Fault Lines: How Hidden Fractures Still Threaten the World Economy Read online

  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

  The National Homeownership Strategy

  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 Ownership Society

  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:

  But I believe owning something is a part of the American Dream, as well. I believe when somebody owns their own home, they’re realizing the American Dream…. And we saw that yesterday in Atlanta, when we went to the new homes of the new homeowners. And I saw with pride firsthand, the man say, welcome to my home. He didn’t say, welcome to government’s home; he didn’t say, welcome to my neighbor’s home; he said, welcome to my home. …He was a proud man…. And I want that pride to extend all throughout our country.36

  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.

  Lending Goes Berserk

  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 d
o 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.

  The greater expansion in mortgage lending to subprime ZIP codes is associated with higher house-price growth in those ZIP codes. Indeed, over the period 2002–2005 and across ZIP codes, house-price growth was higher in areas that had lower income growth (because this is where the lending was focused). Unfortunately, therefore, all this lending was driving house prices further away from the fundamental ability of household income to support repayment. The consequence of all this lending was more default. Subprime ZIP codes experienced an increase in default rates after 2006 that was three times that of prime ZIP codes, and much larger than the default rates these areas had experienced in the past.

  Could the increased borrowing by low-income households have been driven by need? After all, I have argued that their incomes were stagnating or even falling. It is hard, though, to imagine that strapped households would go out and borrow to buy houses. The borrowing was not driven by a surge in demand: instead it came from a greater willingness to supply credit to low-income households, the impetus for which came in significant measure from the government.

  Not all the frenzied lending in the run-up to the recent crisis was related to low-income housing: many unviable loans were made to large corporate buyouts also. Nevertheless, subprime lending and the associated subprime mortgage-backed securities were central to this crisis. Without any intent of absolving the brokers and the banks who originated the bad loans or the borrowers who lied about their incomes, we should acknowledge the evidence suggesting that government actions, however well intended, contributed significantly to the crisis. And the agencies did not escape the fallout. With the losses on the agencies’ mortgage portfolios growing and hints that investors in agency debt were getting worried, on Sunday, September 7, 2008, Henry J. Paulson, secretary of the treasury, announced what the market had always assumed: the government would take control of Fannie and Freddie and effectively stand behind their debt. Conservative estimates of the costs to the taxpayer of bailing out the agencies amount to hundreds of billions of dollars. Moreover, having taken over the agencies, the government fully owned the housing problem. Even as I write, the government-controlled agencies are increasing their exposure to the housing market, attempting to prop up prices at unrealistic levels, which will mean higher costs to the taxpayer down the line.

  The agencies are not the only government-related organizations to have problems. As the crisis worsened in 2007 and 2008, the FHA also continued to guarantee loans to low-income borrowers. Delinquency rates on those mortgages exceed 20 percent today.43 It is perhaps understandable (though not necessarily wise) that government departments will attempt to support lending in bad times, as they play a countercyclical role. As Peter Wallison of the American Enterprise Institute has pointed out, it is less understandable why the FHA added to the subprime frenzy in 2005 and 2006, thus exacerbating the boom and the eventual fall.44 Delinquencies on guaranteed loans offered then also exceed 20 percent. The FHA will likely need taxpayer assistance. The overall cost to the taxpayer of government attempts to increase low-income lending continue to mount and perhaps will never be fully tallied up.

  Interesting Differences in the United States

  As house prices rose between 1999 and 2007, households borrowed against the home equity they had built up. The extent of such borrowing was so great that the distribution of loan-to-value ratios of existing mortgages in the United States barely budged over this period, despite double-digit increases in house prices.45 House-price appreciation also enabled low-income households to obtain other forms of nonmortgage credit. For instance, according to the Survey of Consumer Finances conducted by the Federal Reserve Board, between 1989 and 2004 the fraction of low-income families (families in the bottom quartile of income distribution) that had mortgages outstanding doubled, while those that had credit card debt outstanding grew by 75 percent.46 By contrast, the fraction of high-income families (families in the top quartile of income distribution) that had mortgages or credit card debt outstanding fell slightly over this period, suggesting that the rapid spread of indebtedness was concentrated in poorer segments of the population.

  Indeed, although housing booms took place around the world, driven by low interest rates, the boom in the United States was especially pronounced among borrowers who had not had prior easy access to credit, the subprime and Alt-A segments of the market. Detailed studies indicate that this housing boom was different because house prices for the low-income segment of the population rose by more and fell by more than they did for the high-income segments. By contrast, in previous U.S. housing booms, house prices for the high-income segment were always more volatile than for the low-income segment.47 Relative to other industrial countries like Ireland, Spain, and the United Kingdom, all of which had house-price booms that turned to busts, U.S. house prices overall were nowhere as high relative to fundamentals.48 But the boom was concentrated
in those least able to afford the bust. The U.S. boom was different, at least in its details.

  Some progressive economists dispute whether the recent crisis was at all related to government intervention in low-income housing credit.49 This certainly was not the only factor at play, and to argue that it was is misleading. But it is equally misleading to say it played no part. The private financial sector did not suddenly take up low-income housing loans in the early 2000s out of the goodness of its heart, or because financial innovation permitted it to do so—after all, securitization has been around for a long time. To ignore the role played by politicians, the government, and the quasi-government agencies is to ignore the elephant in the room.

  I have argued that an important political response to inequality was populist credit expansion, which allowed people the consumption possibilities that their stagnant incomes otherwise could not support. There were clearly special circumstances in the United States that made this response more likely—in particular, the many controls the government had over housing finance and the difficulty, given the increasing polarization of U.S. politics, of enacting direct income redistribution. Moreover, the objective of expanding home ownership drew on the politically persuasive historical symbolism of small entrepreneurs and farmers in the United States, all owning their property and having a stake in society and progress. These specific circumstances would not necessarily apply in other industrial countries.