Free Market + Liberal Entitlement=Disaster

CT

To us at PCT it has become imperative that the people of the United States know the truth about the Subprime Bust and what "REALLY" got us here. Opie and myself both agree that the economy is to sophisticated and intricate to be demolished by one group, one bad decision, or one person. This was more about an intermingling of two philosophies that are polar opposites and the effect was devastating to our economy. All of the information we drew from seems to point to that conclusion, minus all of the nuances of macroeconomics.

The Basics of the Bust:

In the mid-90's mortgage lenders relaxed strict credit standards thereby allowing people who would not normally qualify for home loans to be able to obtain them. Interest rates on these loans were greatly increased to compensate for the greater risk involved. Mortgage companies contributed more risk to the market by further lowering underwriting standards to increase the availability of the sub prime loans. Here are some numbers via the Heritage Foundation showing the percentage changes form late 90's-2006 due to the availability of subprime loans.

As a consequence, the availability of risky loans soared from the late 1990s through 2006. In 2001, newly originated subprime, Alt-A, and home equity lines (seconds) totaled $330 billion and amounted to 15 percent of all residential mortgages. Just three years later, in 2004, these mortgages accounted for almost $1.1 trillion in new loans, equal to 37 percent of the total. Their volume peaked in 2006 when they reached $1.4 trillion and 48 percent of the total. Over a similar period, the volume of mortgage-backed securities (MBS) collateralized by subprime mortgages increased from $18.5 billion in 1995 to $507.9 billion in 2005. [1]

Here is how Wall Street fits in to this scenario, enter a little "financial engineering." Large banks like Goldman Sachs or Lehman Brothers would buy hundreds of millions of dollars of these low quality loans from a mortgage underwriter and then bundle them together. They were organized by risk level into "tranches". This worked out well because analysts and rating agencies believed that by bundling up these loans you lowered your risks by depending on thousands of people paying the interest and principal rather than a single entity. The danger of everyone defaulting was minimal and since housing value was on the rise and interest rates were lowering. Even if someone defaulted on their loan you could re-structure the debt and still make a profit. This worked out great for everyone until there were a large number of defaults on the subprime loans which sent everything into a tail spin.

This is the mechanics of the bubble and the bust but this is the how and why, It started with the Community Reinvestment Act of 1977. Here is the definition provided by the Federal Reserve Board.

The Community Reinvestment Act is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound operations. It was enacted by the Congress in 1977 (12 U.S.C. 2901) and is implemented by Regulation BB (12 CFR 228). The regulation was substantially revised in May 1995, and was most recently amended in August 2005.
[2]

Now, we jump ahead to 1999 and the Financial Services Modernization Act of 1999, it is defined as this,

Allowing firms to transform themselves into financial holding companies that can engage in a wide range of financial services will give rise to more competition, and consumers will benefit from lower prices, onestop financial services, and innovation leading to more products. U.S. firms will be better able to compete globally. [3]

The FSMA was created to allow banks that loan to you and I to become financial holding companies as well. They could deal in insurance, security underwriting, portfolio investments, etc. But in order to get this legislation passed through Senator Phil Gramm had to accept CRA amendments to the FSMA in order to get it passed through the Clinton White House.

There are two things about the CRA amendments and its accountability measures that draw my suspicions to it contributing to the subprime bust.

Information collected for CRA ratings does create a database for class-action lawyers to use in suing banks servicing low-income areas.
[3]

An unsatisfactory CRA rating does prevent a bank from merging or being acquired. [3]

If banks did not fulfill their obligations to the CRA amendments they could be lined up for a class action lawsuit from any number of "community activist groups". Also if they did not have a history of lending to low income consumers then they would not be allowed to reap the financial potential provided by the FSMA. I believe they saw an opportunity through the FSMA and its CRA amendments to really open up the market for subprime loans through some disastrously creative "financial engineering". This kept groups like ACORN at bay, allowed them to meet regulatory guidelines, and make a healthy profit in the meantime.

The CRA also imposes a larger cost on society by misallocating capital. In the absence of government intervention, credit markets efficiently allocate funds on the basis of risk and return. High-risk borrowers are charged higher interest rates to compensate lenders for the increased likelihood of nonpayment. Borrowers with a low probability of default borrow on more advantageous terms. To remain competitive, banks have devised sophisticated models for rating borrowers and allocating funds. That does not mean that low-income or high-risk borrowers are excluded from credit markets. Banks are willing to extend credit to any group if such loans,on average, are profitable. [3]

As noted above the credit markets could have regulated themselves through the profitability of the loans they were issuing. None of this was necessary, the FSMA and CRA should never have been coupled, it created a market with high octane potential for calamity. Simply this venue was used as a tool by the financial market. They were motivated by, ironically, regulatory fears and simple greed to reap a profit with some less than lustrous effects. I have asked this question before, "How do you regulate an attempt a deregulation?"

Now onto President Bush and the 2003-04 Congress's complicity. Welcome to the American Dream Downpayment & Zero Dwonpayment Acts.

American Dream Downpayment Act,

That chance will arise when the House is asked to approve by unanimous consent the American Dream Downpayment Act -- a bill that would require the U. S. taxpayers to provide $200 million per year to fund cash grants of as much as $10,000 to individuals and families wanting to buy a house, but without subjecting themselves to the burden of having to save for the downpayment. [4]

Zero Downpayment Act,

The Zero Down Payment Act of 2004, introduced by Rep. Pat Tiberi (R-OH), would require the Federal Housing Administration (FHA) to offer federally insured mortgage loans to certain eligible households to buy a house without a down payment. Although the bill could lead to a very modest increase in the homeownership rate, it would do so by exposing the FHA—and ultimately taxpayers—to major losses stemming from high default rates, as evidence from similar FHA programs shows. The Congressional Budget Office estimates that the new program would cost the government $618 million from 2006 through 2009. [5]

These furthered the initiatives of allowing low income families and individuals the opportunity to gain access to loans that they could obviously not pay back. In summary, the CRA and FSMA were tools and venues brought about by poor decision making by Congressional Republicans and Democrats and the Clinton White House. The biggest mistake was putting together free market capitalism with a liberal entitlement program. Both fed off of each other and allowed Wall Street to exploit the weakness. President Bush went further along with this "new" philosophy of pairing somewhat far right and left thinking with his contributions; the American Dream Downpayment Act and Zero Downpayment Act, accelerating the bubble into a bust. Due to the length of this post I will cover ACORN, Freddie Mac and Fannie Mae in a separate one.

-CT

"Hunting Happily!"

[1] Subprime Mortgage Problems: A Quick Tour Through the Rubble
[2] Community Reinvestment Act
[3] Gramm-Leach-Bliley Act: A Good Start in Need of Fine-Tuning
[4] American Dream Downpayment Act: Fiscally Irresponsible and Redundant to Existing
Homeownership Programs
[5] Congress's Risky Zero Down Payment Plan Will Undermine FHA's Soundness and Discourage
Self-Reliance