CHAPTER 19
FROM WASHINGTON
TO WALL STREET
Roots of the Great Housing Deformation
THE LONG CYCLE OF MONETARY DEFORMATION TRIGGERED BY THE events of August 1971 stood at the heart of the home mortgage crash in 2007–2008. Needless to say, it took time and numerous twists and turns to get there.
First came the brutal margin squeeze on traditional bank and thrift mortgage lenders during the Great Inflation of the 1970s. In Old Testament fashion, that breakdown begat the misguided deregulation and crash landing of the savings and loan industry in the 1980s. The demise of these traditional bricks-and-mortar Main Street lenders, in turn, begat the explosive growth of broker-based mortgage finance by Freddie and Fannie in the 1990s.
In due course, the spread of mortgage boiler rooms from coast to coast enabled the rise of Wall Street–based subprime finance after the turn of the century. All the while, the Fed’s interest repression policies fostered massive overinvestment in mortgage finance and housing, thereby aggravating these deformations still further.
THE GREAT INFLATION’S LEGACY: BUSTED MORTGAGE LENDERS THE FREE MARKET COULDN’T FIX
The repudiation of sound money at Camp David and the subsequent monetary depredations of Arthur Burns led to the Great Inflation and its assault on the balance sheets of traditional mortgage lenders. Yet, even after double-digit inflation was crushed by Paul Volcker in 1980–1982, its long shadow weighed heavily on the future of home finance.
In fact, Volcker’s signal success came too late. By then the traditional home mortgage finance industry had been essentially bankrupted by the negative spread between soaring interest rates on deposit liabilities and the low fixed rates embedded in legacy mortgage portfolios. Self-evidently, the resulting hemorrhage of losses among bank and thrift mortgage lenders was an artifact of failed monetary policy, not a product of the free market.
The free market could not be expected, therefore, to solve a problem it hadn’t created, meaning that deregulation of the savings and loans (S&Ls) was a profoundly misguided cure for the ill effects of bad money. The only real solution was wholesale liquidation of thousands of insolvent banks and thrifts.
Needless to say, not even the Reagan administration had the political stomach for the correct free market answer. So its well-intended alternative, liberalization of S&L lending charters, actually made matters worse.
Deregulation, as we will see below, encouraged traditional bricks-and-mortar bankers, who knew everything about home mortgage lending, to flee into commercial real estate and junk bond investment, about which they knew nothing. In this wholly discombobulated setting, the housing finance industry clung for dear life to the only lifeline available; namely, the government-sponsored mortgage guarantee programs at Freddie Mac and Fannie Mae.
CRUSHED BY THE GSES
Not surprisingly, high on the Reagan administration’s free market agenda was the elimination of the GSEs and their taxpayer-subsidized channel of housing finance. As director of the Office of Management and Budget, I championed a plan to eliminate the GSEs through a slow financial euthanasia.
The mechanism was a federal “guarantee fee” designed to raise the cost of Freddie and Fannie financing to private market–clearing levels. It would have permitted the taxpayers to capture the spread between the private market rate and the Treasury’s lower cost of financing.
Needless to say, if the GSEs had been required to pay market rates for their capital and funding, there is no reason to believe they would have survived competition from the traditional “originate and hold” model of depository institutions. For that reason, the guarantee fee catalyzed the forces of crony capitalism like rarely before in the history of federal housing programs. Home builders and suppliers of lumber, hardware, HVAC, and electrical products joined real estate agents, mortgage bankers and brokers, title lawyers, and dozens more in a mighty coalition to keep private enterprise humming on cheap, socialized credit.
As Ralph Nadar observed years later, “Fannie Mae and Freddie Mac are fast learners … [they] have swiftly and skillfully managed to pick up the roughshod tactics of the private corporate world … [and] cling tightly to one of the Federal government’s deepest and most lucrative welfare troughs.”
The danger of government subsidization and control of housing finance would eventually be painfully evident. But in 1981, when the GSEs were still in their relative infancy and there was an honest chance to smother them in the cradle, Republicans on Capitol Hill led the charge to kill the OMB-proposed guarantee fee. The American housing industry, they averred, was too important to be left to the whims of the free market.
Four decades after its accidental birth in New Deal–era filing cabinets, therefore, Fannie Mae was adopted by Republican foster parents. Now it would morph into a destructive monster with no legislative check on its growth. Thus, during the first Reagan term, the combined guarantees and direct mortgage holdings of the GSEs doubled from $200 billion to $400 billion and then doubled again by 1988.
When George H. W. Bush left office in 1992, the footings of the GSEs totaled $1.5 trillion. During twelve years of Republican rule, the balance sheets of Freddie and Fannie (and Ginnie Mae) had not simply grown rapidly; they had, in fact, metastasized, reaching a size that was seven times greater than when they had been furtively challenged by the Reagan Revolution.
VOODOO ECONOMICS STRIKES BACK
So the era of Republican rule did not roll back Big Government in the nation’s largest industry; that is, housing construction and finance. Even worse, in one of his final acts as president, George H. W. Bush signed the calamitous Housing and Community Development Act of 1992.
This abomination gave new meaning to the term “voodoo economics,” the very epithet Bush had thrown at Ronald Reagan in the 1980 primary campaign. Yet in his final act as president it was Bush who turned out to be the greater practitioner of economic folly.
One major title of the bill, for example, made a mockery of its own bold-print heading. Under the rubric “financial safety and soundness,” Freddie and Fannie were permitted to leverage their balance sheets 200 to 1 in the case of guaranteed mortgage pools, and by more than 100 to 1 overall.
The Bush White House’s woolly-minded rationalizations for this madness surely delighted the crony capitalists who crowded the signing ceremony. Embracing the bill as the second coming of motherhood, Bush averred that it would “target assistance where it is needed most, expand homeownership opportunities, ensure fiscal integrity and empower recipients of Federal housing assistance.”
What the bill actually did was set in motion a pervasive, relentless degradation of underwriting standards that was pure financial poison. The so-called affordable housing goals initially required that 30 percent of GSE volume consist of low- and moderate-income borrowers (later raised administratively in steps to 56 percent). It further provided that underwriting standards could be drastically weakened to achieve these targets, including authorization for the GSEs to virtually scuttle the historic requirement that borrowers have “skin in the game” in the form of a meaningful cash down payment.
It goes without saying that nonrecourse mortgage loans with token down payments, in the context of what turned out to be a decade-long bubble in housing prices, were a recipe for disaster. While it took the GSEs time to chip away at their traditional underwriting disciplines, one signal breakdown occurred several years later when Fannie Mae introduced its “Flex 97” product. That bit of affordable housing lunacy permitted borrowers to post a mere 3 percent down payment, and it didn’t even have to be their own cash.
This initiative was symptomatic of Washington’s truly foolish obsession with promoting home ownership, especially in the face of housing prices which were rising preternaturally. In those circumstances, the GSEs should have significantly boosted, not eviscerated, their required down payment ratio in order to provide a cushion against subsequent market reversals in the value of housing collateral.
Accordingly, what the ill-defined and elastic “affordable housing” mandate actually did was unleash full-bore crony capitalism in home finance. Indeed, in only a few years’ time stock-option-crazed executives turned Freddie and Fannie into housing bubble machines funded by Uncle Sam’s credit card.
HOW THE STOCK OF FREDDIE AND FANNIE SHOT THE MOON
For a moment in time, the stock prices of Freddie and Fannie took on the trajectory of a moon shot. Yet these billowing Wall Street valuations were always preposterous, a truth eventually punctuated by the hapless Hank Paulson. Standing knee-deep in the carnage of the GSEs in July 2008, he vainly attempted to prop up what remained of their stock prices by claiming that he had a bazooka in his pants pocket.
Still, this failed moon shot had taken a quarter century to run its course. When the House Republicans rescued the GSEs from the threat of free market economics in 1981, the market cap of Fannie Mae was less than $1 billion, and Freddie Mac was not yet even publicly traded. By the time George H. W. Bush signed the misbegotten housing bill eight days before the 1992 election, their combined market cap amounted to only a few billion.
Soon thereafter, however, the stock prices of Fannie and Freddie went parabolic. As it happened, the 1992 statute was virtually a blank check of authority to promote home ownership, and thereby perfectly suited to the agenda of the genuine liberals Clinton installed in the Department of Housing and Urban Development (HUD) and the GSEs. HUD Secretary Henry Cisneros soon devised the “National Homeownership Strategy” and launched it with much hoopla at a conference in August 1994 attended by crony capitalists and community organizers in equal numbers.
Since Uncle Sam was picking up the tab, the two sides found themselves in remarkable unanimity. In a strategy document that was embraced by both ACORN (Association of Communities for Reform Now) and the mortgage bankers, it was agreed that huge gains in home ownership could be achieved if only the inconvenience of down payments and monthly mortgage payments could be overcome! In a fit of blinding insight, the document thus noted that “the lack of cash to accumulate the required down payment and closing costs is the major impediment to purchasing a home” and that many households “do not have sufficient income available to make monthly payments.”
The answer to this roadblock was “financing strategies, fueled by the creativity and resources of the private and public sectors.” The obvious “resource” in question was the balance sheet of the GSEs, which expanded by one-half trillion dollars during the next four years.
Yet the thing which really grew was the market cap of Freddie and Fannie. By 1997 they had a combined market cap of $80 billion, and by early 2000 Wall Street was valuing the stock of the GSE twins at an astonishing $140 billion. Here was the jet fuel that ignited the final housing craze.
While the miraculous ride of the GSE stocks stirred the speculative juices on Wall Street, the real mania broke out right inside the C-suite of Freddie and Fannie. Stock options exploded in value, causing top GSE managers to become as obsessed with their stock price as the most myopic dot-com executives; and that, in turn, meant feeding Wall Street increasingly higher earnings and ever more spectacular feats of growth.
FREDDIE AND FANNIE:
PURE ECONOMIC PARASITES, ALL THE TIME
Unfortunately, the GSEs had only one route to achieve growth, and that was reaching deeper into the sludge at the bottom of the nation’s potential mortgage credit pool. This dubious route to higher financial postings was, in turn, a function of the dark truth of the GSEs; namely, that they were not real businesses, nor did they contribute any value added to the US economy. Accordingly, they had no honest way to grow and couldn’t possibly have been worth $140 billion, or even $14 billion, or really anything at all.
Despite their massive balance sheets and towering Wall Street valuations, the GSEs were essentially economic parasites which harvested rents by deploying the public credit of the United States at no charge from the Treasury. The smoking-gun evidence that they produced no economic value added was hidden in plain sight on their income statements: the GSEs had virtually no cost of production beyond the trivial head counts which were needed to man and maintain their data processing systems.
During fiscal 2000, for example, Fannie Mae booked $7.0 billion of interest income and guarantee fees but had only $900 million of operating expenses, resulting in 87 percent gross profit. In truth, there was nothing behind the imposing brick exterior of Fannie Mae’s headquarters except a toll booth where fees were collected in return for stamping “guaranteed” (implicitly by Uncle Sam) on pools of conforming mortgages.
Based on pure accounting theory, of course, the GSEs’ true cost of production was future losses, similar to any other insurance company. Every time they stamped “guaranteed” on another pool of mortgages, therefore, the GSEs should have incurred an expense for loan loss reserves. Yet during fiscal 2000 it set aside only $100 million for future losses, a trivial 1.7 percent of revenues.
It was on this obvious point that the era of bubble finance made a shambles of GSE financial reporting. Virtually from the day of the Clinton administration’s August 1994 housing conference, housing prices started rising and never looked back. At the same time, the newly launched national crusade to increase home ownership pushed GSE credit quality into its relentless cycle of deterioration.
This confluence carved a toxic path into the future. On the one hand, the GSEs’ historical credit loss experience became increasingly irrelevant to each year’s new book of lower-quality business. At the same time, briskly rising housing prices were masking growing losses owing to continuous refinancing of delinquent mortgages.
THE MOTHER OF ALL CREDIT BUBBLES:
130 STRAIGHT MONTHS OF HOUSING PRICE GAINS
Beginning in July 1995, national housing prices rose every single month for nearly eleven years. By the midway point at the end of 2001, the Case-Shiller index was up by 60 percent, and at the final peak in May 2006 it had gained 195 percent. In short, under what was an utterly freakish financial deformation, even if it was one that the nation’s monetary politburo insisted, ludicrously, could not be detected, housing prices rose at a compound rate of 11 percent for eleven consecutive years.
As a result, the true credit losses owing to the home ownership crusade were nowhere to be found in the GSE performance data. When borrowers got behind, their mortgages were simply refinanced, usually with a big enough increase in principal to re-pay the arrearage. Serial refinancings and the constant churn of the existing housing stock temporarily buried the growing GSE losses in Alan Greenspan’s monetary bubble.
The tailwind of rising housing prices and negligible actual default losses enabled the GSE management teams to book exceedingly minimal reserves for future losses. Accordingly, they continued to book nearly 90 percent profit margins on a soaring volume of business. These sterling results caused their stock prices to rise by further leaps and bounds, providing powerful incentives for management to drive GSE underwriting standards still lower and mortgage volume ever higher.
Thus, in 1998 alone, the combined GSE balance sheet grew by $200 billion, or by the amount of total footings that had existed at the time of the Reagan challenge. Three years later, the GSE balance sheets expanded by nearly $400 billion, bringing their total outstanding mortgage credit exposure to $3.1 trillion. In the face of soaring volumes and virtually no charges for future losses, Freddie and Fannie were literally minting profits.
This pell-mell volume and earnings growth did wonders for the stock price of Freddie and Fannie, which in turn generated fabulous management bonuses and stock option gains: several billion
dollars over the span of 1990–2002. In a financial folly that had no precedent, a housing-crazed government had thus turned over the public credit of the United States to a small cadre of GSE executives and Wall Street punters who then gorged themselves on ill-gotten windfalls.
Needless to say, when the housing price bubble peaked and reversed direction in 2006, the hidden losses buried in the GSE mortgage portfolios began to emerge—slowly at first and then with an explosive rush after mid-2008. Accordingly, the nearly $200 billion of losses recorded by Freddie and Fannie since then have wiped out all of the profits they ever booked historically, and then some.
CRONY CAPITALISM AND THE FOUNDATION OF SUBPRIME
Apart from the unearned windfalls that were bestowed on Wall Street punters, the preposterous $140 billion market cap of the GSEs had another untoward impact. It gave Freddie and Fannie so much walking-around money that there was literally no one they couldn’t buy in Washington and throughout the byways of the housing-industrial-finance complex. The creation of the Fannie Mae foundation from the sale proceeds of a tiny fraction of its red-hot stock became a $350 million slush fund. It flat-out bought policy support from housing sector participants ranging from academic researchers to city councils and community organizers.
ACORN, the controversial poor people’s housing advocacy organization, was virtually a wholly owned subsidiary of the Fannie Mae foundation. The foundation even nakedly invaded Capitol Hill, providing direct funding to the nonprofit arms (so-called) of the congressional black caucus and the congressional Hispanic caucus.
By the end of the 1990s the fatal nexus was in place. Through its foundation, Fannie Mae was actually funding a vast mobilization of housing advocates and cronies to bring lobbying pressure on exactly itself. The gambit was to claim it had been “forced” by political pressures to reduce its own underwriting standards and to virtually eliminate down payments.
The Great Deformation Page 56