It's said the road to Hell is paved with good intentions, and some people sweating through the credit-market meltdown might agree. Underlying the wreckage are decades of regulatory and legislative decisions that opened the door to today's financial woes.
Some policy choices were high-minded, some were deregulatory, and some just seemed like a good idea at the time. But, with passage of the Troubled Asset Relief Program (TARP), we're on the right track now, aren't we? Maybe not. According to Anthony Sanders, professor of finance at the W. P. Carey School of Business, TARP falls short as a deterrent to future financial troubles. "It has nothing in it to prevent this from happening again," he says. Laws and other conditions that paved the road to ruin are still on the books. Professor Sanders feels that the name TARP is appropriate since it will be easily blown away in the next financial storm.
Home sweet home
Among the biggest culprits that helped torpedo the U.S. financial system, Sanders points to the Community Reinvestment Act of 1977 (CRA). According to him, the law aimed to end "redlining," a discriminatory practice among lenders. Bankers would "draw a red line around areas with low-income households" and refuse to make loans in those neighborhoods.
Sanders sees how CRA reform could reflect noble intentions. "If these are legitimate borrowers who were being discriminated against because of a red line around their neighborhood, that was clearly wrong," he says. The CRA required banks to prove they were offering loans to the whole community, not just the wealthier parts of it.
But, Sanders points: "When you start lending money to people with lower-than-average income and credit scores, you face a problem: higher risk."
Still, Sanders and others maintain that the CRA didn't stand alone in opening up subprime mortgage markets. Robert Mittelstaedt, Dean of the W. P. Carey School, credits a "moral suasion" that was pervasive in Washington over the past two decades. "There is an idea that has been pushed by Congress and multiple presidents for years," he says. "The idea is that everyone should own a home." Sanders notes that, because of Federal tax laws, many households are actually better off renting rather than owning, and the recent downturn in house prices has proved his point.
This idea gained power with the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. Among other things, the act established affordable housing goals for the U.S. Department of Housing and Urban Development (HUD), then overseers of Fannie Mae and Freddie Mac.
Prior to this act, Fannie and Freddie steered clear of purchasing subprime loans because such transactions didn't fit into the mortgage purchasers' underwriting guidelines. Beginning in 1993, however, HUD set goals for the number of mortgages Fannie and Freddie should buy that originated in "underserved" or low- to moderate-income neighborhoods.
"Banks got CRA credit for making loans, which Fannie and Freddie were encouraged to purchase," Sanders says.
Spirit of the times
For an inkling of the moral suasion Mittelstaedt mentions, one need only search New York Times archives. A March 10, 1994 article reports that "Freddie Mac loosened its guidelines for low-income mortgages a few weeks ago," and Fannie Mae was soon to follow.
A September 30, 1999 article covers similar news, and includes this eerie warning: "In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But, the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's."
A May 12, 2004 story also reports that HUD upped its targets for the number of mortgages from lower-income households that Fannie and Freddie would buy. "The housing department has proposed raising that target to 53 percent next year and to 57 percent by 2008," the story states.
Amid the homeownership-for-all mania, subprime lending flourished. According to Sanders, subprime lending accounted for only about 7 percent of loan originations in 2001, but grew to 20 percent of new loans by 2007. Alt-A loans saw similar growth: They equaled 2 percent of mortgage originations in 2001 and 14 percent in 2006.
Opening up alternatives
Not long after Washington started to push affordable housing, it also opened up new lending options for banks. In 1980, Congress passed the Depository Institutions Deregulation and Monetary Control Act (DIDMCA). According to Dennis Hoffman, a W. P. Carey School professor of economics, "In an attempt to stem the tide of disintermediation from certain banks, it allowed greater competition for deposits by raising the ceiling on deposit interest rates. S&Ls were allowed to offer credit cards and pursue trust business. "
Plus, DIDMCA freed up lending institutions, particularly savings and loans. "It allowed them to be much more aggressive across their balance sheets in terms of the loans they could make, the people they could lend to and the deposits they took in," Hoffman notes. "That, in turn, prompted banks to take more risks as competition with traditional banks heated up."
He adds: "We turned pretty conservative S&L businesses into some highly leveraged, gambling outfits."
Another act that, in retrospect, perhaps acted against our financial interests was the Alternative Mortgage Transactions Parity Act of 1982. Prior to it, banks could only make conventional, fixed-rate mortgage loans. With its passage, banks were given more lending options.
Sanders says he has no problem with the 1982 act, which allowed banks to develop options such as adjustable-rate mortgages and price-level adjusted mortgages. He explains: "The fixed-rate mortgage does not perform well in high-inflationary times." According to him, banks were getting crushed by holding mortgages that paid 6 percent, while the cost of money was much higher. Here, again, "The legislation was put in with good intentions," he says. But, adjustable-rate mortgages, though not inherently bad, do beg for "tighter underwriting. They are not for everyone, particularly borrowers with erratic income."
Such underwriting wasn't demanded. At the same time, new, unregulated investment vehicles began to emerge.
"The major problem that brought things crashing down was the market for credit-default swaps," says the W. P. Carey School's Mittelstaedt. "This is a financial instrument that basically sells insurance on mortgage-backed securities. The securities themselves going down was a big problem. Worse, a huge amount of money was in the credit-default swaps."
How much? MarketWatch places the figure at more than $50 trillion. In contrast, the 2008 CIA World Fact Book claims a gross domestic product of $13.8 trillion for the United States, the world's largest economy.
Credit-default swaps are the most widely traded credit derivative product, but are only as good as the models underlying them. Sanders, in a recent paper, showed that most derivative and hedging models were wrong when it came to house prices and defaults; when house prices slowed and began to fall in 2006, defaults on subprime mortgages accelerated far more rapidly than any historically-based pricing or hedging model predicted. In 2002, financial legend Warren Buffett called such derivatives "financial weapons of mass destruction." Now we know why.
"There was no oversight, no reporting, no understanding of the magnitudes of credit-default swaps that were out there," says Herbert Kaufman, vice chair of the W.P. Carey School's Finance Department.
Congress passed the Commodities Futures Modernization Act in 2000. It deregulated the market for credit-default swaps.
Kaufman says the few regulations that were in place "were not strictly enforced." And, until recently, investment banks were allowed to use much more leverage than they're permitted today. Some held just $1 in capital backing up $28 or more of assets, he notes. Yet, few outside their own boards, perhaps, knew the institutions were so highly leveraged. "There was an overarching lack of transparency."
"For a free market to function well, you need information and, in the past several years, we have not had enough information," Kaufman continues. Going forward, he calls for "much more intelligent regulation" that delivers "more transparency and oversight," but doesn't strangle market players.
Mittelstaedt is in favor of regulation that takes a broader view of companies. For example, he point to AIG being evaluated as an insurance company, where regulators in each of 50 states might look at the company "very narrowly. They look at policies written in their own state and whether the company has sufficient reserves to handle losses with those specific policies. But, who's looking at the whole company?" It was the failure of just one, high-risk piece of AIG that "put the whole company at risk."
Sanders thinks there should be a requirement that banks "post some capital for the loans they originate." According to him, when mortgage lenders sold their loans into the secondary market, they also sold the risk. There was a disconnection between the actions of making a loan and suffering the consequences of loan defaults.
"We didn't have banks post sufficient capital backing up these loans." So, for example, if the initiating banks had to take on the first 10 percent of losses on loans that default, they would make fewer really risky loans, he maintains.
He's also concerned about TARP's increase of depository protection provided by the Federal Depository Insurance Corporation. By upping the insurance from $100,000 to $250,000 through the end of 2009, he says: "We're providing more incentive for banks to take on risks." And, although he's a self-affirmed free-market guy, he says this move means "the FDIC should have mandatory national banking guidelines on loan underwriting -- because taxpayers are on the hook."
In addition, Sanders thinks it may be time to nix the Community Reinvestment Act. "The worst thing you can do is take low-income households and have them invest all their money in housing. When the housing market tanks, they're worse off than they were when they began," he says. In fact, he made this argument back when Michael Dukakis ran for the U.S. presidency.
In another blast from the past, Herbert Kaufman favors privatizing Fannie Mae and Freddie Mac. "People started talking about privatization in the mid-1980s," he says. "Yet, every time legislation was introduced over the past 20 years, nothing ever came of it."
Given recent events, perhaps something will come of such efforts now.
A number of laws and political choices, though well-intentioned, paved the way for today's credit crisis.
These laws include a 1977 act that aimed to end discriminatory mortgage lending by encouraging loans to low-income borrowers, a 1992 bill that put Fannie Mae and Freddie Mac into the business of buying subprime loans, plus bills ending usury laws and opening up alternative-mortgage options.
Lack of regulatory oversight -- and resulting lack of transparency -- also contributed, particularly where credit-default swaps are concerned.
Credit-default swaps, an unregulated derivative investment vehicle, were backed by subprime loans and proved toxic to many financial institutions.
Lenders, investment banks and investors around the globe based their pricing and hedges on assumptions fundamentally changed between house prices and subprime defaults.