I worked for one of the major sub-prime lenders for four years in the late 1990s near the beginning of the rise in that market. I saw firsthand how eager they were to expand their business in that arena. They were looking at major competition from lenders of traditional home loans and wanted a way to increase revenues in areas where the competition was less and returns higher.
What generated that competition?
In part, it was the natural outcome of rising income as the economy expanded. Incomes had been rising since the end of WWII, though there were dips along the way, such as after the S & L debacle of the late 1980s, early 1990s. With that behind them, homeowners and lenders sought out one another in ever greater numbers, since private home ownership is hotly desired by most who can afford it.
But there was another element to that market, one more closely associated with lower incomes: the sub-prime market. "Sub-prime" loosely (but not too loosely) speaking is a section of home mortgage lending that concerns itself with borrowers with less than stellar credit. The "sub" doesn't mean "lower interest rates" but "lower credit ratings," chiefly anyone with a FICO score below 540.
[That number is calculated according to secret, proprietary algorithms by the major credit rating companies, TransUnion, Experian, and Equifax. Major elements include the number of late payments and how late they are, 30 days, 60 days, etc., and overall debt levels.]
In decades past, lenders would rarely touch anyone with a FICO under 540, unless they had ample collateral (for example, in the form of a large down payment). When they would, the borrower had to pay a premium rate.
Lending Practices Changed
In the 1990s, the rules and standards got relaxed.
Traditionally, 20% was the norm, but that gradually was reduced to 15%, or 10%, or even lower. Before long, even that 5-15% was often borrowed, in the form of a "second" (the lender would lend even the down payment at the same time as the "first," usually at interest rates several points higher).
Before long, down payments were considered optional. Many borrowers would pony up only to lower their rate and/or monthly mortgage payment. Those without the funds to do that, accepted a somewhat higher rate and higher monthly payment.
That shift alone is a recipe for disaster, since those who could less afford higher rates and higher payments came to be a larger percentage of home loans, almost guaranteeing a higher default rate on mortgage loans. But worse was yet to come.
To offset the risk of those loans, lenders could securitize them. That is, they could pool loans together into a fund, that was then sold in the form of securities traded on the bond markets. Hence were born Mortgage Backed Securities in a dizzying array of forms. The practice had been going on since the 1970s, but expanded considerably in the 1980s.
Not long after the MBS became popular something was added to the mix: derivatives. [Derivative: A security, like an option or future, whose value is derived from another underlying security.]
That allowed further spreading of risk. Far from increasing the risk of sub-prime lending, securities and derivatives help reduce it — by spreading it to others. For taking a risk, investors receive a return when they guess right and suffer a loss when they guess wrong.
All that may or may not have been a bad business idea. But if it were, poor business practices in a free market are always self-limiting. Those who engage in them lose money. So, they either change their ways or they eventually go out of business. Only the employees and shareholders of that company would suffer a loss. Nothing in that scenario allows for a nationwide financial meltdown.
Something else was at work.
Government on the March
In 1977, a year when Democrats held a majority in both Houses, Congress passed the Community Reinvestment Act. President Carter signed it. According to the Federal Reserve website:
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 modified in 1995, when Republicans held a majority, then signed by President Clinton, who had campaigned on the issue.
The CRA requires that each insured depository institution's record in helping meet the credit needs of its entire community be evaluated periodically. That record is taken into account in considering an institution's application for deposit facilities, including mergers and acquisitions.It's been suggested (mostly by Leftists) that the CRA is unrelated to the current financial crisis. Yet, looking at the language and the purpose of the CRA is alone enough to disprove that. Lending institutions are ranked, in part, on how substantially they lend to low and moderate income households (which are typically the same as low credit ranking, high risk households).
CRA examinations (see Exam Schedules) are conducted by the federal agencies that are responsible for supervising depository institutions: the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS).
These revisions with an effective starting date of January 31, 1995 were credited with substantially increasing the number and aggregate amount of loans to small businesses and to low- and moderate-income borrowers for home loans.More evidence is provided by the authors of the reform. As stated by Clinton's Asst. for Economic Policy, later Treasury Secretary (and current economic adviser to Barack Obama), Robert Rubin:
The President, as you know, has a broad, comprehensive strategy for dealing with the economic problems of the country for putting the country back on the right track for the long-term. A lot of the legislative and executive actions that have taken place in 1993 have been pursuant to that long-term economic strategy of the President's.The motive of the legislation was made crystal clear by Eugene Ludwig, Comptroller of the Currency, a major participant:
An important component of that strategy is to deal with the problems of the inner city and distressed rural communities — pursuant to his belief that we must make real progress in those areas if this country is going to be successful in the future for all of us. The reform of the Community Reinvestment Act is an essential building block in the efforts I've just mentioned.
Fifteen years ago, Congress passed the Community Reinvestment Act. Passed it to ensure that banks and thrifts served the financial needs of their entire communities; and in particular economically empowered persons of low and moderate income. But the CRA has never achieved its full promise.Among other things, the legislation introduced the CRA ranking, a score that helps determine which lenders are 'doing their part' to "serve the financial needs" and "empower persons of low and moderate income."
Those rankings influence, for example, whether those businesses are allowed to expand into certain geographical regions and business sectors. The determination, though, is essentially made by bureaucratic whim.
Neither the CRA nor its implementing regulation gives specific criteria for rating the performance of depository institutions. Rather, the law indicates that the evaluation process should accommodate an institution's individual circumstances.It isn't difficult to see how this sort of vagueness can easily lead to, at best, subjective decisions and (as is so often the case) outright bribery of public officials (albeit in the 'polite' form of healthy campaign contributions).
There was, indeed, nothing coincidental about the increase in the size of the sub-prime market. Quoting again from Mr. Rubin:
[I]n conjunction with the President's Community Development Bank and financial institution legislation, which recently passed the House of Representatives, CRA reform will generate billions of dollars in new lending and extend basic banking services to the inner cities and to distressed rural communities around the country.Echoing him, Ludwig declared,
It will channel billions of dollars a year in new credit into America's distressed communities...Well, in that, they succeeded.
The number of CRA mortgage loans increased by 39 percent between 1993 and 1998, while other loans increased by only 17 percent.What guided their efforts?
This reform package is the product of five long months of consultation and deliberation. Before we made a single decision on proposing reform, we turned to the people to ask what the people thought what the people needed. We walked through South Central Los Angeles, in a predominantly minority neighborhood in New York City to see with our own eyes and to listen with our own ears to what should be done. We talked with representatives of the Navajo Nation; to bankers, large and small banks, inclusive; to poor people in rural North Carolina and elsewhere. We saw and what we heard shaped this reform package.Government-engineered altruism raised its ugly head again. Lenders responded.
By replacing paperwork requirements with performance tests, this package would stimulate bank lending, investment and service in low and moderate income communities. This proposal is not about formulas. Community groups and bankers both emphasized the need for flexibility. So this proposal recognizes the diversity of banks and the markets they serve. It reduces the examination burden, particularly on small banks without reducing their obligation to serve their communities; and it recognizes that regular public participation is critical if we are to achieve the goals of the law.
As recently as April, 2007, Bank of America was boasting:
McGee announced Bank of America was notified last week by the Office of the Comptroller of the Currency that for the sixth-consecutive period the bank has achieved an "outstanding" rating on its recently completed Community Reinvestment Act (CRA) exam.
Fannie Mae and Freddie Mac
Much of the security market described above was taken up by Fannie Mae (Federal National Mortgage Association) and, later, Freddie Mac (Federal Home Loan Mortgage Corporation.) Both were created by the Federal Government, as so-called GSE (Government Sponsored Entities).
Fannie was founded in 1938 as part of the New Deal, though it was made quasi-private in 1968. For a 32 year period, Fannie had a monopoly on the secondary mortgage paper market. Freddie was founded in 1970 to provide some quasi-competition. Freddie bought the mortgage loans, pooled them, and then sold MBSs to investors.
Among the many forms, Fannie Mae created CMOs (Collateralized Mortgage Obligations) in 1983. The government helped expand the market as part of the Tax Reform Act of 1986. The Act created REMICs (Real Estate Mortgage Investment Conduits, a security that allows investors to tailor the risk they want to take in exchange for different returns. Freddie and Fannie are the largest issuers.
Together, they had roughly half of the $12 trillion dollar mortgage-related secondary financial market by mid-2007.
The Rest of the Story
The penultimate chapter of this story is by now well-known to everyone.
After rising to unsustainable levels, housing prices fell. When the price of the collateral underlying a security falls, the price of the security tends to follow. Homeowners with adjustable rate mortgages saw their monthly payments rise. Roughly 5% of borrowers defaulted on their loans. Banks lost money. Investors lost money. Together, Freddie and Fannie lost $12 billion between the summer of 2007 and 2008. Credit got tight, even though interest rates were kept artificially low by the Federal Reserve.
Then, as is usually the case and to our never-ending regret, the Federal Government was called in to 'solve the problem.' Repeatedly.
[We'll examine in the remaining segments of the series its reactions to the crisis and how they plan to do that.]
[Note: Updated since first publication.]
[UPDATE: Mark Perry, Professor of Finance at U of Michigan, supplies some helpful details that support my basic - and admittedly very incomplete - history.]