*Fragile by Design*

by on February 15, 2014 at 3:08 am in Books, Economics, History, Political Science | Permalink

That is the new banking book by Charles W. Calomiris and Stephen H. Haber and the subtitle is The Political Origins of Banking Crises & Scarce Credit.  I went to review it, but came back to the thought that I liked Arnold Kling’s review better than what I was coming up with, here goes:

I am now reading Fragile by Design by Charles Calomiris and Stephen Haber. I posted a few months ago on an essay they wrote based on the book. I also attended yesterday an “econtalk live,” where Russ Roberts interviewed the authors in front of live audience for a forthcoming podcast. You might look forward to listening–the authors are very articulate and they speak colorfully, e.g. describing the United States as being “founded by troublemakers” who achieved independence through violence, as opposed to the more boring Canadians.

I think it is an outstanding book, although in my opinion it is marred by their focus on CRA lending as a cause of the recent financial crisis. This is a flaw because (a) they might be wrong and (b) even if they are right, they will turn off many potential readers who might otherwise find much to appreciate in the book. Everyone, regardless of ideology, should read the book. It offers a lot of food for thought.

I am only part-way through it. The story as far as I can tell is this:

1. There is a lot of overlap between government and banking. Governments, particularly as territories coalesced into nation states, needed to raise funds for speculative enterprises, such as wars and trading empires. Banks need to enforce contracts, e.g., by taking possession of collateral in the case of a defaulted loan. Government needs the banks, and the banks need government.

2. If the rulers are too powerful, they may not be able to credibly commit to leaving banks assets alone, so it may be hard for banks to form. But if the government is not powerful enough, it cannot credibly commit to enforcing debt contracts, so that it may be hard for banks to form.

3. Think of democracies as leaning either toward liberal or populist. By liberal, the authors mean Madisonian in design, to curb power in all forms. By populist, the authors mean responsive to the will of popular coalitions of what Madison called factions.

4. If you are lucky (as in Canada), your banking policies are grounded in a liberal version of democracy, meaning that the popular will is checked, and regulation serves to implement a stable banking system. If you are unlucky (as in the U.S.), your banking policies are grounded in the populist version of democracy. Banking policy reflects a combination of debtor-friendly interventionism and regulations that favor rent-seeking coalitions who shift burdens to taxpayers. The result is an unstable system.

I may not be stating point 4 in the most persuasive way. I am not yet persuaded by it. In fact, I think libertarians will be at least as troubled as progressives are by some of the theses that the authors promulgate.

Andre February 15, 2014 at 3:17 am

I’ve never understood the focus on the CRA as a cause for crisis. Sure it sounds good but the non bank entities that were originating all the loans weren’t subject to it. East Coast banks making loans in Nevada and California couldn’t satisfy their CRA requirements with those loans. Buying up securitized loan products wouldn’t satisfy their requirements either. So where’s the beef?

JonFraz February 15, 2014 at 4:53 pm

Not “all” the loans, but certainly a good many of them, and generally the most imprudent, ignoring long-established lending standards and hawking poorly tested and poorly understood “new” loan models (80/20 mortgages, no doc mortgages, cash out refis etc.)

Peter Schaeffer February 15, 2014 at 6:58 pm

Andre,

Your history is a tad off. The “CRA” in this context is shorthand for the

“General abandonment of proper mortgage and loan evaluation in response to political pressure to expand minority lending”

Even though liberals hate it, that is simply a statement of fact. Two liberals wrote a rather good book “Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time” on the subject. They document how the CRA was just the visible tip of the iceberg and how the entire banking system was dominated by ever expanding pressure to expand minority lending. No financial institution was immune because essentially all were being continuously subject to what amounted to a racial quota system.

Don’t believe it? Read the book and try again. Typical story from the period. The Democrats initially blocked the repeal of Glass Steagal. They signed on in exchange for… Yet another extension of minority lending mandates.”

Peter Schaeffer February 15, 2014 at 7:01 pm

A,

“Sure it sounds good but the non bank entities that were originating all the loans weren’t subject to it”

In real life, all financial institutions were subject to ever expanding minority lending pressures, mandates, quotas, etc.

“East Coast banks making loans in Nevada and California couldn’t satisfy their CRA requirements with those loans. Buying up securitized loan products wouldn’t satisfy their requirements either. So where’s the beef?”

Is simply wrong. In real life, minority loan portfolios were actively traded to meet “CRA” quotas. In some cases, loan portfolios were essentially rented for just days to make quota.

Boonton February 15, 2014 at 9:37 pm

Is simply wrong. In real life, minority loan portfolios were actively traded to meet “CRA” quotas. In some cases, loan portfolios were essentially rented for just days to make quota. -

You may have recalled during the crises it was pointed out that many foreclosures could have been avoided if the owners of the mortgages simply rewrote them to lower the payments for the current borrowers. Yet as simple as that sounded it was almost impossible to pull off because no one could figure out who exactly owned the mortgage, after it got sliced up in the CDO’s so many times.

How exactly were loans to non-whites used as a ‘quota system’ when the financial markets weren’t even sure who owned what?

Peter Schaeffer February 15, 2014 at 11:55 pm

B,

“How exactly were loans to non-whites used as a ‘quota system’ when the financial markets weren’t even sure who owned what?”

Not that hard. A pool of loans was defined as being X% minority, Y% low income, Z% urban, etc. You don’t need to be able to track every loan to do that. All you need is a few numbers. Gretchen Morgenson and Joshua Rosner provide several examples of loan trading (borrowing in some very cynical cases) exactly along these lines..

Andre February 15, 2014 at 10:10 pm

As a matter of fact trading batches of loans will not stratify CRA requirements. Banks are assigned an assessment area geographically local to the actual physical location of their branch network. The loans made directly within that assessment area are what count towards their CRA requirement. Certainly that can be a big task for a nationwide bank, but buying blocks of loans from Countrywide wouldn’t have cut it.

I’d think this is much more typical:

http://www.ft.com/intl/cms/s/2/f718296e-8ec1-11e3-b6f1-00144feab7de.html

A local west coast real estate company and financer taking bulk financing from banks, straw buyers making up 15%(!!) of the loans made in a pretty large region. Maybe he was making loans to ‘those people’ but it wasn’t to satisfy a CRA requirement. Dropping of lending standards happened for everyone not just minority borrowers. I think the suggestion just cheapens the argument.

Peter Schaeffer February 16, 2014 at 12:33 am

Andre,

As has been mentioned several times, the “CRA” is a shorthand for a wide-ranging and pervasive set of policies that imposed minority lending quotas on the entire financial system and systematically undermined lending policies to make it happen. Looking at how single banks complied with the CRA is an exercise in pointillism that misses the forest for a pine needle.

Let’s try a little history here. See “Rate Watch #795 The National Homeownership Strategy.” (http://bit.ly/193AKPg)

“On November 3, 1994, President Clinton sent a letter to Secretary Cisneros at HUD.
… (you can read it online)
In response HUD formulated the National Homeownership strategy.

“For many potential homebuyers, the lack of cash available to accumulate the required downpayment 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, should address both of these financial barriers to homeownership.”

The highlighted phrases are telling: lack of cash, do not have sufficient income to make the payments, fueled by creativity. HUD got what HUD asked for.”

and

“HUD however saw this as a process with no limits. After Cisneros resigned , Andrew Cuomo (present governor on New York) took over. During the Cuomo years, mortgage industry officials and housing advocates wanted Fannie Mae and Freddie Mac to purchase higher volumes of riskier loans that were offered to less creditworthy borrowers. Cuomo’s HUD continued to pressure Fannie and Freddie to increase the portion of their portfolios consisting of loans to moderate-income borrowers. It was Andrew Cuomo’s HUD that in 1999 mandated that Fannie and Freddie purchase 50% of the “mortgage loans to benefit low- and moderate-income families. Cuomo applied pressure by having HUD publicly “investigate” whether Fannie and Freddie were sufficiently in compliance with government fair-lending standards designed to prevent discrimination.”

Note that neither HUD nor the GSE’s were formally subject to the CRA. In real life the “CRA” ruled all.

See also “Pressured to Take More Risk, Fannie Reached Tipping Point” (http://www.nytimes.com/2008/10/05/business/05fannie.html?pagewanted=all)

“Those computer programs seemingly turned Fannie into a divining rod, capable of separating pools of similar-seeming borrowers into safe and risky bets. The riskier the loan, the more Fannie charged to handle it. In theory, those high fees would offset any losses.

With that self-assurance, the company announced in 2000 that it would buy $2 trillion in loans from low-income, minority and risky borrowers by 2010.”

“The ripple effect of Fannie’s plunge into riskier lending was profound. Fannie’s stamp of approval made shunned borrowers and complex loans more acceptable to other lenders, particularly small and less sophisticated banks.”

“Capitol Hill bore down on Mr. Mudd as well. The same year he took the top position, regulators sharply increased Fannie’s affordable-housing goals. Democratic lawmakers demanded that the company buy more loans that had been made to low-income and minority homebuyers.

“When homes are doubling in price in every six years and incomes are increasing by a mere one percent per year, Fannie’s mission is of paramount importance,” Senator Jack Reed, a Rhode Island Democrat, lectured Mr. Mudd at a Congressional hearing in 2006. “In fact, Fannie and Freddie can do more, a lot more.”

But Fannie’s computer systems could not fully analyze many of the risky loans that customers, investors and lawmakers wanted Mr. Mudd to buy. Many of them — like balloon-rate mortgages or mortgages that did not require paperwork — were so new that dangerous bets could not be identified, according to company executives.

Even so, Fannie began buying huge numbers of riskier loans.

In one meeting, according to two people present, Mr. Mudd told employees to “get aggressive on risk-taking, or get out of the company.””

See also “Some Recent Historical Perspective on the Agencies’ Impact on Housing” (http://www.stratmorgroup.com/RobChrismansBlog.aspx?Article=35)

“This is right up HUD’s alley, and it came back with, among other things, “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, should address both of these financial barriers to homeownership.”

If one can’t change the borrowers, perhaps one can change the lenders. And the easiest way to do this is through underwriting guideline and documentation changes. Homeownership went up. After Cisneros resigned and Andrew Cuomo took over HUD, Clinton took credit for the boom in housing and the economy boomed. During the years Andrew Cuomo (present governor on New York) ran HUD, mortgage industry officials and housing advocates wanted Fannie Mae and Freddie Mac to purchase higher volumes of riskier loans that were offered to less creditworthy borrowers. Cuomo’s HUD continued to pressure Fannie and Freddie to increase the portion of their portfolios consisting of loans to moderate-income borrowers. In 1999 the directive came out that Fannie and Freddie should purchase 50% of the mortgage loans to benefit low- and moderate-income families.

Eventually the agencies lowered their underwriting standards to satisfy the increasing demands from HUD, and HUD continually pushed higher the percent of loans that the agencies had to do to people who previously could not qualify. And other companies were willing to increase their market share by originating loans that the agencies would not do, securitize them, have them rated by the rating agencies, and sell them to investors. And while all this was happening, of course, as more and more people who could not make mortgage payment and had no down payment were encouraged to buy homes the demand rose to an unnaturally high level and the housing bubble delusion lived for too many years. Most analysts believe that the fall in values we have seen for five years is merely the sound of the market getting back to a sane level.”

See also

““Countrywide Expands Commitment to $1 Trillion in Home Loans to Minority and Lower-Income Borrowers …

ORLANDO, Fla., Jan. 14 /PRNewswire/ — Countrywide Home Loans, Inc., a national leader in expanding homeownership across America, today announced an extension of its We House America(R) initiative to fund $1 trillion in home loans to minorities and lower-income borrowers and communities through 2010.

“The $1 Trillion We House America Challenge, expanded from $600 billion announced in 2003, embodies Countrywide’s long-standing commitment to lead the mortgage industry in closing the homeownership gap for minority and lower-income families and communities,” said Countrywide Financial Corporation Chairman and CEO Angelo Mozilo, who announced the initiative at the International Builders’ Show in Orlando.

“For several years now, Countrywide has been a leading lender to minorities and lower-income households,” Mozilo said. “I am proud of our lending record and pleased to announce the expansion of our lending commitment to $1 trillion. The We House America program has already placed 2.4 million families into homes, and we expect to nearly triple that number by 2010.”

To help reach the $1 trillion funding goal, Countrywide will build on its existing comprehensive programs and policies that have made it the industry leader. The company will continue to develop innovative programs emphasizing non-traditional lending criteria, thus helping to address challenges Mozilo has made to the industry, such as calling for improved underwriting systems that eliminate the over-reliance on traditional credit scores that can mask a borrower’s true credit-worthiness. Countrywide is already responding to this challenge with the launch last year of its successful Optimum Loan program. That program addresses major obstacles for hard-to-qualify borrowers, such as allowing for non-occupant co-borrowers, other secondary income, and pooled funds for down payments.”

Was Countrywide subject to the CRA? Technically no. Was the CRA used to pressure Countrywide into dubious loans? Yes. Did Countrywide eventually build a cash machine luring minorities into fatally flawed loans that were then resold to the GSE’s? Yes.

Boonton February 16, 2014 at 7:15 am

Peter,

I’m not seeing a requirement here. I see a speech Clinton made setting a vague ‘goal’ to increase homeownership. You seem to admit that the CRA required none of the things people assert it did, but you try to get around that by claiming CRA was some type of ‘shorthand’ for a ‘spirit’ of making more loans with less money down and this was being forced on financial firms by the gov’t.

Yet this is much more consistent with a simple bubble in real estate followed by an even larger bubble in CDO’s and related instruments.

Countrywide was not subject to the CRA as you stated. Nobody did or could use the CRA to ‘pressure’ Countrywide to make bad loans. Countrywide was pressured to make bad loans for the same reason a Ponzi scheme runner is pressured to bring in new clients, like a shark that has to keep moving to breath, Countrywide had to keep writing new loans to survive. The CEO convinced himself that he was serving the greater good by brining a wonderful new product to millions of people who previously wouldn’t have been able to get loans.

Steve Sailer February 15, 2014 at 7:28 pm

Blaming the CRA is intended to get George W. Bush off the hook for his campaign against downpayment and documentation requirements in the name of racial equality in homeownership.

bob February 16, 2014 at 1:30 am

Peter

I link to the following New York Times story.

Pressured to Take More Risk, Fannie Reached Tipping Point

http://www.nytimes.com/2008/10/05/business/05fannie.html?pagewanted=all

It describes how Daniel Mudd, the CEO from 2004 onward, traveled out to see the CEO of Countrywide, Angelo Mozilla, Mozilla told Mudd that if he did not loosen underwriting standards that Countrywide would shift their business to the investment banks. Otherwise Fannie would lose Countrywide’s business. Mozilla said Fammie was about to become “irrelevant”.

A question:

Why did the investment banks play in this game. They had lots of other places to put their money? Why, in 2004, were their underwriting standards lower and Fannie Mae felt compelled to compete? The investment banks were not subject to CRA.

JonFraz February 16, 2014 at 12:01 pm

Lord knows I’m happy to blame George W Bush for anything under the sun, but I don’t recall this one. It was the lenders themselves who pioneered “no doc” loans and the 80/20 loan thing.

bob February 16, 2014 at 12:42 am

I don’t know if I have read the referenced book. I think so but I have read about six on the crisis.

But in the other books they talk a lot about liar loans. This is where people did not have to demonstrate proof of income. I read many examples of incomes being inflated to qualify for mortgages I read of an example of one mortgage broker who added a zero to the income of a maid, with an income of $15,000, so she had a reported income of $150,000 so she could qualify for a house. and when the incomes were inflated it knocked them out of CRA consideration.

I read many examples of incomes being inflated but never once have I heard of someone, erasing the one of an income of $130,000 to lower it to $30,000 to qualify for a CRA loan. As William Black has pointed out if in fact CRA was a motivation then lendors would have deflated income, not inflated it.

Boonton February 15, 2014 at 7:08 am

The US system doesn’t strike me as very ‘borrower friendly’. The CRA theory has at this point been demonstrated a red herring IMO. Keep in mind not too long before the crises ‘bankruptcy reform’ passed in the US making bankruptcy harder. Likewise after the crises the bailouts went to the financial system, little to nothing actually went to borrowers.

derek February 15, 2014 at 10:48 am

CRA could be a bit of a lazy reference to the general abandonment of proper mortgage and loan evaluation. Throw in credit scores instead of personal evaluations, as well as securitization that allows the shuffling off of risk.

Everything has seemed to be ‘discredited’ as a cause for the collapse, oddly enough.

Boonton February 15, 2014 at 11:38 am

Except nothing in the CRA says you have to make loans without personal evaluations or lower acceptable credit scores or accept lower down payments. Nothing in the CRA says you can’t confirm income or employment. All these things were done not even by the banks but by ‘mortage companies’ which sprung up not because the CRA asked them to exist but because they saw an opportunity.

My working theory is that the bad loans were really not the problem. The system was premised on producing and selling a constant stream of new loans. This was based on the assumptions:

a. Property values were ever increasing, hence even bad loans would get paid off by either refinancing or in foreclosure auctions where a new borrower would take over the property (via a new loan of course).

b. CDO’s were game changing innovations (like Smartphones or the Internet) that fundamentally altered the challenge of risk management. They were actually right about this. It’s more sensible to own 1000 pieces of subprime mortgages than 100 subprime mortgages, but like the dotcom boom they overestimated just how much potential there was in this.

This leads to the fact that bad loans to poor people weren’t the problem. Most of the money was tied up in loans to upper middle-class and rich. Consider a loan on a very small home that might have been given to a poor person. I could see how a $90K home can get inflated to $150K then collapse back down to $90K. That’s a loss of $60K, assuming the poor person doesn’t pay the loan, which they might. Now consider a $450K ‘McMansion’ that inflated to $800K and then crashed back down to $450.

The potential loss here is 350K for the bank. Even if the borrower hasn’t lost his job, he has an extreme incentive to let the property go into foreclosure since he is so far underwater.

derek February 15, 2014 at 1:00 pm

As I said CRA is a lazy reference. I agree with what you say, and it was a multi point failure, at all levels. Easier credit standards and low interest rates brought more buyers into the market, drove prices up, which created a feeling of wealth that no central banker or politician would dare touch. The leverage practices as well as the desire to own US assets made these more valuable. Throw in an utter failure at risk management by banks, rinse and repeat. Everyone loved it; the jobs, the revenues from taxation and increase in evaluations, the home owners, the asset owners, everyone. A wild and profitable ride for everyone, and no one dared to step off.

msgkings February 15, 2014 at 5:10 pm

+1. We all want one villain to point to when in reality it’s all of us to some extent.

Peter Schaeffer February 15, 2014 at 7:20 pm

B,

“Except nothing in the CRA says you have to make loans without personal evaluations or lower acceptable credit scores or accept lower down payments. Nothing in the CRA says you can’t confirm income or employment.”

Is simply false. There were numerous government efforts to explicitly block personal evaluations, the use of credit scores, and eliminate down payments to enable “CRA” lending. Read “Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time” on the subject.” before you write statements that are overtly false. Quote

“HUD [requested] that the Urban Institute, a nonpartisan and nonprofit economic policy and research organization, conduct research on the current efforts by Fannie and Freddie to finance mortgages for low-income people in “underserved” communities. The report, “A Study of the GSEs’ Single-Family Underwriting Guidelines,” was funded by HUD and published in April 1999.

….

“The GSEs’ guidelines, designed to identify creditworthy applicants, are more likely to disqualify borrowers with low incomes, limited wealth, and poor credit histories; applicants with these characteristics are disproportionately minorities,” the study said. “Informants said that some local and regional lenders serve a greater number of creditworthy low- to moderate-income and minority borrowers than the GSEs, using loan products with more flexible underwriting guidelines than those allowed by Fannie Mae or Freddie Mac.”

The message was clear: Fannie and Freddie’s underwriting standards were too high; low-income originations were too low. (p. 115)”

From the same book

“The story begins in 1992 with Alicia Munnell, an employee of the Boston Fed, who, along with her co-authors, published a paper showing that blacks and Hispanics were far more likely than whites to be rejected for mortgage loans, for no other reason than their race. Boston Fed President Richard F. Syron applauded the study and jumped on the discrimination bandwagon.

Scholars would later find that the study was not valid, but in the interim it triggered an outcry from the usual suspects in the race-baiting industry, who claimed that banks were violating the spirit if not the law of the Community Reinvestment Act of 1977, which had been passed to stop the red-lining practice of banks not writing mortgages in poor neighborhoods.

Eventually, the uproar resulted in a lowering of mortgage underwriting standards and the growth in power and profits of the government-sponsored enterprises of Fannie Mae and Freddie Mac, which had the mission of buying mortgages from banks and other mortgage originators, packaging them into mortgage-backed securities, and selling them to investors.

In order to increase the number of mortgages for minorities, down-payment requirements were lowered to five percent or less from the traditional standard of 20%, and the use of credit history as an important factor in determining credit worthiness went out the window, as did the old limit of mortgage payments not being more than 28% of a borrower’s income. At the same time, Fannie Mae’s capital requirements were lowered to a level that was significantly below the level set for banks. A perfect financial storm was forming. ”

As a practical matter you are missing the distinction between the wording of a law and the regulations that went into implementing it. Even if the CRA doesn’t ban personal evaluations, credit scores, etc. the agencies that implemented the law were very clear about what had to go.

Steve Sailer February 15, 2014 at 7:24 pm

“This leads to the fact that bad loans to poor people weren’t the problem. Most of the money was tied up in loans to upper middle-class and rich.”

Numerous academic studies of the mortgage crisis have now been conducted using huge data sets, although they have gotten little publicity. What they show is that the mortgage bubble default crisis in the Sand States (CA, FL, AZ, NV) was primarily a working class phenomenon, typically centered in areas with large and rapidly growing Hispanic populations. The median home to default in California in 2008 was 1600 square feet, but it had had been valued at close to a half million dollars a couple of years before.

Boonton February 15, 2014 at 9:03 pm

“The median home to default in California in 2008 was 1600 square feet, but it had had been valued at close to a half million dollars a couple of years before.”

9 homes are purchased for $150K and are modest homes. The tenth is purchased for $1000K. All default,9 of the homes sell at foreclosure for $100K, the 10th home sells for $500K.

The ‘median’ home is a modest $150K home that defaulted. But in the set of ten 50% of the losses were generated by a single house. In other words if gov’t swooped in and paid off 90% of the mortgages you’d eliminate almost all of the foreclosures, yet the banks (or whoever owned the mortgages) losses would have only been cut in half.

This is why I asked elsewhere here “where were all these minorities”? For the trillions of dollars involved, there simply aren’t enough minorities in America to have given it all to them….unless every non-white person gota mansion in 2007, which I think would have been a notable development.

Steve Sailer February 15, 2014 at 9:06 pm

This myth has been studied and found wanting. It would be satisfying if all the default money was lost on Thurston Howell III-types, but the big losses were in places like San Bernardino, not in Bel Air.

Boonton February 15, 2014 at 9:34 pm

You haven’t addressed my point. You asserted the median home to default was not a “Thurston Howell III-types”, it doesn’t have to be. That’s like pointing out the median car sold in any given year is a used car at a modest price. Well yes, each year there’s only one year’s worth of brand new cars to sell and lots of previous year’s used cars that get sold. But in terms of money new cars are a huge deal even though they are a fraction of all car sales.

Of course the median home sold in the boom is going to be for a ‘median type person’. Most people only buy one house so you can’t make a boom out of a minority of people…whether it’s the top or bottom of the socio-economic scale. But in terms of the crash one expensive home equals many less expensive ones in terms of damage. In the above example the bank that made those 10 loans could have cut their losses in half if they made 9!

JonFraz February 16, 2014 at 12:10 pm

The Boom and Bust was mainly due to middle class (no, not wealthy) borrowers, and to two phenomena among them. The first was house flipping with borrowers who started out with a small nest egg buying multiple properties for resale purpose, renting them out during the hold-for-sale period. When the music stopped these people found themselves with properties they could not sell for what was owed, and could not even rent for sufficient income to pay the mortgages. The second was the “house-as-ATM” phenomenon whereby people who were already homeowners drained the equity from their houses (often equity derived only from bubble level prices) and when prices fell they found themselves under water. It was not loans to the poor, but loans to middle class borrowers very often in these two areas that produced the boom and bust. By the way I had a ringside seat for the final phase of the boom and for the bust, working in the mortgage purchase and securitization unit of a major Wall Street Bank– and living in Florida. The trope that this due to poor and dark skinned people is an evil lie that should be buried at a crossroad with a stake through its heart, and those who spread it ought not be welcome in polite society.

Dan Weber February 15, 2014 at 2:18 pm

30 year fixed rate with no prepayment penalty and (often, depending on state) the ability to walk away if you turn over the property. That’s very borrower friendly. It wouldn’t exist without substantial government intervention.

Boonton February 15, 2014 at 2:45 pm

Except it’s also lender friendly in the sense that lenders are free to price the value of such a loan however they want. In the financial market imagine there’s mortgage A which has a prepayment penalty and mortgage B which does not. You (quant for Wall Street firm) are allowed to bid as you please on those two different loans. No doubt you’d value A higher than B since A entails risk for you. Likewise B will be cheaper.

Boonton February 15, 2014 at 4:14 pm

Also the 30 year fixed rate mortgage with no prepayment penalty has been a fixture in American homeownership since after the Great Depression. Since it’s been around multiple generations why exactly would it not cause an explosion until 2007?

Yancey Ward February 15, 2014 at 5:10 pm

Because it didn’t wait for 2007 to cause a problem. You are revising the actual history of the period 1933-2007.

msgkings February 15, 2014 at 5:13 pm

The 2007 change in mark-to-market rules was the main thing that turned what may have been a problem on the order of the S&L crisis of the 1980s and 90s into the massive mess it was instead. When Barney Frank said they’d lean on them to change the rule back in March 2009 the stock market literally hit bottom that very day and started rocketing higher.

It was insane that banks had to value loans at what they’d sell for right then in a crisis and not based on their long term cash flows and viability. From the 1930s to 2007 they didn’t have to, then they did and voila.

Boonton February 15, 2014 at 8:54 pm

1. Mortgage based financial crises between 1934 and 2006? When?

2. “It was insane that banks had to value loans at what they’d sell for right then in a crisis and not based on their long term cash flows and viability ”

If the loans had a lot of long term cash flow and viability why would the market not set a decent price for them?

Peter Schaeffer February 15, 2014 at 6:46 pm

B,

From derek

“CRA could be a bit of a lazy reference to the general abandonment of proper mortgage and loan evaluation”

He is right as far as he goes. A better version might be

“CRA could be a bit of a lazy reference to the general abandonment of proper mortgage and loan evaluation in response to political pressure to expand minority lending.”

Even though liberals hate it, that is simply a statement of fact. Two liberals wrote a rather good book “Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Created the Worst Financial Crisis of Our Time” on the subject. They document how the CRA was just the visible tip of the iceberg and how the entire banking system was dominated by ever expanding pressure to expand minority lending. No financial institution was immune because essentially all were being continuously subject to what amounted to a racial quota system.

Don’t believe it? Read the book and try again. Typical story from the period. The Democrats initially blocked the repeal of Glass Steagal. They signed on in exchange for… Yet another extension of minority lending mandates.

Boonton February 15, 2014 at 8:51 pm

Peter,

There’s lots of books to read but less time to read them. There’s a real problem with your theory:

1. If gov’t pressured or forced banks or financial firms to make risky loans to minorities or the poor, then why would the market reward such loans? Why would financial firms, under no requirement to make any type of mortgage loans to anyone, bid against each other to buy subprime mortgage companies making these bum loans? Why would bonds created by the bum loans be priced like they were made out of gold?

2. Where exactly are all these minorities? We are talking trillions of dollars here. Did every black person get a 50 room mansion in 2007? I think I missed that. That wasn’t where the money was IMO….giving a poor person a $150K loan to buy a home that is now only worth $100K. The real money is the $850K loan for a McMansion that now sells for only $400K.

Since you read the book you, I’m sure, can briefly address these points in an interesting manner.

Now let me present you with an alternative theory. In the bubble environment the financial markets believed:

a. Real estate prices would always remain stable or rising. Never fall dramatically.
b. CDO’s and other financial innovations were game changing discoveries that dramatically revolutionized risk management.

If these two premises were believed, making lots of loans to ‘poor and minorities’ made a lot of sense. Such loans were either going to get paid off by more loans or if they fell into foreclosure by selling off the property (which, since prices would always go up would never be much of a loss). It had nothing to do with ‘racial quotas’ but ‘loan quotas’. TO make money one had to make loans, If credit quality didn’t matter, the best place to find people to make more loans too would be people who never had loans before.

Of course you’ll find plenty of speeches and quotes by politicians praising this back then. What politician doesn’t take credit for a sunny day? But just because politicians made speeches praising the extension of lending to previously under served it doesn’t follow the speeches were the cause of the lending.

Peter Schaeffer February 16, 2014 at 1:04 am

B,

You are succumbing to the ‘single origin’ fallacy. The housing bubble and subsequent crash had several roots. Let me quote from Steve Sailer, who nails it.

“The problem with arguments over the causes of the Housing Bubble/Bust is that the usual partisan and ideological frameworks are of little help. For example, Republicans want to blame Democrats, so they focus on the CRA and Fannie Mae, but those are only pieces of the puzzle. You might think that Democrats would focus on the large role played by George W. Bush’s catastrophic undermining of traditional credit standards (down payment and documentation requirements) in the name of promoting diversity and racial equality in home ownership rates, but that would interfere with the successful tactic of tarring Republicans as racist. Libertarians want to figure out some way that it was all the government’s fault, but lots of private businessmen went hog wild. Liberals want to blame a lack of government regulation, but the hog-wild businessmen were doing what government regulators had been encouraging them to do since 1968: lend more to minorities and lower income borrowers. The reality was that members of the Overclass exploited the notions of Diversity and Fighting Racism for their own selfish ends, but that is far too disturbing a concept to catch on.”

To answer your specific questions

“If gov’t pressured or forced banks or financial firms to make risky loans to minorities or the poor, then why would the market reward such loans? Why would financial firms, under no requirement to make any type of mortgage loans to anyone, bid against each other to buy subprime mortgage companies making these bum loans? Why would bonds created by the bum loans be priced like they were made out of gold?”

Not too hard to understand. Historically, the U.S. had reasonably rigid loan standard (income ratios, LTV, credit history). Loans that met these standards were called “conforming loans”. Only conforming loans were purchased by the GSE’s and were eligible for securitization. For political reasons. these rules were jettisoned to enable minority / low income lending. This shift gave a ‘good housekeeping seal of approval’ to loans and loan packages that was historically lacking.

It should be no surprise that foolish and greedy people in the private sector embraced toxic loans and products built on toxic loans. Wall Street has a long record of selling bad products that looked good for a while. However, without the GSE policy change, the products could never have been created.

Of course, there is another connection. The housing bubble (particularly in low income / minority areas) was notably fueled by 100%+ LTV NINJA loans. Without the relentless shift to higher LTVs, the housing bubble would have been impossible in many areas. The availability (lack) of cash for down payments would have set a low ceiling on home prices. At 100% LTV, even the sky isn’t the limit.

“Where exactly are all these minorities? We are talking trillions of dollars here.”

This has been researched to death. Losses were concentrated in low-income, high minority areas. See the comments for “Did the Community Reinvestment Act (CRA) Lead to Risky Lending?” (http://marginalrevolution.com/marginalrevolution/2012/12/did-the-community-reinvestment-act-cra-lead-to-risky-lending.html)

“But just because politicians made speeches praising the extension of lending to previously under served it doesn’t follow the speeches were the cause of the lending”

in a word, no. To use just one example, HUD’s loan quotas were policies, not speeches.

As for the “a housing bubble just happened and we don’t know why” theory. Sure there was a housing bubble. In the absence of a systematic weakening of loan standards, losses would have been far lower. Beyond that, declining loan standard were part of the fuel for the fire.

Boonton February 16, 2014 at 7:44 am

Peter,

The problem with blaming Bush for lowering credit standards is that Bush had no authority to do any such thing. Only the GSE’s could lower the standards on the loans they wanted to purchase. The fact was the boom began and took off not with ‘conforming’ loans the GSE’s could purchase or insure, but with ‘nonconforming’ subprime loans that the major financial firms created, bundled and sold to clients (as well as to themselves).

“It should be no surprise that foolish and greedy people in the private sector embraced toxic loans and products built on toxic loans. Wall Street has a long record of selling bad products that looked good for a while. However, without the GSE policy change, the products could never have been created. ”

FALSE, the whole point of the CDO market was to create securitized products out of mortgages that the GSE’s couldn’t or wouldn’t touch! The whole idea was that mortgages the GSE’s wouldn’t touch could be spun into gold by bundling them into ‘tranches’ of high and low risk, ‘insuring’ them with credit default swaps, and getting rating agencies to stamp them as high quality debt. Then sell those products to money managers and traders all over the world.

Wall Street firms needed, then, subprime loans as the ‘raw material’ for their products. This is why Wall Street firms almost tripped over each other trying to buy companies like Countrywide…so they could have an ‘in house’ supplier of subprime loans rather than having to compete on the open markets.

I’ll ask again, where are all these minorities?

Your answer:

This has been researched to death. Losses were concentrated in low-income, high minority areas. See the comments for “Did the Community Reinvestment Act (CRA) Lead to Risky Lending?”

You’ve confused ‘riskier lending’ with the bubble. The paper you cited says the researchers found that in the 6 quarters around a bank being examined by the CRA, lending increased by 5% and loans made in those quarters had a 15% more defaults. Bank mortgages traditionally have a low default rate so 15% higher defaults is not much. This is like when you hear something like “X doubles your risk of rare cancer Z” well if your chance of getting Z is 1 in 100,000 doubling that is 2 in 100,000.

The boom consisted of a massive increase in nonbank lending, much more than 5% of bank lending. And a increase in defaults more along the lines of 500%+, not 15% (see http://www.housingviews.com/wp-content/uploads/2011/06/Mortgage-Default-Rate-420×286.jpg).

Here we see the source of your confusion over cause and effect. The ‘pressure’ on GSE’s both by politicians and Wall Street to lower their standards was created not by politicians seeking higher minority lending but by the bubble. Wall Street had thought it had made the GSE’s redundant. Via the magic of securitization, default swaps, highly complicated ‘financial engineering’ they had created a way to make more mortgages with lower standards than the GSE’s and they were supposedly safer too. The pressure on the GSE’s to start buying subprime mortgages came for the same reason during the dot com boom there was pressure on gov’t agencies to set up a web site. If you believed in the boom, and Wall Street did, the GSE’s were in danger of becomming irrelevant.

Boonton February 16, 2014 at 10:44 am

Side note, your CRA paper wasn’t even talking about all bank lending. It was talking about bank lending 6 quarters around a CRA examination. Presumably then banks that were not audited by the CRA had no rise in lending or defaults on loans (otherwise the paper would have found no relationship). That indicates that even bank lending (which is just a portion of mortgage lending) was only slightly impacted by the CRA (since only a small portion of banks would be audited by the CRA in any given year).

Look the CRA was pushing 30 years old in the late 2000′s. It was a known entity that had a modest impact on some bank lending and banks felt no great push to alter their behavior due to the CRA or it’s enforcement. The pressure banks felt was seeing new non-bank companies like Countrywide making hundreds of millions in mortgage loans every month while they plogged along with their ‘stogy’ rules. The pressure banks felt was Wall Street telling them their risk management procedures were old fashioned in a world where their ‘financial engineering’ could create high grade securities cobbled together from low grade mortgages and then make them even more ‘risk free’ by insuring them with default swaps.

Which all brings me back to my question “what minorities”? Look at homeownership rates by ethnic group on http://upload.wikimedia.org/wikipedia/commons/thumb/a/a4/US_Homeownership_by_Race_2009.png/360px-US_Homeownership_by_Race_2009.png. Homeownership rates for Blacks and Hispanics went from about 47% around 2000 to a tad under 50% at the peak. Minorities are call minorities because they are….wait for it….a minority! Less than 50%.

In other words there simply was not enough Black and Hispanic people to give loans to to fuel a bubble. With the amount of money that went into the bubble, you could have given every black person a very decent house and still not account for it all. In reality ownership rates only went up by 2-3% of the minority population. So the CRA, whether you’re talking about the actual CRA or sometype of ‘mental placeholder’ for ‘CRA-like’ policies, isn’t even a sideshow of a sideshow.

JonFraz February 16, 2014 at 12:12 pm

Re: Even though liberals hate it, that is simply a statement of fact.

No. It is a propagandist lie.

Peter Schaeffer February 17, 2014 at 3:00 am

JF,

Facts are stubborn things. Let’s try a little history here. See “Rate Watch #795 The National Homeownership Strategy.” (http://bit.ly/193AKPg)

“On November 3, 1994, President Clinton sent a letter to Secretary Cisneros at HUD. … (you can read it online) In response HUD formulated the National Homeownership strategy.

“For many potential homebuyers, the lack of cash available to accumulate the required downpayment 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, should address both of these financial barriers to homeownership.”

The highlighted phrases are telling: lack of cash, do not have sufficient income to make the payments, fueled by creativity. HUD got what HUD asked for.”

and

“HUD however saw this as a process with no limits. After Cisneros resigned , Andrew Cuomo (present governor on New York) took over. During the Cuomo years, mortgage industry officials and housing advocates wanted Fannie Mae and Freddie Mac to purchase higher volumes of riskier loans that were offered to less creditworthy borrowers. Cuomo’s HUD continued to pressure Fannie and Freddie to increase the portion of their portfolios consisting of loans to moderate-income borrowers. It was Andrew Cuomo’s HUD that in 1999 mandated that Fannie and Freddie purchase 50% of the “mortgage loans to benefit low- and moderate-income families. Cuomo applied pressure by having HUD publicly “investigate” whether Fannie and Freddie were sufficiently in compliance with government fair-lending standards designed to prevent discrimination.”

Of course, none of that ever happened. It’s just a propagandist lie. Orwell knew about lies.

“Who controls the past controls the future. Who controls the present controls the past.”

Boonton February 17, 2014 at 5:59 am

In 2002, after Clinton was gone from the WH Fannie/Freddie backed about 50% of all mortgage loans in the country. In 2007 their share was only 30%. If your bubble and bust had happened 1992-2002 you might have a case but unfortunately your dates do not add up. And I notice you continue the tactic of citing statments, speeches and letters of politicians as a cause of the bubble rather than the effect.

Balaji Sundaresan February 15, 2014 at 7:53 am

Tyler,
Thanks for the brilliant book recommendation as always.
I always wanted to ask you this question after you wrote that you cancelled the preorder of Taleb’s book Antifragile (I couldn’t find that post on your blog).
Did you read Antifragile? You are a man who doesn’t like to involved in controversies… (Taleb is known for that :-) )

rayward February 15, 2014 at 8:46 am

How can the US banking system be both populist and dominated by rent seekers? Would a populist banking system bail out the bankers but not the borrowers? I suppose I should read the book, but my time, like resources, is limited, and I don’t believe spending time on a book, whose central thesis is that poor people, the populists with the pitch forks, forced the bankers into making bad loans and then forced the government to bail out said bankers, would be very insightful. But I am curious as to whether the authors offer an explanation for the financialization of the economy, and whether said financialization provides stability or instability for the banking system and the economy. Note to Cowen: let us know when your dialogue with McArdle is re-scheduled. Her new book seems to hit a nerve, in particular among all those helicopter parents. I often tell people, based on my own experience, that fear is the best motivator. I look forward to a lively discussion between Cowen and McArdle.

derek February 15, 2014 at 10:32 am

US banking regulation up till after the Savings and Loans crisis of the 80′s was written to protect small banks, with the ridiculous in retrospect limitations on branch numbers and proximity, etc. The rhetoric was to protect against the evil New York banks, still a great sell, and the rent seeking is obvious.

Bill February 15, 2014 at 9:33 am

Here is a link to a PowerPoint presentation of their book that they gave at the IMF

https://www.imf.org/external/np/seminars/eng/2012/spr/pdf/SH_p.pdf

derek February 15, 2014 at 10:39 am

I’ll look forward to the econtalk recording, but a question.

Canada’s population is about the same as California, and it’s economy is more than a trillion, compared to 16 or 17 for the US. If you scale our banking system up to the US size economy, could the regulatory structures, formal and informal, as well as the political tightwalk that engendered it be maintained?

How much is this like the old silliness that the US should be like Sweden in social welfare programs and the like. Sweden is 7 million people. Scale matters greatly.

Ted Craig February 15, 2014 at 12:30 pm

Plus two-thirds of that population live in two contiguous provinces.

john personna February 15, 2014 at 12:39 pm

America can’t learn nuthin’ because we are to big?

Sometimes it feels that way. After all here we are talking about national banking regulations that we, Canada and Sweden all agree “scale.” The “pattern” of savings and loan or etc. is just repeated, as needed.

derek February 15, 2014 at 1:13 pm

If you don’t understand how things can’t scale, then there is nothing to say.

5 large banks in Canada is a far different picture than 5 large banks in the US.

john personna February 15, 2014 at 1:42 pm

Things can’t scale? He said on the Internet?

Ted Craig February 15, 2014 at 7:10 pm

What the fudge do you think the Internet has to do with anything? That is a pathetic argument.

john personna February 15, 2014 at 12:42 pm

(It would be different to name specific technical reasons that the Canadian or other system cannot scale. As opposed to noting national sizes and calling it quits.)

Dan Weber February 15, 2014 at 2:22 pm

Things that I’m not sure would work well because of our size:

- Canada has like 5 or 6 large banks, and that’s it. They are all too big to fail yet they never fail.

Things that we could bring in except people would consider them Un-American:

- No 30-year fixed loan.
- Pre-payment penalties
- You can’t just walk away from the property if your house goes underwater.

john personna February 15, 2014 at 4:58 pm

- doubt that a limit on banks to “5 or 6″ is central.

- the 30 year mortgage is getting to it, a structural issue strongly shaping investment risk, a rule not subject to scaling issues.

- similarly penalties and etc. No scaling issues.

john personna February 15, 2014 at 5:02 pm

(Joe is short and has red shoes. Bob is tall and has blue shoes. Do red shoes not scale?)

Boonton February 18, 2014 at 10:02 am

We’ve had 30 year loans for something like 75 years or more, many of the subprime loans were, in fact, not your traditional 30 year loans but more exotic ones with balloon payments, adjusting rates or strange terms.

There’s no special reason why a system built on 30 yr mortgages without prepayment penalities shouldn’t be workable.

Boonton February 15, 2014 at 4:39 pm

I think scale is very important here because a competiting hypothesis is that the cause of the financial crises was the popping of a bubble and bubbles are a feature of large scale, diverse markets. Canada may have avoided a real estate bubble because they do not have an environment suitable for one. Part of that is scale but not all of it (after all, I’m sure the Tulip Mania took place in a market a fraction of the size of Canada’s present day one). Another part of it is probably market diversity.

Let me also introduce another possibility from the world of cancer. Sometimes when surgeons remove a large tumor, many small ones pop up shortly afterward. The large tumor essentially sends out signals that say ‘feed me’ to the body, drowning out the signals of many other smaller ones. When the large one is gone, the body can ‘hear’ the cries of he smaller ones and respond. Perhaps Canada enjoys financial stability because the much larger market to the south can generate much larger bubbles that attract people’s attention and money. This gives Canada a false impression of stability.

Henri Tournyol du Clos February 15, 2014 at 12:51 pm

The problem is that Calomiris’ record is abysmal: from a 1999 paper entitled “The Impending Collapse of the European Monetary Union” ( http://object.cato.org/sites/cato.org/files/serials/files/cato-journal/1999/1/cj18n3-14.pdf ) to his pronuncement at the Atlanta Fed’s April 2013 Financial Markets Conference that “the French banking system is effectively insolvent” ( https://twitter.com/pdacosta/status/321691352112971776 ) via his denial on November 23rd, 2007 that a financial crisis was actually happening ( http://www.voxeu.org/article/subprime-turmoil-or-minsky-moment ) the guy has been dead wrong on a number of important issues. So, frankly, unless he turns out to be a reliable contrarian indicator like HW Sinn, a compass that always points to the wrong direction, I wonder if there is a point to listening to him at all?

leftist conservative February 15, 2014 at 6:52 pm

3. Think of democracies as leaning either toward liberal or populist. By liberal, the authors mean Madisonian in design, to curb power in all forms. By populist, the authors mean responsive to the will of popular coalitions of what Madison called factions.

==========

controlling the faction of the majority is what madison and the other founding plutocrats were after. The primary purpose of the structure of the fed govt they created: to preserve wealth INequality, as madison wrote, and to “protect the minority of the opulent against the majority.”

Madison wrote that by enlarging the voting districts by creating federal voting districts, that ugly brutish majority would not be able to discover their common interest and unite. Unite against whom? Why, against madison, washington, jefferson, morris and the rest of the minority of the opulent. Oh, you left that part out…didn’t ya?

John Trevor February 16, 2014 at 10:36 pm

ART, CELEBRITIES, REVIEWS AND MORE!

http://www.trevorjohn.blogspot.com

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