“Unfortunately, some of the largest financial institutions were victims of the same misapprehensions as regulators and academics about the quality of mortgages outstanding and the safety of the mortgage market, but they have been blamed by the government, the media, and ultimately the American people for excessive risk-taking. This view, a product of both the absence of accurate data and the government’s efforts to avoid blame…

…has led to calls for what are essentially public hangings of the alleged malefactors…principally banks and their managers. Although placing responsibility for the financial crisis where it belongs may be seen by some as a defense of banks and their officials, it is not. Clearly, the private sector made serious errors in the crisis, but one fact is difficult to dismiss: the banks and investment banks got into serious trouble because they kept….they did not sell…..the mortgage-backed securities, based on NTMs (nontraditional mortgages), that declined so sharply in value in 2007 and 2008.”, Peter J. Wallison, Hidden in Plain Sight: What Really Caused The World’s Worst Financial Crisis And Why It Could Happen Again

“The term Alt-A is said to derive from the market practice of referring to the GSEs as “Agencies”. Alt-A mortgages are said to be “Alternative to Agencies” or mortgages that the GSEs wouldn’t buy. Ironically, in order to meet the affordable housing goals, the GSEs eventually became the biggest buyers of Alt-A loans.”, Peter J. Wallison, Hidden in Plain Sight

“Because of the gradual deterioration in loan quality after 1992, by 2008 half of all mortgages in the United States….31 million loans…..were subprime or Alt-A. Of these 31 million, 76 percent were on the books of government agencies or institutions like the GSEs that were controlled by government (affordable housing) policies. This shows incontrovertibly where the demand for these mortgages originated. Table 1.1 shows where these 31 million loans were held on June 30, 2008.”, Peter J. Wallison, Hidden in Plain Sight

Part One: Key Excerpts from the Introduction of Peter J. Wallison’s: Hidden in Plain Sight: What Really Caused The World’s Worst Financial Crisis And Why It Could Happen Again:

“The 2008 financial crisis was a major event, equivalent in its initial scope….if not its duration…to the Great Depression of the 1930s.”

“The history of events leading up to the crisis forms a coherent story, but one that is quite different from the narrative underlying the Dodd-Frank Act.”

“If these regulations were really necessary to prevent a recurrence of the financial crisis, then there might be a legitimate trade-off in which we are obliged to sacrifice economic freedom for the sake of financial stability. But if the crisis did not stem from a lack of regulation, we have needlessly restricted economic growth.”

“In the wake of the crisis, many commentators saw it as a “crisis of capitalism,” an inevitable consequence of the inherent instability…..as they see it…of a free-market or capitalist system. The implication was that crises of this kind will be repeated unless we gain control of the financial and economic institutions that influence the direction of our economy. That was the unspoken impulse behind the Dodd-Frank Act and the underlying assumption of those who imposed it.”

“But it is not at all clear that what happened in 2008 was the result of insufficient regulation, deregulation, or an economic system that is inherently unstable. On the contrary, there is compelling evidence that the financial crisis was the result of the government’s own housing policies. These policies, as we shall see, were based on an idea…still popular on the left….that underwriting standards in housing finance are excessively conservative, discriminatory, and unnecessary. If it is true that the crisis was the result of government policies, then the supposed instability of the financial system is a myth, and the regulations put in place to prevent a recurrence at such great cost to the economic growth were a serious policy mistake. Indeed, if we look back over the last hundred years, it is difficult to see instability in the financial system that was not caused by the government’s own policies.”

“How, then, did government housing policies cause the 2008 financial crisis? Actually, “cause” is too strong a word. Many factors were involved in the crisis, but the way to think about the relationship between government housing policies and the financial crisis, as I will discuss in this book, is that the crisis would not have occurred without those policies; they were, one might say, the sine qua non of the crisis….the element without which there would not have been a widespread financial breakdown in 2008. In this sense, throughout this book, I will say that the U.S. government’s housing policies caused the crisis.”

“The seeds of the crisis were planted in 1992 when Congress enacted “affordable-housing” goals for the two giant government-sponsored enterprises (GSEs), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Before 1992, these two firms dominated the housing finance market, especially after the savings and loan (S&L) industry….another government mistake….had collapsed. The role of the GSEs, as initially envisioned and as it developed until 1992, was to conduct what were called secondary market operations. They were prohibited from making loans themselves, but they were authorized to buy mortgages from banks, S&Ls, and other lenders. Their purchases provided cash for lenders and thus encouraged homeownership by making more funds available for traditional mortgages.”

“The increasing dominance of the housing market by the GSEs and the government is well illustrated in Figure 1.1, which covers both the mortgage pools they guaranteed and their portfolios of mortgages and mortgage-backed securities (MBS).”

“Although Fannie and Freddie, as they were called, were owned by public shareholders, they were chartered by Congress and carried out a government mission by maintaining a liquid secondary market for mortgages. As a result, market participants believed that the two GSEs were government-backed and would be rescued by the government if they ever encountered financial difficulties. This widely assumed government support enabled them to borrow at rates only slightly higher than the U.S. Treasury itself; with these low-cost funds they were able to drive all competition out of the secondary market for middle class mortgages. Between 1991 and 2003, the GSEs’ share of the U.S. housing market increased from 28.5 percent to 46.3 percent.”

“From this dominant position, they (Fannie and Freddie) were able to set the underwriting standards for the market as a whole; few mortgage lenders would make middle-class mortgages…..by far the predominant market….that could not be sold to Fannie and Freddie.”

“Over time, the GSEs had learned from experience what underwriting standards kept delinquencies and defaults low. These standards required down payments of 10 to 20 percent, good borrower credit histories, and low debt-to-income (DTI) ratios after the mortgage was closed. These were the foundational elements of what was called a prime loan or traditional mortgage….”

“Mortgages that did not meet these standards were called “subprime” if the weakness was caused by the borrower’s credit standing, and were called “Alt-A” if the problem was the quality of the loan itself. Among other defects, Alt-a loans might involve reduced documentation; negative amortization; a borrower’s obligation to pay interest only; a low down payment; a second mortgage; cash-out refinancing; or loans made to an investor who intends to rent out the home. In this book, subprime and Alt-A mortgages are together called nontraditional mortgages, or NTMs, because they differ significantly in default risk from mortgages that Fannie and Freddie had made traditional in the U.S. housing finance market.”

“The term Alt-A is said to derive from the market practice of referring to the GSEs as “Agencies”. Alt-A mortgages are said to be “Alternative to Agencies” or mortgages that the GSEs wouldn’t buy. Ironically, in order to meet the affordable housing goals, the GSEs eventually became the biggest buyers of Alt-A loans.”

“Many observers of this market believe that tight underwriting standards….occasionally called a “tight credit box”….adversely affect the homeownership rate in the United States; however, even though the GSEs insisted on tight underwriting standards before 1992, the homeownership rate in the United States remained relatively high, at 64 percent, for thirty years between 1965 and 1995.”

“Most important, as mission regulator, HUD was given authority under the 1992 legislation to administer affordable-housing goals, which are discussed at much greater length in later chapters of this book.”

“In a sense, the ability of the GSEs to dominate the housing finance market and set their own strict underwriting standards was their undoing. Community activists had had the two firms in their sights for many years, arguing their underwriting standards were so tight that they were keeping many low-and moderate-income families from buying homes. Finally, as housing legislation was moving through Congress in 1992, the House and Senate acted, directing the GSEs to meet a quota of loans to low-and moderate-income borrowers when they acquired mortgages. At first, the low- and moderate-income (LMI) quota was 30 percent: in any year, at least 30 percent of the loans Fannie and Freddie acquired must have been made to LMI borrowers….defined as borrowers at or below the median income in their communities. Thirty percent was not a difficult goal.”

“But in giving HUD authority to increase the goals, Congress cleared the way for far more ambitious requirements….suggesting in the legislation, for example, that down payments could be reduced below 5 percent without seriously impairing mortgage quality. HUD received the signal. In succeeding years, HUD raised the LMI goal in steps to 42 percent in 1997, 50 percent in 2001, and 56 percent in 2008. Congress also required additional “base goals” that encompassed low and very-low income borrowers and resident of minority areas described as “underserved.” HUD increased these base goals between 1996 and 2008, and at a faster rate than the LMI goals. Finally, in 2004, HUD added subgoals that provided affordable housing goals credit only when the loans were used to purchase a home (known as a purchase mortgage), as distinguished from a refinancing.”

“As HUD increased the goals after 1992, it became considerably more difficult for the GSEs to find creditworthy borrowers, especially when the quota reached and then exceeded 50 percent. To do so, Fannie and Freddie had to reduce their underwriting standards. In fact, as we will see, that was explicitly HUD’s purpose. As early as 1995, the GSEs were buying mortgages with 3-percent down payments, and by 2000 Fannie and Freddie were accepting loans with zero down payments. At the same time, they were compromising other underwriting standards, such as borrower credit standing and debt-to-income ratios (DTIs), in order to find the NTMs (nontraditional mortgages) they needed to meet the affordable-housing goals.”

“Mortgage lending is a competitive business: once Fannie and Freddie started to loosen their underwriting standards, many borrowers who could have afforded prime mortgages sought the easier terms now available so they could buy larger homes with smaller down payments……Although the initial objective had been to reduce underwriting standards for low-income borrowers: the advantages of buying or refinancing with a low down payment were also flowing to high-income borrowers.”

“Because of the gradual deterioration in loan quality after 1992, by 2008 half of all mortgages in the United States….31 million loans…..were subprime or Alt-A. Of these 31 million, 76 percent were on the books of government agencies or institutions like the GSEs that were controlled by government policies. This shows incontrovertibly where the demand for these mortgages originated. Table 1.1 shows where these 31 million loans were held on June 30, 2008.”

“Before 1992, it was relatively easy to tell the difference between a subprime and a prime loan. Subprime loans were a niche market, perhaps 10 percent of all mortgages; they were made by specialized lenders. The GSEs seldom acquired these loans. A subprime loan, therefore, was one made by a subprime lender, or a loan that Fannie and Freddie wouldn’t buy. After the enactment of the affordable-housing requirements, however, the GSEs began to acquire loans that were subprime or Alt-A by their characteristics….that is, they might not have been originated by a subprime lender or insured by the FHA, but they had the same deficiencies as traditional subprime or Alt-a loans, and they performed the same way.”

“However…and this is a key point….even after they began to acquire large numbers of subprime mortgages, the GSEs continued to define subprime loans as mortgages that they bought from subprime lenders or that had been sold to them as subprime mortgages. This misleading definition allowed them to maintain for many years that their exposure to subprime and Alt-A was minimal. In addition, when lenders reported their loans to organizations such as First American LoanPerformance (now CoreLogic), a well-known, data aggregator and publisher in the housing market, loans that had been sold to Fannie and Freddie were classified as prime loans. The GSEs took advantage of this highly misleading classification system, failing to acknowledge loans with subprime characteristics as subprime or Alt-A, even though these loans would inevitably have much higher rates of default than prime loans.”

“LoanPerformance and other data aggregators such as Inside Mortgage Finance (IMF), not in the business of classifying loans, simply assumed that loans sold to the GSEs were prime loans and carried them in that category. IMF noted, “Some subprime and Alt-A loans were likely reported by lenders as conventional conforming mortgages if they were sold to Fannie Mae and Freddie Mac.””

“For that reason, many respected academic, government, media, and professional commentators who discussed the financial crisis did not at the time of the crisis…..and still do not…..understand that the number of NTMs (nontraditional mortgages) in the financial system was far higher in 2008 than what LoanPerformance’s data showed, and the number of prime loans, accordingly, were much lower.”

“This was confirmed by Fannie and Freddie in non-prosecution agreements with the SEC, discussed in Chapter 3. The NTM (nontraditional mortgage) numbers used in this book will include loans that should properly be labeled subprime or Alt-A because of their characteristics, not because the GSEs or the originators of these loans happened to label them that way. Indeed, after they were taken over in a government conservatorship, Fannie and Freddie disclosed the extent of their exposure to NTMs (nontraditional mortgages).”

“The failure of the GSEs to report the full extent of their NTM acquisitions is only one of the factors that might account for the general failure of risk managers, rating agencies, regulators, and housing market analysts to recognize the dangers that were building up in the mortgage market through the mid-2000s. Other elements were the growth of the bubble, which (as discussed below) tends to suppress delinquencies and defaults; the fact that no one could imagine a decline in housing prices nationally of 30-40 percent, or indeed a decline of 30-40 percent anywhere, and the misplaced belief that automated underwriting had made it possible to eliminate much of the risk of subprime lending.”

“Unfortunately, some of the largest financial institutions were victims of the same misapprehensions as regulators and academics about the quality of mortgages outstanding and the safety of the mortgage market, but they have been blamed by the government, the media, and ultimately the American people for excessive risk-taking. This view, a product of both the absence of accurate data and the government’s efforts to avoid blame, has led to call for what are essentially public hangings of the alleged malefactors…principally banks and their managers. Although placing responsibility for the financial crisis where it belongs may be seen by some as a defense of banks and their officials, it is not. Clearly, the private sector made serious errors in the crisis, but one fact is difficult to dismiss: the banks and investment banks got into serious trouble because they kept….they did not sell…..the mortgage-backed securities, based on NTMs (nontraditional mortgages), that declined so sharply in value in 2007 and 2008.”

“Two academics, Viral V. Acharya and Matthew Richardson argue that banks held onto the AAA-rated tranches (the levels most protected against loss) of these disastrously risky securities to evade the Basel capital regulations, but at some level they must have believed that these instruments were safe. Ironically, if the banks had sold these securities, the losses would have been distributed more widely throughout the global financial system, where there was more capital to absorb them; instead, the losses were concentrated in the largest financial institutions in the United States and abroad, creating a financial crisis when these firms were so weakened that they could not continue to supply liquidity to the financial system.”

Posted on February 3, 2015, in Postings. Bookmark the permalink. 1 Comment.

  1. Nice to see the truth emerging in a such a solid way, backed by real data….thanks for adding additional illumination, Mike!

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