The Financial Crisis IV. Where Do We Go From Here?

 

“It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.                                                                    former Congressman Barney Frank, 2010

“Only by understanding the factors that led to and amplified the crisis can we hope to guard against a repetition.”
                                                   former Federal Reserve Chair, Ben Bernanke, 2010

As I explained in my last post, my views on the financial crisis are most heavily influenced by John Allison, President of the CATO Institute; Sheila Bair, former Chair of the FDIC; and Peter Wallison, a financial policy analyst at the AEI, as follows:

  • The primary cause of the crisis was the affordable housing policy, created by Congress and administered by HUD, under which higher and higher percentages of mortgages acquired by the GSEs Fannie Mae and Freddie Mac had to be made to low and moderate income borrowers. This policy, aided by the very low interest rates maintained by the FED from 2002-2004, created the housing bubble which burst in 2007 leading to an unprecedented number of delinquencies and defaults.
  • Subprime lending abuses could have been avoided if the FED had used the authority it had under the Home Ownership Equity Protection Act of 1994 to require appropriate mortgage lending standards. In other words, lax regulation, but not deregulation, was a major contributor to the crisis.
  • Investment Banks, such as Bear Stearns and Lehman Brothers, magnified the misallocation of credit to the housing market with financial products such as CDOs and derivatives.

Clearly congressional action was needed to address the financial abuses leading up to the crisis.  But the Dodd-Frank Act is an overreaction.  It requires 398 new regulations which are taking a big toll on the economy as shown by the chart below from the American Action Forum.
CaptureDodd-Frank should be scaled back so that its provisions apply only to the very largest financial institutions where the abuses were the greatest.  This can be accomplished with capital requirements which increase proportionally with the size of the institution so that smaller banks are better able to compete with the giants.
Faster economic growth is critical for our future.  It will not only create more jobs and higher paying jobs but will also alleviate our deficit problem by bringing in more tax revenue.  Paring back and streamlining Dodd-Frank would be a big step in the right direction.

The Financial Crisis II. Is Peter Wallison Credible?

 

“It was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.
 
                                                             former Congressman Barney Frank, 2010

“The ferocity of the left in defending Fannie Mae, Freddie Mac, and the government’s housing policies before 2008 is sometimes shocking, especially when even Barney Frank has given up.  It makes you wonder why this is so important to them.  They have no data, no policy arguments, just a virulent denial that anything other than the private financial sector could possibly be responsible for the financial crisis.”
                                                  “Hidden in Plain Sight,” p 42, by Peter Wallison, 2015

My last post, “The Financial Crisis I. The Cause” reported on a new book “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again” by Peter Wallison, a financial policy analyst at the American Enterprise Institute.  He makes a very strong case, with voluminous documentation, that the basic cause of the financial crisis was the HUD policy requiring government agencies like Fannie Mae, Freddie Mac and the FHA to gradually acquire an increasing percentage of subprime mortgages.  When the housing bubble finally burst in 2007, the enormous number of delinquencies and defaults among these nontraditional mortgages, aggregate value over $5 trillion, drove down housing prices and caused the financial crisis.
CaptureAs noted above by Mr. Wallison himself, such an explanation is simply unacceptable to people who insist on blaming the private sector for the crisis.  Rather than dealing with public records and data available, they instead try to discredit Mr. Wallison.  My purpose today is to give two vivid examples of the types of documents which Mr. Wallison uses to make his case:

  • (Fannie Mae 10-K report, 2006). “We have made, and continue to make, significant adjustments to our mortgage loan sourcing and purchase strategies in an effort to meet HUD’s increased hosing goals and new subgoals.  These strategies include entering into some purchase and securitization transactions with lower expected economic returns than our typical transactions.  We have also relaxed some of our underwriting criteria to obtain goals-qualifying mortgage loans and increased our investments in higher-risk mortgage loan products that are more likely to serve the borrowers targeted by HUD’s goals and subgoals, which could increase our credit losses.
  • (statement by Daniel Mudd, former Fannie Mae CEO, April 2010). “Fannie Mae’s mission regulator, HUD, imposed ever-higher housing goals that were very difficult to meet during my tenure as CEO.  The HUD goals greatly impacted Fannie Mae’s business, as a great deal of time, resources, energy and personnel were dedicated to finding ways to meet these goals.  HUD increased the goals aggressively over time to the point where they exceeded the 50% mark, requiring Fannie Mae to place greater emphasis on purchasing loans in underserved areas.  This became particularly problematic when goal requirements grew to far exceed the proportion of eligible mortgages originated in the primary market.”

Mr. Wallison’s book is filled with this type of detailed documentation for the case he is making.  It should be persuasive to anyone with an open mind.  It certainly is to me.  Now that Mr. Wallison’s credibility is established, it is time to discuss the implications of his thesis.  Stay tuned!

Preventing the Next Housing Crisis: Shared Responsibility Mortgages

 

It is now commonly agreed that the Financial Crisis of 2008 was caused by the collapse of the housing bubble beginning in 2007. There were three main aspects to the huge collapse of wealth caused by the Financial Crisis:
Capture

  • It Destroyed Mainly Middle Class Wealth. During the Great Recession housing values collapsed by $5.5 trillion, a large fraction of the total $14 trillion economy. As shown in the above chart, most of this loss of wealth came at the expense of middle- and lower-income families.
  • Foreclosures on Underwater Mortgages Lowered Housing Values across the Board. When foreclosed houses are sold at steeply discounted prices, the appraised value of all other houses in the area are lowered as well.
  • The Loss of Wealth of Indebted Households Forced Them to Cut Back on Their Overall Spending. The decline in aggregate demand due to wealth loss of the indebted then becomes a problem for everyone in the economy.

In a new book, the economists Atif Mian and Amir Sufi have proposed a new way to set up mortgages, called Shared Responsibility Mortgages (SRM), to protect holders of underwater mortgages during a housing crisis.
Consider a house bought for $100,000 with a 20% down payment and a 30 year mortgage of $80,000 at 5% interest.  The annual mortgage payment is $5,204 per year.  Suppose the value of the house drops 30% to $70,000.  With an SRM the owner’s equity drops to 20% of $70,000 or $14,000.  The annual mortgage payment would also drop 30% to $3,643.  It would continue to be adjusted each year until the house returns to 100% of original value at which point the payment would revert to and remain at the original amount unless the value again drops below 100% of original value.
In return for sharing in the loss caused by a drop in value, the mortgage holder would receive 5% of any capital gain realized whenever the house was sold or refinanced in the future.
Suppose that all mortgages in 2007 had been SRMs.  All three of the problems outlined above would have been avoided.  The financial crisis would have been much less severe!