Political Origins of the Financial Crisis

6 October 2008 at 11:47 am 6 comments

| Dick Langlois |

Okay, so maybe I’ll write about the financial crisis after all.

Stan Liebowitz has been pointing for a long time to the political origins of lowered lending standards — pressure on Fannie Mae to increase “affordable housing” — and to the role of those lowered standards in the mortgage bubble. “[I]n an attempt to increase homeownership, particularly by minorities and the less affluent, an attack on underwriting standards was undertaken by virtually every branch of the government since the early 1990s. The decline in mortgage underwriting standards was universally praised as an ‘innovation’ in mortgage lending by regulators, academic specialists, GSEs, and housing activists. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble.”

Today the AEI has posted a nice piece by Peter Wallison and Charles Calomiris saying much the same thing. Even more interesting, however, is a long article in Saturday’s New York Times that chronicles the process in great detail.

Capitol Hill bore down on Mr. Mudd as well. The same year he took the top position, regulators sharply increased Fannie’s affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.

“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.”

The “Mr. Mudd” referred to is Daniel H. Mudd, then chairman of Fannie Mae and son of the TV newscaster Roger Mudd. The Times notes that politicians saw Fannie Mae as a supplier not merely of “affordable housing” but of fiscal stimulus as well.

Lawmakers, particularly Democrats, leaned on Fannie and Freddie to buy and hold those troubled debts, hoping that removing them from the system would help the economy recover. The companies, eager to regain market share and buy what they thought were undervalued loans, rushed to comply.

The White House also pitched in. James B. Lockhart, the chief regulator of Fannie and Freddie, adjusted the companies’ lending standards so they could purchase as much as $40 billion in new subprime loans. Some in Congress praised the move.

“I’m not worried about Fannie and Freddie’s health, I’m worried that they won’t do enough to help out the economy,” the chairman of the House Financial Services Committee, Barney Frank, Democrat of Massachusetts, said at the time. “That’s why I’ve supported them all these years — so that they can help at a time like this.”

Notice that this is in principle a real explanation for the crisis: a reduction in standards increased the demand for mortgages, since it allowed more people to become potential demanders. Peter and others have written about the monetary side — the Fed pumping money into the system — which would have shifted out the supply of loanable funds. (Do I have this right, macro guys?) The two effects work in the same direction, increasing the number of mortgages; and as mortgages and houses are strongly complementary, this drives up the price of housing. Has anyone tried to integrate these two stories?

Entry filed under: - Langlois -, Business/Economic History, Law and Economics, Public Policy / Political Economy.

Amethyst and Public Choice Humorous Headline of the Day

6 Comments Add your own

  • 1. stevphel  |  6 October 2008 at 12:34 pm

    Gotta put this out there from The Economist’s View…

    As Robert Gordon shows, however, this is crap. First, there’s the timing. CRA came in 1977. The crisis came in 2007. Indeed, by 2004, the Bush administration had weakened the CRA — and after that (though not, presumably, because of it), bubble lending really took off. Further, CRA only governs a certain class of federally insured banks. Problem is, half of the subprime loans came from mortgage companies with no CRA involvement at all. Another 25%-30% came from companies with very little CRA exposure. For those who left their abacus at home, that’s 80% of the loans which were fully or largely outside CRA jurisdiction. More than that, the non-CRA mortgage firms made subprime loans at twice the rate of CRA-covered firms. Which basically leaves a stake in the heart of this particular theory. Indeed, until now, some conservatives have been moaning that no one is talking about the CRA part because it’s so racially charged. Poppycock. It’s just a false charge…

  • 2. stevphel  |  6 October 2008 at 12:46 pm

    From: “The Housing Bubble, in Four Chapters,” Alec Klein and Zachary A. Goldfarb of the The Washington Post

    The young woman who walked into Pinnacle’s Vienna office in 2004 said her boyfriend wanted to buy a house near Annapolis. He hoped to get a special kind of loan for which he didn’t have to report his income, assets or employment. Mortgage broker Connelly handed the woman a pile of paperwork.

    On the day of the settlement, she arrived alone. Her boyfriend was on a business trip, she said, but she had his power of attorney. Informed that for this kind of loan he would have to sign in person, she broke into tears: Her boyfriend actually had been serving a jail term.

    Not a problem. Almost anyone could borrow hundreds of thousands of dollars for a house in those wild days. Connelly agreed to send the paperwork to the courthouse where the boyfriend had a hearing. As it happened, he was freed that day. Still, Connelly said, “that was one of mine that goes down in the annals of the strange.”

    Strange was becoming increasingly common: loans that required no documentation of a borrower’s income. No proof of employment. No money down. “I was truly amazed that we were able to place these loans,” Connelly said.

    It was a world removed from his start in the business, in 1979, when the University of Maryland graduate joined the Springfield office of a savings and loan. For most of his 25 years in the industry, home buyers provided reams of paperwork documenting their employment, savings and income. He’d fill out the forms and send away carbon copies for approval, which could take 60 days.

    Connelly was now brokering loans for Orlando-based Pinnacle or for subprime specialists such as New Century Financial that went to borrowers with poor credit history or other financial limitations. Connelly said he secured many loans for restaurant workers, including one for $500,000 for a McDonald’s employee who earned about $35,000 a year.

    Lenders saw subprime loans as a safe bet. Home prices were soaring. Borrowers didn’t have to worry about their payments ballooning — they could sell their homes at any time, often at a hefty profit. Jeffrey Vratanina, one of Pinnacle’s co-founders, said Wall Street wanted to buy more and more of the mortgages, regardless of their risk, to pool them and then sell them to investors. “Quite candidly, it all boils down to one word: greed,” he said.”

  • 3. Peter Klein  |  6 October 2008 at 1:06 pm

    Gordon (and Thoma) are being sloppy here. There’s a lot of careful research, by Liebowitz and others (Gordon seems unaware of it, apparently thinking that Liebowitz is an op-ed columnist) on the effects of the CRA (and other policies) on weakening underwriting standards. Pointing out that CRA was passed in 1977 is silly. What matters is how the CRA and related policies were enforced and what effects they had on lending, and there’s plenty of evidence that these effects were large and economically significant. Merely shouting, “Politically correct lending standards could not alone have caused the housing bubble!” is nothing but knocking down a straw man, and avoids any serious analysis of government policies toward underwriting.

  • 4. rlanglois  |  6 October 2008 at 2:47 pm

    Thanks for the comments. In the article I cite, Liebowitz mentions the CRA only in passing in a historical sketch; he is clearly talking about the early 1990s on. In any case, I was marveling at the very recent pressure on Fannie Mae in particular. I don’t see the Public Choice issue as one of political correctness but rather of ordinary pandering — of currying favor with voters by providing through government something those voters desire. Again, I think that the interesting question is how important this explanation is relative to the monetary story (and, of course, other possible explanations). I notice in one of Liebowitz’s graphs that the interest rate failed to rise over the peirod of increased lending (and may have declined), which, in a simple model, means that the supply of loanable funds must also have been shifting out. But that’s a simple model, and I’m not a macro guy.

  • 5. Michael E. Marotta  |  6 October 2008 at 10:52 pm

    1) Working as a contract service employee onsite at a mortgage bank, I had the opportunity to read industry trade periodicals from Oct. 2006 forward. To be specific, ABN AMRO, the Dutch bank, bought Standard Federal’s mortgage business, “Interfirst.” Reconstructing the earlier history, from older accounts, it is clear that at first, ABN AMRO did well by being conservative. However, after the first two years, the price of their common stock began to weaken. ABN AMRO had only been taking on strong mortgage loans. As ABN AMRO’s managers saw it, the general market wanted them to move into subprimes, so they did. Their common stock recovered and gained.

    2) My wife and I are self-employed. When we bought a home, we produced income tax statements and other supporting documentation, but -sub rosa- the process was called a “liar’s mortgage.” That was in 1996.

    From our point of view, it would be the worship of mediocrity to only lend money to people with lifetime unionized employment, nominally the best risks. Of course, now those cushy blue collar jobs are long gone.

    Today, I knocked out another contract feature article while my wife is being paid twice her normal rate to quickly proofread a book. Making ends meet is much more stressful than it was in 1997. That, however, is a microeconomic problem.

    The macroeconomic challenge is to write a single set of federal laws for federally regulated banking that fairly address every possible circumstance. It would be much better to let a completely unregulated market bring together the borrowers and lenders. That, however, requires a deep and consequential paradigm shift.

  • 6. Rajiv Krishnan KOZHIKODE  |  18 October 2008 at 1:23 pm

    Here is my theory on the crisis (or should it be called so?)

    Many observers suggest that this crisis was triggered by under-regulation of the financial markets in the US. Although this view could be true, it only explains the $700 billion (which I agree is a phenomenal amount), but it does not explain the base $30 billion of defaulted loans by the borrowers in the US (which though is relatively miniscule, is the underlying asset that bubbled into the $700 billion credit derivative crisis). Of course, some observers might immediately argue that this could simply be an incentive issue. Yes, it is an incentive issue, but the issue could be much deeper than mere agency concerns. The incentive system and competition in the lending market might have prompted the lenders (like commercial banks and other lending agencies like Freddie Mac) to lure borrowers into borrowing loans that they would have difficulty in repaying. However, this isn’t a recent phenomenon, this is how growth in the economy has been triggered for ages. Many of you would agree that liquidity could trigger economic growth. The central bank sets caps on borrowing and lending rates as a means of managing the liquidity in the economy. When the lending and borrowing rates are lowered, it results in greater credit offtake, lesser savings and more spending. This in turn enhances corporate profitability and it creates new jobs, which in turn increases the repaying capacity of the society as a whole and makes the economy stronger. So, what did actually go wrong? It might be important to look at the factors that might have affected this economic cycle in the US to get a better perspective.

    The interconnectedness of the markets that Brayden was speaking in his post in orgtheory.net perhaps might explain this… I believe that the increase in liquidity in the US market might have had its desired consequence – more credit offtake, lesser savings, greater spending. But, the cycle should have taken a different turn from there… thanks to globalization. The US trade deficit explain some part of this story. Yes, people in the US have been spending a lot and the corporates have been gaining out of this increase in spending, but the share of the US spending that goes to demestic firms should have taken a toll…thanks to cheap imports from emergign economies. So, lesser profitability for US firms, which means lesser jobs in domestic US firms that have traditionally been employing domestic employees. Addionally, the cheap international labor market takes a major share of those remaining jobs in the US (what is popularly known as outsourcing). Net on net, there are fewer good jobs for an average American and lesser is the average repaying capacity of the Americans, which results in increased bad loans…

    So… Are we as a global community in a bad shape? Probably not? As I said, the emerging economies have benefitted tremendously from the liquidity in the US and in other developed economies. These economies have seen their growth rate soring and even a high inflation and the resultant checks on liquidity seemed not to have slowed down these economies. Of course, when the key buyers (the consumer in developed economies) reducing their buying spree there would certainly be a reduction in the growth of the emerging economies, but in the last decade or so the wealth of the average individual in these emergign nations have increased and the drop in the buying capacity of the US consumers might be taken care of by the gain in the buying capacity of the consumers of the emerging economies. So… what we see might be just a shift in the financial balance and not an overall collapse…

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