Saturday, September 27, 2008

How Deregulation Drove Things Along

From a timeline of the crash at The Big Picture blog:
2003-'07: The Federal Reserve failed to use its supervisory and regulatory authority over banks, mortgage underwriters and other lenders, who abandoned such standards as employment history, income, down payments, credit rating, assets, property loan-to-value ratio and debt-servicing ability. The borrower's ability to repay these mortgages was replaced with the lender's ability to securitize and repackage them.

2004: The SEC waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. This 2004 exemption allowed them to exceed this leverage rule. Only five firms -- Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley -- were granted this exemption; they promptly levered up 20, 30 and even 40 to 1.
In the comments of that post, the notion that the Community Reinvestment Act contriubuted to this problem is debated. It's worth reading. In the end, however, the fact that Fannie and Freddie bought hundreds of billions of dollars of bad loans is most certainly a key part.
HUD stuck with an outdated policy that allowed Freddie Mac and Fannie Mae to count billions of dollars they invested in subprime loans as a public good that would foster affordable housing.
No matter how much Fannie and Freddie drove this disaster, claiming that free market purity would have prevented this mess is clearly false.

Update: This press release from HUD put out in 2006 is pretty damning evidence that the government was using Fannie and Freddie as tools for social engineering.


Anonymous said...

The one thing I don't see in your take is that the main problem was lenders got divorced from the borrowers. Because instead of keeping and servicing the mortgages they gave to borrowers, banks packaged them up and resold them on a secondary market, they suddenly had much less incentive to vet their borrowers. They were going to be somebody else's problem. The more mortgages they wrote, the more money they made, there was now a disincentive to deny a loan because they weren't the ones getting paid back.

Then you also had the banks paying the regulators that were saying a certain group of mortgages was ok to put into a bundle, and in many instances telling a bank just how much sub-prime crap they could lard into one of these instruments. This was a clear conflict of interest.


K T Cat said...


The one thing I don't see in your take is that the main problem was lenders got divorced from the borrowers.

AMEN! I just thought that this was such a simplistic and naive approach that I hesitated to mention it. It seems to me that if you had to service the loans you originated, none of this would ever have happened.

Well said!

How did this detachment come about?

Anonymous said...

They call it securitization and it isn't usually bad, that's how stocks and bonds all float. You sell these instruments in the secondary market, then take the cash and loan it out again. It increases the money available for mortgages; this was how the government increased home ownership. The problem is that it really takes stronger regulation to verify that the mortgage bankers are doing their due diligence; and also transparency on exactly what type of risk is in the instruments.

Even now you have this process where the banks are valuing this stuff all over the board. They operate on such thin capital, losses can cause them to completely pull in their horns, now they're scared to even loan to each other.

You're exactly right; the government wanted to extend home ownership through securitizing mortgages, the Republicans wanted less regulation and between the two you end up with mortgage bankers handing out gobs of money to anyone willing to lie about their income. The two ideologies combine to form a perfect storm. Everything went OK until property prices actually started to fall, then the riskier banks were caught with this stuff in their portfolios.