jurann left a comment on my post last week that reminded me of this, and reminded me that I've never tried to organize all of my thoughts on What Went Wrong. Because of course, it's not all the fault of the FMs, although they helped.
I'm going to try writing about the gestalt now. I'm not sure I'm going to make it through everything, because there's just so much.
Fannie Mae is the Federal National Mortgage Association. It was created as a government entity to create a secondary mortgage market -- that is, to allow banks and mortgage brokers to make loans, and then sell those loans to other investors. Once the loans were sold on the secondary market, banks and mortgage brokers could go make more loans. This was a reasonable idea, as xthread pointed out on my previous rant, because it diversifies risk. If Itty Bitty Bank makes a bunch of loans to people in Small Town, a crisis in Small Town could destroy Itty Bitty Bank. If Itty Bitty Bank sells a portion of those loans instead, and then buys some portion of loans from across the country, they're protected against localized crises. The secondary market also lets more people play in the game.
In 1954, Fannie Mae became a "mixed ownership" corporation (both private investors and the federal government held stock in it). In 1968, Fannie Mae was privatized and officially no longer owned by the government.
The big problem with the 1968 change is that no one has ever believed it. Prior to the 1968 change, everyone assumed that if there was a disastrous default in FM-guaranteed mortgages that FM could not cover, then the federal government would bail out bondholders. After the 1968 change, there was no longer any actual or implicit guarantee by the federal government backing FM. In fact, their charter explicitly stated that the feds did not guarantee them. But the market pretty much assumed that nothing substantive had changed: Fannie Mae was too big to fail, and so of course if they did, the feds would bail them out.
In 2008, when there was a disastrous default in FM-guaranteed mortgages that FM could not cover, the federal government bailed out bondholders.
In 1970, the government chartered Freddie Mac to provide a competitor to Fannie Mae. Like Fannie Mae, Freddie Mac was a public corporation whose portfolio was explicitly not backed by the US gov't; as with Fannie Mae, the market nudged and winked at the fed gov't: "Ha! Good one!" Freddie Mac was too big to fail, and the feds would bail them out if they were going to. Which the feds did.
This is not hindsight; you can look through the archives of Wall Street Journal opinion columns and find numerous rants about the FMs' competitive advantage due to their perceived federal backing.
Why was it bad to give the FMs a competitive advanatage? Because it led the market to misprice risk. FM-guaranteed mortgages were regarded as nearly as low risk as US treasury bonds. That meant that the FMs could offer lower rates and have lower credit standards, and the market would buy their product anyway because (they thought, correctly) the US gov't would get behind them if there ever was a major problem.
Plus, for decades, there were no major problems. The FMs were fairly conservative in the terms and types and size of loans they would guarantee; other than the low interest rates, they weren't doing much else.
The belief that the US gov't had the FMs' back was bolstered by the FMs' cozy relationship with Congress and other government agencies. This isn't because Congress was corrupt or the FMs were evil. Congressmen like Representative Barney Frank backed the FMs because they saw the FMs as the driving engine behind low interest rates, and as a vehicle by which home ownership could be expanded to low and moderate income borrowers. In 1999, the feds used regulatory pressure to push the FMs to do more lending to lower-income borrowers. In other words, Congress supported the FMs because they thought the FMs were helping poor people achieve the American Dream. Congressional support for the FMs was not especially partisan. Yes, their most vocal supporters were Democrats, and in 2003 the Bush administration did ask Congress to pass legislation to increase oversight of the FMs and to limit the kinds of loans they could make. But Congress did not do it, and Congress was Republican-controlled at the time.
Around here -- in the late 90s and early 2000s, the mortgage markets started getting creative. The US housing market was pretty stable and had real estate had a long history of steady appreciation in value. Defaults on primary residences were rare. Lenders and regulators alike were not very concerned about risk -- as noted above, the feds were pressuring the FMs to make more loans to less credit-worthy borrowers. Private lenders also wanted to make more loans to less credit-worthy borrowers, for a litany of reasons:
* The FMs controlled much of the market to prime borrowers; subprime borrowers and those above the threshold that FM would guarantee were what was left. This was an area of the market that was less well-documented and less well-understood.
* As long as housing prices always go up, there is little risk in lending to subprime borrowers to purchase houses -- even if it turns out they can't afford payments, they can always sell the house. The borrower profits on the sale, the lender profits on the loan, everyone wins.
* The US government wanted to expand home ownership: home ownership gives individuals an investment in their community and encourages them to take care of their property and to care about their neighborhood, factors which reduce crime. Home ownership is also perceived as (and can be, but is not always) an investment and a means to prosperity.
* Default rates were low, suggesting that current underwriting standards were too conservative
* The information age meant that financiers could better analyze and diversify risks.
* CDOs were growing in popularity, creating a larger market for loans, which required more loans to be made.
CDOs ("collateralized debt obligations") are creative financing in and of themselves. I explained these before, but to summarize: a mortgage-backed security is when a large group of similar loans are bundled together, and then individual investors buy small equal pieces of each loan. A CDO is when a mortgage-backed-security is divided into different chunks (called tranches) with each tranch carrying a different risk level and a different interest rate. Some very simple examples:
Bob has a $200,000 loan at 6% interest, Mary has a $100,000 loan at 5.75% interest, and Tom has a $150,000 loan at 5.00% interest. A standard mortgage-backed security might bundle these together into the BMT Security, which would sell 10,000 shares costing $45 each and each paying 5.611%.
The CDO version of this product might be three different securities: BMT A, BMT B, and BMT C. BMT A is the 80% of the three loans that gets paid back first, and the interest rate that BMT A pays is only 5.0%, because it has the least risk. BMT B is the 10% that gets paid back after BMT A is paid off, and BMT B gets a 6.0% interest rate. BMT C is the last 10% and gets an interest rate of 8.0%. (Interest rates and percentages in each group here are completely fictitious; I don't actually know what the proportions are or what rates were allocated to each, but hopefully this demonstrates the theory).
The tranch that gets paid back first (BMT A in the example above) was widely considered risk-free, because the mortgages were secured by real-estate and even if the loan failed and the market dropped, it wouldn't drop so much that you couldn't recoup 80% of the initial loan value, right? And even BMT C is pretty secure because the housing market is very stable and even in the event of a default you can probably get most of your money back, and default rates are low so it's not like a big chunk of the underlying mortgages are all going to sour at once, right? (Hint: wrong.) And you're making POTS of money on it! Lookit that yield!
Then the Internet bubble burst. This provided even more incentive to invest in real estate. Real estate was widely regard as safe, stable, and boring, and had been that way for decades if not centuries. It was the antithesis of the Internet companies that just burned so many investors. Everyone wanted to buy bonds, which meant banks had even more incentive to lend money at enticingly low rates to get borrowers so they could sell mortgages. Plus, the Federal Reserve dropped its target interest rate to low levels to keep the economy from stalling out, so interest rates were already rock-bottom.
High demand for CDOs and mortgage-backed securities, and low interest rates for prime borrowers, meant that even people with low income and bad credit were starting to look like attractive candidates for loans. The broker could charge more interest to them without interest rates looking very high objectively (because the base rate was so low). Packaging subprime loans into CDOs gave the top tranch a good return and an investment-grade credit rating.
Oh, I forgot the part that rating agencies played in this. Federal regulations make credit rating agencies responsible for assessing risk in the market; many institutions (like banks) can't purchase financial instruments that don't have an investment-grade credit rating. Credit rating agencies are not actually very good at this job. Like everyone else, they're assessing future risk based on past performance, and they came to much the same conclusions that everyone else did. But because they were credit rating agencies and impartial and expert, their judgment lent an air of authority to what were, in retrospect, some rather dubious ventures.
But back to creative financing.
Apart from CDOs and loans to subprime borrowers, lenders were loosening underwriting standards in various other respects, all in the name of making ever-more loans to suit the seemingly bottomless appetite of the secondary market. This included low-doc loans, where the borrower did not need to produce proof of income. Low downpayments -- downpayments of 5% or less were common in this period. Existing borrowers were encouraged to refinance their houses for more money, to take advantage of rising home values. Teaser rates, where the rate for the first year might be set at 3% even though the index it was based on was currently 6%, and thus it would be expected to rise significantly at the end of that year. Interest-only loans, where the borrower made no payments against the principal for the one to five years.
None of these products are inherently evil, senseless, or insane. None of them are necessarily against the borrower's best interests. For example, if you're buying a house to remodel it and plan to sell it in a year, getting a teaser rate or an interest-only loan makes perfect sense.
I want to emphasize that these creative financing deals were not designed to take advantage of consumers by forcing them into bankruptcy. Lenders do not make money by forcing borrowers into bankruptcy and foreclosing. They lose money by doing that. So any sensible lending institution is only going to make or purchase loans if they think the loans are sound. In general, the logic that accompanied these deals was: "Houses always increase in value, so the borrower will always be able to sell the house to pay us back. Lending someone money today so that he can make money tomorrow is profitable for both of us." By this logic, using creative financing to get homes into the hands of borrowers was a good idea, because the house was a no-risk investment and therefore so was the loan.
And for several years, this worked. Exactly as described. And the more it worked, the stupider the banks that weren't doing it looked. "You're not lending 100% on construction loans? Why not? My bank is making 8% a year on these and we haven't had one go bad in four years!"
One reason that it worked was that it was a self-fulfilling prophecy. By making credit cheaper and easier to obtain for people who'd never bought a house before, more people entered the market to buy houses. Which meant demand for houses went up, which meant the price of houses went up. Which meant that an ordinary consumer could buy a house, hold it for six months, and then sell it for a nice profit. And the more people who did it, the stupider people who weren't buying looked. "What are you waiting for? The cost of real estate is only going up!"
This connects to the underlying problem with cheap credit: it drives up prices. Lenders and the FMs were enabling more people than ever to get loans, but the very availability of that loans meant that all those buyers were competing to purchase houses, and thus paying more for those houses than they would have it -- paradoxically -- they had not been able to get the loan to buy.
Another underlying problem is the notion that "home ownership is right for everyone". Home ownership is not right for everyone. If you live in an area where the cost of mortage payments on a 30-year loan are more than the cost of rent on an equivalent home, then buying a home is only a money-making proposition if you're speculating that rent will rise and/or that housing prices will rise. The main financial value of home ownership is that you do not have to pay rent; if the cost of rent is less than the cost of the funds you are using to purchase the house, then the financial incentive to buy is low. There are reasons beside the financial to buy a home: I bought my house in part because it was closer to my job than any rental properties and in part because I didn't want to be forced to move again because of the actions of a landlord. You might buy a home because you like the neighborhood, or because there are no attractive rental properties, or because the school district you want to live in doesn't have any available rentals, etc. These are good reasons, but they don't apply to everyone. Many people do not want to own a home because they value mobility and do not want the hassle of selling a home when they move. Or because they don't want to handle home maintanence or lawn care themselves. There are lots of good reasons to rent. By constructing a system that's tailored to homeowners, we squeeze out those people who have a legitimate interest in renting.
The cycle of easier credit -> more demand for houses -> higher prices -> even easier credit so the higher prices are affordable -> more demand -> etc. finally unraveled as the housing market reached an unsupportable height: the terms of loans were too generous, the underwriting standards too lax, the number of people left who were still willing to buy a house at inflated prices too few.
Housing prices weakened first. In the fall of 2007, housing sales started to drop off. Construction companies couldn't sell just-completed houses fast enough any more. Speculators were stuck with properties they couldn't afford. Then the subprime borrowers started to weaken: they couldn't afford their existing payments, or their loans were going to reset to a higher interest rate that they couldn't afford -- which had been a risk all along, but for the years when the market only went up these people could just sell the home, no disaster. With housing prices falling, selling was no longer an attractive option; in some cases, it was not even a viable one. Foreclosing on those houses only made the situation worse, because it further depressed housing prices. Tightening credit standards: also depresses housing prices. Soon, the problem spreads to prime borrowers, because some of them were also counting on being able to sell their houses for what they paid for them and now they can't. And since CDOs and other mortgage-backed securities are such an integral part of the broader market, it's a sickness that infected everyone, leading to the meltdown of one firm after another, until the fall of 2008, when it looked like the entire system might collapse in panic, until Congress stepped in and passed TARP, which -- whether it was the right thing to do or not -- did stop the panic.
I have other thoughts on this, but this post is already enormous, so I'll stop here and perhaps write more about it later.