The Housing Bubble and the Community Reinvestment Act
2011-10-31
Ed Bradford
"low income lending" != {Black,Hispanic,any_particular_minority} lending
Low income lending is exactly that.
If you had $200,000 in your IRA and wanted to increase it
by investment, would you invest in the precinct in the city
with the lowest incomes or the precinct with the highest incomes?
The Community Reinvestment Act was passed into law under
President Jimmy Carter's administration. It lay dormant until
President Clinton came to office [proving the dangers in allowing
laws to lie dormant].
CRA created the Federal Government desire (a desire
without Constitutional justification) that more people (a greater
percentage of Americans) should own homes. Government was not
actively interfering in the housing market before the CRA. All
admit the housing market was running just fine before the
Government entered the fray [some red-lining examples excepted].
Presidents Clinton and George W. Bush made it a mission
to increase home ownership under the CRA banner. Both believed
(erroneously) it was the Federal Government's job to 'increase
home ownership'. For that to happen, there had to be more
money available and underwriting standards would have to be
lowered so more people would qualify for a loan.
Our old friend "fractional reserve" banking and the Fed
helped create the additional money. [I can explain how,
but in the interest of brevity, I will await a request.]
Once that was created a small sector of the Financial world
created new interesting loans (Ninja, Alt-A, no downpayment, ARMs,
interest only, ...). However, to create more money
a company like CountryWide would have to get rid of the
loans it had on its books (sell them) so it could use
the proceeds from that sale to make more loans. To CountryWide,
Ameriquest, and other subprime lenders it was about the fees,
not the mortgage service. The mortgage brokers sold their subprime
mortgages as fast as they could. They warehoused them until
they had enough to sell to a Lehman, Bear, Fannie or Freddie, ...
To buy those loans, investment banks (Lehman, Bear, Fannie,
Freddie and others) needed to also 'lay them off' bookmaker style.
For that, Quantitative Finance created a bunch of derivative options
(CDO, CDO-squared, credit default swaps, synthetic CDO, and
more). "Lay them off" means 'get rid of risk' to the bankers.
Banks needed to reduce the risk of owning a bucket of 5000 SUBPRIME
mortgages. Thus, the bundling of mortgages into buckets became
an industry in itself and the laying off of risk, a 'science'.
Enter the ratings agencies - the NRSRO's (Moody's, S&P, Fitch).
Mortgage originators collected 5000 mortgages and sold them to
financial services organizations or investment banks.
Those organizations (Fannie, Lehman, Bear, Freddie,BofA,...) declared
the entire bucket of mortgages to be a Collateralized Debt
Obligation (CDO) - something they could sell(!?). However, to
have a good market for the sale, the "CDO" (a bond) would
have to be rated by one or two of the NRSRO's (Moody's, S&P,
Fitch) because to sell that 'bond' the seller
needs to appeal to Banks, retirement funds, mutual funds
and state government investment funds. Those funds require
'AAA' ratings from NRSRO's [your federal government required
those fund managers to invest only in "investment grade"
securities rated by NRSRO's]. The Bond contains only subprime
mortgages.
How would you rate such a bond?
The NRSRO's decided that:
+ since housing prices always go up (they were wrong)
+ they didn't understand the risk models being
used by the big banks and didn't have the resources to dispute them in
any case.
[they accepted the analysis of the CDO originating organization when
they should have walked away from the fees].
+ the Federal Government required "safe" investments to be
rated 'investment grade' by NRSRO's
NRSRO's were the bottleneck for money.
NRSRO's accepted their client's "risk analysis"
as accurate and freely gave the "AAA" rating. They did not have
the resources to dispute.
IMO: Fed Gov screwed up by requiring underfunded free enterprise
companies to guess at ratings.
SOLUTION: Remove Fed Gov requirement for any and all
NRSRO ratings.
SUMMARY: "NO RATING" IS BETTER THAN AN "IGNORANT RATING".
+ interest rates were very low (Fed Reserve) and a lot
more money was made available by Federal Reserve at
VERY LOW INTEREST rates. IMO, Fed (Greenspan & Bernake screwed up!)
they would rate most of the 5000 subprime mortgage bond AAA.
(Read the the next paragraph with the following in mind:
All CDO's I talk about consist of subprime mortgages. "Subprime"
refers to those who just barely qualify for a mortgage during economic
'economic growth', will struggle "big time" during 'economic stagnation' and
fail quickly during 'economic decline').
The NRSRO's could do that because the bond originator (Lehman,
Fannie,...) sold the bond in 'layers' = 'tranches'.
Tranche:
Imagine 5000 mortgages in a bucket -- all subprime and
indistinguishable. Then, slice them, so 10% of investors invest
in the returns, but are last to suffer. Next 70% get returns, but
suffer before the top 10% tier. Last, the lowest 20% get returns but
suffer first. A-High; B-Mezzanine; C-Low
Tranches (layers):
C gets highest ROI if no defaults!
B gets 2nd highest ROI if no defaults
A gets lowest ROI if no defaults
Assume also, "Housing prices ALWAYS go up!"
That, my friends, is the model.
The top tranche survived the bankruptcy of all tranches below. It was so
well respected that it was called "Super Senior" and some thought it was
more valuable than Treasuries. The top tranche consisted of the top
10% of the mortgages in the CDO (I think "10%" is representative).
The middle (mezzanine - maybe the next 60-70%) tranche survived the
bankruptcy of the lowest tranche and yielded a higher return than
the top tranche. The lowest tranche was the first to lose all in
a bankruptcy but provided the highest returns. It was assumed by
the CDO creators that the 'bond' would fail randomly according to
past mortgage market history. Very few applied the 1932 housing
market dynamics to the CDO. No one considered what would happen
if unemployment went up to 10%.
Remember, all assumed "Housing Prices Always Go Up".
90+% of quants, bank CEO's, risk managers,
federal government regulators, Treasury Secretaries, Federal Reserve
economists, hedge funds, banks operated
with the following as GOSPEL:
1. House prices ALWAYS go up
2. Interest rates are low, so sell while the opportunity exists
3. 70+% of a bucket of subprime mortgages can, as a unit, be rated
an AAA or investment grade investment, justified by 'quantitative
finance' risk models - understood and accepted by commercial
banks, investment banks, mortgage brokers, Fannie, Freddie, the
SEC, the Fed, OCC, OTS, FDIC, HUD, DOJ, ... and most importantly,
NRSRO's. But wrong, as events have proven!!
[As an aside, I am a Ph.D in Physics. Many Quants were too. I think
they used Mathematics to create their own wealth. They abandoned
real science because they were not competitive in physics. They
convinced "finance people" they knew more than finance people.
Finance people were bamboozled! I was not competitive in physics,
but I knew it. Quants did not. They screwed America!]
4. Safe investments must be rated "investment grade" - a rule enforced
by the Federal Government. Fed Gov required rating by NRSRO's!
[IMO: dumb!]
5. NRSRO 'AAA' ratings are as safe (or more so) as Treasuries
6. Cats always act like cats. Wall Street will find a legal profit
in anything the Federal Government regulates!
Now then, imagine 5000 subprime mortgages with unknown
owners (CountryWide, Ameriquest, ... sold your mortgage) and individual
human beings as borrowers. Imagine all of the subprime borrowers
would not have qualified for a loan 25 years ago by the 1986
underwriting standards. Imagine that, for some reason, you magically
qualified and now 'own' a home. Are you nervous?
Readers - ask yourself - What if the economy has a down turn? What
if unemployment goes from 4.5% to 9.8%? What percentage of the
5000 SUBPRIME loans in that CDO bucket might be in danger of
default? Is there a top 10%? If a neighborhood has 15% of the
houses for sale because of foreclosure, what is the value of the
remaining 10% of subprime mortgages whose borrowers are still
working?
Here is my list of contributors to the subprime crisis
in NO PARTICULAR ORDER:
1 Community Reinvestment Act - Carter,Clinton+Gingrich,Bush
CRA created a Federal Government motivation to increase
home ownership. Participating Fed agencies include:
HUD
DoJ
OCC (Comptroller of Currency)
OTS
Board of Governors of Fed Reserve
FDIC
FHFB - Fed Housing Finance Board
FTC
NCUA - National Credit Union Administration
OFHEO
[ see: http://www.ots.treas.gov/_files/25022.pdf ]
Federal Government has no such responsibility according
the the United States Constitution. Find it, if you disagree.
2 Repeal of Glass Steagall
Happened under Clinton, but as far as I can tell had
NOTHING to contribute to housing bubble.
3 Fed low interests (Greenspan/Bernanke)
Using low interest rates, produced the fantastic amounts of money
required to inflatethe housing bubble. What was Greenspan thinking?
Fed should stick to inflation control or cease to exist, IMO.
4 Quantitative Finance (David X. Li, and a bunch of others)
Risk models NO ONE understood were accepted by everyone -
ALL fed agencies, Investment banks, Commercial Banks, Mortgage
Brokers, NRSRO's and most academics.
How could that happen? We now know the meaning of 'bubble'.
5 Goldman Sachs,AIG,Lehman, ... - eagerness to sell securities that
could not be analyzed for risk.
Goldman also shorted mortgages while selling them to their
customers. Others did that also. Goldman did it better than
their competitors.
Wall Street cannot be faulted for doing what Wall Street does --
Make money. They did it legally because there have been no
successful criminal charges prosecuted. Morally, they failed, IMO.
6 Fannie Mae/Freddie Mac - The source of funds for the housing bubble.
Today, F&F own 90+% of USA mortgages. They lowered their underwriting
standards so they could (Jim Johnson and Franklin Raines) get into
the huge profits associated with fees. At the time, F&F owned less
than 50% of all mortgages in America.
7 People who took out a loan based on:
Liar loans - "Alt-A" loans
NINJA - No Income, No Job, No Assets
ARM's - Adjustable Rate Mortgages
Interest Only loans
These folks include the 'flippers' ("Flip This House") and those
who were bamboozled. While they should have been smarter, they
are not the cause or even primary culprits. However, they are
not totally innocent, either. They are victims, IMO.
8 Mortgage brokers who falsified mortgage applications for the fees.
All should be prosecuted and put in jail for a while. Lies during
legal negotiations are unacceptable and must be criminally
prosecuted. Withholding facts during legal negotiations should
be a major misdemeanor and should prevent the perpetrator from ever
participating in any manner associated with finance in the future.
Here, licensing at the state level [where states are 100%
communicative with other states about loss of licenses] can solve.
A simple website posting all discredited
Doctors
Financial people
Lawyers
with URLS pointing to the factual reasons would be SOOO helpful
to America.
9 Ratings agencies (Moody’s,S&P,Fitch) who gave AAA ratings to
CDO's they didn't understand;
NRSRO's [Moody's, S&P and Fitch] should have walked away.
The NRSRO's are directly responsible for the size of the problem.
Without their AAA ratings, banks (investment and commercial),
retirement funds, hedge funds and a lot more would not have
bought the Collateralized Debt Obligations that could not be
accurately rated for risk. [IMO, Fed Gov should dis-enfranchise
NRSRO's now! They screwed America. "No rating" is SOOOOOO much
better than "AAA". Think about it!]
10 NRSRO's: Ratings agencies who must be paid by the person who wants
the rating [NRSRO's have a conflict of interest. A CDO creator pays
Moody's to rate it. The CDO Creator tells Moody's "We need
an AAA rating, how much will that cost?"]
11 Ratings agencies who get involved in politics (Georgia's Fair Lending
Act 2002)
CEO's of NRSRO's should be sued in civil courts for all they
have and all they ever will have. They should be transformed into
poor people immediately for negligence.
12 Fannie & Freddie political donations
The record of lobbying by Fannie (Jim Johnson and Franklin Raines)
is disgusting. Both should be sued in Criminal Courts for $100 billion
each [i.e. all they have and all they ever will have]. They should be transformed
into poor people immediately. Morality, they lack in spades!
13 Fannie & Freddie perq's from being a GSE
Government Sponsored Enterprises (GSE's) are assumed by all to
be backed by the Federal Government. That belief has proven true.
F&F lowered underwriting standards to 'win in the marketplace' of
subprime mortgages. Starting in late 2005, F&F doubled or tripled
their subprime liability by increasing their 'assets' by more than
$1 Trillion.
14 Federal regulators (FDIC,Fed,SEC,...) who didn't see a problem
Federal 'regulation' has proven over the past 112 years (since
the creation of the ICC) to not be up to the task. Is it time to
figure out a better way to fix social problems?
15 Community Reinvestment Act - CRA - A law passed in President
Carter's administration addressing "red-lining". President Clinton
embraced it, deciding it was his job and responsibility to help
Americans own a home. He believed the Federal Government had that
responsibility (it does not! If I am wrong, show me in US
Constitution where that mission is upheld, please). He created
policies
http://www.ots.treas.gov/_files/25022.pdf
that would encourage lenders to lend to those who could not
make the payments. GWB perpetuated those policies. "Encourage"
means
HUD
DoJ
OCC (Comptroller of Currency)
OTS
Board of Governors of Fed Reserve
FDIC
FHFB - Fed Housing Finance Board
FTC
NCUA - National Credit Union Administration
OFHEO
were VERY INTERESTED in whether or not blacks, hispanics, 'the poor'
and any other victims in America could get a loan, irrespective or
their means to pay for it. Should any of those organizations be dissatisfied
with the performance of a bank, they could and did make life uncomfortable
for that bank.
I do not believe CRA was primary cause of housing bubble. But to say
it did not contribute would be denying the obvious.
Ed's #1 best possible federal law within the
limits of the United States Constitutional:
IF YOU ENGAGE IN COMMERCE BETWEEN THE MANY STATES
OR BETWEEN THE STATES AND THE ABORIGINAL TRIBES OR
BETWEEN ONE OR MORE STATES AND ONE OR MORE FOREIGN
COUNTRIES, THERE IS NO LIMITED LIABILITY, STATE LAW
NOTWITHSTANDING.
This can be done with a law. No Constitutional Amendment is required.
Ed
PS:
Billy Ray Valentine:
Yeah. You know, it occurs to me that the best way
you hurt rich people is by turning them into poor people.
"Changing Places" Eddie Murphy
