Fault Lines: How Hidden Fractures Still Threaten the World Economy (7 page)

As evidence mounted in the early 1990s that more and more Americans faced stagnant or declining incomes, the political establishment started looking for ways to help them with fast-acting measures—certainly faster than education reform, which would take decades to produce results. Affordable housing for low-income groups was the obvious answer, and Fannie and Freddie were the obvious channels. Congress knew it could use Fannie and Freddie as vehicles for its designs because they benefited so much from government largesse, and their managers’ arms could be twisted without any of the agencies’ activities inconveniently showing up as an expenditure in government budgets.

In 1992, the U.S. Congress passed the Federal Housing Enterprise Safety and Soundness Act, partly to reform the regulation of the agencies and partly to promote homeownership for low-income and minority groups explicitly. The act instructed the Department of Housing and Urban Development (HUD) to develop affordable-housing goals for the agencies and to monitor progress toward these goals. Whenever Congress includes the words
safety and soundness
in any bill, there is a distinct possibility that it will achieve exactly the opposite, and that is precisely what this piece of legislation did.

Even though the agencies could not head off legislation, they could shape it to their advantage. They ensured that the legislation allowed them to hold less capital than other regulated financial institutions and that their new regulator, an office within HUD—which itself had no experience in financial-services regulation—was subject to congressional appropriation.
²⁹
This meant that if the regulator actually started constraining the behavior of the agencies, the agencies’ friends in Congress could cut the regulator’s budget. The combination of an activist Congress, government-supported private firms hungry for profits, and a weak and pliant regulator proved disastrous.

At first Fannie and Freddie were not eager to put their profitable franchise at risk. But seeing the political writing on the wall, they complied. Steven Holmes, a reporter for the
New York Times,
offered a prescient warning in the 1990s: “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulty in flush economic times…. But the government sponsored entity may run into trouble in an economic downturn, prompting a government rescue similar to that of the Savings and Loan industry in the 1980s.”
³⁰
As housing boomed, the agencies found the high rates available on low-income lending particularly attractive, and the benign environment and the lack of historical experience with low-income lending allowed them to ignore the additional risk.

Under the Clinton administration, HUD steadily increased the amount of funding it required the agencies to allocate to low-income housing. The agencies complied, almost too eagerly: sometimes it appeared as if they were egging the administration on to increase their mandate so that they would be able to justify their higher risk taking (and not coincidentally, management’s higher bonuses) to their shareholders. After being set initially at 42 percent of assets in 1995, the mandate for low-income lending was increased to 50 percent of assets in 2000 (in the last year of the Clinton administration).

Some critics worried that the agencies were turning a blind eye to predatory lending to those who could not afford a mortgage. But reflecting the nexus between the regulator and the regulated, HUD acknowledged in a report in 2000 that the agencies “objected” to disclosure requirements “related to their purchase of high-cost mortgages,” so HUD decided against imposing “an additional undue burden”!
³¹

Congress was joined by the Clinton administration in its efforts. In 1995, in a preamble to a document laying out a strategy to expand home ownership, President Clinton wrote: “This past year, I directed HUD Secretary Henry G. Cisneros … to develop a plan to boost homeownership in America to an alltime high by the end of this century…. Expanding homeownership will strengthen our nation’s families and communities, strengthen our economy, and expand this country’s great middle class. Rekindling the dream of homeownership for America’s working families can prepare our nation to embrace the rich possibilities of the twenty-first century.” What did this mean in practice? The strategy document went on to say: “For many potential homebuyers, the lack of cash available to accumulate the required down payment and closing costs is the major impediment to purchasing a home. Other households do not have sufficient available income to make the monthly payments on mortgages financed at market interest rates for standard loan terms. Financing strategies,
fueled by the creativity and resources of the private and public sectors
[italics mine], should address both of these financial barriers to homeownership.”
³²

Simply put, the Clinton administration was arguing that the financial sector should find creative ways of getting people who could not afford homes into them, and the government would help or push wherever it could. Although there was some distance between this strategy and the NINJA loans and “liar” loans (loans for which borrowers could come up with creative representations of their income because no documentation was required) that featured so prominently in this crisis, the course was set.

The Clinton administration pushed hard in other ways. The Community Reinvestment Act (CRA) passed in 1977 required banks to lend in their local markets, especially in lower-income, predominantly minority areas. But CRA did not set explicit lending goals, and its enforcement was left to regulators. The Clinton administration increased the pressure on regulators to enforce CRA through investigations of banks and threats of fines.
³³
A careful study of bank mortgage lending shows that lending went up as CRA enforcement increased over the 1990s, especially in the highly visible and politically sensitive metropolitan areas where banks were most likely to be scrutinized.
³⁴

Recall also that the Federal Housing Administration guaranteed mortgages. It typically focused on riskier mortgages that the agencies were reluctant to touch. Here was a vehicle that was directly under political control, and it was fully utilized. In 2000, the Clinton administration dramatically cut the minimum down payment required for a borrower to qualify for an FHA guarantee to 3 percent, increased the maximum size of mortgage it would guarantee, and halved the premiums it charged borrowers for the guarantee. All these actions set the stage for a boom in low-income housing construction and lending.

The housing boom came to fruition in the administration of George W. Bush, who also recognized the dangers of significant segments of the population not participating in the benefits of growth. As he put it: “If you own something, you have a vital stake in the future of our country. The more ownership there is in America, the more vitality there is in America, and the more people have a vital stake in the future of this country.”
³⁵
In a 2002 speech to HUD, Bush said:

Later, explaining how his administration would go about achieving its goals, he said: “And I’m proud to report that Fannie Mae has heard the call and, as I understand, it’s about $440 billion over a period of time. They’ve used their influence to create that much capital available for the type of home buyer we’re talking about here. It’s in their charter; it now needs to be implemented. Freddie Mac is interested in helping. I appreciate both of those agencies providing the underpinnings of good capital.”
³⁷

The Bush administration pushed up the low-income lending mandate on Fannie and Freddie to 56 percent of their assets in 2004, even as the Fed started increasing interest rates and expressing worries about the housing boom. Peter Wallison of the American Enterprise Institute and Charles Calomiris of Columbia University argue that Fannie and Freddie moved into even higher gear at this time not so much because of altruism, but because the accounting scandals that were exposed in those agencies in 2004 made them much more pliant to Congress’s demands for more low-income lending.
³⁸

How much lending flowed from these sources, and when? It is not easy to get a sense of the true magnitude of subprime and Alt-A lending by Fannie, Freddie, and the FHA, partly because as Edward Pinto, a former chief credit officer of Fannie Mae, has argued, many loans on each of these entities’ books were subprime in nature but not classified as such.
³⁹
For instance, Fannie Mae classified a loan as subprime only if the originator itself specialized in the subprime business. Many risky loans to low-credit-quality borrowers thus escaped classification as subprime or Alt-A loans. When the loans are appropriately classified, Pinto finds that subprime lending alone (including financing through the purchase of mortgage-backed securities) by the mortgage giants and the FHA started at about $85 billion in 1997 and went up to $446 billion in 2003, after which it stabilized at between $300 and $400 billion a year until 2007, the last year of his study.
⁴⁰
On average, these entities accounted for 54 percent of the market across the years, with a high of 70 percent in 2007. He estimates that in June 2008, the mortgage giants, the FHA, and various other government programs were exposed to about $2.7 trillion in subprime and Alt-A loans, approximately 59 percent of total loans to these categories. It is very difficult to reach any other conclusion than that this was a market driven largely by government, or government-influenced, money.

As more money from the government-sponsored agencies flooded into financing or supporting low-income housing, the private sector joined the party. After all, they could do the math, and they understood that the political compulsions behind government actions would not disappear quickly. With agency support, subprime mortgages would be liquid, and low-cost housing would increase in price. Low risk and high return—what more could the private sector desire? Unfortunately, the private sector, aided and abetted by agency money, converted the good intentions behind the affordable-housing mandate and the push to an ownership society into a financial disaster.

Both Clinton and Bush were right in worrying that growth was leaving large segments of the population behind, and their solution—expanded home ownership—was a reasonable short-term fix. The problem with using the might of the government is rarely one of intent; rather, it is that the gap between intent and outcome is often large, typically because the organizations and people the government uses to achieve its aims do not share them. This lesson from recent history, including the savings and loans crisis, should have been clear to the politicians: the consequences of the government’s pressing an agile financial sector to act in certain ways are often unintended and extremely costly. Yet the political demand for action, any action, to satisfy the multitudes who believe the government has all the answers, is often impossible for even the sensible politician to deny.

Also, it is easy to be cynical about political motives but hard to establish intent, especially when the intent is something the actors would want to deny—in this case, politicians using easy housing credit as a palliative. As I argue repeatedly in this book, it may well be that many of the parts played by the key actors were guided by the preferences and applause of the audience, rather than by well-thought-out intent. Even if no politicians dreamed up a Machiavellian plan to assuage anxious voters with easy loans, their actions—and there is plenty of evidence that politicians pushed for easier housing credit—could have been guided by the voters they cared about.
⁴¹
Put differently, politicians may have tried different messages until one resonated with voters. That message—promising affordable housing, for example—became part of their platform. It could well be that voters shaped political action (much as markets shape corporate action) rather than the other way around. Whether the action was driven by conscious intent or unintentional guidance is immaterial to its broader consequences.

A very interesting study by two of my colleagues at the University of Chicago’s Booth School, Atif Mian and Amir Sufi, details the consequences in the lead-up to the crisis.
⁴²
They use ZIP codes to identify areas that had a disproportionately large share of potential subprime borrowers (borrowers with low incomes and low credit ratings) and show that these ZIP codes experienced credit growth over the period 2002–2005 that was more than twice as high as that in the prime ZIP codes. More interesting, the number of mortgages obtained in a ZIP code over that period is
negatively
correlated with household income growth: that is, ZIP codes with lower income growth received more mortgage loans in 2002–2005, the only period over the entire span of the authors’ study in which they saw this phenomenon. This finding should not be surprising given the earlier discussion: there was a government-orchestrated attempt to lend to the less well-off.