Much ink has been spilt over the causes of the financial crisis, which is still having a devastating effect on the world’s markets and the global economy. Banks, in particular, are subject to ever-increasing regulations and scrutiny. Little attention is being paid to the source of the crisis in the US mortgage market.
It all began in 1995, when president Clinton decided to turn the familiar rhetoric of homeownership for all into a reality, partly because banks allegedly discriminated against minorities and also to cut the budget for public housing.
He aimed to help eight million families own their own homes by 2000, “without spending any more tax money”. President Bush proposed similar aims in 2002 but by 2004, his administration sought to restrain the activities of Fannie Mae and Freddie Mac but Congress refused to change its charters.
The Community Reinvestment Act was amended so banks had to lend an ever-increasing proportion of mortgages to low and moderate-income and very low-income families. The targets were set by the Department of Housing and Urban Development and imposed on the loans purchased by Fannie Mae and Freddie Mac, hybrid organisations owned by their shareholders but subject to public policy goals, whose function was to increase liquidity in the mortgage market by buying loans from lenders.
The CRA played a more important role than many have admitted because the Riegle-Neal Act (1994) came into force at the same time, allowing interstate banking for the first time. Banks wanting to acquire or merge with a bank in another state had to have an “outstanding” rating from regulators in terms of lending to minorities and low-income groups.
By 2008, the target for low to moderate-income groups was 57 per cent, 27 per cent for very low-income groups and 27 per cent for underserved areas.
The 1992 charter for Fannie and Freddie gave them special privileges, including issuing their own debt, which did not, as explicitly stated, have “the full faith and credit” of the US government, which no one believed.
Because of this belief, they issued debt at a lower cost than the guarantees they gave to lenders in return for the loans they bought. High and steady returns for shareholders and bonuses for senior executives were assured through their “accounting irregularities”. They used the all-pervasive affordable housing ideology to their advantage, teaming up with sub-prime lenders offering flexible underwriting, so low-income families could buy their own homes. Declared income could take the form of welfare benefits, with the result that the extent of sub-prime loans was far greater than anyone realised, constituting 27 million mortgages out of the 55 million outstanding mortgages in 2008.
This meant the mortgage-backed securities, CDOs and CDSs were even riskier than they appeared, only to be exposed when falling house prices and higher interest rates led to a rising tide of defaults from mid-2006 onwards.
No one knew which banks and other financial institutions held which assets, or anything about their quality. Banks then refused to lend to one another, creating the worldwide credit crunch as the sheer size of the US financial markets and its central role as an investment destination contributed to the spread of the crisis.
That part of the crisis is not yet over. Attention is now focused on European banks and sovereign debt. The outstanding loan guarantees through federal credit programmes stand at $3.2trn for Fannie Mae and $2trn for Freddie Mac. Nothing has been done to reduce these off-balancesheet guarantees.
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