As opposed to a desperate liberal legend.
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The decline in underwriting standards is clear in the financial disclosures of Fannie and Freddie. From 2005 to 2007, Fannie and Freddie bought approximately $1 trillion in sub-prime and Alt-A loans. This amounted to about 40 percent of their mortgage purchases during that period. Moreover, Freddie purchased an ever-increasing percentage of Alt-A and sub-prime loans for each year between 2004 and 2007. It is impossible to forecast the total losses the GSEs will realize from a $1.6 trillion portfolio of junk loans, but if default rates on these loans continue at the unprecedented levels they are showing today, the number will be staggering. The losses could make the $150 billion S&L bailout in the late 1980s and early 1990s look small by comparison.
The GSEs’ purchases of sub-prime and Alt-A loans affected the rest of the market for these mortgages in two ways. First, it increased the competition for these loans with private-label issuers. Before 2004, private-label issuers—generally investment and commercial banks—specialized in subprime and Alt-A loans because GSEs’ financial advantages, especially their access to cheaper financing, enabled them to box private-label competition out of the conventional market. When the GSEs decided to ramp up their purchases of sub-prime and Alt-A loans to fulfill their affordable housing mission, they began to take market share from the private-label issuers while simultaneously creating greater demand for sub-prime and Alt-A loans among members of the originator community.
Second, the increased demand from the GSEs and the competition with private-label issuers drove up the value of sub-prime and Alt-A mortgages, reducing the risk premium that had previously suppressed originations. As a result, many more marginally qualified or unqualified applicants for mortgages were accepted. From 2003 to late 2006, conventional loans (including jumbo loans) declined from 78.8 percent to 50.1 percent of all mortgages, while subprime and Alt-A loans increased from 10.1 percent to 32.7 percent. Because GSE purchases are not included in these numbers, in the years just before the collapse of home prices began, about half of all home loans being made in the United States were non-prime loans. Since these mortgages aggregate more than $2 trillion, this accounts for the weakness in bank assets that is the principal underlying cause of the current financial crisis.
In a very real sense, the competition from Fannie and Freddie that began in late 2004 caused both the GSEs and the private-label issuers to scrape the bottom of the mortgage barrel. Fannie and Freddie did so in order to demonstrate to Congress their ability to increase support for affordable housing. The private-label issuers did so to maintain their market share against the GSEs’ increased demand for sub-prime and Alt-A products. Thus, the gradual decline in lending standards—beginning with the revised CRA regulations in 1993 and continuing with the GSEs’ attempts to show Congress that they were meeting their affordable housing mission—came to dominate mortgage lending in the United States.
FEDERAL HOUSING INIATIVES are not the only culprits in the current mortgage mess—state-based residential finance laws give homeowners two free options that contributed substantially to the financial crisis. First, any homeowner may, without penalty, refinance a mortgage whenever interest rates fall or home prices rise to a point where there is significant equity in the home, enabling them to extract any equity that had accumulated between the original financing transaction and any subsequent refinancing. The result is so-called cash-out refinancing, in which homeowners treat their homes like savings accounts, drawing out funds to buy cars, boats, or second homes. By the end of 2006, 86 percent of all home mortgage refinancings were cash-outs, amounting to $327 billion that year. Unfortunately, this meant that when home prices fell, there was little equity in the home behind the mortgage and frequently little reason to continue making payments on the mortgage.
The willingness of homeowners to walk away from their “underwater” mortgages was increased by the designation of mortgages as “without recourse” in most states. In essence, non-recourse mortgages mean that defaulting homeowners are not personally responsible for paying any difference between the value of the home and the principal amount of the mortgage obligation, or that the process for enforcing this obligation is so burdensome and time-consuming that lenders simply do not bother. The homeowner’s opportunity to walk away from a home that is no longer more valuable than the mortgage it carries exacerbates the effect of the cash-out refinancing.
Tax laws further amplified the problems of the housing bubble and diminished levels of home equity, especially the deductibility of interest on home equity loans. Interest on consumer loans of all kinds—for cars, credit cards, or other purposes—is not deductible for federal tax purposes, but interest on home equity loans is deductible no matter how the funds are used. As a result, homeowners are encouraged to take out home equity loans to pay off their credit card or auto loans or to make the purchases that would ordinarily be made with other forms of debt. Consequently, homeowners are encouraged not only to borrow against their homes’ equity in preference to other forms of borrowing, but also to extract equity from their homes for personal and even business purposes. Again, the reduction in home equity has enhanced the likelihood that defaults and foreclosures will rise precipitously as the economy continues to contract.
Bank regulatory policies should also shoulder some of the blame for the financial crisis. Basel I, a 1988 international protocol developed by bank regulators in most of the world’s developed countries, devised a system for ensuring that banks are adequately capitalized. Bank assets are assigned to different risk categories, and the amount of capital that a bank holds for each asset is pegged to the asset’s perceived riskiness. Under Basel I’s tiered risk-weighting system, AAA asset-backed securities are less than half as risky as residential mortgages, which are themselves half as risky as commercial loans. These rules provided an incentive for banks to hold mortgages in preference to commercial loans or to convert their portfolios of whole mortgages into an MBS portfolio rated AAA, because doing so would substantially reduce their capital requirements.
Though the banks may have been adequately capitalized if the mortgages were of high quality or if the AAA rating correctly predicted the risk of default, the gradual decline in underwriting standards meant that the mortgages in any pool of prime mortgages often had high loan-to-value ratios, low FICO scores, or other indicators of low quality. In other words, the Basel bank capital standards, applicable throughout the world’s developed economies, encouraged commercial banks to hold only a small amount of capital against the risks associated with residential mortgages. As these risks increased because of the decline in lending standards and the ballooning of home prices, the Basel capital requirements became increasingly inadequate for the risks banks were assuming in holding both mortgages and MBS portfolios.
PREVENTING A RECURRENCE of the financial crisis we face today does not require new regulation of the financial system. What is required instead is an appreciation of the fact—as much as lawmakers would like to avoid it—that U.S. housing policies are the root cause of the current financial crisis. Other players—greedy investment bankers; incompetent rating agencies; irresponsible housing speculators; shortsighted homeowners; and predatory mortgage brokers, lenders, and borrowers—all played a part, but they were only following the economic incentives that government policy laid out for them. If we are really serious about preventing a recurrence of this crisis, rather than increasing the power of the government over the economy, our first order of business should be to correct the destructive housing policies of the U.S. government.
A man of faith in a godless age is hitting Americans where it hurts.
Mr. and Mrs. American Spectator Reader, let P.J. O’Rourke talk sense to your kids.
In Britain, defending your property can get you life.
The debacle of this president’s administration is both a cause and a symptom of the decline of American values. Unless Congress impeaches him, that decline will go on unchecked. An eminent jurist surveys the damage and assesses the chances for the recovery of our culture.
It won’t take long for conservatives to scratch this presidential wannabe off their 2008 scorecard.
The American Christmas, like the songs that celebrate it, makes room for everybody under the rainbow. Is that why so many people seem to be hostile to it?
Was the President done in by the economy, or by the politics of the economy?
H/T to National Review Online