "the Justice Department from relying on statistical patterns of discrimination, forcing it to rely instead on cases of demonstrable bias against specific individuals." In other words, if a minority and a non-minority were on equal footing in terms of lending criteria and both were denied a loan, then there could be no charges of racism. The ratio of loans given to minorities versus non-minorities would be immaterial in the absence of a finding of at least some actual racism. Further, the challenge would have stopped "community activists" – and community organizers - from blocking "banks with bad community-lending records from obtaining regulatory approval for mergers, acquisitions and other transactions." These changes were "strongly opposed" by "House Democrats, community activists and the Clinton Administration." " . . . Democrats as well as consumer and community groups accused Republicans of . . . undermining affirmative action."

The effect of these changes would have created a level playing field with no impetus to adopt fiscally unsound lending policies. The changes would have done nothing to weaken the sound prohibition against red-lining. Nonetheless, the NYT grossly mischaracterized the effect of these provisions as to "eliminate most enforcement of the Federal law that requires banks to lend in poor neighborhoods as well as rich ones." And then, a few days later, the NYT editorial board in June of 1995 played the race card:

. . . Banking legislation working its way through the House would also cause damage, both socially and economically. It would remove the Justice Department's authority to sue bankers and realtors who systematically block blacks and other minorities from renting apartments or getting mortgages. Apparently Justice has been too vigilant fighting discrimination for the G.O.P.'s taste. . . .

The bill . . . would . . . gut the Community Reinvestment Act, which requires banks to lend money in the neighborhoods where they take deposits or else possibly relinquish the right to merge or open and close branch offices.

Again in 1999, Republicans, this time led by Senator Phil Gramm, tried to push through a bill that, as part of a major restructuring of our financial laws, would also have changed the nature of CRA similar to the earlier House plan. As the NYT reported in Oct, 1999:

. . . . Mr. Gramm has repeatedly criticized the way regulators have interpreted the [CRA], saying that the Government should not be in the business of ''reallocating capital'' and that the law imposes unnecessary and burdensome requirements on small banks and savings associations.

His critics say that the Financial Services Act of 1999, as his bill is called, would roll back the Community Reinvestment Act. Those critics include the Congressional Black Caucus, a group that helped save Mr. Clinton's Presidency during the Senate trial proceedings early this year.

There were fresh signs today that Democrats and Republicans were hardening their views. Nine Republicans sent a letter to Mr. Gramm urging him to hold the line and not make any significant concessions on the issue. At the same time, the Rev. Jesse Jackson said in an interview that he was urging the White House to hold firm and that a compromise on the Community Reinvestment Act would undermine the President's commitment to raising capital in poor areas.

President Clinton’s promise "to veto the legislation unless major changes were made on the provisions in the Community Reinvestment Act" won the day. One side note that came out of this is worthy of mention. In order to buttress support for the CRA, the Clinton White House, in 1999, "instructed bank examiners . . . to seek testimonials from bankers about the Community Reinvestment Act." It ultimately came out in a report on this incident that the regulators asking banks for CRA testimonials while conducting CRA compliance inspections – all of which certainly seems a tremendous abuse of power. But even with that "the examiners ultimately did not find any executives to speak on behalf of the Community Reinvestment Act."

The changes worked by the Clinton administration not only provided for stiff civil penalties that could be imposed by the Justice Dept., but also allowed individuals and community groups to bring private law suits claiming discrimination in lending. This served a dual purpose for far left organizations. Against some, they actually filed law suits to force greater lending to minorities, seemingly irrespective of credit worthiness. The second purpose was – and is – as a shakedown vehicle, getting promises of funding in order to refrain from lawsuits or creating bad publicity. Both have been effective. As the NYT described it in 1999:

Critics led by Phil Gramm, . . . argu[e] that [the CRA] imposes unfair regulatory burdens on banks and allows advocacy groups to ''extort'' money from institutions that do not want bad publicity over their lending records.

. . . Consider Bank of America, which estimates that its community lending and investment business . . . Created when Nationsbank acquired BankAmerica last year, the bank . . . pledged a 10-year, $350 billion package of community-development lending and investment to assuage regulators and activists . . .

. . . After Congress passed the law in 1977, many banks ignored it until the early 1990's, when regulators and the Clinton Administration stepped up examinations while community advocates intensified protests of mergers involving banks with spotty records. The law requires periodic reviews of banks to insure that they meet the credit needs of the communities they serve, particularly lower-income neighborhoods. Poor compliance can hurt efforts to expand or acquire other banks, though such setbacks rarely happen.

Nevertheless, figures supplied by both community groups and banking industry officials suggest that the law has been effective over the last decade. Today, 29 percent of home mortgage loans are made to low- and middle-income borrowers, compared with 18 percent nine years ago, according to the National Community Reinvestment Coalition, a nonprofit group made up of 700 community lending organizations.

Some places have experienced far greater changes. In Texas, for instance, the proportion of Nationsbank's home loans to low-income borrowers leapt from 1 percent in 1989 to more than 20 percent over the last decade, Ms. Bessant said.

And lenders have promised more than $1 trillion to future community lending and investment in low-income areas. Nearly all of that has been pledged in the last few years, after regulators changed the compliance rules to focus more on actual dollar amounts, while community groups sought assurances that a spate of recent industry mega-mergers would not hurt loan volumes in poorer neighborhoods. . . .

Senator Gramm has a more specific objection to the law, which, in his view, amounts to a shakedown: He contends that banks that want to merge or expand have to deal with opportunistic advocacy groups who agree to silence their outrage over lending records only after being paid off with grants, consulting fees or other payments. He has sought to require disclosure of details of most of these payments and agreements.

As an example, his committee circulated copies of what he said were secret agreements in which advocacy groups promise to end protests in exchange for money for their organizations. In one such document, in which the names were blacked out, a protester agreed not to object to any bank expansion in return for payments including $7.5 million in grants over 10 years and $200,000 to pay for new offices. . . .

These were the kind of lawsuits ACORN specialized in and which Obama participated as a lawyer. Stanley Kurtz did a detailed article and an interview on community organizer Obama’s efforts to help ACORN and their involvement in pushing subprime lending on Chicago banks. Kurtz has also composed a more recent article at NRO discussing the key role ACORN played in successfully lobbying for the changes to the CRA, the gutting of lending standards, and the creation of a market for such loans through Fannie Mae.

Having created the contagion, the Clinton administration now spread it by using creating immense markets for mortgages based on these "innovative" lending standards. Fannie Mae and Freddie Mac were the vehicles. Fannie Mae was created in 1938 as part of the New Deal. It was spun off as a Government Sponsored Enterprise in 1968. While technically a private corporation, it was subject to direct federal oversight. As it existed in 1990, HUD exercised authority of Fannie and Freddie through a relatively toothless regulator, OFEHO.

The concept behind Fannie Mae was that it would provide a secondary market for mortgages, thus allowing loan originators to quickly recoup liquidity which in turn allowed them to make more loans. Fannie issued no mortgages directly, but rather purchased mortgages from originators. Fannie kept some of these mortgages for its own portfolio while bundling the majority into "mortgage backed securities" which were sold to investors.

The Clinton Administration pushed Fannie and Freddie into the ‘subprime’ market in a big way. With Jim Johnson at the helm, Fannie announced in 1994 a "$1 trillion dollar initiative" aimed at putting 10 million middle and lower income families into housing through use of "innovative products." As pointed out by the LA Times:

Fannie Mae . . . agreed to buy more loans with very low down payments–or with mortgage payments that represent an unusually high percentage of a buyer’s income. That’s made banks willing to lend to lower-income families they once might have rejected.

And indeed, in 1994, "46 percent of Fannie Mae's total business was in low- and moderate-income mortgages, and 31 percent was in central cities." This was followed in 1995 when the Clinton Administration, under the rubric of affordable housing, established through HUD minimum goals for purchases of subprime mortgages.

ACORN, the organization that Obama so closely associated with in Chicago, was a key player in these and subsequent developments. As Stanley Kurtz writes at the NRO:

By July of 1991, ACORN’s legislative campaign began to bear fruit. As the Chicago Tribune put it, “Housing activists have been pushing hard to improve housing for the poor by extracting greater financial support from the country’s two highly profitable secondary mortgage-market companies. Thanks to the help of sympathetic lawmakers, it appeared...that they may succeed.” The Tribune went on to explain that House Democrat Henry Gonzales had announced that Fannie and Freddie had agreed to commit $3.5 billion to low-income housing in 1992 and 1993, in addition to a just-announced $10 billion “affordable housing loan program” by Fannie Mae. The article emphasizes ACORN pressure and notes that Fannie and Freddie had been fighting against the plan as recently as a week before agreement was reached. Fannie and Freddie gave in only to stave off even more restrictive legislation floated by congressional Democrats.

A mere month later, ACORN Housing Corporation president, George Butts made news by complaining to a House Banking subcommittee that ACORN’s efforts to pressure banks using CRA were still being hamstrung by Fannie and Freddie. Butts also demanded still more data on the race, gender, and income of loan applicants. Many news reports over the ensuing months point to ACORN as the key source of pressure on congress for a further reduction of credit standards at Fannie Mae and Freddie Mac. As a result of this pressure, ACORN was eventually permitted to redraft many of Fannie Mae and Freddie Mac’s loan guidelines.

. . . With the advent of the Clinton administration, however, ACORN’s fortunes took a positive turn. Clinton Housing Secretary Henry Cisnersos pledged to meet monthly with ACORN representatives. For ACORN, those meetings bore fruit.

Another factor working in ACORN’s favor was that its increasing success with local banks turned those banks into allies in the battle with Fannie and Freddie. Precisely because ACORN’s local pressure tactics were working, banks themselves now wanted Fannie and Freddie to loosen their standards still further, so as to buy up still more of the high-risk loans they’d made at ACORN’s insistence. So by the 1993, a grand alliance of ACORN, national Democrats, and local bankers looking for someone to lessen the risks imposed on them by CRA and ACORN were uniting to pressure Fannie and Freddie to loosen credit standards still further.

At this point, both ACORN and the Clinton administration were working together to impose large numerical targets or “set asides” (really a sort of poor and minority loan quota system) on Fannie and Freddie. ACORN called for at least half of Fannie and Freddie loans to go to low-income customers. At first the Clinton administration offered a set-aside of 30 percent. But eventually ACORN got what it wanted. In early 1994, the Clinton administration floated plans for committing $1 trillion in loans to low- and moderate-income home-buyers, which would amount to about half of Fannie Mae’s business by the end of the decade. Wall Street Analysts attributed Fannie Mae’s willingness to go along with the change to the need to protect itself against still more severe “congressional attack.” News reports also highlighted praise for the change from ACORN’s head lobbyist, Deepak Bhargava.

This sweeping debasement of credit standards was touted by Fannie Mae’s chairman, chief executive officer, and now prominent Obama adviser James A. Johnson. This is also the period when Fannie Mae ramped up its pilot programs and local partnerships with ACORN, all of which became precedents and models for the pattern of risky subprime mortgages at the root of today’s crisis. During these years, Obama’s Chicago ACORN ally, Madeline Talbott, was at the forefront of participation in those pilot programs, and her activities were consistently supported by Obama through both foundation funding and personal leadership training for her top organizers.

Finally, in June of 1995, President Clinton, Vice President Gore, and Secretary Cisneros announced the administration’s comprehensive new strategy for raising home-ownership in America to an all-time high. Representatives from ACORN were guests of honor at the ceremony. In his remarks, Clinton emphasized that: “Out homeownership strategy will not cost the taxpayers one extra cent. It will not require legislation.” Clinton meant that informal partnerships between Fannie and Freddie and groups like ACORN would make mortgages available to customers “who have historically been excluded from homeownership.”

The next expansion into ever more risky mortgages came in 1999 when Fannie Mae CEO Franklin Raines announced an even further loosening of the lending criteria Fannie would accept. As reported by the NYT in 1999 article:

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. The action . . . will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.

. . . Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits. . . .

''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''

Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market. In moving . . . into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, . . .

Thus, as 2000 drew to a close, the left had set in motion what was to become the most costly failed engineering/affirmative action project of all time. Their greatest sin was throwing out color-blind lending standards and replacing them with incredibly weak and risky standards based on identity politics. As will be discussed in part II, that has not only lead to risky subprime mortgages, but it has infected all classes of mortgages. When combined with the ever expanding market for such loans by Fannie, a rating system that broke down, and low interest rates in the wake of 9-11, the protection of Fannie by Demorats, and yet another huge expansion by Fannie into the subprime market in 2005, the hurricane went from category two to category five. And it did so under the protection of racial politics played continuously by the left.

But is there anything of the left's claim that the current economic crisis really has nothing to do with their socialist engineering, but rather that it is a failure of capitalism and a direct result of Republican sponsored deregulation? Some of the acts of deregulation occurred after 2000, but some occurred prior to 2000, on the watch of Democrats and Bill Clinton. These were the levees that were supposed to protect against this type financial hurricane. What of these?

1993 – 2000: The Levees

The Glass Steagall Act

The left likes to point to it as an example of deregulation that has caused the current mess. It is not.

Glass Steagall was a New Deal law that, among other things, set up a wall between the activities of investment banks and commercial banks. This was unique to American law, and indeed, banks in Europe and elsewhere in the world have always operated without such separation. Further, it was a wall that "had already been breached over many years, with the approval of regulators. Besides, the first major failures of this crisis, Bear Stearns and Lehman Brothers, were investment banks that did not go into commercial banking in a big way." And indeed, one of the staunchest defenders of the move to repeal Glass-Steagall was President Clinton. As he notes, the repeal has actually helped to limit some of the major the damage now being done to our financial institutions.

Credit Default Swaps

Credit Default Swaps (CDS) are not the cause of the hurricane. Rather, they are a levee that has been totally overcome by the hurricane's storm surge. Credit Default Swaps were created on the watch of President Clinton, supported by Fed Chairman, Alan Greenspan, and raised no red flags from any Republican or Democrat in Congress.

Newsweek has a good article discussing the creation, purpose and development of CDS’s. These were developed in 1994 by J.P. Morgan as a method for large institutions to spread their risk and free up capital that otherwise had to be held in reserves:

What the bankers hit on was a sort of insurance policy: a third party would assume the risk of [a debt instrument held by the bank] going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices.

Dinah Lord, a former trader, has more on CDS. On its face, there is nothing inherently risky in the CDS model. That said, it is now clear that the model fails when the debt instruments underlying the swaps fail catastrophically and in large number. That is what is happening with CDS’s tied to mortgage backed securities today. It must be noted that while CDS’s are failing, this is not creating any new debt obligations. With or without CDS’s, someone would be left holding the downside risk on the failing mortgage backed securities. All CDS’s have done is make the CDS holder, Company A, feel the pinch rather than the mortgage backed security holder, Company B.

That said, there are two downsides of CDS’s. The market for all CDS’s is massive – somewhere in the neighborhood of $50 trillion dollars world wide. They clearly have added a layer of complexity to the financial markets that, because of the mass failure of the underlying mortgages, has introduced a strong measure of uncertainty into the markets. Further, it would seem that some financial institutions have used CDS’s to get around capital reserve requirements. This has heightened the fragility of some of our major institutions, though is clearly not all as some, such as J.P. Morgan and Bank of America – organizations with a strong commercial banking component – are financially sound.

During the first six years of their existence, CDS’s were unregulated. They were deemed a good way to spread risk by virtually all in the financial industry and in government. Indeed, Fed Chairman Alan Greenspan spoke before Congress on the issue, finding no reason for the Fed to regulate CDS’s. No one in Congress disagreed. President Clinton did not disagree. And ultimately, a law was passed in 2000 that held that CDS’s would not be regulated by the Commodity Futures Exchange.

This is not surprising. We regulate to protect against fraud and unfair practices that impact the average investor. For the same reason, we regulate to insure a measure of sound practices. We do not regulate to protect sophisticated investors. That is why, for example, hedge funds, which are vehicles in which sophisticated investors are allowed to take part, operate unregulated.

The role of CDS’s in the subprime crisis will need to be thoroughly dissected in a post mortem. That said, while CDS’s have failed to protect us by efficiently distributing risk, they have not been the cause of the economic meltdown. That still rests squarely with mortgage industry the CDS’s were built upon.

Rating Securities

One of the most questionable aspects of the subprime meltdown is how mortgage backed securities being pumped out by Fannie Mae and others, were vastly underrated as to the actual risk they represented. This is another horror story that centers on the tearing down of "outdated and arbitrary" lending criteria. From the information available today, it appears that, when the old standards were labled "racist" under Clinton, the rating agencies tried to adapt to the new "market innovations" without reliance on old standards. This from Stan Liebowitz of the University of Texas:

[Why were] the rating agencies were willing to give [risky loans] AAA ratings? . . .

[T]he housing price bubble that was caused in part by these relaxed underwriting standards tended to reduced defaults and obscure the impact of the standards while prices were rising because almost no one would default when they could, instead, easily sell the house at a profit. Rating agencies could suggest that these loans were no more risky than the old antiquated loans and provide empirical support for that conclusion, given the still low default rates at the time, although to do so was short sighted to the point of incompetence.

In fact, the rating agencies seemed overly concerned with the trees and lost sight of the forest. For example, a Wall Street Journal article (which is the basis for the following three quotes) reports on rating agencies’ benign treatment of piggyback mortgages (taking out a second mortgage to cover the downpayment required by the first mortgage). In previous decades, mortgage applicants unable to come up with the full downpayment and therefore thought to be more at risk of default, were required to pay ‘mortgage insurance’ which raised the interest rate on the loan. Piggyback loans allowed borrowers to avoid this mechanism, thus presumably making the loan riskier. Nevertheless, the article reports that rating agencies did not consider these loans more risky:

Data provided by lenders showed that loans with piggybacks performed like standard mortgages. The finding was unexpected, wrote S&P credit analyst Michael Stock in a 2000 research note. He nonetheless concluded the loans weren't necessarily very risky.

The finding was unexpected because it contradicted what had generally been known about mortgages by a prior generation of mortgage lenders—that when applicants made smaller downpayments, increasing the loan-to-value ratio, the probability of default increased. This finding contradicted common sense. Further, these measurements were being made at the front end of a housing price bubble (Figure 1 below shows that prices were rising smartly in 2000), likely biasing downward any default statistics. Relaxed lending standards also had a short enough track record that rating agencies could not know how they would perform in the long run or in adverse conditions, meaning that it isn’t clear that sufficient information existed to even rate these securities. So how did the rating agencies defend their counterintuitive ratings?

One money manager, James Kragenbring, says he had five to 10 conversations with S&P and Moody's in late 2005 and 2006, discussing whether they should be tougher because of looser lending standards… Other analysts recall being told that ratings could also be revised if the market deteriorated. Said an S&P spokesman: "The market can go with its gut; we have to go with the facts."

Whether such a myopic view of the “facts” was responsible for all or most of the excessively high ratings I cannot say, but these ratings were consistent with the views of the relaxed lending standards crowd. The real facts, of course, eventually soured the view of the rating agencies:

By 2006, S&P was making its own study of such loans' performance. It singled out 639,981 loans made in 2002 to see if its benign assumptions had held up. They hadn't. Loans with piggybacks were 43% more likely to default than other loans, S&P found.

In spite of their inaccurate ratings, the rating agencies, nevertheless, were making great profits from rating mortgage-backed securities, a quasi-sinecure created by the government which required many financial organizations (e.g., insurance companies and money market funds) to invest only in highly rated securities as certified by government (Security and Exchange Commission) approved rating agencies (NRSROs). There were only three such approved rating agencies for most of the last decade (S&P, Moody’s and Fitch). Given that government-approved rating agencies were protected from free competition, it might be expected that these agencies would not want to create political waves by rocking the mortgage boat, endangering a potential loss of their protected profits.


The biggest levee that should have stopped the damage of this hurricane - if not prevented the development of the hurricane itself - was the rating system for mortgage backed securities. This needs to be thoroughly investigated. Credit Default Swaps have exacerbated the current fiscal crisis, but their failure is a mere symptom of the mortgage meltdown. Glass-Steagall is a red herrirng.

Any claim that the left is not wholly responsible for this hurricane now pounding our financial markets has no anchor in the formative events that occurred between 1972 and 2000. Part II will look at the final years as this hurricane grew to level 5 under the same protective race umbrella before finally smashing upon our coast. This will also take a look at suspension of the uptick rule, reduction of capital requirements for some of the major trading houses, and introduction of mark to market accounting.


Jason said...

Do you have a Private mortgage insurance (PMI) policy? If you do have one your PMI insurer passes their risk to others by bundling 100 policies together and selling them as a credit default swaps (CDS). They do this in order to protect themselves by large payment to mortgage providers such as insurers in the event your home is repossessed. In the mortgage industry this has been the case for decades. If you bought a PMI to protect your lender then you are building the CDS market. To avoid this put at least 20% down on your home or pay what it takes now to get rid of the PMI policy. http://nomedals.blogspot.com

Anonymous said...

Your explanation of the subprime mess and concomittant financial crisis is entirely offbase. For a more thorough analysis from a non-partisan source, see the Bank of International Settlement's report: http://www.bis.org/publ/work259.pdf?noframes=1. Note footnote 6 on page 5, which cites work done by Yellen (SF Fed) who has repeatedly noted that the past, present and projected default rates of CRA loans (like Fannie and Freddie loans) is less than one-half the rate of private sector entities. This would not be true if your explanation held water. You also do not account for the huge impact that the unregulated credit default swaps played in the mess, which Warren Buffett correctly warned about in 2002 and which both the Clinton and Bush White Houses and the Republican Fed Chairman Greenspan repeatedly refused to oversee or rein in. You do a great disservice to the few readers of your blog by so incorrectly characterizing serious financial problems for narrow partisan interests. We need an enlightened electorate more than we need a conservative one. And the truth in this case is a serious indictment of laissez-faire economic theory.

GW said...

Anonymous - thank you for stopping by and commenting.

I have read the work you site ( http://www.bis.org/publ/work259.pdf?noframes=1 ) and, indeed, it fully comports with what I have written here. The sole exception is the author's treatment of the CRA in a three sentence footnote. The author spends a large part of his work explaining how degraded lending standards were at the heart of the housing boom and the housing crisis. He does not explain how they came about. That is what I have done in the above post.

Blaming this mess on Credit Default Swaps is akin to blaming a gun for homicide rather than the person that pulled the trigger. Yes, CDS's are implicated, but the trigger was pulled by the mortgage meltdown. Granted the meltdown that extends beyond subprime mortgages, but if you are trying to make the case that the degradation of lending standards throughout the mortgage industry is not traceable to the CRA and the Clinton Administration, you, sir or madame, are the partisan. But, feel free to make your case. I will be happy to argue this one.

dg said...

You have attempted to blame the government for the relaxation of lending standards, without any data. While the BIS merely cites via a footnote, the SF Fed has much data definitively showing that the CRA and GSE loans are performing much better than the private sector loans, which is strong proof that greedy lenders in a time of hubis made bad loans and would have done so without the legislation (e.g., CRA) that you cite. That this legislation came about much earlier adds additional proof. Your explanation remains very weak given the lack of correlative timing or any quantitative proof, nor any rebuttal of counter evidence that is quantified by the SF Fed. This is not a partisan claim, as Yellen was appointed by Greenspan, is also REpubliican, and is making this argument. I would love to see your quantified argument against Yellen's (and my) claims...

The CDS's took down Lehman and AIG, and the key point is that in the absence of any regulation this ability to concentrate large amounts of risk on balance sheets was greatly enhanced by the lack of regulations on CDS. Your main contention is that government regulation was the cause of the financial meltdown, but here is a product and a market entirely beyond the reach of government regulators that hastened the demise of two leading financial institutions. This constitutes disproof of your theory, once again. By the way, several economists (and Greenspan) recently have noted that even minimal regulation would have avoided the massive risks associated with CDS's, since they could have eliminated the 5-10 concurrent bets being simulataneously placed on a single default (creating massive overleveraged positions). Since there were only about 15 major CDS desks worldwide trading the bulk of the product, the logistics of such regulation would have been fairly easy as well. Again, I would love to see you explain how this major contributor to the credit freeze up (i.e., the unregulated CDS market is multiple orders of magnitude larger than the CRA or even the GSE market) was somehow tied to CRA and GSE policies passed a decade or more earlier. Would love to see some numbers too in order to cut through the BS...

dg said...

What you are missing, is that lending standards are not government-made rules. Loads of private entities voluntarily started loaning out 10x gross income without so much as a pay stub. There was no reduction in lending standards prescribed in the CRA legislation that allowed this type of lending behavior. Please show what specific legislative language (which no proponent of your view seems to do) would have allowed, much less forced, lenders to undertake such poorly collateralized loans. And please explain why the lending entities specifically targeted by legislative specifications are experiencing lower default rates than those that were merely "influenced" by those standards. Should be interesting reading...