Politicians, Regulators and The Mortgage Meltdown

When the 2008 recession hit, the foreclosure rate increased dramatically; the mortgage-backed securities went bust; banks that were heavily invested in these funds lost trillions; new residential construction ground to a halt; more and more bank-held mortgages went into foreclosure; and the Feds stepped in to bail out the banks.

While the banking industry and the Federal Reserve Board are mostly at fault, a large share of the blame belongs to the President, Congress and departments within the federal government. First, had the Glass-Steagall Act not been repealed, the Great Recession would likely have been just an ordinary recession, and the banking industry would have recovered much more easily. Second, the Federal Deposit Insurance Corporation (FDIC), the Securities and Exchange Commission (SEC), the Comptroller of Currency, the Federal Reserve Board, and other federal agencies were charged with the regulation and oversight of the banking industry — in my opinion they were sleeping on the job (or hoping for jobs in the private sector). Third, as mentioned before, de-regulation allowed the industry to veer far away from traditional banking services and into highly speculative investments that unwisely risked the taxpayer’s money. Fourth, blame can be placed on federal programs like the Department of Housing and Urban Development (HUD), the Federal Housing Administration (FHA), the Veteran’s Administration, (VA) Government National Mortgage Association (Ginnie Mae), Farmer’s Home Administration, and similar agencies that are in business to either make or guarantee mortgage loans to individuals who would not qualify according to accepted credit standards. Remember that these programs were operating simultaneously with the unscrupulous lenders.

The result of these programs is that borrowers with negligible down payments and low credit scores entered the housing market.

At What Cost?

· Because these borrowers carried a higher risk, there was a greater probability that foreclosures would result than if the programs did not exist.

· The money loaned to these individuals represented real capital, which is a scarce commodity. In other words, money was taken out of the capital flow that could have been used in a more economically beneficial manner. Therefore, a disproportionate percentage of our nation’s wealth went to housing and the banking industry as opposed to other industries. This contributed to the resulting housing bubble. It also caused the building industry to over-expand.

· Quality housing is also a scarce commodity. Less qualified borrowers were competing with more highly qualified borrowers for the same house (higher down payments, better credit scores). This resulted in bidding wars that artificially exaggerated the bubble.

· Because these programs were so popular, there was an increased number of questionable mortgages that would ultimately be foreclosed.

· When the recession hit, along with high rates of unemployment, many marginal borrowers, who under normal conditions could have afforded their mortgage payments, were now being foreclosed.

· Housing prices have to make sense based on the true value of the home. Prices can only go so high before they become unsustainable. Leading up to the housing slump there was a glut of buyers who bid up home prices. However, as prices rose, there were fewer and fewer buyers until eventually — no buyers.

· Those homeowners who purchased during the bubble and subsequently experienced financial problems, like the loss of a job, reduction in hours, losses in the stock market, unexpected medical expenses, etcetera, could no longer afford their mortgage payments.

· Hundreds of thousands of homeowners found it in their financial best interests to simply walk away from homes that were worth significantly less than their mortgage balance.

· Remember that we are the taxpayers! The federal insurance that protected depositors, was our money. The money that paid for the banking bailout was our money. The mortgages that were made or guaranteed by a federal agency, again our money.

· Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage (Freddie Mac), both quasi-federal entities, underwrote the majority of mortgages made in America. This enormous federal involvement in the housing market helped create an artificially high demand, adding to the bubble; and when the housing market crashed, it was taxpayer money that bailed them out.

· The Home Mortgage Interest Deduction. Homeowners with a mortgage were (and are) able to reduce their taxable income by the amount paid in mortgage interest on their principal residences. Therefore, the bigger the house, the more mortgage interest paid; resulting in a bigger tax deduction, which helps subsidize the purchase of bigger and bigger homes. (One result is that middle and upper middle-class homeowners benefit far more than lower income homeowners. Renters, of course, don’t receive any of this real estate windfall. I have never heard one economist suggest that this is good public policy. Nor have I ever heard a politician even attempt to justify the obvious unfairness. After all, why should the federal government reward me for taking out a mortgage? Why should the federal government even care if I am renting or buying a home? The answer is that special interests have once again successfully lobbied Congress and the President for favored legislation. Who wins if the federal government subsidizes home purchases? The National Association of Realtors, the American Bankers Association, the National Association of Homebuilders, the Mortgage Bankers Association, American Land Title Association, and others. These are powerful lobbies that spend hundreds of millions of dollars a year to make sure legislation artificially props up home purchases and correspondingly, prices.)

· The Community Reinvestment Act. To understand this legislation, we first need to discuss the practice of redlining. It used to be the practice of banks to take a red pen and outline geographical areas where the real estate was unlikely to hold its collateral value. As you might expect, these were typically poor inner-city neighborhoods. The practice of redlining followed the enactment of the National Housing Act of 1934.

In 1935, the Federal Home Loan Bank Board (FHLBB) asked Home Owners’ Loan Corporation (HOLC) to look at 239 cities and create ‘residential security maps’ to indicate the level of security for real-estate investments in each surveyed city.

Now fast forward to 1977 when it was determined that the practice discriminated against minorities. It wasn’t enough to simply ban the practice and monitor compliance. Congress determined that the banking industry needed to make amends (for this government-initiated practice). While the Community Reinvestment Act didn’t mandate that banks do anything, it was a pressure tactic that threatened to limit a bank’s ability to expand unless the bank accrued enough credits for its efforts to engage minority neighborhoods. There were credits for counseling programs, the introduction of bank branches and other direct investments in minority dominated neighborhoods — but primarily loans, mortgage loans in particular were needed to comply with the new legislation. Even though the act stipulated that only sound credit criteria be used to evaluate applicants, in reality, credit and collateral standards were loosened in an effort to get regulators off the banker’s backs. These inner-city loans, at least in the Detroit market, were the first to go bad and when the real estate market turned sour in 2008. City of Detroit real estate values were dropping at over 50% per year, far more pronounced than any of the suburban markets.

· In 2010, the FHA created the Hardest Hit program in a handful of states. This program was created to make second and third mortgages, on the same residence, to borrowers in the process of losing their homes to bank foreclosures. The U.S. taxpayer was (and still is) backing these mortgages — saddling borrowers with additional debt — in spite of the fact that they couldn’t (and can’t) afford their existing loans. Again, looking at Detroit, thousands of these homes were ultimately lost to either first mortgage bank foreclosures or municipal tax foreclosures basically just throwing away taxpayer’s money.

What Can Be Done?

Here are a few suggestions. First, the banking industry should return to Glass-Steagall era regulations. Meaning that commercial banks should again divest their interests in investment banking entities. These spin-offs could become independent entities or be acquired and consolidated by larger investment banks; but they would not be insured or guaranteed by taxpayers. Investment banking and commercial banking are two entirely different business animals, each with its own risks and rewards. There are overlaps, but also potential conflicts of interests, the most important being the desire to maximize profits and, in doing so, the potential of taking excessively high risks. These risks are not only born by the stockholders, but also the taxpayers through the FDIC and Congress in the case of a future bailout. I don’t see a problem with banks owning the retail side of investment banking (the stock brokerage business), as well as financial planning services for their wealthy clients. In this capacity, commercial banks would function as independent agents for the investment banking industry.

I would also advise a ten-year phase-out of all government involvement in the mortgage financing business. There is a legitimate function for “Freddie” and “Fannie” type entities, perhaps with some modifications. They could continue to hold large quantities of packaged mortgages and also act as conduits between retail mortgage banking and a resurgence of the private secondary market, which is where mortgages are bundled into mortgage-backed bonds and then sold to investors; this time with only a modest use of derivatives. Under this plan, federal regulators would demand that the mortgages originated by federally insured banks all conform to standard credit and collateral requirements. It would be critically important that investors know the levels of risk associated with these bonds, because if an investment goes bust, taxpayers will once again be on the hook. Private lenders, on the other hand would be free to risk their own capital on less qualified mortgage borrowers, and even bundle these mortgages into high risk bonds that could be sold to investors who would be fully aware of the risk.

Today, over 60% of all mortgages are backed by the government in some way, primarily by Freddie Mac, Fannie Mae, HUD, VA, or USDA Rural Development Mortgages. The mortgage defaults which began in 2008 completely wiped out the solvency of both Freddie Mac and Fannie Mae. This caused the Federal Government to inject $170 billion into these entities, which was the costliest government bailout in history. At the present time, taxpayers have been paid back; however, it appears that Fannie and Freddie’ stockholders will never see a dime of their investment, instead, all profits ($20 billion in 2016) are sent to the Treasury Department’s General Fund. This means that, at least for now, the two entities are nothing more than highly profitable, de facto government agencies.

(From the Book Greed, Power and Politics, the Dismal History of Economics and the Forgotten Path To Prosperity, by Daniel Cameron)

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