The Real Truth Behind the Economic Meltdown and Subprime Mortgage Crisis

Posted by hllf on Jul 13, 2010 in Politics |

Back on March 5, 2009, I wrote a blog post on a now-defunct blog called Washington Follies about the state of the economy and the so-called subprime mortgage crisis. Given some recent discussions on Twitter and other forums, I thought it was relevant for me to post it again, this time on my own website. Even though 16 months have passed since I wrote this article, the content still applies to the current situation in which we all find ourselves.

And now for the post…

It should be the duty of every American to ask, “How did we arrive at the current economic situation in which we find ourselves?” There is so much information and so many opinions floating out there, and 99% of them are completely politically driven and without an ounce of truth. Not only that, but the vast majority of what is said doesn’t even make any economic sense, but given the poor state of education in this country, many Americans lack the intellectual tools necessary to figure this out.

Under normal circumstances, it would be the job of the media to ask these tough questions, to bring to the forefront the people responsible for the economic meltdown, to hold those individuals accountable for their actions or inactions. But the media is about as partisan and agenda-driven as it has ever been in the history of this country, and therefore, the people involved cannot–and will not–perform their most fundamental duties as journalists.

It may surprise many readers to find out that the virus that began to tear apart the fabric of our economic and financial system and which eventually led to today’s problems was not introduced a few months ago; it was not introduced a year ago, nor was it even introduced 10 years ago. It was actually enacted over three decades ago. The name of this virus? The Community Reinvestment Act (CRA).

The CRA was signed into law in 1977 by President Jimmy Carter. Its purpose was to encourage commercial banks and savings associations to meet the needs of borrowers in all segments of their communities, specifically those in low- and moderate-income neighborhoods. Put simply, the CRA was enacted because banks were not giving out loans to those individuals they considered to be higher-risk, or if they were, those loans had unfavorable terms or high interest rates, and of course, many of these individuals happened to be low-income people.

I am sure the irony of this hasn’t escaped any of you. The very thing that the CRA encouraged banks to do is the same exact practice that banks are today vilified for, namely having given out loans to people that should not have gotten those loans. You may ask, “Under the CRA, How were the banks encouraged to give out these loans they otherwise were not doing so?” Well, in order to enforce the statute, federal regulatory agencies examine banks for CRA compliance, and take this information into consideration when approving applications for new bank branches or for mergers or acquisitions.

Now just sit back and think about this. The implications of the CRA were huge. It in effect took away market-driven reasons for giving out loans, and instead, put the federal government in charge of the process. Let me illustrate with an example. You have an irresponsible friend who lost his money because he gambled it away. Now this friend comes to you and asks you to loan him some money. You of course turn him down, as you don’t have the necessary confidence you need that he will ever pay you back. Then six months later, you want to build yourself a brand-new kitchen in your house. You apply for the necessary permits from your government…but you are turned down. The reason? Because you didn’t loan your friend the money six months ago, and the government feels you should have.

I do not wish to stray too far from the topic of this post, but I want to emphasize a very important point here. When decisions are made by an individual or by the market, the decision is made for the purpose of maximizing productivity, maximizing self-interest, and maximizing the general welfare of the individual or group. And this occurs in a relatively predictable way. But when government makes a decision, it is made for only one purpose, and that is to maximize votes. And this is typically done in an entirely unpredictable way, which breaks down our entire system of market economics, as investments are always based on a degree of predictability of future performance. But a lesson in basic economics is beyond the scope of this post.

After Jimmy Carter signed the CRA into law, it remained a relatively obscure statute until the 1990s, when President Bill Clinton gave it a whole new dimension. In a July 15, 1993 speech on the South Lawn of the White House, Clinton claimed, “The CRA has not lived up to its potential.” Following this announcement, Clinton made appointments who shared his views on expanding the CRA.

In keeping with Clinton’s vision for the CRA, Attorney General Janet Reno appeared at numerous high-profile press conferences, where she announced fair-lending settlements. Most notable of these was one during which she made statements about the CRA when she announced a settlement in January of 1994 with the First National Bank of Vicksburg and the Blackpipe State Bank:

“today’s actions demonstrate that we will tackle lending discrimination wherever and in whatever form it appears. No loan is exempt, no bank is immune. For those who thumb their noses at us, I promise vigorous enforcement.”

Now just imagine you are a bank executive, and you hear the attorney general of the United States make such a statement; what do you think your reaction is going to be? Do you think that you just may go out to your loan officers and underwriters and tell them to give questionable applications a second look, perhaps tell them to relax their standards, so the bank doesn’t run into any future legal/regulatory problems with the top lawyer in the country?

But it didn’t stop there. Henry Cisneros, Secretary of the Department of Housing and Urban Development (HUD), and Assistant Secretary Roberta Achtenberg (both members of the Clinton Administration) developed new rules for lenders. These rules encouraged them to increase approval rates for loans to minority applicants by 20 percent within one year, increase the hiring of minorities by 5 percent, purchase more goods and services from minority-owned businesses, and perhaps the most egregious, reward those employees who effectively serve lower-income applicants.

There are many more examples of things the Clinton Administration did in order to expand the power and reach of the CRA, but the most important are those that involved the two now-infamous government sponsored enterprises, Fannie Mae and Freddie Mac.

Back in 1992, Congress passed a law, called the Federal Housing Enterprises Financial Safety and Soundness Act, that required Fannie and Freddie to devote a percentage of their lending to support affordable housing. In October of 2000, Fannie Mae committed to purchase and securitize $2 billion of loans made under the CRA. Fannie said it was doing this in order to expand the secondary market for affordable community-based mortgages and to increase liquidity for CRA-eligible loans.

let me expand upon this a bit. In the world of the stock market, there are individual stocks. Then there are companies who invest in or combine a group of stocks into convenient packages, called mutual funds. When you buy a mutual fund, you are buying a vehicle that consists of a multitude of stocks.

This same principle applies to the mortgage industry as well. When banks make individual loans, they often take a group of these loans, do something called securitization, and come up with a financial instrument known as a mortgage-backed security (MBS). In simple terms, an MBS is like a mutual fund that consists of individual mortgages instead of stocks. Under normal circumstances, MBSs are generally very safe investments, as risk is spread over many mortgages. Even if one or two loans default, the impact on the MBS as a whole is minimal.

So in effect, here is what Fannie Mae and Freddie Mac were doing: They were loaning money to low-income individuals (or acquiring such loans made by other banks), combining these loans into mortgaged-back securities which they then would sell to investors, and then using the money they received from the investments in the MBSs to start the vicious cycle all over again and give out or acquire more such loans. It is precisely these loans that eventually became known as subprime loans and subprime mortgages.

In November of 2000, the Department of Housing and Urban Development, then headed by Clinton-appointee Andrew Cuomo, announced it would soon require Fannie Mae and Freddie Mac to dedicate 50% of their business to low- and moderate-income families. The result of this was to flood the subprime mortgage industry with new cash. Not only did it introduce new cash, but it gave banks a convenient way to fulfill their requirements under the CRA. Because Fannie and Freddie were in the business of buying up subprime loans from banks, this limited the exposures banks had in making such loans. On the one hand, banks faced incredible and ever-increasing pressures to make loans to people the bank would otherwise consider to be high-risk and not worthy of receiving a loan. On the other hand, the banks had Fannie Mae and Freddie Mac who would come in and buy up those loans from them, in effect taking the loans off their hands. This led to a huge increase in the subprime mortgage business.

During the Bush administration, officials and Republicans in Congress tried no less than 11 separate times to try to regulate Fannie Mae and Freddie Mac because they realized the situation was spiraling out of control. However, they were stymied by the Democrats each and every single time. The only crime of President Bush and the Republicans was not to push the issue further, not to publically warn everyone of the impending danger, not to stand up to the Democrats. Of course, if they had, they would have been labeled by the media as racists and bigots for trying to take loans away from low-income individuals, but sometimes, that is the price one pays for doing the right thing. The reality of course is that Republicans are labeled as such by the Democrats and the media no matter what they do, so they might as well do the right thing.

You may of course be asking, “Why did the Democrats do nothing about this?” The primary reason of course has to do with politics and liberalism, but I won’t get into that here. There is, however, another reason. Fannie Mae and Freddie Mac have donated very strategically throughout the years, and the number 1 recipient of their contributions has been Chris Dodd, chairman of the Senate banking and Finance committee, a very influential committee in the affairs of Fannie and Freddie. In fact, if you look at the politicians who have received the most donations from the two enterprises from 1989 to 2008, there are some very recognizable names. Here are the top 5: Chris Dodd, Senator, Democrat-CT; John Kerry, Senator, Democrat-MA; Barack Obama, President, Democrat-IL; Hillary Clinton, Senator, Democrat-NY; Paul Kanjorski, Representative, Democrat-PA.

All of this resulted in the creation of an artificial environment, completely driven by government and special interest policies and rules, not by the market nor reality. Banks were required to give out loans to people who shouldn’t have gotten them, Fannie Mae and Freddie Mac were making huge amounts of cash available for such loans, and new securities were being created with these loans and backed by two U.S. government enterprises, all serving to introduce even more liquidity into the subprime mortgage space. To make matters even worse, new financial instruments were created as well, the most important of these being credit default swaps. How CDSs work is beyond the scope of this post, but essentially, buying a CDS is like buying an insurance policy on your investment. So now on top of everything, there were financial firms who were selling insurance policies on the subprime mortgages.

With so much money now available to loan to low-income individuals, the market for home buyers was greatly expanded. With an expanded market came more demand, as more and more people wanted to buy homes. And what happens as demand goes up? Prices go up. And this is exactly what happened. New homes were constructed to meet the increased demand. Prices of homes started to rise. As the value of homes went up, people started to sell their homes to make a profit. This resulted in even more homes exchanging hands, further increasing prices.

Even as the price of homes increased, so did the pressure for banks to lend money under the CRA. In order to make it possible for low-income individuals to afford ever-more expensive homes, new types of mortgages were created. These mortgages had very favorable terms for the first few years, such as making interest-only payments, or even in some cases, making less than even just the interest on the loan. Eventually, these mortgages had to be offered to people with higher incomes, as the prices for homes were becoming too high for even them to afford.

But despite all this, the expansion of the home-buyer market wasn’t complete. More and more people continued to buy homes, driving prices yet higher. No one questioned the absolute folly of the subprime loans, because as long as prices continued to increase, nothing would go wrong. Even if someone couldn’t afford a mortgage after the first two years, this wasn’t a problem; they would simply sell the house before that happened and sell it for a profit, pay back the loan in full, pocket the difference, then move on to the next home.

More and more banks were entering the subprime mortgage business in order to meet the demand. Fannie and Freddie were buying more and more of these loans. More and more securities were created with these loans. More and more financial derivatives were being created, all backed by these loans. And most devastatingly, more and more financial institutions were becoming heavily invested in financial instruments, built on layers upon layers of paper, but all with these subprime loans at their core. The result was an artificial bubble, the size of which dwarfed even the .com bubble of the mid to late 90s.

Even more than a bubble, it was a very precarious house of cards, with subprime mortgages at the bottom, and the entire housing market, financial sector, and our economy built on top of it. And what was it all built on? It was all built on debt. Our entire economy was built on debt. And not just any debt; debt that should never have been given out in the first place.

Eventually, the market could not be sustained. The number of people buying homes were saturated. Prices could not go up any further. Many people that had obtained subprime loans hit the crucial time in their mortgage terms when their payments ballooned, and they could no longer afford their payments. They also could not sell their house, because the value wasn’t high enough to cancel out the loan. So what happened? Foreclosure. As more and more people began to be foreclosed upon, not only did prices stopped going up, but they started to fall. As prices fell, even more people couldn’t sell their houses and couldn’t afford their payments, resulting in yet more foreclosures.

Thus began the collapse of the largest house of cards we have ever seen. As the bottom was pulled out, The value of the subprime loans as a whole started to plummet. This made the securities that were built with them worthless. This made all the credit default swaps worthless. Sitting right in the middle of all of it was Fannie and Freddie, which fell. After Fannie and Freddie, the financial institutions that were invested in the ‘house of cards’ started to fall one by one. This disrupted the entire dynamic of our financial system. As the financial system started to collapse, it took along with it our national economy. Consumer confidence fell, further hurting the economy. And since so much of the world economy is dependent on the U.S. economy, so too fell the world economy.

And now, we find ourselves in the situation we do today. The cause of it was not predatory lenders, it was not greedy corporations, it was not outrageous CEO salaries, it was not corporate jets, it was not the lack of regulation over Wall Street, and it was not lavish trips to Las Vegas nor putting one’s name on a baseball stadium. It was former presidents Jimmy Carter and Bill Clinton, members of their administrations, and the Democrats in Congress who created the framework that allowed subprime mortgages to flourish, and repeatedly continued to strengthen that framework, despite attempt after attempt to stop them. And it is the same exact people who gave us this economic mess–and single handedly destroyed the world financial system–who are now enacting the policies to get us out of it. It is my belief that eventually, history will reflect the truth; namely, that this entire economic crisis has been the single greatest fraud ever perpetrated upon the American people and the people of the world by none other than the Democrats who were in positions of power in the United States government.

1 Comment

Christopher Bartlett
Jul 13, 2010 at 8:44 pm

I actually agree with a lot of this analysis. Since you were interested in the veiw from the inside, here are some specific thoughts.

The rationale provided to the customers for the loans you describe wasn’t so much about selling quickly, although if we determined that someone was an investment buyer rather than a residential customer, then we were told to emphasize the high rates of property growth from 2001 on to say that one could make a profit flipping the house before the two years that were the usual term of the sub-prime loans’ low rate period. But for the residential customers, it was all about using your equity to pay down high interest loans such as credit card or auto debt. Then, with your new and improved credit score, you would go back into the finance market and get a better loan, not incidentally feeding us, the middle men in the process.

Our favorite vehicle became the so-called pick-a-pay loan, an instrument where the payment was picked by the borrower from as little as interest only. The rates started quite low and moved up annually to well above the thirty-year fixed rate by the time five years had passed. Combine this with penalties for loan pay-off before three years and you have a nice trap for people when the bubble went. Friends of mine got caught in that trap, and sadly, I was part of the problem as I sold them their loan, though I did my damnedest to make sure they understood exactly what they were getting themselves into, unlike my compatriots. I still feel bad about that, though not as bad as I could if I had really set out to screw them.

Then there were the 2/28 and 2/38 loans, loans given to sub-prime borrowers with a two-year teaser rate and a punishing rate afterwards. These were loans we marketed to people with sometimes sub-600 FICO scores, telling them to get their financial house in order and then refi before the two-year period came up. I know some lenders had penalties for early refinancing in these loans too.

But what is important to understand is the active conspiracy among mortgage brokers and the lenders we worked with to get the deals done. With instruments such as the infamous NINA (no income, no assets) loans where you got to make up an income and assets i nexchange for a higher interest rate in the market, it’s no wonder people got themselves in trouble.

Your analysis of the securitization is I think correct. But you have to add the madness of the times. You stated that markets work on rational economic bases that government action distorts. I agree with the second half, but I don’t believe, and there is research to demonstrate that the rational actor model in economic theory is not sufficient to explain the ways markets work. You said lessons in basic economic theory were beyond the scope of your post.

Thanks for the thought-provoking read.


 

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