Bailout Nation

by Barry Ritholtz

  It’s telling that, amid all the recent recriminations, even lenders have not fingered CRA. That’s because CRA didn’t bring about the reckless lending at the heart of the crisis. Just as sub-prime lending was exploding, CRA was losing force and relevance. And the worst offenders, the independent mortgage companies, were never subject to CRA—or any federal regulator. Law didn’t make them lend. The profit motive did.11

  Consider this Federal Reserve Board data, as compiled by the McClatchy Company:• More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.

  • Private firms made nearly 83 percent of the subprime loans to low-and moderate-income borrowers that year.

  • Only one of the top 25 subprime lenders in 2006 was directly subject to the CRA.

  • Only commercial banks and thrifts must follow CRA rules. The investment banks don’t, nor did the now-bankrupt nonbank lenders such as New Century Financial Corporation and Ameriquest that underwrote most of the subprime loans.

  • Mortgage brokers, which also weren’t subject to federal regulation or the CRA, originated most of the subprime loans.

  It was as a political talking point that the “blame CRA” meme seemed to find new life. (The same occurred with Fannie and Freddie.) It spread among the partisan crowd during the 2008 presidential campaign.

  One thing it did was provide a valuable time saving service: Those who mindlessly repeated these talking points—in print, on television, or on radio—identified themselves as partisans, not serious housing or credit analysts. This allowed the informed reader or listener to quickly dismiss the talking heads they might have otherwise wasted time on.

  Fannie Mae and Freddie Mac, aka “Phonie & Fraudie”

  Contrary to another one of these talking points, the government-sponsored enterprises (GSEs) were not a significant factor in causing the mortgage or housing crisis.

  They were, however, a mess of an entirely different making.

  Understanding the GSE story requires grasping their role within the housing sector.

  Fannie Mae was not a government entity, but an independent, publicly traded firm. Fannie and Freddie were allowed to borrow at better rates than banks because they were GSEs. They bought what they did in an attempt to grab share and profits—and they did a lot of dumb things as the housing boom expanded and lending got really silly from 2002 to 2007.

  For decades, Fannie and Freddie took advantage of their quasi-government status for access to cheap cash to crank out reliable profits. But for the most part, they followed their charters and only bought conforming mortgages. Fannie and Freddie eventually changed their mortgage-buying rules, allowing each firm to buy lower-quality loans. But by then, the housing boom was already nearing its peak, and the crash was all but inevitable.

  Ironically, many of the political hacks focused their energy on the wrong place. Subprime wasn’t the GSEs’ biggest problem; it was their medium-quality loans that were going bad at an alarming rate. According to Barron’s, Alt-A mortgages were what caused their demise:

  A substantial portion of Fannie’s and Freddie’s credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers’ income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers. In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities. 12

  No doubt the GSEs were important cogs in the great mortgage securitization machinery. One might have thought Fannie Mae, a firm that had been in the business of securitizing mortgages since 1938, would have some insight into what was actually going on in the mortgage markets. No such luck.

  This was their biggest contribution to the current crisis: Given their expertise, they were ideally situated to identify the massive credit bubble as it was inflating—and they completely missed it.

  I was never enamored with Fannie Mae, and my firm started shorting FNM at $42+ later in 2007. (Given the company’s penny stock price, I wish we were still short.) There had been all sorts of issues: Fraud, incompetence, and corruption were just starters. Imagine in the era of quantitative mortgage analysis, their computer systems did a poor job analyzing risky loans. And on top of that, from 2004 to 2006, Fannie operated without a permanent chief risk officer.

  They were a disaster waiting to happen.

  T he folks who want to place the crisis at Fannie and Freddie’s doorstep seem to be focusing on minor factors and irrelevancies. This was not a “grand social engineering” experiment, as the radical right has called it. This was a profit-motivated private company that was poorly managed and rife with extreme shortsightedness.

  When Fannie hired Daniel Mudd as its new CEO in 2004, he arrived to find a company in utter disarray. At the time, Fannie Mae was still recovering from a massive accounting scandal in which the company had overstated billions in profits. Senior management had pocketed hundreds of millions in illicit stock option gains based on this phony income.13

  This was the GSEs’ real crime: simple fraud. Fannie overstated profits by $6.3 billion from 2001 to 2003, and in 2008 the Office of Federal Housing Enterprise Oversight (OFHEO) sued former CEO Frank Raines. The OFHEO recovered $24.7 million of ill-gotten stock option bonuses that were predicated on phony profits.14 The stock options that Raines had exercised so profitably between 1998 and 2004 were priced at $77.10; Fannie Mae stock (FNM), now under federal conservatorship, recently traded at 37 cents.

  Moreover, CEO Mudd arrived in 2004 to find “the company was under siege,” as the New York Times described in an October 2008 autopsy on Fannie’s failure:

  Competitors were snatching lucrative parts of its business. Congress was demanding that Mr. Mudd help steer more loans to low-income borrowers. Lenders were threatening to sell directly to Wall Street unless Fannie bought a bigger chunk of their riskiest loans. So Mr. Mudd made a fateful choice. Disregarding warnings from his managers that lenders were making too many loans that would never be repaid, he steered Fannie into more treacherous corners of the mortgage market. 15

  Those lenders included Countrywide Financial. Their CEO, Angelo Mozilo, was demanding that Fannie start buying the lender’s riskier loans. When Fannie resisted, Mozilo threatened to terminate their partnership.

  This was no idle threat. Countrywide was the nation’s largest mortgage lender, and losing its business might have been fatal to Fannie. That’s because by 2004, Fannie had lost 56 percent of its loan-reselling business to Wall Street.

  When Mozilo said, “Jump,” Fannie Mae said, “How high?”

  Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers—more than three times as much as in all of its earlier years combined, the New York Times reported, citing company filings and industry data. “We didn’t really know what we were buying,” Marc Gott, a former director in Fannie’s loan servicing department, told the New York Times. “This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through the gears.”16

  Meanwhile, over at Fannie’s little brother, Freddie Mac:

  The chief executive of the mortgage giant Freddie Mac rejected internal warnings that could have protected the company from some of the financial crises now engulfing it, according to more than two dozen current and former high-ranking executives and others. That chief executive, Richard F. Syron, in 2004 received a memo from Freddie Mac’s chief risk officer warning him that the firm was financing questionable loans that threatened its financial health.17

  Poor risk management and poorer timing make for a dangerous combination.

  It is a tenet of faith among right-wing supporters that abuses by Fannie Mae and Freddie Mac were aided and abetted by Democrati
c members of Congress, notably Representative Barney Frank. They blame much of the housing and credit crisis on the misuse of GSEs to further the liberal goal of maxing out home ownership for everyone, most notably minorities.

  Many adherents of this “blame the Dems” viewpoint point to the 2004 House Finance hearings where then OFHEO director Armando Falcon was harshly treated for daring to so much as criticize the accounting breakdowns at Fannie and Freddie. A YouTube highlight reel of the hearing has received nearly three million hits as of this writing.18

  The great irony is Fannie and Freddie spread around hundreds of millions of dollars corrupting members of Congress of both parties. A December 2008 AP story detailed Freddie Mac’s “multi-million dollar campaign to preserve its largely regulatory free environment, with particular pressure on Republicans who controlled Congress at the time.” Famed conservative Newt Gingrich was a notable recipient of Fannie’s largesse. 19

  Indeed, Fannie and Freddie were among the most prolific lobbyists on K Street. For a long time they were successful in preventing closer oversight and in thwarting tighter regulation. The Republicans may have been a less natural ally than the Democrats when it came to Fannie and Freddie, but exonerating the GOP for the GSEs’ misdeeds misses the larger point: Like much else in our Bailout Nation, it points to a bipartisan failure.

  F annie has been around since 1938, Freddie since 1968, and the CRA since 1977. Suddenly, all of housing goes to hell in 2006, and then credit collapses two years after—and the best explanation some people can come up with is Fannie, Freddie, and CRA? Gee, isn’t that rather odd—especially after 70 years?

  While reducing the complexities of economic history into bumper-sticker phrases is politically expedient, it does not help us get to the root cause of our problems. And it gets in the way of helping us fashion a solution for the future. This is why I hold the weasels who are attempting to obscure reality and rewrite history in such disdain.

  For the nonpartisan, nonhacks among you, for the policy makers and academics and economists who are truly interested in how this came to pass and what we can do to fix it, the bottom line remains: The CRA was irrelevant to the current crisis, and Fannie Mae and Freddie Mac were mere cogs in a very complex financial machine with many moving parts.

  But the primary cause of the mess? Not even close.

  Chapter 21

  The Virtues of Foreclosure

  Home sales are coming down from the mountain peak, but they will level out at a high plateau, a plateau that is higher than previous peaks in the housing cycle.

  —David Lereah, National Association of Realtors’ chief economist, December 20051

  I don’t know, but I think the worst of this may well be over.

  —Alan Greenspan, October 20062

  By now, you may have noticed that housing has played a starring role in our Bailout Nation. It is the unifying theme that runs through much of the bailout narrative.

  Housing was the prime driver of the economic cycle of 2001 to 2008: It was a disproportionate source of newly created jobs. Mortgage equity withdrawal (MEW) was an outsized contributor to consumer spending. Home mortgages were a huge portion of much of the twenty-first century’s consumer debt creation. On Wall Street, the securitization of mortgages was a major factor driving revenue and profits; residential mortgage-backed securities (RMBSs) were bundled by the Street, and then repackaged into collateralized debt obligations (CDOs). Pseudo insurance policies written on all those CDOs were credit default swaps (CDSs), a key element in the demises of Bear Stearns, Lehman Brothers, and AIG.

  But that was then. Where does housing fit into the economy in our modern, postbailout world?

  Today, housing presents a tricky catch-22. Allow me for a moment to be a two-handed economist: On the one hand, housing remains overpriced relative to historic norms; indeed, by nearly every major real estate metric, it has yet to revert to regular pricing levels. One the other hand, as prices fall, that leads to even more foreclosures, causing all manner of problems for the already battered banking sector.

  Resolving the current crisis—the credit markets, the economy, the banking sector, and its toxic derivatives—is dependent on a nearly impossible goal. The ideal solution requires finding a way for home prices to normalize while simultaneously keeping foreclosure rates from spiking. It is quite a sticky balancing act.

  Consider how interrelated these various elements are:• Housing is a key part of the economy. Home purchases and refinancings drive other durable goods sales, like appliances, furniture, and automobiles. When housing sales run significantly below trend, as they have over the past few years, the negative economic impact is significant. For the economy to begin improving, housing must stabilize.

  • During the five-year period from 2002 to 2007, the combination of ultralow rates and nonexistent credit standards created between five and seven million more home buyers than usual. Home ownership rose from 62 percent in 1960 to 66 percent in 2000. It peaked at just over 69 percent in the 2004-2007 period.3 By Q4 2008, it had slipped to 67.5 percent.4

  • The influx of new buyers helped drive prices several standard deviations higher (meaning more expensive than they should be). Even though home prices have since fallen more than 25 percent nationally (according to the Case-Shiller indexes5), housing still remains relatively overpriced in many areas.

  • There have been over two million foreclosures in the United States as of the end of 2008. The many people who bought homes they could not afford are in the process of reverting back to being renters. There may be anywhere from another one to four million more foreclosures in the next few years. As disruptive as foreclosures are to families and neighborhoods, the silver lining is they help drive prices back toward normalized levels.

  • A recent report by First American CoreLogic determined that 20 percent of homes with mortgages (8.3 million) are underwater—the mortgage debt is greater than the value of homes. Call them “home-owers.” These properties tend to be at greater risk for walkaways, jingle mail (mailing keys to lender), and foreclosures.6

  • There have been over 5.1 million jobs lost so far in the recession that began in December 2007.7 Employment generally lags the economic cycle, meaning it stays low even after the economy begins to recover. I would not be surprised to see another two to three million more job losses before the recession ends.

  • Perhaps most significantly, as the recession continues, job losses are still rising and foreclosures increasing. The trillions of dollars in toxic paper held by banks and insurers become worth less and less with each economic downtick. More foreclosures = more bank failures = bigger FDIC/federal obligations.

  This helps to explain why the Federal Reserve and the Treasury have been so desperate to stop foreclosures; it is also why the White House was willing to throw $75 billion at a foreclosure abatement program. While the intentions are good, the main issue remains: Homes are still too expensive.

  This is the heart of our catch-22. It is an issue that seems sacrilegious to many economists: Home prices remain too high for stabilization and/or a housing bottom to form.

  As Figures 21.1 to 21.3 show, the wreckage in the real estate sector has brought house prices down from wildly overvalued levels of a few years ago. But they are still too high by most valuation metrics. Consider such metrics as the ratio of median income to median home price, the cost of renting versus owning, and housing capitalization of gross domestic product (GDP); in each of these, home prices are still significantly elevated above historic norms.

  Figure 21.1 Home Prices as a Percentage of Gross Domestic Product

  SOURCE: Chart courtesy of Calculated Risk, www.calculatedriskblog.com

  Figure 21.2 Price-to-Rent Ratio

  SOURCE: Chart courtesy of Calculated Risk, www.calculatedriskblog.com

  Figure 21.3 Home Prices versus Median Household Income

  SOURCE: Chart courtesy of Calculated Risk, www.calculatedriskblog.com

  In all of these charts, ho
using has come about half to two-thirds of the way back into line. But consider this grim reality about future home prices: Markets rarely revert just back to the mean. In most instances where assets have become dramatically overextended (stocks, commodities, bonds, and, yes, housing), the reversion tendency has been to overshoot to the downside.

  Therein lies the crux of the problem: Propping up home prices or forestalling foreclosures might only serve to delay the inevitable. To effect true stabilization, including a real housing bottom and recovery, these overpriced assets will likely fall even further. (Either that, or a few million new buyers must come into the market.)

  When prices drop enough, good things happen. The prime bubble areas—California, South Florida, Arizona, Las Vegas—each suffered enormous foreclosure surges of 80 to 120 percent, followed by huge price decreases of 40 to 50 percent. But now these states contain the few areas of the country where home sales are increasing—driven by sales of homes in foreclosure.

  It’s not that people are unwilling to buy real estate in the United States; it’s that buyers are unwilling to overpay.

  And therein lies the heart of the problem with most rescue plans. They are designed to prevent the continued downward spiral of the housing market, which unfortunately is precisely what is needed. The artificial demand of the ultralow rates and lax lending standards sent prices to unsustainable levels, and put millions of people into homes they could not afford. The markets are correcting these excesses as people trade out of those homes. It is a classic unwind of a bubble.

  In much of the country, home prices remain too high, and the overpriced homes are not moving. That’s reflected in the huge inventory overhang of unsold homes. (See Figure 21.4.) And the inventory data of homes for sale does not include the shadow inventory—all of the homes purchased as investments, by flippers, as second homes, or as rental units. These owners are waiting in the shadows for the opportunity to get rid of their properties. Any improvement in the real estate market is likely to bring forth this additional supply.