The US Housing Crisis...How it Happened
The Origins of a Distorted Market
One of the most impactful recessions in US history began with the linchpin of the inflated US housing collapse which culminated in 2008. This has been one of the most discussed topics in recent years, as it has had a profound economic impact on both the United States as well as citizens around the world. Yet still many seem to be unaware of the origins of this crisis, and the fact that many of the policies which led up to this crisis still continue on today with few changes.
In order to understand how to prevent such a crisis, it is imperative to first understand the genesis of the problem. The 2008/2009 economic crisis was primarily a crisis of the credit markets. Credit is the life blood of a functioning economy. Most of us have multiple forms of credit such as credit cards, overdraft protection, auto loans/leases, and home loans. Without this credit being extended to both individuals and business entities, the global economy comes to a screeching halt. The freezing of credit makes it nearly impossible to transact business, particularly in the digital age in which we live today. So how exactly did the credit markets freeze ???
Banks are the primary origin of credit in the private sector. In order to extend credit, a bank like anyone of us must balance its assets and liabilities. A loan made by a bank to an individual is essentially an asset which is designed to produce an investment return. The bank as an entity can get into financial trouble by carrying loans, which are assets to the bank that are non-performing. That essentially means a loan that may not be paid back. In general banks don’t like to loan money to individuals or businesses whom can’t pay them back for the same reason you or I would not like to loan money to someone who would not repay us. Yet over the years, we began to see a change in banking policy which led to excessive credit being extended to individuals who historically would have had a great deal of trouble gaining access to a loan. So why the progressive change in bank policy ??? In reality there are many factors which led to these changes.
Monetary policy is controlled by the Federal Reserve Bank. The Federal Reserve has numerous functions which are designed to influence economic outcomes. Among them would be the setting of short term lending rates. The Fed, which creates currency determines several short term rates which directly impacts the rates we pay when we borrow money, or what we earn on our savings accounts and CD’s. Following the crash of the “Tech Bubble” and the 2000 recession along with the impact of Sept 11th, the Fed had dropped short term rates to unusually low levels. Although by today’s standards they would be considered high. This extremely low interest rate environment created incentive for borrowing money at extremely low rates to generate higher potential returns on your invested cash. This served as a direct stimulus to borrowing. Many, including myself believe that the Fed held rates too low for too long. Yet low rates incent a borrower to engage in borrowing. But they do not create much incentive for banks to loan money excessively to individuals or entities with poor credit. Many of these incentives began many years before, and culminated with the perfect storm.
Community Reinvestment Act
In 1977 the United States congress signed into law the Community Reinvestment Act. The CRA act was designed to encourage banks to loan money in communities that typically had difficulty obtaining credit due to the less desirable economic conditions. The belief was that banks practiced a policy known as “redlining”. This was a practice of mapping out communities geographically and predetermining loan denial. This practice was deemed to be discriminatory. CRA essentially enforced a form of affirmative action in lending policy. Failure to comply with the CRA could lead to numerous penalties such as restricting banks from opening additional branches. The CRA regulations state that lending practices should take place in a “safe and sound manner”. Unfortunately, in a practical sense a financial institution cannot always find the necessary qualified loans in many low income areas. So in order for banks to comply with the regulations and build a loan portfolio, they are often forced to engage in lending practices that they would otherwise avoid. In some cases, out of concern for compliance with CRA, loans were issued that may not have fallen under CRA standards, but still otherwise would not have met with traditional loan standards. Part of the reason for this is over the years the CRA standards during an audit were quite arbitrary and not clearly defined. So banks often made loans of relatively poor quality that they hoped would meet these CRA requirements, yet actually never fell into the CRA loan pool.
Many of the CRA regulations were strengthened throughout the 1990’s which helped lower the lending standards throughout the banking industry. In 2008 at the peak of the financial crisis, an audit of Bank of America revealed that its CRA portfolio made up only 7% of its residential mortgages…yet was responsible for 29% of their losses. A recent study published by economists from the National Bureau of Economic Research found that from 1999-2009, the necessity to conform to CRA standards led banks to engage in riskier lending practices. A copy of the study can be found here...
There were losses in other area of the real estate market not influenced by CRA such as the commercial real estate market. Yet the severity of the crisis in commercial real estate market was not nearly as severe, and realized a much quicker recovery. More importantly, the default rates were lower. This was because the lending standards in commercial real estate required much higher levels of collateral, and were not subject to such policies of social engineering. CRA was most certainly a factor as the act was strengthened over the last two decades leading up to the financial crisis. But CRA alone was not nearly enough to create such a major market dislocation.
Government Sponsored Enterprises
Federal Home Loan Bank, Federal Farm Credit, Fannie Mae and Freddie Mac are what are known as government sponsored enterprises (GSE’s). The GSE’s are financial service corporations that are created, owned and controlled by the US Congress. Their stated charter is to enhance the flow of credit to targeted sectors of the economy. The GSE’s are not a new concept and have been around since the turn of the last century. Yet, over the decades their role and influence changed dramatically.
Loans are often securitized, meaning they are packaged together as an investment instrument to be sold. These are known as mortgage backed securities (MBS). Securitized loans on their own are not a negative and can offer an excellent investment opportunity for many investors. However, as a mechanism to increase the number of loans issued in lower income area’s the GSE’s began to create a great degree of artificial demand. They began to buy up securitized loans in large numbers. Banks began to further drop lending standards, because the concern about the viability of the lender repaying their loan was less important as they would not hold the loan to maturity as they traditionally had, nor would other players in the marketplace. When another bank or investor was creating the demand for these loans, they would be properly evaluated for their investment quality and the market would set a price based on viable supply and demand. So a bank would need to take lending standards more seriously, as there is little benefit in creating a security that nobody wants to buy. Yet once the GSE’s began to play a major role in terms of demand to purchase these securities, the standards dropped. The reason is the GSE’s were not interested in the return on these investments, but only that these loans continued to be issued in order to meet their goals of increased home ownership.
Ultimately, the GSE’s removed the risk component from the bank’s loan issuance and transferred it in advance to the taxpayer. Some supporters of the role of the GSE's have pointed out that their overall loan portfolio declined during the peak of the financial crisis from about 55% of the market to a 40% market share. This was a result of private banks increasing loan issuance in an attempt to get them underwritten and into the marketplace that was totally distorted. By 2007 there were approximately 55 million mortgages in the US financial system. Half of these loans were classified as subprime and other low quality loans. Yet a whopping 70% of all these below investment grade loans were held on the books of a Federal Agency. In fact back in 1992 the GSE's were actually under government mandate to make sure that a minimum of at least 30% of all mortgages bought by the GSE's from lenders had to be from low-moderate income borrowers. By 2007 that mandate had increased to 55%. It wasn't until 2002 that Wall Street issued over $100 billion in mortgage backed securities backed by subprime or other weak loans. But by this point in time the GSE's had already bought over a $1 trillion in such loans. One major problem was that the GSE's were so overwhelmed with accounting problems that the extent of their sub prime activity was largerly unknown until well after the housing collapse. A later SEC investigation in 2011 alleged that the GSE's had held over 2 trillion in sub prime loans as of June 2008. Many loans had been simply misclassified, and later reclassified as sub prime. Today, the total aggregate mortgage holdings across all the GSE's is an astonishing 5 Trillion dollars !!!
In 2004 the US Senate and the House of Representatives held various hearings looking into the alleged accounting scandals that surrounded these GSE’s. The Office of Federal Housing Enterprise Oversight had released a report about illegal bookkeeping practices in which losses were being shifted so senior executives, who were appointed by the Congress could continue to collect millions of dollars in bonuses. Eventually the SEC ruled that Fannie Mae would have to restate 3 ½ years of earnings and report a loss of approximately 9 billion dollars. On May 19th 2005 former Federal Reserve chairman Alan Greenspan gave a speech warning of the out of control practices of the GSE’s and suggested they be assigned strict portfolio limits. Various members of congress continued to deny there was a problem, and refused any further oversight of the GSE’s while their appointed executives continued to make millions at the tax payer’s expense. The GSE’s continued to be plagued by various other scandals over the years, until eventually they were deemed to be insolvent, and taken into conservatorship at the expense of the US taxpayer.
This collapse of the GSE’s immediately halted the excessive demand for many of these loans that would have in many cases never been issued without the GSE’s influence. Except now the banking industry was stuck with an inflated mortgage market filled with products they never expected to have on their books. The day the GSE’s entered conservatorship, the financial markets entered a tailspin.
Many have referred to banks as “greedy”. Yet greed is balanced only by risk in a functioning marketplace. So imagine that you were in the business of selling shoes. You would typically only keep in inventory enough shoes to meet the demand your customers provided you with. If at some point a Federal agency began to buy shoes in massive quantities, would you simply refuse their purchase requests and watch your competitors get rich because you believed them to be creating artificial demand ??? In all likelihood, you would participate and sell shoes rather than risk being swallowed up by your competition. Unfortunately, the GSE’s were a classic case of the government attempting to socially engineer an outcome that produced the all too often unintended consequence as a corrupt bureaucratic system ran out of control. The initial intent of the GSE’s role might have very well been a noble one. Yet as always is the case, attempts to socially engineer segments of the economy produce distortions that eventually cause substantial harm to the system. In this case the GSE’s were likely the singled largest contributing factor to distorting the marketplace.
It should also be noted that the Federal government also influences the "affordable" mortgage marketplace through other agencies which are NOT GSE's, but rather wholly owned subsidiaries of the Federal government such as the Government National Mortgage Association (Ginnie Mae), which is another substantial player in the home loan market.
US Department of Housing and Urban Development
Also known as HUD it was created in 1965 by the Johnson administration. HUD has various responsibilities including oversight and regulation of the GSE’s. HUD provides things such as block grants and has also served as a regulator of financial institutions. HUD is another agency that has been plagued with scandals. As a regulator HUD was famous for pressuring financial institutions to make loans that would otherwise not have qualified for lending. In 1998 under the accusations of discrimination, then HUD secretary Andrew Cuomo stated in a press conference that under his leadership HUD took aggressive steps to make sure that banks would issue loans to people they would not have otherwise lent money to. He stated in one press conference that “They would not have qualified but for this affirmative action on the part of the banks”. This was nothing new as HUD policy, but was simply being amplified to a much larger degree under his leadership. During this duration of new increased banking pressures, HUD increased loan issuance to unqualified borrowers in the amount of 2.4 trillion dollars over a ten year period.
Mark to Market
In the wake of the Enron scandal the congress enacted the Sarbanes-Oxley legislation in 2002. This was a complex piece of legislation designed to create accounting reforms. Much of this was also well intended, but poorly designed. As part of the legislation, the new accounting rules required public entities to value assets on their books on a mark to market basis. In simple terms, this means that you must use the value of what the asset is worth should you sell it in the open market immediately. In general this sounds like an excellent idea. However, when looking at the housing crisis the banks were faced with a freeze in the liquidity of mortgage backed securities once the GSE’s collapsed. They had created all of this excess supply, and no longer there as a primary buyer. As a result banks had many loans on their books that they had been able to easily sell in the marketplace just weeks earlier. In many cases these were performing loans from lenders with excellent credit and a history of paying on time. Unfortunately, because these loans as securitized investments had no market to sell them into at that moment in time, the banks were forced to value them on a mark to market basis. That meant you may have been paying your mortgage on time, but according to accounting procedures the underlying property had declined in value, therefore the loan portfolio is now perceived to be more risky. It didn’t matter that the majority of their customers had solid credit and paid on time. They were forced to devalue their portfolios substantially in a short period of time. In the short term this exasperated the risk for banks, as they now had substantially less collateral and made their balance sheets look significantly more impaired and over leveraged than they were in reality.
As an example…Imagine you had bought a home for 500k and put down 250k…50%. If you had sufficient cash flow to pay the mortgage payment each month, by most standards, your debt to equity ratio would be considered fairly manageable. If you were to see a decline in the estimated value of your home to 300k, you might be quite upset. But presuming you were willing to stay in the home and still had the income, it may not matter all that much in the long run...as the home has a longer term economic value. But what if because your debt to equity ratio had just declined substantially, all of your credit cards were cancelled on you, and any further credit was instantly halted. Even though you have made your payments timely, you have been almost instantly cut off with one giant margin call. This is what happened to banks. Many had leverage ratios were considered to be quite reasonable, until the value of their portfolios were revalued in the wake of the GSE's collapsing. But in a practical sense, many of these loans were still valuable to the banks, and continue to perform even today. Yet almost instantly some banks were perceived to have excessive leverage beyond sustainable degree’s which was quite misleading, as those same loan portfolios were well within normal standards just weeks earlier. And many of these loan portfolios recaptured the gains later without ever having altered the loans they were holding.
In 1933 there was legislation passed known as the Glass-Steagall Act which served to separate the activities of investment banks and commercial lending institutions. In 1999 after declaring the act no longer appropriate, then President Clinton signed into law a repeal of the act which separated these two different types of institutions. Many have pointed to this act as significant cause of the problems that led to the 2008/2009 financial crisis. While there may be some validity to this, it appears that this was overstated. In reality the act had not been observed for decades. Many financial institutions simply formed holding companies and held each division which participated in both business models under the holding company. Additionally, many of the financial institutions that had the greatest degree of difficulty in weathering the financial storm were firms that had a singular business model such as Bear Sterns and Lehman Brothers. The lack of a diversified revenue stream from different business activities made it difficult for them to diversify the risk of the firm. While firms like JP Morgan which had a diversified model from the beginning played an integral role in assisting the Fed with aiding these troubled firms. There are certainly viable intelligent arguments that can be made which can be critical of the repeal of this act. However, the data appears to be weak, and one of the reasons the act has not been brought back.
Many have pointed to the role of the GSE’s and other forms of affirmative action measures in the housing market as vital to the role of increasing homeownership in low income areas. Yet, at what expense to the overall system was this achieved. The notion that banks actively discriminate against individuals for reasons related to anything other than credit is simply not the case. Any form of discrimination is not wide spread and pervasive. Anyone who has ever worked for a bank knows that they care about only one color…Green. They are only interested in making money. And if you can’t pay them back, they are not likely to want to lend to you. Influencing lending standards to improve economic outcomes in low income areas is a poor way to improve home ownership rates. Individuals should purchase a home because they have the ability to pay for it, not because the government lowered standards. In reality some of us should not be homeowners. Some are simply not responsible enough to take on such a responsibility. And historically banks were far more responsible about how they extended credit when they themselves carried the liability for their actions.
Unfortunately, very little has changed in most of these policies. The GSE’s remain large players in the MBS market, and are now joined by the Federal Reserve Bank which is also buying MBS products for the first time in its 100 year history. The GSE’s continue to cost the tax payer billions of dollars in an attempt to further influence the home ownership rates across the country. Ironically, the role of the GSE’s has distorted the marketplace so much, that in many areas home prices have seen a slower recovery. This is because asset prices have difficulty achieving equilibrium when investors can’t determine how much of the current price is due to organic supply and demand relative to government influence. This slows demand, and forces a potential buyer to hesitate when evaluating relative price.
Additionally, the Fed continues to hold rates low and unprecedented levels as a mechanism to subsidize the national deficit and simultaneously push investors to take risk that they would otherwise avoid when making prudent decisions. This policy has begun to produce signs of numerous other unintended consequences outside of the housing market. Simultaneously, new regulations around Dodd-Frank have laid out stricter standards to banks that are in direct conflict with other existing regulations. As a result, banks are now hesitant to lend to anyone, including qualified buyers out of fear of violating new regulations that are not clearly defined. The result has been that lending has become excessively difficult for the average citizen who would otherwise be a solid borrower. The average credit score denied a loan in 2012 was a FICO score over 700
Ultimately, the single biggest contributing factor that led to the housing crisis was that the government transformed itself from a regulator of a market into a market participant. Unfortunately, government agencies such as the GSE’s have little economic incentive to implement sound fiscal policies, as those making decisions are not required to answer to shareholders. These government agencies used both forms of affirmative action and artificial demand in the marketplace to influence bank lending practices and alter outcomes. Yet inevitably when the government becomes a market participant, prices get distorted and markets are dislocated. The mortgage market had lost all forms of price discovery as the marketplace was subsidized at the tax payer’s expense in order to achieve a political outcome. The transferring of this liability off of the balance sheets of financial institutions in order to achieve increased home ownership rates was the trigger that led to excessive lending, and increased leverage throughout the financial system.
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