The Bailout and the CRA

[billroper]

A friend of mine commented about how most of the subprime lending that sunk the markets wasn't the result of loans that satisfied obligations under the Community Reinvestment Act. And he's right.

Having done a little research and talked to my wife, the former banker, the picture is just a bit more complex than that.

The original version of the Community Reinvestment Act had very few teeth. It was revised in the mid-1990s and teeth were put into it. If your bank wanted to expand or merge with another bank, it had to have a good CRA record. One of Gretchen's good friends was the compliance officer for the bank that she worked for, so she heard a good bit about the difficulty of complying and the amount of paperwork required.

The problem was that the banks were trying really hard to stay in compliance with the CRA, but finding borrowers who actually qualified for the kind of mortgage loans that Fannie Mae and Freddie Mac were allowed to buy was difficult and sometimes impossible. This meant that if the banks made mortgage loans to less-creditworthy customers in order to stay in compliance with the CRA, they were stuck with them.

The banks, quite understandably, didn't want all of this potentially bad paper on their books. Thus Congress loosened up the regulations on Fannie Mae and Freddie Mac and told them they could buy this sort of crappy loan, because Congress wanted the banks to make the crappy loans to people in the CRA areas.

What they didn't say to Fannie and Freddie was that the only crappy loans you can buy are ones that are made for the sake of CRA compliance. That's not too much of a surprise, I suppose, since doing anything else would have appeared to be blatantly discriminatory.

Well, once Fannie and Freddie stood ready to buy crappy mortgage loans, there was a sudden boom of people who were ready to originate crappy mortgage loans, because they had a place to get rid of them to. They could get the profits from originating the loan without having to carry the long-term risk.

As usual, you get the behavior that you create the incentives for.

So the story starts with the CRA, but doesn't end there.

Fair enough?

Comments

Blaming the CRA . . .

[wick-deer.livejournal.com]

for the financial meltdown is like blaming a snowflake for a blizzard. It's part of the problem, but the whole picture is much more complex.

Fannie and Freddie were only two of multiple markets for the crappy mortgages.

Much of the idiotic lending was driven by market forces. There was a tremendous demand in the financial world for mortgage based securities. In order to create the securities, investment banks needed to buy mortgages. In order to meet that demand, mortgage companies had to sell more mortgages.

In order to meet the demand, the investment banks kept loosening their standards on the mortgages that they would accept in order to create the mortgage backed securities.

This American Life had a wonderful piece talking to the naive and/or greedy and/or idiotic buyers, the mortgage agents, and the financial guys. It is available on-line at http://www.thislife.org/Radio_Episode.aspx?episode=355.

Please note that the CRA was expanded under Clinton, but the mortgage bubble didn't start blowing up in earnest until well into the Bush Administration.

Re: Blaming the CRA . . .

[billroper]

To mangle an old aphorism, Rome didn't fall in a day. You start the pebble rolling down the hill, eventually you get the avalanche.

According to the data that I've seen, Fannie and Freddie were by far the largest market for the crappy mortgages.

And you might note this New York Times article from late September, 1999 about how Fannie Mae was loosening credit requirements again. It takes time for things to go sour, you know. The fact that the process started under Clinton and blew up under Bush doesn't negate the fact that the process started under Clinton, especially when you can find various references to Bush attempting (unsuccessfully) to rein in the problem.

[jrittenhouse.livejournal.com]

The story may include that as a side note, but the real fire to this was that an awful lot of people all over the world got this idea to jump into the bubble and make all sorts of pseudo-business out of a lot of dumb loans and Big Business stuff, with the idea that the bubble was forever, and the big business was endless and unstoppable. More bonuses, bigger stock options, huger quarterly reports, and on and on. Buy up your competitors for huge sums, and show what a master of the universe you are when you DOMINATE THE MARKET!!!

The Gods of the Copybook Headings don't care about your quarterly reports.

"Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew
And the hearts of the meanest were humbled and began to believe it was true
That All is not Gold that Glitters, and Two and Two make Four
And the Gods of the Copybook Headings limped up to explain it once more."

Re: Forever

[polaris93.livejournal.com]

Always people assume that what's true now is true forever -- until conditions change, and then they panic. Also, if times are good, or seem that way, people embrace that as if it were forever in the same way that substances addicts act as if there will always be a source of whatever their beloved substance is, that they will always be able to get it somehow, somwhere. Same state of mind. That's a good part of how we got into this mess. I wonder what will happen before we get out of it?

Re: Forever

[jrittenhouse.livejournal.com]

Well, read the whole Kipling poem (http://www.kipling.org.uk/poems_copybook.htm) and then tell me what you think.

Re: Forever

[polaris93.livejournal.com]

Oh, I love that! Thanks -- that's one Kipling poem I'd never run across. And yes, the Gods of the Copybook Headings forever return, and do outlast the Marketplace Gods rather handily. I think They're names are Eris and Lord Murphy, and They rule entropy, uncertainty, and chaos. All three of which, BTW, are absolutely necessary to the rise and maintenance of Life and Mind, not to mention their evolution through time. (If you're curious as to why -- though you probably already know that -- ask and I shall elaborate. Aleister Crowley (who adored Kipling's work) said that "Magick is the Art and Science of causing change in conformity with Will." Too much of that, or too much of that in conflict with the Will of one's neighbors, however, and things tend to go horribly RWGNO, and we are back to Square One, and here come the Copybook Gods again, with all Their terror and bloodshed (not to mention Famine, Pestilence, and plenty of Death). If we could keep up the Magick forever, without slack, change, or damage, then things would remain as we would like them to be. But change brings the unexpected, slack (however pleasant) brings complacency and lack of awareness, and damage brings the wrong sort of change. Thus the price of Life is the occasional unforeseen catastrophe. {sigh}

[docstrange.livejournal.com]

"The story may include that as a side note, but the real fire to this was that an awful lot of people all over the world got this idea to jump into the bubble and make all sorts of pseudo-business out of a lot of dumb loans and Big Business stuff"

Isn't that true each and every time a major, perverse market incentive is created?

I certainly think the problem started with the CRA; it's not like a snowflake in a storm - it's the pushed boulder that started the avalanche, with Congress going, "what do you MEAN no one was regulating the rocks below?!" In hindsight the results are predictable. Create a strong perverse incentive to run an unregulated market segment in overdrive... and it will go into overdrive.

[jrittenhouse.livejournal.com]

I think it started with greed, not with the CRA. I think that the greed and Master-of-the-Universe stuff is and has been 99.999999999999999999999999999% of the whole thing right along. If you like, we can debate this, but I'm not up to endlessly swatting this down.

Re: Greed and Power-Hunger

[polaris93.livejournal.com]

You're right. Blaming everything on the CRA is a cop-out. People love things that glitter and cracking the whip over others. The Gods of the Copybook Headings are us, no more, no less, no other, given that "us" = "humanity." Our human nature contains mean, bad streaks, and these lurk ever watchful within us, waiting for chance and opportunity to make their move . . .

[docstrange.livejournal.com]

Sorry for the late reply, here. Several day break from most onlininess.

Any major governmental program that does not even begin to take into account human nature has a rather high chance of failure and potentially catastrophic failure, downstream. CRA has been such an animal. Create an incentive for social engineering reasons, but do nothing to manage its likely impact on markets, given totally predictable human nature? Does Congress get a pass on an excuse like, "But we didn't know people would be GREEDY!" I don't think so. As I said, CRA was just one boulder, but complaining the market was GREEDY is like complaining the rocks below had MASS.

Markets - people - are going to go where the money is. Create a market incentive for a good reason but take not one step to manage those incentives, and you have... well, you have a strong perverse incentive introduced into an unregulated market segment. Overdrive is almost a guaranteed outcome.

[jrittenhouse.livejournal.com]

http://www.mcclatchydc.com/251/story/53802.html

Federal housing data reveal that the charges aren't true, and that the private sector, not the government or government-backed companies, was behind the soaring subprime lending at the core of the crisis.

Subprime lending offered high-cost loans to the weakest borrowers during the housing boom that lasted from 2001 to 2007. Subprime lending was at its height vrom 2004 to 2006.

Federal Reserve Board data show that:

* More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.

* Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.

* Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that's being lambasted by conservative critics.

[billroper]

Yes, and they then sold those loans off to Fannie Mae and Freddie Mac, as we've discussed before. If the FMs weren't making a market for the subprime loans, we wouldn't have had a private industry spring up to originate them.

Figures don't lie, but liars sure can figure.

Which is not to say that you're a liar, but you are misusing statistics and failing to address the original point.

[docstrange.livejournal.com]

Agreed. The FHA required many, many *private* institutions to issue high-risk loans. The use of the term "direct" in that quote is intentionally wiggle-wordy.

That they went hog wild once there was a universal buyer of last resort should have come as no surprise.

Actually, if you read further . . .

[wick-deer.livejournal.com]

The article Jim cites addresses the point you make:

"This much is true. In an effort to promote affordable home ownership for minorities and rural whites, the Department of Housing and Urban Development set targets for Fannie and Freddie in 1992 to purchase low-income loans for sale into the secondary market that eventually reached this number: 52 percent of loans given to low-to moderate-income families.

To be sure, encouraging lower-income Americans to become homeowners gave unsophisticated borrowers and unscrupulous lenders and mortgage brokers more chances to turn dreams of homeownership in nightmares.

But these loans, and those to low- and moderate-income families represent a small portion of overall lending. And at the height of the housing boom in 2005 and 2006, Republicans and their party's standard bearer, President Bush, didn't criticize any sort of lending, frequently boasting that they were presiding over the highest-ever rates of U.S. homeownership.

Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.

During those same explosive three years, private investment banks — not Fannie and Freddie — dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data."

So actually, when the Sub-prime bubble was blowing up, Fannie and Freddie's market share was shrinking. Investment banks were the primary customers for the mortgages.

Re: Actually, if you read further . . .

[wick-deer.livejournal.com]

http://money.cnn.com/2007/03/19/news/economy/next_subprime/index.htm

This discusses limited verification loans to persons with good credit ratings. Please note that of the five largest players listed in the article, three, IndyMac, Countrywide, and WashMu, have gone broke.

Sure enough,by August 2008, the Alt A loan default rate has gone way up:

http://seattletimes.nwsource.com/html/nationworld/2008090007_mortgage04.html

[jrittenhouse.livejournal.com]

See also:
http://www.newsweek.com/id/162789
http://wcg.livejournal.com/514662.html
http://news.yahoo.com/s/ap/20081009/ap_on_bi_ge/eu_iceland_meltdown

A stock market boom in the mid-1990s supported the rapid growth of Iceland's banking sector, which came to dwarf the rest of the economy and provided financing for deals that ranged across Europe and conquered swaths of the British economy, from fashion retailers to top soccer teams..

The strategy gave Iceland one of the world's highest per-capita incomes, but when liquidity markets dried up around the world, the banks struggled to refinance those heavy debts.

Now Icelanders are watching helplessly as their economy implodes, causing ripples throughout Europe, where tens of thousands of people have accounts with subsidiaries of the Icelandic banks..

Haarde said on Wednesday that the banking sector had "become too big" as he acknowledged that it will take the tiny Nordic nation of just 320,000 people several years to recover from the current crisis.

[phillip2637.livejournal.com]

Being a computer geek, one of the more interesting (to me) takes on the whole thing came through a technology mailing list:
http://bits.blogs.nytimes.com/2008/09/18/how-wall-streets-quants-lied-to-their-computers/

It talks about how people manipulated data to avoid being warned of risk, while still 'complying' with regulations. "It was like a weather forecaster [...] talking about the onset of Hurricane Ike by giving the average wind speed for the previous month."

[billroper]

Ah, yes. Garbage In, Garbage Out. *sigh*

Thanks for the link!

Re: Avoiding warnings

[polaris93.livejournal.com]

You did a rare thing: I am stunned. I mean, I know there are stupid people, and that people do stupid things, but this stupid? That's almost supernatural. Not to mention truly appalling. Thanks for the heads up.