Getting Ready for the Next Bust

January 11, 2012

Over the course of several decades, politicians encouraged banks and mortgage companies to ease lending standards in hopes of making housing more affordable for the poor.  They also urged the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae to purchase the resulting low-quality loans from lending institutions.  This freed up money, enabling banks to make more loans than would have otherwise been possible.  These actions, along with low short-term interest rates set by the Federal Reserve and tax advantages for home buyers, sparked a housing boom, says The Freeman.

Home prices soared and investors flocked to purchase mortgage-backed derivatives.  Confidence in the continued rise of housing prices was largely fueled by guarantees from the two aforementioned GSE housing giants.

  • By 2007 Freddie and Fannie held $227 billion (one in six loans) in nonprime loans (classifications of lending in which ability to pay was ignored entirely), and approximately $1.6 trillion in low-quality loans altogether.
  • From 2005 through 2007, the GSEs purchased over $1 trillion in subprime and Alt-A loans, driving up the housing bubble and driving down mortgage quality.

Fannie and Freddie continued along this unsustainable path because they were given little choice by government officials.  The Community Reinvestment Act (CRA) of 1977 pushed banks to engage in a number of market-intervening practices, such as increasing loans to low-income and minority borrowers, hiring minorities, and earmarking loans for minority-owned businesses.  In return, banks were granted freedom from certain regulations, allowed to open branch offices and continue with planned mergers without harassment.  This give-and-take with federal regulators led to numerous loans that were made with little confidence of repayment.

  • Critics argue that only 6 percent of the subprime loans made to low-income home buyers were provided by CRA-covered banks.
  • However, CRA loans contributed disproportionately to the defaults -- according to Bank of America's October 2008 quarterly report, CRA loans represented only 7 percent of its total mortgage lending, yet these loans made up 29 percent of its mortgage losses.

The truly surprising fact is that, after the crisis, little has changed.  Lending institutions still feel pressure from government regulators.  And even as the Federal Housing Finance Agency prepares lawsuits against banks for risky lending, members of the federal government request racial and income preferences of private-sector lenders.

Source: Richard W. Fulmer, "Blowing Bubbles: Getting Ready for the Next Bust," The Freeman, January/February 2012.

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http://www.thefreemanonline.org/featured/blowing-bubbles-getting-ready-for-the-next-bust/

 

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