“Our House is a Very Very Very Fine House”

The financial crisis of 2008 has been the source of post-mortem by the popular media, politicians, and academics among others. But for the first time, I have read a book that gets beyond the politics and looks at the actual data and facts around the subprime/housing meltdown that clearly drove the crisis. Peter Wallison’s Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why it Could Happen Again published in January delves into and analyzes the numbers in detail (and finally gets at the “real” numbers of non-conforming and subprime mortgages that were being underwritten, that even the Fed was unaware of as recently as 2010). Wallison also evaluates the various theories regarding its cause. I highly recommend the book to all those who are interested in the topic. It turns on its head the conventional wisdom that the crisis was caused by Wall Street greed, risk taking and insufficient regulation. Instead, Wallison carefully analyzes what actually happened in terms of the growth in subprime and non-conforming mortgages, the substantial growth of Fannie Mae and Freddie Mac, commercial lending practices, and the changes in government regulations and housing policies during the 15-year lead up to the crisis. His conclusion based on the factual evidence: federal government housing and mortgage policies were the primary cause (or the “sine qua non” ) of the 2008 financial crisis.

Wallison notes that the seeds of the crisis were planted in 1992 when Congress enacted “affordable housing” goals for the two giant governments-sponsored-enterprises (GSE)- the Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). The GSEs were private entities BUT were chartered by Congress (so there was an assumption by most market participants that they would be backed by the Feds if they were to get in trouble). They were not allowed to make loans to individuals buying homes but served an important role in “underwriting” the loans (i.e. acquiring the loans from the banks that originated them, freeing the banks up to make further loans). Because the GSEs were considered to be implicitly backed by the US government, their borrowing costs were low (only slightly above Treasuries). With these low-cost funds, Fannie and Freddie effectively drove all competition in the secondary mortgage market for the middle class. In fact, between 1991 and 2003 , the GSE market share of the total US housing market rose from 28.5 to 46.3 percent.

The 1992 affordable housing goals required the two GSEs to meet a quota of loans to low and moderate income (LMI) borrowers and after the law, they were subject to oversight by HUD (Housing and Urban Development). HUD also served as the GSE “mission regulator” with power to assure that they were performing the role that the government had assigned to them. In other words, except for their “for-profit” status, the GSEs were increasingly serving as agents for government policy, if not acting as outright government agencies. The LMI quotas started out at 30 percent in 1992. (at least 30 percent of the new mortgage loans that Fannie and Freddie acquired must be made to LMI) but then were ramped up substantially by HUD to 42 percent in 1997, 50 percent in 2001 and 56 percent in 2008. Meanwhile, HUD  also required “base goals” for low and very low-income borrowers and residents of minority areas described as “underserved”. HUD increased these goals between 1996 and 2008 at an even faster rate than the LMI goals.

The effect of the quotas was to fundamentally alter what had been the GSEs’ underwriting standards for borrowers for decades and what constituted “prime” mortgages which prior to the 1990s were the only mortgages that the GSEs would buy. Prime mortgages required significant down payments (generally 10-20 percent of the loan amount), good borrower credit histories and low debt-to-income ratios for the borrowers. These principles of underwriting had yielded low default rates even during recessions. However, during the 1990s and particularly the early 2000s, in order to attract more LMI borrowers, “subprime” or non-traditional mortgages (NTM) became increasingly the norm which offered very low or even zero down payments, interest-only loans, and allowed borrowers to have low credit ratings and high debt-to-income ratios. Mortgage lending is a competitive business and many borrowers who could have afforded prime mortgages sought out the better terms now being underwritten by Fannie and Freddie and other GSEs. This effectively allowed buyers who could have afforded a 20% down payment on a $200,000 house to buy a bigger $400,000 house with a 10% down payment.

As a result of all this, there was an explosion in mortgage demand which helped fuel the housing bubble of 1997-2007 during which housing prices soared. (Historically, housing prices had moved in up roughly in line with general inflation, but during this period, U.S. average real prices DOUBLED relative to inflation, according to economist Robert Schiller in his seminal work Irrational Exuberance). The housing bubble was further inflated by cuts in prime interest rates (due to Fed’s loose monetary policy) during 2000-2004 when rates dropped from 9.5 percent to 4.0 percent. This meant that the same monthly payments on a standard 30 year fixed rate loan in early 2000 would allow for the purchase of almost twice as an expensive home in 2004.

Housing bubbles are highly “procyclical”. In other words, as the bubble grows, it creates conditions that encourage further growth. For one, higher prices are inversely proportional to default rates, or put another way, rising prices suppress defaults because there is more equity in existing loans and more expensive loans can be refinanced more cheaply. As HUD thru the GSEs pressed on with its policy of reducing down payments and allowing for more highly leveraged loans, this had the effect of increasing mortgage loan demand, and created more demand for more expensive homes pushing home prices up further.

However, the effect of greater leverage is also procyclical when prices are falling and the bubble is deflating. This is because homeowners with low or zero down payments are extraordinarily vulnerable to loss when housing prices decline. For example, an owner of a $100,000 home with a 3% down payment ( very common in the early 2000s), would encounter major downside if prices fall only 5%.  He will be unable to refinance without putting in more equity into the home and won’t be able to  move to find a better job without paying off the bank the difference between the mortgage and the loan amount. In many instances, the situation became so dire that the homeowner simply defaulted on his loan and walked away from their home, which of course increased home inventories and pushed prices down further , leading to even more defaults.

Wallison describes another serious problem that emerged during the bubble and exacerbated the financial crisis in 2008 in his aptly named Chapter 10 “Flying Blind into the Storm”. After 1992, Fanny and Freddie began to misclassify many mortgage loans as “prime” even though they were subprime and non-traditional mortgages (NTMs) (i.e. much riskier loans) by their characteristics. The GSEs continued to use the definition of subprime that had existed BEFORE 1992, when the GSEs seldom acquired these loans and subprime mortgages were generally only made by specialized lenders. In short, the GSE only classified loans as subprime or non-prime if they (1) bought the loan from one of these specialty subprime lenders OR (2)  the loan had been sold to them “labelled” as a subprime mortgage. Moreover, when lenders reported their loans to organizations such as Loan Performance (now CoreLogic) and other data aggregators and housing publishers, they generally reported their loans as “prime” and the data aggregators, who were not in the business of classifying loans, simply assumed that if they were sold to the GSEs they should carry them as prime. In fact, the total federal government exposure (through the GSEs) to subprime/NTM mortgages had grown enormously. By mid-2008, the GSEs had 24 million of such loans on their books with an unpaid principal balance of $3.4 trillion, which was at least 76 percent of the total NCM/subprime loans!

As a result, many respected academics, government media, professional commentators and even the Fed had no idea that the number of NTMs was far higher than reported in 2008 and the number of prime loans was far lower. (Wallison notes that they “still do not” understand this even today). This meant that the Fed and Treasury were making predictions that the default losses would not spread to other economic sectors during 2007 based on this very faulty data. This also meant that banks and investment banks did not understand the risk of mortgage-back securities (such as credit default swaps) and did not sell many of these disastrously risky securities which would have distributed the losses more widely throughout the global system where there was more capital to absorb them. Instead , the losses concentrated in a few of the largest financial institutions in the US and Europe, creating a financial crisis when these firms were so weakened that they could not continue to supply liquidity to the financial system.

In addition to making an iron clad case as to what caused the crisis, Wallison also spends a considerable amount of the book debunking the popular/political theories of why we had the crisis.  Per usual, he bases this entirely on the actual facts and sound economic analysis, something that in the rush to judgement of the media and the politicians in 2008-09 was largely lacking in the popular and now conventional wisdom claims of what caused the crisis. I won’t detail the evidence here, but I found his evidence and analysis very persuasive.

****************************

While the book is lengthy and gets even more technical than I have described above, it makes a very convincing case based strictly on the facts and the data regarding the primary causes of the financial crisis. The bottom line is that the root cause of the 2008 financial crisis was federal government housing policy and specifically the rapidly increasing quotas for LMI and underserved borrowers required by HUD during the 1990s and early 2000s. These quotas directly resulted in a significant reduction in Fannie and Freddie underwriting standards and given their market dominance, this resulted in mortgage loan quality being reduced across the entire market. The lower standards fueled a huge increase in first time and trade up housing buyers, which in turn directly led to the housing bubble (which was also inflated by the Feds loose interest rate policy during 2000-2004 period.). To make matters worse, the low quality and the high risks of the bulk of Fannie and Freddie’s secondary mortgages was not understood at all at the time of the crisis due to the mislabeling of many such mortgages as “prime” rather than subprime/NTMs.

To be sure there was plenty of bad behavior on the part of politicians in both parties (while the Dems were the main instigators during the Clinton administration and beyond, the Bush administration was actively pushing “an ownership society” during the 2004 campaign and was doing nothing to reverse the large HUD quotas). Some of the private sector excesses have been well documented such as the Countrywide Financial “liar loans” where income and other borrower information was fabricated in order to sell the loans. But the important point and the lesson that we SHOULD learn from the crisis is that it was OVERregulation by the Federal Government and Congress that pushed for the legislative changes that led to the crisis, NOT deregulation which was the more popular, political reaction in 2009 and beyond.

Unfortunately, this lesson has NOT been learned by Congress who has pursued greater regulation of banks with its onerous Dodd-Frank regulations passed in 2009 as the primary knee jerk reaction to the crisis. At the same time, Wallison points out that Congress has slipped back into old habits ignoring the high default rates of NCMs (and why Fannie and Freddie effectively went bankrupt) in order to provide greater credit availability and the newly created Consumer Financial Protection Bureau instituting a QM (a minimum qualifying mortgage) and eventually a QRM (supposedly a high quality mortgage required under Dodd-Frank) that required no down payment or minimum credit score for the borrower. In the last paragraph of the book, Wallison soberly notes “Unless at some point the narrative about the financial crisis is supplanted by an account of what really caused the financial crisis, it is only a matter of time before the ideas that produced the FHFA strategic plan, the QM/QRM rule and the Johnson-Crapo bill will carry the day. If that happens, we can be sure that another financial crisis awaits us in the future”. My less sanguine view is that Congress or the federal government as a whole will NEVER accept the factual narrative that it was government policy and regulation that caused the crisis (though at least Barney Frank now accepts this explanation). Unfortunately, Congress is very good at blaming others for their own incompetence.