While most of the public is consumed by the health care-death-march spectacle, Senators Bob Corker and Chris Dodd are making serious progress on the Senate’s “financial services reform” legislation. The legislation was dead just a couple weeks ago, but Sen. Corker thought he could snag a seat at the grown-up table and stepped forward to ‘cut a deal.’
As is the new DC operating procedure for major legislation, there are almost no firm details on the current language. We know there will be a large new federal bureaucracy, somewhere within government, to provide “consumer protection” for financial products. We know there will be a $50 billion tax on banking customers to provide a permanent bailout fund, or as Sen. Corker would describe it, a “wind-down” fund. Unfortunately, we also know that the bill will do nothing to reform Fannie Mae or Freddie Mac, who continue to drain billions from the U.S. Treasury.
We’re told the Corker-Dodd Bailout Bill is a necessary response to the financial melt-down triggered by the collapse of the housing bubble. But, if it doesn’t take even small steps to reform Fannie and Freddie, then, simply, it isn’t a serious proposal. Its like rebuilding the porch on a house, while ignoring it’s cracked foundation.
Washington politicians would rather ignore this, but the housing bubble was the result of very explicit government policy. Throughout the 90’s and early 2000’s, officials from both parties became addicted to forever pushing homeownership rates higher than the laws of economics would otherwise allow.
If you want to identify the roots of the homeownership-cult among elected officials, fire-up the way-back machine and check out a little report issued by the Federal Reserve Bank of Boston in the early 90’s. Under the leadership of Richard Syron, then-President of the Boston Fed (more on him later), the report was the result of discussion among the bank’s staff and the usual collection of academics and professional activists. It was to make recommendations to the nation’s bankers on addressing alleged discrimination in mortgage lending.
Most of the report is innocuous pablum; a kind of cross between a Hallmark Card and corporate-ese. But, a few of the report’s recommendations are, in hindsight, more ominous. And while they were just ‘recommendations’, they were being made by one of the Fed banks, which carries a certain, shall we say, weight with bankers. From the intro:
The Federal Reserve Bank of Boston wants to be helpful to lenders as they work to close the mortgage gap. For this publication, we have gathered recommendations on “best practice” from lending institutions and consumer groups. With their help, we have developed a comprehensive program for lenders who seek to ensure that all loan applicants are treated fairly and to expand their markets to reach a more diverse customer base.
As far as it goes, fine. But, consider this:
Obligation Ratios: Special consideration could be given to applicants with relatively high obligation ratios who have demonstrated an ability to cover high housing expenses in the past. Many lower-income households are accustomed to allocating a large percentage of their income toward rent. While it is important to ensure that the borrower is not assuming an unreasonable level of debt, it should be noted that the secondary market is willing to consider ratios above the standard 28/36.
Got that. Banks should use their normal risk-based underwriting standards, because low-income people can carry more debt than families with higher income. Oh, and wink-wink, the secondary market will consider higher risk ratios. In other words, go ahead and underwrite the mortgage and you can probably sell it off. More:
Credit History: Policies regarding applicants with no credit history or problem credit history should be reviewed. Lack of credit history should not be seen as a negative factor. Certain cultures encourage people to “pay as you go” and avoid debt. Willingness to pay debt promptly can be determined through review of utility, rent, telephone, insurance, and medical bill payments. In reviewing past credit problems, lenders should be willing to consider extenuating circumstances. For lower-income applicants in particular, unforeseen expenses can have a disproportionate effect on an otherwise positive credit record. In these instances, paying off past bad debts or establishing a regular repayment schedule with creditors may demonstrate a willingness and ability to resolve debts.
Nothing can go wrong there. But, this is one of the more interesting items noted in the report:
Institutions that sell loans to the secondary market should be fully aware of the efforts of Fannie Mae and Freddie Mac to modify their guidelines to address the needs of borrowers who are lower-income, live in urban areas, or do not have extensive credit histories.
Boy, would Fannie and Freddie ever modify their guidelines. While the Boston Fed Report was being written, Fannie and Freddie were implementing their first congressional mandate to increase their holdings of mortgages to low-income buyers. From the Village Voice:
[Andrew]Cuomo’s predecessor, Henry Cisneros, did that for the first time in December 1995, taking a cautious approach and moving the GSEs toward a requirement that 42 percent of their mortgages serve low- and moderate-income families. Cuomo raised that number to 50 percent and dramatically hiked GSE mandates to buy mortgages in underserved neighborhoods and for the “very-low-income.”
At some point, the supply of low-income buyers who meet conventional loan standards is going to run out. It would be impossible for Fannie and Freddie to meet their federal mandate if they only bought conventional mortgages. So, by the end of the decade, Fannie, at the urging of elected officials and activist groups, purchased its first sub-prime mortgage. From the New York Times, September 29, 1999:
In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.
By the time the bubble burst, Fannie and Freddie were imploding under the weight of hundreds of billions in sub-prime and other risky mortgages.
A few more excerpts from the Boston Fed Report:
Even the most determined lending institution will have difficulty cultivating business from minority customers if its underwriting standards contain arbitrary or unreasonable measures of creditworthiness.
And,
Unintentional discrimination may be observed when a lender’s under- writing policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants.
And,
management should be directed to review existing underwriting standards and practices to ensure that they are valid predictors of risk. Special care should be taken to ensure that standards are appropriate to the economic culture of urban, lower-income, and nontraditional consumers.
And, finally, a section that, seen in hindsight, gives me a headache:
The Board may also wish to encourage management to work with the public sector to develop products that assist lower-income borrowers by using public money to reduce interest rates, provide down payment assistance, or otherwise reduce the cost of the mortgage. The Board should also encourage management to work with special secondary mortgage market programs designed for lower-income homebuyers.
To be sure, there were a number of causes that inflated the housing bubble. The Fed’s policy of, essentially, free money in the early part of the decade sloshed money across the financial system and allowed credit to be widely available to anyone with a pulse. Ever more exotic financial products that few understood ingrained themselves into bank balance sheets as little ticking time-bombs.
But, the scope of the crisis would have been far less severe, if it hadn’t been accompanied by explicit government pressure on banks to loosen their lending criteria. Leftist activist groups like ACORN and the Center for Responsible Lending exerted complementary pressure through the media. With nearly-free money, entities like Fannie and Freddie eager buy up even the riskiest loans and near-universal predictions of forever increasing house prices, it is little wonder banks bowed to the outside pressure and loosened their standards. The rest is history.
Oh, about that Richard Syron, who headed up the first Fed report urging banks to loosen their lending standards. He became CEO of Freddie Mac at the end of 2003. He certainly put our money where his mouth was. In the final years of the bubble, 2005-2007, 40% of the loans Freddie took onto its books were junk loans.
Sometimes pablum leaves a mark.
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