Recognizing that monographs have been written on the mortgage market meltdown and the foreclosure crisis by more astute economists than myself, my own sense of intellectual honesty as someone who readily regards himself as an economic theorist and analyst still demands that I contribute at least some explanation of these events in the present context. The purpose of this account, in following from my previous entry, is to assess the history behind the events on the ground in places like Springfield that continue to display relatively high rates of foreclosure on residential property. Again, my intention here is not to absolve foreclosed homeowners of responsibility for their own situation and the broader economic crisis arising from the meltdown. Rather, I mean expressly to say that we cannot place all of the blame in their hands.
We need to situate the culpability of borrowing households in relation to that of the primary mortgage issuers, the secondary mortgage market actors, more distant institutional investors in mortgage backed securities and collateralized debt obligations, Federal Reserve governors as guardians of the banking sector's welfare, and the government executive/regulatory and legislative agents facilitating the unfolding of this entire process. In view of this constellation of agents, how, in particular, did we get to a point where the number of foreclosures and the percentage of bank-owned housing stock, nationally and in individual, regional markets, has arrived at its current threshold level?
My answer to this question, as with everything else in this blog, will not pretend to reflect absolute and universally objective truth. Social science is not about expressing absolute and universal truths, but about making arguments that are intended to clarify a social problem in such a way that the agenda embodied by the theorist/analyst might be advanced in the problem's resolution. No theorist is without an agenda. Succinctly, I aim to portray the events leading up to the foreclosure crisis to show that, left with the independence to steer the financial sector in particular directions that would maximize short term returns at the expense of generating extreme sources of financial volatility, housing market financiers inflicted significant damage not only on the U.S. economy but on the global economy writ large. Moreover, given the fact that no tangible statutory or regulatory actions have been taken to reign in these actors (and, notwithstanding the best efforts of Elizabeth Warren and John McCain to reinstate the Glass-Steagall Act, there does not appear to be any chance that the appropriate steps will be taken to separate commercial and investment banking), there is no indication that the actions of financial sector agents will not produce new economic crises emanating from mortgage markets in the near future.
Financial Sector "Reform" and Its Effects on Capital Investment in the Housing Sector
In the late 1990s, financial sectors in multiple national contexts were engaged in an aggressive wave of mergers and acquisition, resulting, especially in European financial sectors, in the creation of universal banks, simultaneously incorporating commercial banking activities, investment banking, and, at least in some cases, insurance. The apparent benefits from the consolidation process per se arose, typically, from the potential to decrease consumer service redundancies in branch banking, reducing manpower requirements. The appeal of the universal banking model, on the other hand, arises both from the capacity to place a wide range of, in the U.S. context, traditionally unrelated financial services all under one roof and the capacity to more fully integrate capital investment strategies through securitization (i.e. developing new financial instruments so that financial market agents can gamble on economic activities traditionally excluded from financial exchanges) to target traditional retail banking markets (e.g. mortgage issuance). American banks were, however, constrained in moving in this direction by the terms of the Glass-Steagall Act of 1933, which legally prohibited the intermixing of commercial and investment banking (i.e. issuance and underwriting of securities). As European universal banks continued to increase in size and integration of domestic operations across multiple EU national economies, American banks could only watch and complain to Congress of their inability to compete and pursue the sorts of financial process innovations that the universal model held out.
A cry went up across the land to preserve the competitive character of the American financial sector against foreign competitors. The structure of financial sector regulations dating back to the Great Depression was no longer adequate to the turbulent, fast-paced world of 1990s global finance. It was not enough for American investment banks to integrate new technologies to track financial exchange transactions in real time or for commercial banks to integrate full service online consumer functions - they needed to push the organizational envelope by opening up commercial banking for radical expansions in the flow of capital from financial exchange operations. The Clinton administration, with its high-flying Wall Street innovators at Treasury (e.g. Secretary Rubin), agreed completely. So did two Republican houses of Congress, who may have been utterly incapable of seeing eye-to-eye with Clinton on his sex life or his grand jury depositions, but obviously saw a mutual interest with the administration in doing Wall Street's bidding. Thus, against the best efforts of many conscientious Congressional Democrats who (rightly) saw danger in diverging from time-tested Depression-era restrictions, the Gramm-Leach-Bliley Act of 1999 was passed, eliminating the firewall between commercial and investment banking and opening the U.S. financial sector to universal banking. Not only could American banks harmonize their strategies in appealing to retail consumer markets for traditional banking products and financial market investments, but capital could readily flow into banking markets to expand lending opportunities in traditionally undercapitalized areas.
Under the effect of Gramm-Leach-Bliley, the secondary market for mortgages, pioneered by the government sponsored secondary lenders Fannie Mae and Freddie Mac, exploded, nurtured by the influx of high-powered global capital. As a further consequence, special purpose home mortgage issuers, like Countrywide Financial, assumed a greater prominence in mortgage markets because the expansion of secondary markets opened up a space for the packaging and resale of mortgages not conforming to acceptance guidelines for Fannie Mae and Freddie Mac based on loan limits for housing categories and loan-to-value ratios on property (i.e. down payment requirements). Such special purpose lenders aggressively targeted the highly under served, undercapitalized field of subprime lending. Borrowers in this field typically lack enough accumulated wealth to meet loan-to-value guidelines for Fannie and Freddie and have low credit ratings, reflecting past repayment of debts including late payments and outright default or bankruptcy. In other words, they intentionally concentrated on mortgage submarkets for households that had no business purchasing residential property and, under conventional rules, would have been entirely locked out of the mortgage market. They did so because secondary mortgage markets were awash with new sources of capital, divorced from guidelines established to protect the investment of financiers from elevated risks of default, and because they were able to manipulate the terms of mortgage agreements to make the terms both extremely attractive at the outset for the borrowers and extremely profitable over the term of the mortgage, in relation to conventional, conforming mortgages, for the financiers.
Before moving on to see how they did it, I want to first survey the field of battle in 1999. To one side, we have hundreds of thousands of low to lower-middle income households in rental properties, afflicted with poor credit histories and unable to advance a twenty-percent downpayment or to afford monthly mortgage insurance payments to satisfy the requirements of a conventional conforming mortgage, but otherwise naively smitten with the fantasy of home ownership and all that it confers (e.g. status, capacity to borrow from equity for consumption purchases or to start a business). On the other side, we have big banks (both big commercial banks like Bank of America and big investment banks like Goldman Sachs) , some of which would, one day, be too big to fail, who demanded a reform of the U.S. financial system so that they could become too big and so utterly complex in the scopes of their operations that they could never be allowed to fail by the federal government at the risk of inflicting a doomsday scenario on the U.S. economy. We also have specialty mortgage issuers, salivating at the thought of accessing new fields of capital to exploit opportunities to pull many more subprime borrowers into the housing market. These erstwhile allies are unified through secondary mortgage markets that the Wall Street players had always dreamed of getting into to exploit every last opportunity for high-risk profiteering. Perhaps reluctantly, we have Fannie Mae and Freddie Mac, who thought to play by the rules and did so rather faithfully until they started to cave in on underwriting guidelines for conventional mortgages around 2005 both because the Bush administration pushed the expansion of home ownership as a national priority to be advanced through the government sponsored secondary market players and because non-conventional secondary market financiers were making significant inroads onto their turf. We, likewise, have lots and lots of third party institutional investors (e.g. insurance companies like AIG, pension funds, and offshore hedge funds), in the U.S. and elsewhere, who purchased mortgage backed securities and collateralized debt obligations loaded with subprime and Alt-A mortgage agreements or insured such securities against default through credit default swaps (i.e. they accepted financial hot potatoes in whose values they could never have suspected such a poisonous trap).
Beyond these direct participants in primary and secondary mortgage markets, we have the Federal Reserve Board of Governors and its Chairman Alan Greenspan, who own at least some responsibility for the creation of a housing price bubble between 2002 and 2006 when they initiated significant reductions in their interest rate targets between 2001 and 2004. By making interbank lending extremely inexpensive, they made it possible for banks in areas with aggressive housing market demand to increase mortgage creation activities. When they, subsequently, began increasing interest rate targets in 2004, their actions contributed to the housing market slowdown that inevitably caused prices to crash, leaving millions of homeowners under water in their mortgage obligations relative to the diminished value of their properties. Conservatives and libertarians like to drag out the Fed as a culprit in the mortgage meltdown, in large part, because they object to the idea of using monetary policy (i.e. interest rate manipulation) to stimulate economic growth. I want to reserve a comment against this critique of monetary stimulation until my next post. For now, it suffices to say that the role of Fed in the mortgage meltdown remains rather ambiguous - it needs to be evaluated against the background of longer secular trends in the macroeconomy of the U.S. and its engagement with the global economy.
And then we have the U.S. federal government that wanted to play both sides of the fight in the name of expanded home ownership and open ended financial sector profits in the contemporary age of economic globalization. To the credit of conservatives and libertarians who continuously smell something rotten in federal government interventions in the U.S. economy, the federal government enjoys a great degree of culpability in the financial crisis that stuck the global economy in 2008, but not for the reasons that conservatives and libertarian like to assign. No, the Community Reinvestment Act of 1977 was not the source inspiring a massive influx of capital into secondary mortgage markets after 1999, funding high-risk subprime lending. Wall Street investors did not throw hundreds of billions of dollars into collateralized debt obligations composed of parcelized subprime mortgage assets because the federal Department of Housing and Urban Development put guns to their heads, anymore than did so out of an innate ideological zeal to eliminate redlining against low-income minority communities in the name of interracial harmony and community empowerment. Rather, the prescription of conservative and libertarian voices for the financial sector, to relieve the financial sector of its extraneous limitations on innovation enacted under Glass-Steagall, appears to have most contributed to creating the mix of perverse incentives and moral hazard characterizing primary and secondary mortgage markets before the meltdown.
A Republican Congress eager to accept ready quantities of Wall Street electoral contributions passed Gramm-Leach-Bliley, the enabling legislation for the 2008 financial crisis. And a Democratic president eagerly signed it into law. If Republican George W. Bush deserves palpable quantities of blame for the unnecessary, ill informed, extravagantly expensive (in both financial and human terms), and reckless preemptive U.S. invasion of Iraq, then he at least deserves to be, largely, exonerated of direct responsibility for the debacle in U.S. housing and financial markets that took place under his watch. At the most, Bush can be blamed for too aggressively pushing home ownership for low-income populations and, as such, contributing to a loosening of conforming standards for loan purchases by Fannie Mae and Freddie Mac, ultimately undermining the viability of both these organizations. The larger blame for setting this process in motion, however, falls squarely on the shoulders of one William J. Clinton, once again illustrating how small differences between the Democrats and Republicans actually are when it comes to pandering to Wall Street.
The Mechanisms of Financial Market Disaster
Subprime borrowers are, by definition, at high risk for default on loans. As a result, they must pay higher interest on loans they accept to account for the fact that lenders have an elevated expectation that they will be unable to collect on the full value of their loan - in relation to prime borrowers, subprime borrowers owe a risk premium. The fact that subprime borrowers needed to pay more for mortgages historically kept the scale of subprime lending very small in relation to the total residential mortgage market. In the mid-1990s, subprime lending accounted for only about six percent of the total mortgage market. If the subprime component of the mortgage market was to increase, there had to be institutional innovations that would make subprime borrowing and lending more attractive to both low-income potential home buyers and potential secondary market investors.
The first step in this process was Gramm-Leach-Bliley, opening the door to a much wider range of secondary market investors. The ground level innovations, however, involved the creation of new non-conforming hybrid adjustable rate mortgages (ARM). Such devices combine initial fixed interest rates with adjustable interest rates against a defined price index after a stipulated reset date. Mortgages of this variety enabled lenders to offer relatively low initial fixed interest rates to subprime borrowers, deferring the eventual necessity to pay risk premia as a condition of borrowing. Rather, the risk premium would be assessed after the reset date. In and of itself, there is no reason why, if the structure of such loans is properly understood by borrowers, a hybrid ARM should be so attractive to subprime borrowers that they would revolutionize subprime mortgage lending in the U.S. and generate a dramatic increase in home ownership for low-income groups. The magic of the hybrid ARM is twofold. First, the complex terms of the mortgage agreement, including the initially indeterminate character of interest rates after the reset date, make it possible that the borrower will misconstrue how much he may eventually be paying every month once the loan resets. Second, even if the borrower realistically comprehends the fact that the loan will reset to a much higher interest rate after the initial fixed rate period, he may overestimate the potential to refinance to a lower rate before the adjustable rate sets in. Borrowers might have had reasons to expect that they would be able to subsequently refinance their mortgages, if home prices continued their secular inflation and if individual borrowers' own financial circumstances stood to improve before the reset date.
Approaching from the other side of the desk, the popularity of hybrid ARMs can only be explained by the environment created by Gramm-Leach-Bliley. The creation of a much wider secondary market, especially for mortgages not conforming to the loan standards for purchase by Fannie Mae and Freddie Mac, meant that any mortgage issued could potentially be rebundled with many, many other mortgages at diverse levels of default risk into mortgage backed securities (MBSs) and passed off the balance sheets of the issuing lender. With cash in hand from the sale of MBSs and freed from possession of mortgages that might be expected to result in default after the reset date, lenders could continue the process of writing and rebundling new hybrid ARMs for high risk borrowers. The inherent profitability of such processes (as long as the secondary market constituted a viable source of liquidity for high-risk assets) encouraged subprime lenders to maximize their creation of hybrid ARMs by reducing the formal qualification requirements for borrowers. Specialty mortgage issuers like Countrywide mastered the process of watering down qualification requirements, circumventing basic background checks on the credit worthiness of most borrowers. Why bother to check whether a home buyer is credit worthy if you are going to sell his mortgage to some secondary market investor anyway?
Once on the secondary market, MBSs could be cut up based on the relative riskiness of mortgage assets and rebundled into collaterized debt obligations (CDOs), resold to other institutional investors. Finally, investors holding MBSs or CDOs containing assets at high risk for default could insure their assets by entering into off-balance sheet credit default swaps with other institutional investors. Such securitization processes enabled high-risk subprime mortgage based assets to spread throughout the global financial sector, raising the stakes for the health of housing markets and the continued inflation of home prices. In effect, by increasing their exposure to high-risk mortgage market assets, banks, pension funds, and other institutional investors throughout the global financial sector were playing catch with live hand grenades, somehow convinced, perhaps by their own ignorance of what was going on in primary mortgage markets and perhaps by a faulty and corrupted rating process, by ratings agencies with pecuniary incentives to understate risk, that they were not going to eventually go off in their hands.
Assessing the culpability of all actors at this stage, it is clear that the millions of subprime borrowers who achieved home ownership by accepting the terms of hybrid adjustable rate mortgages had no business buying residential property in the first place. If they were forced to go through the traditional process of mortgage issuance by savings banks or other dominant, pre-Gramm-Leach-Bliley primary mortgage lenders, involving extensive checks on credit worthiness and the necessity to conform to rigorous standards on loan-to-value ratios for repurchase by Fannie Mae or Freddie Mac, then they would have been completely locked out of housing markets. My larger point here is, however, that Gramm-Leach-Bliley transformed both primary and secondary mortgage markets, enabling the meltdown of these markets and overexposure to mortgage based assets across the global economy. Subprime borrowers would never have been enabled to take on unsustainable debt if there were no investors who somehow believed that they could profit handily from lending to them, and the change in statutory standards by Congress, removing Depression-era protections against such capital flows into high-risk mortgage lending, led directly to the creation of such circumstances.
No comments:
Post a Comment