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Fannie and Freddie Did Not Cause This Crisis

by: Mark Thoma October 05, 2008 | about stocks: FNM / FRE    

Mark Thoma

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An article in the NY Times, "Pressured to Take on Risk, Fannie Hit a Tipping Point," is causing many people to wonder if Fannie (FNM) and Freddie (FRE) caused the financial crisis.

First, let me clarify the question. We are asking what caused the housing bubble, and, by definition, the cause cannot be explained by changes in an underlying market fundamental. I don't mean that we can't point to, say, a rumor that led to a rapid increase in the price of some goods as speculators rush in, just that bubbles - by definition - are divorced from market fundamentals.

I think a more interesting question is what sets the stage for a bubble to emerge - what allows the rumor, irrational exuberance, etc., to express itself as a bubble? One thing that is needed is liquidity and credit, some way of substantially increasing demand. This is the air that inflates the bubble. Even if all the other conditions for a bubble to emerge are present, if there is no way to inflate the bubble - no way for speculators to rush in and drive up the price - then it won't inflate.

We already know that there was enough available liquidity to inflate a housing bubble. So something went wrong in these markets that allowed the bubble to emerge and then pop, and this is causing us immense problems right now, but what was it?

I think the most important factors are agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system.

With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a bank or mortgage broker, either one.

Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.

If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans.

The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.

Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.

A solution to this is to give each person in the chain a stake in the future outcome of the mortgage. If mortgage brokers' income had been connected to a financial instrument that pays off according to the future performance of the mortgages they write, would they have behaved differently? Probably. (What about homeowners, why didn't they say no? Don't they have a stake in the future price of the home? Homeowners in non-recourse states - and more generally - were basically granted cheap options on their homes. The downside was protected and they had no reason to effectively monitor risk. If prices fell, they could just walk away and know that their other assets remained safe and that their credit reputations could be restored with time. Of course, if everyone walks away other assets such as retirement savings don't remain safe, but that doesn't change the incentive on an individual level.)

Ah, you say, but as you go up the chain why didn't people refuse to take the financial paper, why didn't they conclude it was too risky? The risky mortgages don't have to be stopped at the bottom, this is a linked chain, so why weren't they stopped higher up in the chain where the stakes are higher? Isn't that where Fannie, Freddie, and moral hazard rear their ugly heads? Did they encourage and allow this risky paper to pass through the system?

The mis-pricing and mal-distribution of risk played a key role here (along with poor management decisions in cases where alarms were raised). The agency issues above, and the consequences of the failure to predict and distribute risk are much more important than any moral hazard issues arising from the implicit government guarantee granted to Fannie and Freddie.

Institutions in the shadow banking sector were willing to take large volumes of risky loans as they came up through the system. Why?

The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. As Brad DeLong notes:

  • There is $11T of U.S. mortgages.
  • There is $60T of global financial assets.
  • Even if we had $2T of losses on mortgage-backed securities that shouldn't pose a big problem for Wall Street--actually 48th and Park Avenue.

So if the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of $2T - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the mis-prediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.

Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped.

But back to Fannie and Freddie. The willingness of the non-traditional banking sector - the shadow banking system - to take on these risky assets and still pay investors a relatively high return put tremendous pressure on Fannie and Freddie to follow suit. And their response was unwise - Fannie and Freddie followed the shadow banking sector downward.

There is lots to fault in the behavior of Fannie and Freddie and in government oversight of them - the decisions of management, the lobbying efforts that were funded by their ability to extract a premium from the implicit government guarantee - all of this was a big problem. The bubble, and later the financial crisis expressed itself in these institutions, and they may have also contributed to it to some extent as they took on more risky securities when their business began to go elsewhere.

But the agency issues and the failures of risk models and securitization would have created problems in the largely unregulated shadow banking sector even if these two institutions had taken on nothing but the safest of mortgages. The bubble still would have inflated in the shadow banking system - maybe it's a little smaller, I don't know - but it still would have been large enough to cause big problems when it burst.

The best behavior of Fannie and Freddie would not have been enough to stop the bubble from inflating in other parts of the financial sector, and then turning into a full fledged financial crisis as housing prices plunged.

The problems we are having were caused when lots of available liquidity rushed past the checks and balances that a proper agency provides in pursuit of promises that risk models and complex securities did not deliver. The unexpected losses alone might not have caused a crisis had the losses been widely distributed, but, the losses were concentrated and hidden in ways that created widespread fear and threatened the entire system. Getting rid of that fear is not going to be easy.

Update: Given some of the responses elsewhere to this post and others like it, let me add one more thing. Asking the question "what caused the financial crisis," thinking about it, and then arguing that Fannie and Freddie were not the primary driving forces behind the financial meltdown (though they could have affected the size of the problem as noted above) is not the same as defending Fannie and Freddie.

Whether or not Fannie and Freddie are performing a useful function, and if they are performing a useful function how they should be structured going forward is not a question I've fully resolved. The market failure they are addressing is not entirely evident to me, and until I understand how they improve the efficiency of these markets, I won't take a position.

They certainly should not operate as private entities with an implicit government guarantee as before - that's what set up the situation where the implicit guarantee could be exploited profitably and used to fund lobbyists and ad campaigns to make sure the golden goose kept laying eggs. However, I have posted arguments from other people arguing for their existence, and I am thinking about those as well as arguments against their continuation.

In any case, something to guard against, I think, is to inappropriately blame Fannie and Freddie for the financial crisis and then use that as a reason to shut them down irrespective of any useful function they might serve. So when I see those with an agenda against government intervention trying to do just that - arguing honestly in some cases and dishonestly in others that Fannie and Freddie were a big factor in the crisis so they can use them as an example of government intervention gone awry and also shut them down - a double bonus in their eyes - I have tried to present evidence and arguments that the cause lies elsewhere.

But as I said, that is not the same as defending their existence. My interest is in understanding the true cause of the financial crisis and in stopping it from happening again - and to avoid getting stuck on wrong arguments along the way - not in using the crisis to argue about whether Fannie and Freddie ought to continue as government supported institutions. That can wait for another day.

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This article has 82 comments:

  •  
    Oct 05 08:06 AM
    Agents respond to incentives. FNMA and Freddie set up the incentive to allow unqualified borrowers to apply for loans. THESE AGENCIES SOUGHT SUBPRIME AND ALT-A PAPER in order to expand low income and minority home ownership at the request of the Democrat controlled oversight committees in Congress. To put the blame anywhere but on those who started the chain -- ON PURPOSE -- smacks of malpractice as a financial writer. How typical of the Democrat Party to believe it proper that someone else should pay for their lovely ideas.
    Reply
  •  
    Oct 05 08:34 AM
    RebMarketMaker Pulpit Says, Great Point Of View...But $hit happens & it all caused the start of a bank not lending or trading, i.e. LIBOR...Hencefore a financial mother of a global level stampede, & it is not very far from over, there has already been allot of spilt milk hyannis like blood out there...& it could go either way up or down, but not for to much longer, i mean sooner rather then later, it will be back to big ass biz as usual...for the rea! big guys, & just rementioning, Go Figure...it has all become a free for all irrational market place...& i guess just about anything goes...to & for & by, the ever changing "casino like" house always win$, like rules...i agree with the Dick Grasso & Ken Langone, best of best ever interviews with, Neil Cavuto on Fox Business News,
    Reply
  •  
    Oct 05 08:36 AM
    Look, they are not alone in causing this mess, they had many helpers, both in the market and in Congress. That said, they are clearing culpable for their contribution, and were horribly mismanaged, and our politicians rather than siding with 'caution' panicked and threw all restraints to the wind.

    You can say they were not a major part of the problem, but they also were not sole cause of it.
    Reply
  •  
    Oct 05 08:43 AM
    Ridiculous cop-out by Thoma. Even Barney Frank acknowledges Fannie was the problem but is trying to evade responsibility with a big lie.
    On O'Reilly's "The Factor" , Barney Frank claimed he was not responsible for the Fannie, Freddie debacle because from 1995 to 2007 his party was in the minority on the Housing Committee and he had no power until he became Chairman on Jan. 31, 2007.
    This is a Big Lie.
    For Your Information;
    You should be made aware of the following facts that O’Reilly did not have.
    During that 1995-2007 period Barney Frank was not powerless but had DE FACTO CONTROL of the Housing Committee on matters concerning Fannie, Freddie and sub-prime mortgages.
    Barney Frank was the ranking member and had all the Dems on that committee voting with him as a block and intimidated a few vulnerable Republicans with threats of racism unless they voted with him on matters concerning Fannie and Freddie.
    This gave Frank the majority he needed and DE FACTO CONTROL of the Housing Committee.
    Unfortunately, O'Reilly's staff didn't equip him with this information.
    The bottom line though is Barney Frank, all the Dems on the Housing Committee and Franklin Raines are the prime culprits in the Fannie, Freddie, sub-prime disaster.

    Paraphrasing the WSJ Sept 9, 2008 DEMS and BARNEY FRANK USE FANNIE MAE AS THEIR PIGGY BANK
    "But the biggest payoff for Mr. Frank is the "affordable housing" trust fund he managed to push through as one political price for the recent Fannie reform bill.
    This fund siphons off a portion of Fannie and Freddie profits -- as much as $500 million a year each -- to a fund that politicians can then disburse to their favorite special interests".


    Reply
  •  
    Oct 05 08:56 AM
    Great article though time consuming to read and digest. Let's cut to the chase and sum up the problems. The problem is giving loans to people who did not have a dog in the loan like putting a down payment for the loan. It has been proven many times in the past that when you give someone something for free like the housing projects that the government built then the people will not respect or take care of what they have. If they have a dog in the race like their own money being spent for something then they will take care of it. It is very simple.
    Reply
  •  
    Oct 05 08:57 AM
    All the "experts" are doing the Monday Morning QB, but I have yet to see who will lose their jobs and/or be indicted as co-facilitators in this financial collapse. I'm saying now that FEW, IF ANY, CONGRESSMEN will be voted out of office NEXT MONTH.
    NO WALL STREET SUB-SLIME VULTURES who ran stocks into the ground by FALSE RUMORS & NAKED SHORTING will be prosecuted by SEC.
    NO WALL STREET EXECS will be fined/punished/suspend...
    Power & Influence runs America and those who perpetrated this scam/fraud on the taxpayers will prove to be insulated from personal risk and above the law..........
    IMHO
    Reply
  •  
    Oct 05 09:02 AM
    well frannie did go hog wild to generate big bonuses for the managers, but problem was caused by predatory lenders who grabbed their big fat fees & ran off (to the cayman islands?) with them.
    > jack
    Reply
  •  
    Oct 05 09:03 AM
    The article said nothing about Democrat or Republican. Insiderman your comment only illuminates you and not one of the relevant issues in the article (i.e., the percentage of responsibility for the bubble attributable to Fannie and Freddie). Part of what caused the agency failures in this crisis is a lack of reasonable public discussion focused on issues placed in a proper heirarchy. These get entirley lost as commentary is devoted to rewriting the past and, in this case, rewriting an article that made a truely legitimate attempt simply to be logical and analytical. It is well known that Fannie and Freddie did not start the subprime securitized/derivative... market. The subsequent entry into that market was not necessarily a significant structural event in the chain. Ask yourself these questions: Why is blaming anyone but a member of your party so important? Why is convincing yourself and the public of the benefits of a blanket ideaology more important than fixing a world wide financial crises? Finally, how can you ignore the widely disseminated information that Fannie and Freddie were manned by members of both parties and Fannie and Freddie successfully lobbied both parties?
    Reply
  •  
    Oct 05 09:03 AM
    The people voted for a new Congress in '94 when they found out that Congressmen were using their in house post office as a piggy bank.
    Maybe they'll do the same when they realize Congressmen were using Fannie & Freddie as thier private piggy banks
    Reply
  •  
    Oct 05 09:10 AM
    Fannie, Freddie, and government regulations and incentives to promote home ownership are, in my mind, one giant government hand of intervention. Wall Street's model had problems, but it was government that chose to sanction that model to fit a social agenda. However, all of this is just the symptom of the disease.

    The real cause of the bubble was cheap money created by the Fed. Without that money, Wall Street couldn't have created so much credit and government intervention wouldn't have proved as large a problem.
    Reply
  •  
    Oct 05 09:14 AM
    Sound bites from a hearing of the Socialist Republic of the United States:
    (minutes in extenso tinyurl.com/3g8hmn )


    Quote

    H.R. 2575—THE SECONDARY
    MORTGAGE MARKET ENTERPRISES
    REGULATORY IMPROVEMENT ACT

    Thursday, September 25, 2003
    U.S. House of Representatives,
    Committee on Financial Services,
    Washington, D.C.


    Mr. FRANK.
    …welcome the fact that we have in Fannie Mae and Freddie Mac a means of bringing down housing costs…Fannie Mae and Freddie Mac are sufficiently secure so they are in no great danger…I don't think that we have an impending disaster….
    Mr. KANJORSKI.
    …We must also ensure that the GSEs continue to achieve their statutory obligation of advancing affordable housing opportunities for low-and middle-income families…
    Ms. WATERS.
    …we do not have a crisis at Freddie Mac, and in particular at Fannie Mae, under the outstanding leadership of Mr. Frank Raines. Everything in the 1992 act has worked just fine
    …not to impede their affordable housing mission, a mission that has seen innovation flourish from desktop underwriting to 100 percent loans.
    …In 2002 alone, Fannie Mae provided $279 billion in credit serving low-and moderate-income households.
    …since the inception of goals from 1993 to 2002, loans to African-Americans increased 219 percent and loans to Hispanics increased 244 percent, while loans to non-minorities increased 62 percent.
    I am opposed to a new bureaucracy at HUD to track sub-goals. We should focus on those banks, many of them competitors of these GSEs, who avoid CRA and practice predatory lending.
    Mr. NEY.
    …The United States mortgage and credit markets are the envy of the world.
    …This agency has an important role in ensuring our nation is focused on providing decent and affordable housing for all Americans.
    Mr. BACA
    …One reason Fannie Mae has been successful is because the current status encourages them to be innovative… to be proactive in reaching out to low-income families…
    …we should not interfere with GSEs ability …to meet the needs of low-income families in underserved areas
    …GSE must …fulfill the responsibility of their congressional charter and housing mission.
    STATEMENT OF FRANKLIN RAINES, CEO, FANNIE MAE
    Mr. RAINES
    Today Fannie Mae is one of only two companies in America to guarantee the nationwide flow of low-cost mortgage capital at all times, even when other suppliers of mortgage capital cannot or choose not to provide such capital.
    …Fannie Mae has amassed over $30 billion of private equity capital to finance $2 trillion of mortgages today.
    …In 1994, we launched our trillion-dollar commitment, a pledge to provide $1 trillion in financing for 10 million underserved families before the decade was over.
    …In 2000, after we met this pledge, we launched a redoubled new pledge, our American Dream Commitment, to provide $2 trillion for 18 million underserved families before this decade is over.
    …lead the market in serving minority families. We pledged to provide $420 billion to help serve 3 million minority families…Fannie Mae boosted our pledge to $700 billion
    …Our senior debt of course is rated AAA.
    …It is by having new programs, with low down payments, and with the ability to deal with people with impaired credit and other innovations that have really allowed us to expand affordable housing.
    …we are one of the only people who will buy mortgages on Indian reservations that are governed solely by the Indian judicial system…
    …every time we had a new idea, a new activity, a new product, we had to go and get prior approval, that would … slow the process down…will bring innovation within the housing finance industry to a screeching halt.
    Mr. BACA.
    …I particularly want to thank Frank Raines…The work you do in the Latino community is very important. Both companies have impressive track records of expanding minority home ownership…
    Mr. FRANK.
    I don't see any financial crisis. You can always make things better, but I do think we should dispel the notion that we are here because there is something rotten that has gone on.
    Mr. RAINES. We are vitally committed to our housing mission…it is our number one priority.
    …Our housing mission, however, does require us to raise capital around the world. Our investors invest in Fannie Mae not because they necessarily share our housing mission, but because they think that Fannie Mae will be a good steward of the capital.
    Mr MILLER
    …either considering safety and soundness or considering how to make credit available…among…racial and ethnic minorities and just low-wealth families in general.
    EXECUTIVE DIRECTOR, INSTITUTE FOR OPPORTUNITY AND EQUALITY, NATIONAL URBAN LEAGUE
    Mr. SPRIGGS
    …the size of the securities and mortgage-backed security instruments issued by GSEs is …a little larger than the U.S. Treasury-note market. And so that means that all of us should be concerned about the safety and soundness of these enterprises, and that they are very important to the security of the American economy, if not the world's capital markets.
    …However, it is equally important to remember why Congress created the GSEs…to establish increasing access to home mortgages for underserved areas, and this mission must remain paramount in assessing different measures of safety and soundness…

    Unquote

    Have a good day
    Reply
  •  
    Oct 05 09:15 AM
    Whole heartedly agree that the "agency" issue is at the heart of the problem. However I would disagree slightly on two points. The consumer, in affect the home buyers, are motivated by simpler reasons based on baser criteria. The desire to own a home and participate in the widely promoted benefits there in. Consumers have been told for a long time that renting is waisting money and home owneship confers the triumverate of benefits, equity, appreciation, and tax deductible expenses. Naturally the average person would leap at the chance to purchase when it becomes more available through lowered lending standards and cheaper down payments. While not blameless, it is disengenuous to now impose the standard of frugal and puritan morality on the masses of people who took advantage of a buying opportunity. Likewise, it is not so unthinkable that Democratic politicians would encourage enlarging this fiasco to less fortunate consumers, when confronted with the frenzy of inflating home prices and increased purchases, however unwise it was.

    Indeed, the agency problem extends throughout the context of the situation. Perhaps another word to describe this is unfettered greed. Selling more snake oil without haveing to answer to anyone. It would seem disengenuous indeed to then blame the buyers for not knowing better than to buy the snake oil. Some of us will manage to avoid the traps, some can afford to avoid the trap, buy many gullibles are waiting in line for the next promise of improving their lot. Someone simply needs to regulate the snake oil salesman a little more closely, at all levels of the product chain. Fannie and Freddie, should have known better, but in the end the GSE's were just another cog in the system facilitating the spread of the contagion, failing to balance the chartered purpose against the pittfalls of agency greed.
    Reply
  •  
    Oct 05 09:29 AM
    Ultimately, de-regulation allowed investment bankers to apply their complicated financial models w/ uber-leveraging in the mortgage industry. Sort of like giving Dr. Frankenstein the night shift at the morgue.
    Reply
  •  
    Oct 05 10:11 AM
    Cybercorrespondent is correct. Amazingly enough, it's clear that the sheeple are going to elect the man of the two party nominees that can be DIRECTLY tied to financial crisis. Obama and his gestapo of community organizers led by Franklin Raines are going to take over the executive branch.

    The media has shamed McCain into running a Dole-style, gentlemanly campaign, referring to Obama as "Senator Obama" and completely failing to link Obama to the Black Liberation movement, reparations for slavery, and the Community Reinvestment Act.

    McCain has run the least inspiring, least gutsy campaign since 1996, and he's going to lose and electoral landslide.
    Reply
  •  
    Oct 05 10:12 AM
    What position in an Obama administration are you shilling for?
    Reply
  •  
    Oct 05 10:34 AM
    wow. i feel sorry for the 4 daughters being raised by the joseph goebbels. but i'm sure they will turn out as well as gov. palin's kids. then he'll be "raising 4 grandaughters" in no time.

    the actual TRUTH is that it's McCain who's got the party ties to Fannie and Freddie.

    the smears about obama ties to ex-Fannie and Freddie execs (inc. Franklin Raines) are just more Rep. swiftboating LIES.

    "The non-partisan fact-check website Snopes.com looked into these smears, and their conclusions about Barack and the Fannie Mae executives shouldn’t be surprising: “None of them has (or apparently ever had) ongoing roles with the campaign as chief economic advisors.”

    Not an adviser: Frank Raines
    Barack estimates that he and Raines have talked for “maybe five minutes” in their lives, and Frank Raines himself even released a statement saying that he is “not an advisor to Barack Obama, nor have I provided his campaign with advice on housing or economic matters.”

    Not an adviser: Tim Howard
    This supposed connection appears to have been made up completely out of thin air. Snopes.com writes, “We haven’t yet found any tangible connection between Tim Howard and the Obama campaign, however, much less any information supporting the claim that Howard is a ‘chief economic adviser’ to Obama.”

    Not an adviser: Jim Johnson
    Jim Johnson has never held a paid position with Obama for America. He volunteered to help Barack select a vice presidential nominee but stepped down after just one week."


    fightthesmears.com/art...
    Reply
  •  
    Oct 05 10:54 AM
    Yea I agree what position in the Democratic party are you looking for? Obama's full name is Obama Freddie and Fannie Barack. But thankfully the Repulicans stripped the control of Fannie and Freddie from the Democrats not able now to give futrure free money to all minorities who don't have the money to pay for the big house they got. Lets see now if the democrats push to lower the cost of these big homes to give minorities more free money to keep their big house for peanuts.


    On Oct 05 10:34 AM Art Rimbaud wrote:

    > wow. i feel sorry for the 4 daughters being raised by the joseph
    > goebbels. but i'm sure they will turn out as well as gov. palin's
    > kids. then he'll be "raising 4 grandaughters" in no time.
    >
    > the actual TRUTH is that it's McCain who's got the party ties to
    > Fannie and Freddie.
    >
    > the smears about obama ties to ex-Fannie and Freddie execs (inc.
    > Franklin Raines) are just more Rep. swiftboating LIES.
    >
    > "The non-partisan fact-check website Snopes.com looked into these
    > smears, and their conclusions about Barack and the Fannie Mae executives
    > shouldn’t be surprising: “None of them has (or apparently ever had)
    > ongoing roles with the campaign as chief economic advisors.”
    >
    > Not an adviser: Frank Raines
    > Barack estimates that he and Raines have talked for “maybe five minutes”
    > in their lives, and Frank Raines himself even released a statement
    > saying that he is “not an advisor to Barack Obama, nor have I provided
    > his campaign with advice on housing or economic matters.”
    >
    > Not an adviser: Tim Howard
    > This supposed connection appears to have been made up completely
    > out of thin air. Snopes.com writes, “We haven’t yet found any tangible
    > connection between Tim Howard and the Obama campaign, however, much
    > less any information supporting the claim that Howard is a ‘chief
    > economic adviser’ to Obama.”
    >
    > Not an adviser: Jim Johnson
    > Jim Johnson has never held a paid position with Obama for America.
    > He volunteered to help Barack select a vice presidential nominee
    > but stepped down after just one week."
    >
    >
    > fightthesmears.com/art...
    >
    >
    Reply
  •  
    Oct 05 10:58 AM
    Oh, Good Grief!

    All this finger pointing makes me ill. Look, BOTH presidential candidates had/have ties to a myriad of agencies, people, entities, who had a hand in the making of the current situation. No reasonably intelligent person can say that this whole crisis was "unforseeable&quo... people saw it coming, and, as the author of this article states, much of the momentum was provided by brokers who decided to ride the gravy train and then leap off at the last second. Collectively, we are ALL responsible for this, and collectively, we all have to swallow the dern medicine and recover. Face the facts and get on with things, already.
    Reply
  •  
    Oct 05 10:59 AM
    One factor that seems to be overlooked in this and most analysis is the profit motive that drove sub-prime and Alt-A lending. Everyone in the chain – Loan Officers, Mortgage Brokers, Retail and Wholesale Mortgage Bankers, Aggregators, Securitizers (which includes FNMA and FHLMC) and Broker/Dealers – all parties made more money on higher risk business than lower risk business. At least, that was the case before the bubble burst. And, after the bubble burst, not all parties had an equal stake in the performance of the assets. Arguably, Loan Officers and Mortgage Brokers have zero liability for the performance of the product that they originate, aside from the possibility that they could lose their job.
    The simple fact is that there was more money to be made by talking a borrower into a zero down payment stated income loan than a fully documented loan with a healthy down payment. The same can be said about Payment Option ARMs, loans with prepayment penalties, Non-Owner Occupied loans, etc. So, not only could an originator make more money because they could do more loans with aggressive guidelines, they could make more money on each loan when a more aggressive loan program was used.
    It has become typical over the past decade or so to originate loans with no fee or minimal fees charged to the borrower. So how did everyone make money in the loan origination business? The asset must be worth more than face value in order for everyone in the daisy chain to make money. As is typical with all fixed income instruments, there is a price/yield tradeoff. A higher rate instrument is worth a higher price. This relationship is not linier in mortgages, however, because as rate increases, prepayment risk increases, and the prospect of realizing the benefit of higher yield over time decreases. So, an end investor will be reluctant to pay more and more for higher and higher rate loans. Typically, fixed rate fully documented, low loan to value A-paper mortgages with no prepayment penalties tend to “top out” somewhere around 103% of face value, including the value of servicing. That means that if the borrower is not charged a fee, there is 3% of the loan balance to split between all of the players in the chain. By contrast, Alt-A, Payment Option ARMs and sub-prime loans were worth far more than less exotic loans before the bubble burst. Payment Option ARMs received whole loan bids as high as 106% of face value in 2005. True sub-prime loans reached prices as high as 107% earlier in the decade.
    This pricing phenomenon motivated many players in the industry to focus on higher risk products and build incentive and compensation systems to drive business to these product categories. The borrower wants to put 20% down and can fully document income? Why not explain the advantages of higher leverage, lower payment structures, maybe point out that they “qualify” for a much more expensive house than the one that they have in mind if they employ modern financing techniques?
    This profit motive was a huge part of the equation, and FNMA and FHLMC were no exception. Higher risk products earned the GSE’s higher guarantee fees and allowed them to compete for market share between themselves and the GSE alternatives (Wall Street Broker/Dealers).
    Reply
  •  
    Oct 05 11:05 AM
    The problem is with leverage and derivative products. It's not just the fault of too many subprime loans and the irresponsibility of the securitization process.

    I'd lay much of the blame with the SEC and the 2004 decision to permit investment banks with brokerage units to borrow more than permitted. That is the cause of 30:1 leverage and obscene risk-taking.

    I would also fault the total lack of regulation of insurance company parents, who seem to have skipped state and federal regulation altogether in a rush to issue "insured" products that were technically not "insurance." It's those products, with swaps and instruments originally intended to limit risk ($40 trillion, or so, give or take), that are causing the meltdown concern, not the few trillion we may expect from defaulted ALT-A and subprime mortgages.

    The total failure of the regulators to have seen this coming means that we will now have a lot of well-meaning regulation in future which will stifle economic growth.

    And I doubt that new regulators will be any smarter than their predecessors in addressing the next crisis: the default of municipal and state governments on issued debt. Just as with Fanny and Freddie, the politicians will be afraid to touch this until it explodes.

    LordDarley



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    Oct 05 11:05 AM
    Fannie and Freddie are 100% at the center of the mortgage mess...and the process began in the early to mid-1990's. To say anything else is to deny the actual facts and shift all accountability from the top of the financial/governmental... ladder.

    Every lender in the system looks at F/F and either based their lending on the F/F AUS system, ot they design their business model to operate just outside of the F/F AUS model.

    Fannie and Freddie are at the heart of the issue. Their lack of true transparency as the real breadth of their underwriting model is the ultimate in veiled business.

    As for the supporters of Fannie and Freddie...James Johnson, with big tie to the democratic party, is perhaps the first of the villlians who needs to be examined. What ever his current role is Obama, his initial inclusion in Obama's team illustrates 2 key items: First, that Obama cannot really make good decisions on hiring personnel and in his associations; Second, that the decision to work with Johnson may be the result of the amount of payments made by Fannie and Freddie influence peddlers to Obama. Obama is #2 on the "I own your soul list"...that is not a good list to be #2 on...
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    Oct 05 11:08 AM
    Fannie Mae Eases Credit To Aid Mortgage Lending
    By STEVEN A. HOLMES
    In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.
    The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.. Fannie Mae officials say they hope to make it a nationwide program by next spring.
    Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.
    In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.
    ''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''
    Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.
    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.
    ''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''
    Under Fannie Mae's pilot program, consumers who qualify can secure a mortgage with an interest rate one percentage point above that of a conventional, 30-year fixed rate mortgage of less than $240,000 -- a rate that currently averages about 7.76 per cent. If the borrower makes his or her monthly payments on time for two years, the one percentage point premium is dropped.
    Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.
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    Oct 05 11:35 AM
    Goddamn speculative shorts:

    www.deepcapture.com/th.../
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    Oct 05 11:51 AM
    An average young American family has two choices - rent or buy.

    If they choose the first choice, they have lower out of pocket spending since they do not pay for insurance or property tax. The trade off is enormous uncertainty as leases are finite. In upscale neighborhoods, vacancy rates are prohibitive and leases are expensive. It is often difficult to find another similar living situation in the same school district for the children. Your landlord could be a benevolent dictator or a ruthless tyrant. Finally, despite much legislation to the contrary, there is still plenty of discrimination on the basis of race and national origin for many potential renters.

    Home ownership provides a guarantee that a family can stay in a school district and provide a level of stability for the children in places where rent regulation is weak or pro-landlord. When you have a situation where the only affordable rental places are in dangerous neighborhoods, there is a real impetuous to take on more risk in owning a home. Keep in mind that many real estate brokers, lenders and Chairmans of the Federal Reserve assured homeowners that home prices would continue in value and that there would always be the free flow of credit to refinance no money down ARMs. That was the sales pitch, and it seemed plausible. Now the situation has changed and the homeowner who wanted stability, an appreciable asset which could be passed onto the children, a mortgage interest tax deduction and a stake in the community has now become the lazy overleveraged freeloader intent on destroying Wall Street. Why is the Community Reinvestment Act to blame for our problems?

    Fannie Mae and Freddie Mac are not the problem. The problem is that we continue to ignore widening Rich-Poor gap in America which has forced a significant amount of Americans into a risky margin call which financial institutions cannot cover. It is not an economic issue. It is not a price-to-earning ratio issue. It is not a debt to equity ration issue. It is a social issue. Until we get to the root of this divisive nature of American society, our problems will not be resolved.
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    Oct 05 12:24 PM
    Lets not forget about the way to low Interest rates set by the Fed. These ultra low rates drove up the cost of homes by allowing people to buy more house than they could afford. Sellers got as much for there house as buyers could pay. In the heat of the sellers market of the last few years home prices exploded and those Adjustable rate loans are as much the cause as lack of regulation and a fee base lending system.
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    Oct 05 12:51 PM
    "THESE AGENCIES SOUGHT SUBPRIME AND ALT-A PAPER in order to expand low income and minority home ownership at the request of the Democrat controlled oversight committees in Congress."
    ----------------------...
    The democrats didn't gain control of any committees until February of 2007. The republicans were in charge of those committees and not only didn't oversee anything, were actively encouraging banks and lenders to step up their activities. Bush repeatedly stopped efforts by various state governments to rein in predatory lending practices. Minority loans are but a small percentage of troubled mortgages in this market. Here in S. Florida there are thousands of multi million dollar beach front/ocean view properties that are in default that had nothing to do with Fannie or Freddie. You have to remember that Fannie had mortgage limits that have only recently been raised. You could not get an FHA mortgage over, I believe, 300,000 until recently and a large percentage of defaults are over this amount. This blame Fannie by the repubs is trying to draw attention away from their lack of oversight and incompetence and which also has a not so subtle racial element to it although most FHA mortgages are to white folks.
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    Oct 05 01:22 PM
    what's pathetic is the is the premise that each political party is a mortal enemy of the other and must try destroy the other to somehow return the country to health. i see merit on both sides of the argument, but am especially disturbed at the relentless conservative assault on an opponent regarded as an anti-American enemy threatening the security of the country. Absurd. Grow up. There can be legitimate disagreement without class war
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    Oct 05 01:27 PM
    This article is nothing more than a bunch of execuses on behalf of the bankers and the politicians in their pocket. The author is a joke!

    Why don't you call it like it is--cheap money, greedy lenders, crooked investment bankers and dishonest rating agencies all operating with the blessing of the criminals in Washington, including McCain and Obama.
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    Oct 05 01:40 PM
    "Mr. FRANK.
    …welcome the fact that we have in Fannie Mae and Freddie Mac a means of bringing down housing costs…"

    Great quote!
    This may be the only time ever that Congress has accomplished what it set out to do, just in an unintended way.
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    Oct 05 01:42 PM