January, 2010
Examining the Current Financial Crisis
Chris Depaolo
House Financial Services Committee hearing on Fannie Mae and Freddie Mac, Sept. 10, 2003:
“I worry, frankly, that there's a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios.” –Rep. Barney Frank (D., Mass)
These are the words of the current Chairman of the House Financial Services Committee, a committee which oversees all components of the nation's housing and financial services sectors including banking, insurance, real estate, public and assisted housing, and securities. Frank was one of many who failed to see the looming crisis in the financial system which erupted in 2007. In fact, Fannie Mae and Freddie Mac were not fundamentally sound financially and were placed into conservatorship by the federal government in 2008. The collapse of the mortgage market began a chain reaction which has spread to global financial markets and has pushed the U.S. economy into a long and deep recession.
So what happened? The problem began in the early 1990s when subprime mortgages began being used as a way for credit-impaired households to obtain mortgages that they would not have previously qualified for, albeit at higher interest rates. These mortgages included negative amortizing mortgages, adjustable rate mortgages, interest only mortgages, and low or no down payment mortgages. Despite the already added risk associated with these mortgages, previously strict underwriting standards were loosened, introducing additional risk into the system. Still, homeownership rates soared to all time highs especially for minorities who would not have qualified under the previously strict standards. Politicians who had pushed for looser lending standards touted their accomplishments and the banking industry reveled in their newly expanded market.
The housing industry boomed as access to loans increased. Construction workers, mortgage brokers, real estate agents, landscapers, surveyors, appraisers, investors, and building suppliers saw record levels of activity and income. As the demand for housing increased, so did the price of housing. As home prices increased, existing homeowners often refinanced their homes, sometimes converting their increased home equity into cash to spend on home improvements or other consumer goods. The newly loosened standards allowed even qualified prime borrowers to buy beyond their means because of the elimination or lowering of down payments, thus giving them access to more expensive houses previously unaffordable with a traditional prime mortgage. The easy access to financing encouraged many to buy second homes or homes for investment. Strapped borrowers began thinking that they could refinance their way out of any problems, and lenders and investors thought that home prices would continue to rise, thus eliminating any loss in the event of a default.
The mortgage market boomed. The 1968 chartering of Fannie Mae and Freddie Mac created a secondary mortgage market in which banks could sell their mortgages rather than holding them on their own books. Mortgages were bundled into mortgage backed securities which were then purchased as investments. Fannie Mae and Freddie Mac were given a government sponsored monopoly on a large part of this secondary mortgage market. As subprime mortgages became more popular in the 1990s and 2000s, they became a greater portion of the mortgages sold. Fannie Mae and Freddie Mac purchased a large portion of these mortgage backed securities and with lower capital requirements than other banks. Other firms also purchased securities which included subprime mortgages.
However, by 2007, the risky lending led to an escalating number of loan defaults and foreclosures. As foreclosures increased, housing prices fell, leaving many people who had purchased homes with little or no down payment with assets worth less than what they owed. These borrowers often decided to default on their loans and move to less costly rentals. Some borrowers who had seen dramatically increased incomes during the boom and had refinanced, purchased new or second homes, built new homes, and bought consumer goods with the assumption that prosperity would continue, soon saw that the increased income was indeed temporary. They found themselves unable to afford their debt obligations and turned to short selling, foreclosure, and bankruptcy as their only options.
Due to the packaging of subprime loans into mortgage-backed securities, the defaults affected investors in the national and international financial markets where they were sold. Many times the originator of the loans (mostly banks) had agreed to buy back any loans that failed to perform as promised, but when many of these loans defaulted and were returned for repurchase, originators faced obligations in excess of their capital, thus leading to bankruptcy filing. Both investors and mortgage originators were left holding devalued mortgages which were coined “toxic assets.” Dozens of banks have failed due to the crisis and many more would have failed if it had not been for the Trouble Asset Relief Program (TARP) funds which propped up struggling banks. Hundreds of billions of dollars have been spent so far by the government in an attempt to stabilize the system.
While there is a tendency for politicians to blame banks and investors for the events that occurred, they are ignoring their role in the crisis. The Depository Institutions Deregulation and Monetary Control Act of 1980 created the ability to charge high interest rates and fees to borrowers. The Alternative Mortgage Transaction Parity Act in 1982 permitted the use of variable interest rates and balloon payments. The Tax Reform Act of 1986 prohibited the deduction of interest on consumer loans, but allowed interest deductions on mortgages, thus making mortgage debt cheaper that consumer debt for many homeowners. The 1995 strengthening of the Community Reinvestment Act forced banks to provide mortgages to lower lending standards. Because politicians like Barney Frank were willing to “roll the dice a little bit more towards subsidized housing” (House Financial Services Committee hearing, Sept.25, 2003) and prevent the normal functioning of the market, we were left with what Alan Greenspan referred to as “a subsidy that prevents the markets from adjusting appropriately, prevents competition and the normal adjustment processes that we see on a day-to-day basis from functioning in a way that creates stability” (Senate Banking Committee, Feb. 24-25, 2004).