Re: Low Income Borrowers Made Scapegoat Amid Crisis

SteveQuestioner — Tue, 21 Oct 2008 21:11:17 -0000

Great article, but I feel that it understates the role of Freddie and Fannie, as well as the pressure on them that tempted them to underwrite bad loans.

I also would like to comment on factors that led to the combination of unsustainable housing prices with high leverage, and the specific mis-belief that led to AAA ratings on the top "tranche" of a CDO.

First, it wasn't just subprime; at a critical period, they seem to have tossed their previous high standards, as demonstrated by their exposure to Alt-A (unverified income) loans. Here is the official Fannie Mae 2007 document:
http://www.fanniemae.com/ir/pdf/earnings/2007/c...
Note subprime exposure down to $56 Billion, but Alt-A up to $360 Billion!!!
They were relying on credit scores, without verifying sufficient income to maintain payments.

Did government FORCE them to do this? No, but the target percentage of "loans to below median income recipients" had been steadily increased by HUD, under both Clinton and Bush; 52% of all their new loans in 2005 had to be to such recipients, to maintain their government benefits.

Given what competing mortgage companies were doing, and what the government required, they may have faced an impossible situation. Well, not completely impossible: they could have chosen to shrink: to maintain their high standards, and make far fewer loans, since they would no longer have been competitive versus other loan offerings. Is it surprising that they instead chose to increase their risk?

So yes, it was a BUSINESS decision, but it was compounded by the government requirements.

Granted, their actions are still only a secondary cause; the primary causes appear to be years of low interest rates and easy mortgage terms (See *) allowing housing prices to rise to unsustainable levels, plus the interaction of securitization / credit default swaps & non-transparent risks / the ability to duck capital-holding requirements via these financial shell-games.

*: I'd also like to point out something I don't see mentioned much: when everyone was able to get mortgages more easily, that inevitably meant housing prices rose, helping home owners but hurting home buyers. Why? Because if I want a house and you want a house, and we are competing to buy that house, and we are both now able to come up with more money, then one of us is likely to be willing to pay that extra money to be the one who gets the house. This helped drive the housing price boom, which helped drive the illusion that housing prices could keep going up and up. My point is that the unsustainable housing prices weren't just due to Greenspan's < 2% interest rates in 2002-04 increasing the money supply, though those contributed.

It is crucial to understand these US-wide pressures on housing prices, because the unsustainability of prices, combined with unsafe leverage, is what did in the CDO financial instruments that were AAA rated. Historically, housing prices fluctuated differently in different regions of the country. So pooling mortgages across the country reduced risk. But in the current meltdown, housing prices everywhere were revealed to be unsustainable. It started with undocumented loans and subprime loans, but the most important facts about these loans:
0% down - 10% down; and low initial rates that later rose. And if it wasn't the primary loan on the house that left the homeowner with little equity, it was an added equity line of credit. As soon as ANY factor made mortgages harder to get, or potential buyers less able to afford large mortgages, housing prices were bound to drop. As soon as they dropped a little, some buyers owed more on their houses than the house was worth. It was rational to walk away. Or they had a loan with low initial rate, and the rate increased beyond what they could possibly pay, so they had no choice. Once this started happening, the snowballing was inevitable, given such a high percentage of households with little equity and/or rising-rate loans. We hit a bump that affected the whole country (it doesn't really matter what the initial bump was), and soon housing prices everywhere were snowballing downward, plus refinancing suddenly became more difficult as the lenders retrenched. So the number of homeowners with no incentive to stay, or unable to stay, skyrocketed. Often, these were homeowners who had survived the preceding few years with unsustainable borrowing practices, both on their home and on credit cards. Abruptly, lenders stopped extending additional credit, and these borrowers couldn't even maintain payments on the credit they had (many had been surviving by going farther and farther into debt). That this could happen nationwide, on the scale that it did, was inconceivable to the raters who assigned AAA rating to the top CDO tranche. (The top tranche got its money before lower tranches, so it seemed extremely unlikely that enough loans would default to affect it.) That AAA rating lulled some major investors to highly leverage those CDOs: some had their entire net worth exposed to a financial instrument they considered safe. Oops.

It wasn't just low-income people who hit negative equity -- it was across-the-board. And not just individual homeowners: there are partially-built subdivisions that were no longer going to make enough to repay the loans taken out to build them -- so the builders walked away.

Meanwhile, during the boom, people with existing homes pulled their increased equity out, rather than leaving it in. It isn't just the financial companies that exposed themselves to unnecessary risks; so did the average homeowner.

So, pick your poison: irresponsible financial companies with non-transparent securities hiding risk, mistaken AAA ratings, excessive leverage, government monetary policy and housing policy, unsustainable bubble in housing prices, people owning homes with little or no equity, historic levels of household debt, ten trillion dollars in federal debt -- it doesn't require any knowledge of economics to instinctively feel that one way or another something was eventually going to go very wrong. Plenty of blame for everyone.

I certainly agree with the basic observation, that blaming low-income people is .. absurd. And racist. However, that isn't actually what is being claimed. Rather, the claim being made is "unintentional consequences": that well-intended government actions (to help those people) may have exacerbated the situation. This is entirely possible, and shouldn't be dismissed out of hand. Specifically, our government encouraged lending to low-income people, but failed to make sure the lending practices didn't put people into unsustainable situations. Community activists have been complaining about this fact for years. So, it isn't the CRA that is the culprit, but implementation of oversight, both in Congress and HUD, that failed us.

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Re: Low Income Borrowers Made Scapegoat Amid Crisis