Government policies and the subprime mortgage crisis
Encyclopedia
Both deregulation, and excess regulation, of financial institutions have been blamed for the late-2000s subprime mortgage crisis
in the United States
.
A number of writers have claimed that the financial crisis was caused by too much regulation aimed at increasing home ownership rates for lower income people. They have pointed to two policies in particular: the Community Reinvestment Act
of 1977, which they claim pressured private banks to make risky loans, and HUD affordable housing goals for the Government Sponsored Enterprises ("GSEs"), Fannie Mae and Freddie Mac, which they claim caused the GSEs to purchase risky loans.
However, other researchers have made opposing claims.
The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis. The SEC relaxed rules in 2004 that enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.
The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers
) or were sold at fire-sale prices to other banks (Bear Stearns
and Merrill Lynch
) during 2008, creating instability in the global financial system. The remaining two converted to commercial bank models in order to qualify for Troubled Asset Relief Program funds (Goldman Sachs
and Morgan Stanley
).
The SEC is also responsible for establishing financial disclosure rules. Critics have argued that disclosure throughout the crisis was ineffective, particularly regarding the health of financial institutions and the valuation of mortgage-backed securities.
. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm
." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.
Economists Robert Kuttner
and Paul Krugman
have criticized the repeal of the Glass–Steagall Act by the Gramm-Leach-Bliley Act
of 1999 as
possibly contributing to the subprime meltdown, although other economists disagree.
, with detractors claiming it encourages lending to uncreditworthy consumers and defenders claiming a thirty year history of lending without increased risk. Detractors also claim that amendments to the CRA in the mid-1990s raised the amount of home loans to otherwise unqualified low-income borrowers and, for the first time, allowed the securitization of CRA-regulated loans containing subprime mortgages. A study, by a legal firm which counsels financial services entities on Community Reinvestment Act compliance, found that CRA-covered institutions were less likely to make subprime loans (only 20-25% of all subprime loans), and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties.
Federal Reserve Governor Randall Kroszner says the CRA isn’t to blame for the subprime mess, "First, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA-related loans appear to perform comparably to other types of subprime loans. Taken together… we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis," Kroszner said: "Only 6% of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluation purposes."
FDIC Chairman Sheila Bair disputes that the CRA was a problem "Let me ask you: where in the CRA does it say: make loans to people who can't afford to repay? No-where! And the fact is, the lending practices that are causing problems today were driven by a desire for market share and revenue growth ... pure and simple."
exempted derivatives
from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants. Concerns that counterparties to derivative deals would be unable to pay their obligations caused pervasive uncertainty during the crisis. Particularly relevant to the crisis are credit default swaps (CDS), a derivative in which Party A pays Party B what is essentially an insurance premium, in exchange for payment should Party C default on its obligations. Warren Buffett
famously referred to derivatives as "financial weapons of mass destruction" in early 2003.
Like all swaps
and other financial derivatives, CDS may either be used to hedge
risks (specifically, to insure creditors against default) or to profit from speculation
. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008, of which about 8% were CDS.
CDS are lightly regulated. As of 2008, there was no central clearing house
to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group
(AIG), MBIA, and Ambac
faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.
Like all swap
s and other pure wager
s, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth [that is, provided that the paying party can perform]. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers
went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.
Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."
Former President Bill Clinton
and former Federal Reserve Chairman Alan Greenspan
indicated they did not properly regulate
derivatives, including credit default swaps (CDS). A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.
NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems...In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations. U.S. Treasury Secretary Timothy Geithner has proposed a framework for legislation to regulate derivatives.
HUD loosened mortgage restrictions in the mid-1990s so first-time buyers could qualify for loans that they could never get before. In 1995, the GSE began receiving affordable housing credit for purchasing mortgage backed securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities. In 1996, HUD directed Freddie and Fannie to provide at least 42% of their mortgage financing to borrowers with income below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. In addition, HUD required Freddie and Fannie to provide 12% of their portfolio to “special affordable” loans. Those are loans to borrowers with less than 60% of their area’s median income. These targets increased over the years, with a 2008 target of 28%.
In 2004, HUD ignored warnings from HUD researchers about foreclosures, and increased the affordable housing goal from 50% to 56%.
In addition to political pressure to expand purchases of higher-risk mortgage types, the GSE were also under significant competitive pressure from large investment banks and mortgage lenders. For example, Fannie's market share of subprime mortgage-backed securities issued dropped from a peak of 44% in 2003 to 22% in 2005, before rising to 33% in 2007.
In the early 2000s, Fannie Mae aggressively bought Alt-A securities, where these loans may require little or no documentation of a borrower’s finances. In the early 1990s Fannie Mae had abandoned Alt-A products because of their high risk of default. As of November 2007 Fannie Mae held a total of $55.9 billion of subprime securities and $324.7 billion of Alt-A securities in their portfolio. As of the 2008Q2 Freddie Mac had $190 billion in Alt-A mortgages. Together they have over $500 billion in Alt-A mortgages.
Economist Paul Krugman
has also argued in July 2008 that although the GSE are "problematic institutions," they played a small role in the crisis because they were legally barred from engaging in subprime lending. Economist Russell Roberts
has taken issue with Krugman's contention that the GSEs did not engage in subprime lending, citing a June 2008 Washington Post article which stated that "[f]rom 2004 to 2006, the two [GSEs] purchased $434 billion in securities backed by subprime loans, creating a market for more such lending." Furthermore, a 2004 HUD report admitted that while trading securities that were backed by subprime mortgages was something that the GSEs officially disavowed, they nevertheless participated in the market. However, in 2011, the Federal Reserve, using statistical comparisons of geographic regions which were and were not subject to GSE regulations finds that GSEs played no significant role in the subprime crisis.
, effectively nationalizing them at the taxpayers expense. Paul Krugman noted that an implicit guarantee of government support meant that "profits are privatized but losses are socialized," meaning that investors and management profited during the boom-period while taxpayers would take on the losses during a bailout.
Announcing the conservatorship on 7 September 2008, GSE regulator Jim Lockhart stated: "To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size."
The Federal Home Loan Banks
are less understood and discussed in the media. The FHLB provides loans to banks that are in turn backed by mortgages. Although they are one step removed from direct mortgage lending, some of the broader policy issues are similar between the FHLB and the other GSEs. According to Bloomberg
, the FLHB is the largest U.S. borrower after the federal government.http://www.bloomberg.com/apps/news?pid=20601087&sid=aeB5GL6uSr3A&refer=home On January 8, 2009, Moody's
said that only 4 of the 12 FHLBs may be able to maintain minimum required capital levels and the U.S. government may need to put some of them into conservatorship
.http://www.bloomberg.com/apps/news?pid=20601087&sid=aeB5GL6uSr3A&refer=home
, at the insistence of national banks, struck down such attempts as violations of Federal banking laws.
Even more surprising is the way that capital requirements favor private mortgage securities (securities not issued by Freddie Mac or Fannie Mae). Those securities, even when backed by high-risk mortgages, can obtain attractive risk ratings from credit rating agencies through use of tranches that only are subject to losses if a substantial proportion of loans goes into default. FDIC capital regulations give a lower risk weight to highly-rated mortgage securities, which may be backed by loans with little or no down payment, than to loans originated within the bank with down payments of up to 40 percent. These relative risk ratings embedded in capital requirements are the opposite of actual experience.
FDIC Chair Shelia Bair cautioned during 2007 against the more flexible risk management standards of the Basel II
accord and lowering bank capital requirements generally: "There are strong reasons for believing that banks left to their own devices would maintain less capital—not more—than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did."
, chair of the Cato Institute
, criticized the proposals for political favoritism in allocating credit and micromanagement by regulators, and that there was no assurance that banks would not be expected to operate at a loss. He predicted they would be very costly to the economy and banking system, and that the primary long term effect would be to contract the banking system. He recommended Congress repeal CRA
.
Gerald P. O'Driscoll, former vice president at the Federal Reserve Bank of Dallas
, stated that Fannie Mae and Freddie Mac had become classic examples of crony capitalism
. Government backing let Fannie and Freddie dominate the mortgage-underwriting. "The politicians created the mortgage giants, which then returned some of the profits to the pols - sometimes directly, as campaign funds; sometimes as "contributions" to favored constituents."
Some lawmakers received favorable treatment from financial institutions involved in the subprime industry. (See Countrywide financial political loan scandal
). In June 2008 Conde Nast Portfolio
reported that numerous Washington, DC politicians over recent years had received mortgage financing at noncompetitive rates at Countrywide Financial
because the corporation considered the officeholders under a program called "FOA's"—"Friends of Angelo". Angelo being Countrywide's Chief Executive Angelo Mozilo
.
On 18 June 2008, a Congressional ethics panel started examining allegations that chairman of the Senate Banking Committee, Christopher Dodd
(D-CT), and the chairman of the Senate Budget Committee, Kent Conrad
(D-ND) received preferential loans by troubled mortgage lender Countrywide Financial Corp. Two former CEOs of Fannie Mae Franklin Raines
and James A. Johnson
also received preferential loans from the troubled mortgage lender. Fannie Mae was the biggest buyer of Countrywide's mortgages.
On September 10, 2003, U.S. Congressman Ron Paul
gave a speech to Congress where he said that the then current government policies encouraged lending to people who couldn't afford to pay the money back, and he predicted that this would lead to a bailout, and he introduced a bill to abolish these policies.
." According to the New York Times, "he pushed hard to expand home ownership, especially among minorities, an initiative that dovetailed with his ambition to expand the Republican tent — and with the business interests of some of his biggest donors. But his housing policies and hands-off approach to regulation encouraged lax lending standards." He insisted that Fannie Mae and Freddie Mac (the GSE) meet low-income housing goals and advocated government loans to help low-income homeowners make down-payments. The Bush administration also replaced Fannie and Freddie's chief regulator in 2003 immediately after the regulator published a report warning of the risks posed by the GSE.
Efforts to control GSE were thwarted by intense lobbying by Fannie Mae and Freddie Mac. In April 2005, Secretary of the Treasury John Snow
repeated call for GSE reform, saying "Events that have transpired since I testified before this Committee in 2003 reinforce concerns over the systemic risks posed by the GSEs and further highlight the need for real GSE reform to ensure that our housing finance system remains a strong and vibrant source of funding for expanding homeownership opportunities in America … Half-measures will only exacerbate the risks to our financial system." Then house Minority Leader Harry Reid rejected legislation saying " we cannot pass legislation that could limit Americans from owning homes and potentially harm our economy in the process." A 2005 Republican effort for comprehensive GSE reform was threatened with filibuster by Senator Chris Dodd (D-CT).
Economist Paul Krugman
wrote in 2009: "The prosperity of a few years ago, such as it was — profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks. And since the housing bubble isn’t coming back, the spending that sustained the economy in the pre-crisis years isn’t coming back either." Niall Ferguson
stated that excluding the effect of home equity extraction, the U.S. economy grew at a 1% rate during the Bush years. Since GDP growth is a significant indicator of the success of economic policy, the government had a vested interest in not fully explaining the role of home equity extraction (borrowing) in driving the GDP measure pre-crisis.
may have created a moral hazard
and acted as encouragement to lenders to make similar higher risk loans.
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
.
A number of writers have claimed that the financial crisis was caused by too much regulation aimed at increasing home ownership rates for lower income people. They have pointed to two policies in particular: the Community Reinvestment Act
Community Reinvestment Act
The Community Reinvestment Act is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods...
of 1977, which they claim pressured private banks to make risky loans, and HUD affordable housing goals for the Government Sponsored Enterprises ("GSEs"), Fannie Mae and Freddie Mac, which they claim caused the GSEs to purchase risky loans.
However, other researchers have made opposing claims.
Role of the SEC
The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
) or were sold at fire-sale prices to other banks (Bear Stearns
Bear Stearns
The Bear Stearns Companies, Inc. based in New York City, was a global investment bank and securities trading and brokerage, until its sale to JPMorgan Chase in 2008 during the global financial crisis and recession...
and Merrill Lynch
Merrill Lynch
Merrill Lynch is the wealth management division of Bank of America. With over 15,000 financial advisors and $2.2 trillion in client assets it is the world's largest brokerage. Formerly known as Merrill Lynch & Co., Inc., prior to 2009 the firm was publicly owned and traded on the New York...
) during 2008, creating instability in the global financial system. The remaining two converted to commercial bank models in order to qualify for Troubled Asset Relief Program funds (Goldman Sachs
Goldman Sachs
The Goldman Sachs Group, Inc. is an American multinational bulge bracket investment banking and securities firm that engages in global investment banking, securities, investment management, and other financial services primarily with institutional clients...
and Morgan Stanley
Morgan Stanley
Morgan Stanley is a global financial services firm headquartered in New York City serving a diversified group of corporations, governments, financial institutions, and individuals. Morgan Stanley also operates in 36 countries around the world, with over 600 offices and a workforce of over 60,000....
).
The SEC is also responsible for establishing financial disclosure rules. Critics have argued that disclosure throughout the crisis was ineffective, particularly regarding the health of financial institutions and the valuation of mortgage-backed securities.
Repeal of the Glass Steagall Act
The Glass–Steagall Act was enacted after the Great DepressionGreat Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm
Phil Gramm
William Philip "Phil" Gramm is an American economist and politician, who has served as a Democratic Congressman , a Republican Congressman and a Republican Senator from Texas...
." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.
Economists Robert Kuttner
Robert Kuttner
Robert Kuttner is an American journalist and writer. Kuttner is the co-founder and current co-editor of The American Prospect, which was created in 1990 as "an authoritative magazine of liberal ideas," according to its mission statement...
and Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
have criticized the repeal of the Glass–Steagall Act by the Gramm-Leach-Bliley Act
Gramm-Leach-Bliley Act
The Gramm–Leach–Bliley Act , also known as the Financial Services Modernization Act of 1999, is an act of the 106th United States Congress...
of 1999 as
possibly contributing to the subprime meltdown, although other economists disagree.
Community Reinvestment Act
The CRA was originally enacted under President Carter in 1977. The Act was set in place to encourage banks to halt the practice of lending discrimination. There is debate among economists regarding the effect of the Community Reinvestment ActCommunity Reinvestment Act
The Community Reinvestment Act is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods...
, with detractors claiming it encourages lending to uncreditworthy consumers and defenders claiming a thirty year history of lending without increased risk. Detractors also claim that amendments to the CRA in the mid-1990s raised the amount of home loans to otherwise unqualified low-income borrowers and, for the first time, allowed the securitization of CRA-regulated loans containing subprime mortgages. A study, by a legal firm which counsels financial services entities on Community Reinvestment Act compliance, found that CRA-covered institutions were less likely to make subprime loans (only 20-25% of all subprime loans), and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties.
Federal Reserve Governor Randall Kroszner says the CRA isn’t to blame for the subprime mess, "First, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA-related loans appear to perform comparably to other types of subprime loans. Taken together… we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis," Kroszner said: "Only 6% of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluation purposes."
FDIC Chairman Sheila Bair disputes that the CRA was a problem "Let me ask you: where in the CRA does it say: make loans to people who can't afford to repay? No-where! And the fact is, the lending practices that are causing problems today were driven by a desire for market share and revenue growth ... pure and simple."
Financial Derivative Regulation / Commodity Futures Modernization Act of 2000
The Commodity Futures Modernization Act of 2000Commodity Futures Modernization Act of 2000
The Commodity Futures Modernization Act of 2000 is United States federal legislation that officially ensured the deregulation of financial products known as over-the-counter derivatives. It was signed into law on December 21, 2000 by President Bill Clinton...
exempted derivatives
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...
from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants. Concerns that counterparties to derivative deals would be unable to pay their obligations caused pervasive uncertainty during the crisis. Particularly relevant to the crisis are credit default swaps (CDS), a derivative in which Party A pays Party B what is essentially an insurance premium, in exchange for payment should Party C default on its obligations. Warren Buffett
Warren Buffett
Warren Edward Buffett is an American business magnate, investor, and philanthropist. He is widely regarded as one of the most successful investors in the world. Often introduced as "legendary investor, Warren Buffett", he is the primary shareholder, chairman and CEO of Berkshire Hathaway. He is...
famously referred to derivatives as "financial weapons of mass destruction" in early 2003.
Like all swaps
Swap (finance)
In finance, a swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved...
and other financial derivatives, CDS may either be used to hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
risks (specifically, to insure creditors against default) or to profit from speculation
Speculation
In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum...
. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008, of which about 8% were CDS.
CDS are lightly regulated. As of 2008, there was no central clearing house
Clearing house (finance)
A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...
to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group
American International Group
American International Group, Inc. or AIG is an American multinational insurance corporation. Its corporate headquarters is located in the American International Building in New York City. The British headquarters office is on Fenchurch Street in London, continental Europe operations are based in...
(AIG), MBIA, and Ambac
AMBAC
AMBAC may refer to:* Ambac Financial Group, a bankrupt American financial services company* Active Mass Balance Auto Control, a component of Universal Century technology in the fictional Gundam universe...
faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.
Like all swap
Swap
- Finance :* Swap , a derivative in which two parties agree to exchange one stream of cash flows against another* Barter- Technology :* Swap space, related to a computer's virtual memory subsystem...
s and other pure wager
Wager
Wager can refer to:* Gambling* A scientific wager* A legal wager under the Roman legal system* WAGR syndrome - a rare genetic syndrome-Given name:*Wager Swayne , American military Governor-Surname:...
s, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth [that is, provided that the paying party can perform]. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers
Lehman Brothers
Lehman Brothers Holdings Inc. was a global financial services firm. Before declaring bankruptcy in 2008, Lehman was the fourth largest investment bank in the USA , doing business in investment banking, equity and fixed-income sales and trading Lehman Brothers Holdings Inc. (former NYSE ticker...
went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.
Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."
Former President Bill Clinton
Bill Clinton
William Jefferson "Bill" Clinton is an American politician who served as the 42nd President of the United States from 1993 to 2001. Inaugurated at age 46, he was the third-youngest president. He took office at the end of the Cold War, and was the first president of the baby boomer generation...
and former Federal Reserve Chairman Alan Greenspan
Alan Greenspan
Alan Greenspan is an American economist who served as Chairman of the Federal Reserve of the United States from 1987 to 2006. He currently works as a private advisor and provides consulting for firms through his company, Greenspan Associates LLC...
indicated they did not properly regulate
derivatives, including credit default swaps (CDS). A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.
NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems...In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations. U.S. Treasury Secretary Timothy Geithner has proposed a framework for legislation to regulate derivatives.
The role of Fannie Mae, Freddie Mac and the FHLB in the crisis
Pressured to take risks
Fannie Mae and Freddie Mac are government-sponsored enterprises (GSE) that purchase mortgages, buy and sell mortgage-backed securities (MBS), and guarantee nearly half of the mortgages in the U.S. A variety of political and competitive pressures resulted in the GSE taking on additional risk, beginning in the mid-1990s and continuing throughout the crisis and their government takeover in September, 2008.HUD loosened mortgage restrictions in the mid-1990s so first-time buyers could qualify for loans that they could never get before. In 1995, the GSE began receiving affordable housing credit for purchasing mortgage backed securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities. In 1996, HUD directed Freddie and Fannie to provide at least 42% of their mortgage financing to borrowers with income below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. In addition, HUD required Freddie and Fannie to provide 12% of their portfolio to “special affordable” loans. Those are loans to borrowers with less than 60% of their area’s median income. These targets increased over the years, with a 2008 target of 28%.
In 2004, HUD ignored warnings from HUD researchers about foreclosures, and increased the affordable housing goal from 50% to 56%.
In addition to political pressure to expand purchases of higher-risk mortgage types, the GSE were also under significant competitive pressure from large investment banks and mortgage lenders. For example, Fannie's market share of subprime mortgage-backed securities issued dropped from a peak of 44% in 2003 to 22% in 2005, before rising to 33% in 2007.
In the early 2000s, Fannie Mae aggressively bought Alt-A securities, where these loans may require little or no documentation of a borrower’s finances. In the early 1990s Fannie Mae had abandoned Alt-A products because of their high risk of default. As of November 2007 Fannie Mae held a total of $55.9 billion of subprime securities and $324.7 billion of Alt-A securities in their portfolio. As of the 2008Q2 Freddie Mac had $190 billion in Alt-A mortgages. Together they have over $500 billion in Alt-A mortgages.
Criticism for blaming Fannie and Freddie
More than 84 percent of the subprime mortgages came from private lending institutions in 2006 and the share of subprime loans insured by Fannie Mae and Freddie Mac decreased as the bubble got bigger (from a high of insuring 48 percent to insuring 24 percent of all subprime loans in 2006). Despite conservative criticism for government lending programs as the main cause of the crisis, much of the crisis was independent of government home loan programs.Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
has also argued in July 2008 that although the GSE are "problematic institutions," they played a small role in the crisis because they were legally barred from engaging in subprime lending. Economist Russell Roberts
Russell Roberts (economist)
Russell Roberts is a professor of economics at the George Mason University Mercatus Center. Roberts founded and directed the Management Center at the John M. Olin School of Business at Washington University in St. Louis...
has taken issue with Krugman's contention that the GSEs did not engage in subprime lending, citing a June 2008 Washington Post article which stated that "[f]rom 2004 to 2006, the two [GSEs] purchased $434 billion in securities backed by subprime loans, creating a market for more such lending." Furthermore, a 2004 HUD report admitted that while trading securities that were backed by subprime mortgages was something that the GSEs officially disavowed, they nevertheless participated in the market. However, in 2011, the Federal Reserve, using statistical comparisons of geographic regions which were and were not subject to GSE regulations finds that GSEs played no significant role in the subprime crisis.
Federal takeover
By 2008, the GSE owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the amount outstanding. The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion. When concerns arose regarding the ability of the GSE to make good on their nearly $5 trillion in guarantee and other obligations in September 2008, the U.S. government was forced to place the companies into a conservatorshipConservatorship
Conservatorship is a legal concept in the United States of America, where an entity or organization is subjected to the legal control of an external entity or organization, known as a conservator. Conservatorship is established either by court order or via a statutory or regulatory authority...
, effectively nationalizing them at the taxpayers expense. Paul Krugman noted that an implicit guarantee of government support meant that "profits are privatized but losses are socialized," meaning that investors and management profited during the boom-period while taxpayers would take on the losses during a bailout.
Announcing the conservatorship on 7 September 2008, GSE regulator Jim Lockhart stated: "To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size."
The Federal Home Loan Banks
Federal Home Loan Banks
The Federal Home Loan Banks are 12 U.S. government-sponsored banks that provide stable, on-demand, low-cost funding to American financial institutions for home mortgage loans, small business, rural, agricultural, and economic development lending...
are less understood and discussed in the media. The FHLB provides loans to banks that are in turn backed by mortgages. Although they are one step removed from direct mortgage lending, some of the broader policy issues are similar between the FHLB and the other GSEs. According to Bloomberg
Bloomberg L.P.
Bloomberg L.P. is an American privately held financial software, media, and data company. Bloomberg makes up one third of the $16 billion global financial data market with estimated revenue of $6.9 billion. Bloomberg L.P...
, the FLHB is the largest U.S. borrower after the federal government.http://www.bloomberg.com/apps/news?pid=20601087&sid=aeB5GL6uSr3A&refer=home On January 8, 2009, Moody's
Moody's
Moody's Corporation is the holding company for Moody's Analytics and Moody's Investors Service, a credit rating agency which performs international financial research and analysis on commercial and government entities. The company also ranks the credit-worthiness of borrowers using a standardized...
said that only 4 of the 12 FHLBs may be able to maintain minimum required capital levels and the U.S. government may need to put some of them into conservatorship
Conservatorship
Conservatorship is a legal concept in the United States of America, where an entity or organization is subjected to the legal control of an external entity or organization, known as a conservator. Conservatorship is established either by court order or via a statutory or regulatory authority...
.http://www.bloomberg.com/apps/news?pid=20601087&sid=aeB5GL6uSr3A&refer=home
Federal regulatory influence of states
Some have argued that, despite attempts by various U.S. states to prevent the growth of a secondary market in repackaged predatory loans, the Treasury Department's Office of the Comptroller of the CurrencyOffice of the Comptroller of the Currency
The Office of the Comptroller of the Currency is a US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States...
, at the insistence of national banks, struck down such attempts as violations of Federal banking laws.
Inconsistent capital requirements and risk classification
In the United States, capital requirements played an important role in stimulating mortgage securitization. A paper by Paul S. Calem and Michael LaCour-Little points out that mortgages originated and held by banks are put into an arbitrary risk classification that requires more capital than similar mortgages originated by third parties but held as securities. Freddie Mac and Fannie Mae are regulated differently, and for all but the riskiest loans Freddie and Fannie face lower capital requirements and hence lower costs.Even more surprising is the way that capital requirements favor private mortgage securities (securities not issued by Freddie Mac or Fannie Mae). Those securities, even when backed by high-risk mortgages, can obtain attractive risk ratings from credit rating agencies through use of tranches that only are subject to losses if a substantial proportion of loans goes into default. FDIC capital regulations give a lower risk weight to highly-rated mortgage securities, which may be backed by loans with little or no down payment, than to loans originated within the bank with down payments of up to 40 percent. These relative risk ratings embedded in capital requirements are the opposite of actual experience.
FDIC Chair Shelia Bair cautioned during 2007 against the more flexible risk management standards of the Basel II
Basel II
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision...
accord and lowering bank capital requirements generally: "There are strong reasons for believing that banks left to their own devices would maintain less capital—not more—than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did."
Conservative criticism before Congress
During March 1995 congressional hearings William A. NiskanenWilliam A. Niskanen
William Arthur Niskanen was an American economist noted as one of the architects of President Ronald Reagan's economic programme and for his contributions to public choice theory. He was also a long-time chairman of the libertarian Cato Institute.-Education:Niskanen received his B.A. from Harvard...
, chair of the Cato Institute
Cato Institute
The Cato Institute is a libertarian think tank headquartered in Washington, D.C. It was founded in 1977 by Edward H. Crane, who remains president and CEO, and Charles Koch, chairman of the board and chief executive officer of the conglomerate Koch Industries, Inc., the largest privately held...
, criticized the proposals for political favoritism in allocating credit and micromanagement by regulators, and that there was no assurance that banks would not be expected to operate at a loss. He predicted they would be very costly to the economy and banking system, and that the primary long term effect would be to contract the banking system. He recommended Congress repeal CRA
Community Reinvestment Act
The Community Reinvestment Act is a United States federal law designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods...
.
Gerald P. O'Driscoll, former vice president at the Federal Reserve Bank of Dallas
Federal Reserve Bank of Dallas
The Federal Reserve Bank of Dallas covers the Eleventh Federal Reserve District, which includes Texas, northern Louisiana and southern New Mexico....
, stated that Fannie Mae and Freddie Mac had become classic examples of crony capitalism
Crony capitalism
Crony capitalism is a term describing a capitalist economy in which success in business depends on close relationships between business people and government officials...
. Government backing let Fannie and Freddie dominate the mortgage-underwriting. "The politicians created the mortgage giants, which then returned some of the profits to the pols - sometimes directly, as campaign funds; sometimes as "contributions" to favored constituents."
Some lawmakers received favorable treatment from financial institutions involved in the subprime industry. (See Countrywide financial political loan scandal
Countrywide financial political loan scandal
The U.S. financial political loan scandal in 2008-2009 involved politicians who allegedly received favorable mortgage rates.In June 2008 Conde Nast Portfolio reported that numerous Washington, DC politicians over recent years had received mortgage financing at noncompetitive rates at Countrywide...
). In June 2008 Conde Nast Portfolio
Condé Nast Portfolio
Portfolio.com is a website published by American City Business Journals that provides news and information for small to mid-sized businesses. It was formerly the website for the monthly business magazine Condé Nast Portfolio, published by Condé Nast from 2007 to 2009.Portfolio.com is continually...
reported that numerous Washington, DC politicians over recent years had received mortgage financing at noncompetitive rates at Countrywide Financial
Countrywide Financial
Bank of America Home Loans is the mortgage unit of Bank of America. Bank of America Home Loans is composed of:*Mortgage Banking, which originates purchases, securitizes, and services mortgages. In 2008, Bank of America purchased the failing Countrywide Financial for $4.1 billion...
because the corporation considered the officeholders under a program called "FOA's"—"Friends of Angelo". Angelo being Countrywide's Chief Executive Angelo Mozilo
Angelo Mozilo
Angelo R. Mozilo was the chairman of the board and chief executive officer of Countrywide Financial until July 1, 2008. Condé Nast Portfolio ranked Mozilo second on their list of "Worst American CEOs of All Time".-Life and career:...
.
On 18 June 2008, a Congressional ethics panel started examining allegations that chairman of the Senate Banking Committee, Christopher Dodd
Christopher Dodd
Christopher John "Chris" Dodd is an American lawyer, lobbyist, and Democratic Party politician who served as a United States Senator from Connecticut for a thirty-year period ending with the 111th United States Congress....
(D-CT), and the chairman of the Senate Budget Committee, Kent Conrad
Kent Conrad
Kent Conrad is the senior United States Senator from North Dakota. He is a member of the North Dakota Democratic-NPL Party, the North Dakota affiliate of the Democratic Party...
(D-ND) received preferential loans by troubled mortgage lender Countrywide Financial Corp. Two former CEOs of Fannie Mae Franklin Raines
Franklin Raines
Franklin Delano "Frank" Raines is an American business executive. He is the former chairman and chief executive officer of the Federal National Mortgage Association, commonly known as Fannie Mae, who served as White House budget director under President Bill Clinton...
and James A. Johnson
James A. Johnson (businessman)
James A. Johnson is a United States Democratic Party political figure, and the former CEO of Fannie Mae. He was the campaign manager for Walter Mondale's failed 1984 presidential bid and chaired the vice presidential selection committee for the presidential campaign of John Kerry...
also received preferential loans from the troubled mortgage lender. Fannie Mae was the biggest buyer of Countrywide's mortgages.
On September 10, 2003, U.S. Congressman Ron Paul
Ron Paul
Ronald Ernest "Ron" Paul is an American physician, author and United States Congressman who is seeking to be the Republican Party candidate in the 2012 presidential election. Paul represents Texas's 14th congressional district, which covers an area south and southwest of Houston that includes...
gave a speech to Congress where he said that the then current government policies encouraged lending to people who couldn't afford to pay the money back, and he predicted that this would lead to a bailout, and he introduced a bill to abolish these policies.
Policies of the Bush Administration
President Bush advocated the "Ownership societyOwnership society
Ownership society is a slogan for a model of society promoted by former United States President George W. Bush. It takes as lead values personal responsibility, economic liberty, and the owning of property...
." According to the New York Times, "he pushed hard to expand home ownership, especially among minorities, an initiative that dovetailed with his ambition to expand the Republican tent — and with the business interests of some of his biggest donors. But his housing policies and hands-off approach to regulation encouraged lax lending standards." He insisted that Fannie Mae and Freddie Mac (the GSE) meet low-income housing goals and advocated government loans to help low-income homeowners make down-payments. The Bush administration also replaced Fannie and Freddie's chief regulator in 2003 immediately after the regulator published a report warning of the risks posed by the GSE.
Efforts to control GSE were thwarted by intense lobbying by Fannie Mae and Freddie Mac. In April 2005, Secretary of the Treasury John Snow
John Snow
John Snow or Jon Snow may refer to:* Jon Snow, British newscaster* John Snow , founder of epidemiology and a major contributor to the development of anaesthesia* John W. Snow, 73rd United States Secretary of the Treasury...
repeated call for GSE reform, saying "Events that have transpired since I testified before this Committee in 2003 reinforce concerns over the systemic risks posed by the GSEs and further highlight the need for real GSE reform to ensure that our housing finance system remains a strong and vibrant source of funding for expanding homeownership opportunities in America … Half-measures will only exacerbate the risks to our financial system." Then house Minority Leader Harry Reid rejected legislation saying " we cannot pass legislation that could limit Americans from owning homes and potentially harm our economy in the process." A 2005 Republican effort for comprehensive GSE reform was threatened with filibuster by Senator Chris Dodd (D-CT).
Importance of home equity extraction to economic growth
A significant driver of economic growth during the Bush administration was home equity extraction, in essence borrowing against the value of the home to finance personal consumption. Free cash used by consumers from equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period. Using the home as a source of funds also reduced the net savings rate significantly. By comparison, GDP grew by approximately $2.3 trillion during the same 2001-2005 period in current dollars, from $10.1 to $12.4 trillion.Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...
wrote in 2009: "The prosperity of a few years ago, such as it was — profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks. And since the housing bubble isn’t coming back, the spending that sustained the economy in the pre-crisis years isn’t coming back either." Niall Ferguson
Niall Ferguson
Niall Campbell Douglas Ferguson is a British historian. His specialty is financial and economic history, particularly hyperinflation and the bond markets, as well as the history of colonialism.....
stated that excluding the effect of home equity extraction, the U.S. economy grew at a 1% rate during the Bush years. Since GDP growth is a significant indicator of the success of economic policy, the government had a vested interest in not fully explaining the role of home equity extraction (borrowing) in driving the GDP measure pre-crisis.
Moral hazard from other bailouts
A taxpayer-funded government bailout of financial institutions during the savings and loan crisisSavings and Loan crisis
The savings and loan crisis of the 1980s and 1990s was the failure of about 747 out of the 3,234 savings and loan associations in the United States...
may have created a moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
and acted as encouragement to lenders to make similar higher risk loans.