Stop Blaming the Community Reinvestment Act

The right wing talking points, blathered by establishment media pundits, say that all those mortgages forced upon poor black people by the Community Reinvestment Act caused the bubble that caused the financial mess. Basically, it's all Bill Clinton's fault.

Well, Bill Clinton might share the blame as leader of the corporate wing of the Democratic Party, but it wasn't the Community Reinvestment Act that did it; that law was enacted in 1977. According to Aaron Pressman who blogs on Newsweek:

University of Michigan law professor Michael Barr testified back in February before the House Committee on Financial Services that 50% of subprime loans were made by mortgage service companies not subject comprehensive federal supervision and another 30% were made by affiliates of banks or thrifts which are not subject to routine supervision or examinations.

Hard for CRA to be the majority of the subprime problem when it wasn't even a majority of the subprime market. CRA loans had more regulatory supervision, required recipients to receive counseling before and after receiving the loans, CRA Banks were more than twice as likely as other lenders to retain originated loans in their portfolio and the CRA loans were lower intrest rates making them easier to pay (less subject to defaults). This is what the Traiger & Hinckley Study finds (PDF file here).

Paul Krugman provides us the data to show it also wasn't Fannie and Freddie. As I've explained, the hyper profits being made on Wall Street by selling bonds backed by everything, including new mortgages, and all the derivatives of those bonds (basically things like insurance on the bonds, bets on future prices of the bonds and the insurance, and other crazy poker game gizzmoes), generated GREAT DEMAND on Wall Street for new mortgages (like Ross Perot's great sucking sound). When you build profits on a house of cards, you can predict the outcome.

The regulators in Washington let the bubble grow and should have predicted the outcome. They are truly to blame, because regulators should know something about a history rife with speculative booms and busts.

And we know something about insiders walking off with the windfall profits. Our mission, if we choose to accept it, is to claw back those profits from the swindlers.

Sources:

BusinessWeek blog, Community Reinvestment Act had nothing to do with subprime crisis, Aaron Pressman, September 29, 2008.

Fannie Freddie Melt Down will Get the Banks

Private sector capitalism is failing, and the public sector (tax payers) is propping it up. This is a golden opportunity for fundamental socio-economic change.

Fannie Mae and Freddie Mac have been in trouble for a long time, but now the crisis phase has begun. This was all predicted in great detail, documented in the February 2003 report entitled "Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO, [PDF]." The report was issued under the direction of Armando Falcon, Director of the Office of Federal Housing Enterprise Oversight (OFHEO). He warned Congress that many large financial institutions were systemically linked to Fannie Mae and Freddie Mac. If Fannie and Freddie, or real estate in general, tumbled, the rest of the economy could likely be pulled down as well. Falcon's reward for this honest insight and advice was to be fired by the Bush Administration.

This risk of the banks getting sucked down with Freddie Mac and Fannie Mae is summarized in the following, where "GSE" refers to government-sponsored entities, i.e., Fannie and Freddie:

[A]t year-end 2001 over 4,800 commercial banks—over sixty percent of the institutions in the banking industry—held GSE debt in excess of 50 percent of their equity capital. Nearly sixty percent of those banks have less than $100 million in assets; over ninety-seven percent have assets of less than $1 billion. Of banks with assets of more than $1 billion, 123 institutions —over 30 percent of banks of that size —owned GSE debt in excess of 50 percent of their equity capital.

In plain English, if Fannie Mae and Freddie Mac default on their debt, many banks will go under, unless the tax-payer bails them out. If the latter, then we, the people, should demand future part-ownership, and profit-sharing, in the entities we bail out.

For further synopsis of the report, see OFHEO Warning of February 2003.

OFHEO Warning of February 2003

The February 2003 warnings of Armando Falcon are beginning to emerge as people start to default on mortgages and investors start to bail out of real estate holdings on declining prices. Falcon, Director of the Office of Federal Housing Enterprise Oversight (OFHEO), warned Congress that many large financial institutions were systemically linked to Fannie Mae and Freddie Mac. If Fannie and Freddie, or real estate in general, tumbled, the rest of the economy could likely be pulled down as well.

In "Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO, [PDF]" Falcon advised Congress: Give the US Government the authority to take Fannie and Freddie into receivership during a financial crisis. This would avoid a domino effect that would "lead to large looses in the aggregate economy." Falcon's reward for this honest insight and advice was to be fired by the Bush Administration.

It's four years later and Falcon's ghost has returned in the form of "concerns about sub-prime mortgages." That's the tip of the iceberg according to the OFHEO study and current indications.

Role of Fannie Mae and Freddie Mac

The OFHEO report explains that the government creating Fannnie Mae and Freddie Mac (FMFM) to provide low interest financing for low income people even during tight financial periods. The low interests were accomplished in part, by creating a secondary mortgage market and by the perception of lower risk due to being government-backed. In recent years, as a result of relaxed legal restrictions on access to nationwide funding, Fannie Mae and Freddie Mac have been joined by private sector firms that perform the same function.


Hidden in these previous statements are risks that are strongly coupled to the whole ecomony.

First, Fannie Mae and Freddie Mac aren't fully backed by the US Government. This is central to the 2003 OFHEO study recommendation that Congress authorise government receivership of FMFM in the event of a serious financial crisis. Allowing the Government to take over FMFM could help mitigate a wider economic panic.

Second, are risks associated with the secondary mortgage market that is enabled in large part by the creation of FMFM. On the one hand, allowing mortgages to be resold allows FMFM to offer more loans, thereby making home ownership possible for more people of lesser means. On the other hand, this secondary mortgage market invites abuse, and Congress has enabled this by allowing the private sector to operate in this market.

The secondary mortgage market has turned it into a playground for financial speculators (think "irrational exuberance") and a dumping ground for risk. On the latter point, many mortgage lenders evade the risk of loan defaults by selling their mortgages into the "mortgage-backed securities" (MBS) market. The mortgage lenders get paid up front and wipe their hands clean of risk; their disincentive for making risky loans evaporates, because they can sell off the loans. The risk is passed on to the murky secondary market, into which the broader economy has become significantly invested. Many houses have been financed in the past few years with the lender's knowledge that, if housing prices fail to increase, it is almost certain that the buyers will default. We're at that point today.

People with little experience have also bought investment properties and many have bought second homes. All of this has contributed housing price inflation that is not supported by true value and does not reflect the true risk of the market; lack of transparency, and out right fraud, has undermined market discipline.

The "systemic" part of the risk hinges on who is now holding all of those mortgage-backed securities. Large commercial banks, insurance companies, pension funds, endowments and other institutions are deeply invested in what appears to be a house of cards.

Defining Systemic Financial Risk

The OFHEO report gives basic background on "systemic financial events" defined as

a financial crisis that causes a substantial reduction in aggregate economic activity, such variables as housing starts, home sales, consumption, output and employment.

It discusses stages of a systemic event, the effect of consolidation and use of over-the-counter financial derivatives on systemic risk and the difficulties in assessing indirect interdependencies.

Five stages of a systemic event are explored: The preconditions, economic shock, spreading liquidity problems, institutional response, ensuing financial crisis.

In the present case, the wide-spread investment in over-valued real estate and secondary market are the pre-conditions. To some degree, the slow pace of the cooling market has allowed some of the air to be let out of the bubble in a controlled way over the past year. However, the bubble is still significant.

The downward stock market drops of the past few weeks could be part of the shock. In addition, the Nation has experienced the psychological shock of the Iraq Study Group Report and the 2006 mid-term election results that expose the failure of Bush's adventure in Iraq. The war is causing the national debt to accelerate, and US standing in the World to decline. Meanwhile, the main-street economic statistics that matter are being exposed by U.S. Senator Jim Webb during his prime-time response to the President's State of the Union Address and even in a recent Bloomberg piece on concerns over the growing wealth gap.

The spreading liquidity problem is reflected in statements like,

Data from UBS AG show that the default rate for Alt-A mortgages has doubled in the past 14 months.[3]

Alt-A mortgages are a step above sub-prime mortgages where liquidity problems have been widely reported to have contributed to the jitters in the World stock markets. This is reflected in statements like Saxo Bank analyst Torben Krogh Nielsen, who said,

U.S. sub-prime woes are mushrooming. It's hard to believe they'll be contained and not impact the broader U.S. — and by extension, the global — economy... [2]

or by Lee Cheng Hooi, technical analysis manager at EON Capital in Kuala Lumpur:

The U.S. sub-prime concern has cast a great shadow on Asia. The worry is that it could spill over and cause the U.S. economy to slow down, and this will cause a domino effect on the world economy... There could be more bloodbath to come. [2]

February 28 testimony to Congress by Federal Reserve Board Chairman Ben Bernanke contradicts the UBS research on Alt-A mortgages, sounding like a cover-up, which itself is causing anxiety,

Our assessment is that there's not much indication that subprime issues have spread into the broader mortgage market... [3]

Just the fact that Bernanke is talking about a spreading liquidity problem could suggest there is a problem... but there's more evidence. Bloomberg reports that it's not only sub-prime and Alt-A mortgages that are having liquidity problems:

The Mortgage Bankers Association said foreclosures are climbing on loans to borrowers with the best credit ratings, a sign of broader trouble in the housing market.[5]

And the liquidity problems are spreading to financial institutions:

Investors, bracing for a wilting economy, fled the already deflated subprime mortgage sector on more news that lenders New Century Financial Corp., Accredited Home Lenders Holding Co. and General Motors Acceptance Corp.'s residential unit are facing financial problems. [4]

"Accredited Home contributed to the anxiety after it said it is in need of cash. Its shares plunged $7.43, or 65 percent, to $3.97."[4]

What about Institutional Response? The mortgage industry news is filled with it. Housing and Urban Development (HUD) Secretary Alphonso Jackson wants to pass Federal Housing Administration (FHA) legislation in response to the secondary mortgage melt-down (amending the Real Estate Settlement Procedures Act.). Senate Banking Committee Chairman Christopher J. Dodd, (D-CT) agrees, "We may need to get some forbearance or something like that to give them a chance to work through their problems." New York Attorney General Andrew Cuomo is investigating subprime lenders (a little late). There is a consensus within the National Association of Hispanic Real Estate Professionals that mortgage wholesalers and brokers should be held accountable for the loans they originate (They're working on it). The FBI is investigating mortgage fraud, the House and Senate are considering legislation to place Fannie Mae and Freddie Mac under stricter supervision. In short, the institutions are responding.

And the ensuing financial crisis? We're in one, but the authorities and politicians are down-playing it to avoid panic.

Implications: The OFHEO study assesses several potential implications and considers scenarios in which Fannie Mae and Freddie Mac are either stabilizing or destabilizing factors regarding the spread of a financial crisis to the entire economy. One real factor that suggests a failure of FMFM would result in a domino effect is that many banks hold FMFM instruments as a major part of their reserves.

Table 4 on page 77 of the report breaks down the number of banks, by size, that are holding FMFM (GSE) debt, and the percentage of those holdings. A footnote on page 100 of the report indicates a huge exposure of the banks to a failure of FMFM:

[A]t year-end 2001 over 4,800 commercial banks—over sixty percent of the institutions in the banking industry—held GSE debt in excess of 50 percent of their equity capital. Nearly sixty percent of those banks have less than $100 million in assets; over ninety-seven percent have assets of less than $1 billion. Of banks with assets of more than $1 billion, 123 institutions —over 30 percent of banks of that size —owned GSE debt in excess of 50 percent of their equity capital.

In plain English, if Fannie Mae and Freddie Mac default on their debt, many banks will go under, unless the tax-payer bails them out. If the latter, then we, the people, should demand future part-ownership, and profit-sharing, in the entities we bail out.

Sources:

1. Office of Federal Housing Enterprise Oversight (OFHEO), "Systemic Risk: Fannie Mae, Freddie Mac and the Role of OFHEO, [PDF], February, 2003."

2. Associated Press, World stocks fall after Wall Street drop, TOBY ANDERSON, AP Business Writer, March 14, 2007.

3. Mortgage Defaults Start to Spread, Ruth Simon and James R. Haggerty, March 1, 2007.

4. Associated Press, Stocks plummet on subprime lender woes, MADLEN READ, AP Business Writer, March 13, 2007.

5. Bloomberg, European Stocks Slide on U.S. Growth Concern; UBS, RBS Decline, Andreas Hippin
March 14, 2007.