The mortgage crisis was government driven from the start and many years in the making.

The Origins of the Mortgage Crisis

by Kurt Vangsness on Thursday, October 14, 2010 at 9:02pm ·

The mortgage crisis was government driven from the start and many years in the making. FDR helped to create Federal National Mortgage Association (Fannie Mae) as part of the New Deal and Richard Nixon chartered the Federal Home Loan Mortgage Corporation (Freddie Mac) in 1970. Then the Community Reinvestment Act was passed in 1977 to prevent "redlining" by banks of low income neighborhoods.

The Clinton Administration instructed Fannie and Freddie to increase the number of risky mortgages in their portfolio from poor and minority communities. HUD Secretary Cuomo helped to facilitate a mandate to fund poor families with down payments and low interest mortgages, which amounted to "affirmative action" lending. Also, community activist groups like ACORN harassed banks and bank executives as well as threatened action under the CRA if the banks didn't make more money available to poor neighborhoods.

Then starting in 2000 various members of Congress and other outside groups called for stricter regulations on Fannie and Freddie, but many other members of Congress, predominately Barney Frank, Chris Dodd, etc. said there was no problem and threatened to block any stricter regulation of the two GSE's (Government Sponsored Entities).

See: Setting the Record Straight: Six Years of Unheeded Warnings for GSE Reform
http://www.facebook.com/note.php?note_id=60838741791

From an interview with Barney Frank, the Boston Globe reported the following (see link below):

"Frank, in his most detailed explanation to date about his actions, said in an interview he missed the warning signs because he was wearing ideological blinders. He said he had worried that Republican lawmakers and the Bush administration were going after Fannie and Freddie for their own ideological reasons and would curtail the lenders’ mission of providing affordable housing."

Fannie and Freddie were exempted from Sarbanes Oxley reporting rules. The Democrats also threatened to filibuster any legislation designed to place stricter regulations on Fannie and Freddie in the Senate. When it was clear executives at Fannie and Freddie were guilty of accounting fraud to the tune of $200 million, no one went to jail. A number of the executives like Franklin Raines and Jamie Gorelick were former Clinton Administration officials and James Johnson was a Democratic Party Operative, so that had friends in high places who protected them.

Meanwhile, Fannie and Freddie continued to amass large portfolio's of mortgage debt, which were then securitized via Wall Street into CMO's (Collateralized Mortgage Obligations). Per Edward Pinto, a former executive at Fannie, starting in 1993 Fannie often misrepresented mortgages which were subprime in nature, as prime when the mortgages were securitized.

This was due to Congress wanting Fannie to pass its lower cost of funds (due to it's de facto Government backing) on to the consumer, i.e., in the form of lower interest rates on mortgages to borrowers. The problem is that Fannie can't give out a "below market" mortgages and then not expect the market to discount the principal value based on market risk pricing (e.g., a risky loan requires a higher interest rate than a low risk loan). Inherently then Fannie was encouraged to misrepresent the mortgages as prime in order to get full principal.

"There is more to this ugly situation. New research by Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, has found that from the time Fannie and Freddie began buying risky loans as early as 1993, they routinely misrepresented the mortgages they were acquiring, reporting them as prime when they had characteristics that made them clearly subprime or Alt-A." see WSJ.com: "The Price for Fannie and Freddie Keeps Going Up"

Once these securities were sold as CMO's, Fannie actually bought these CMO's in the secondary market and held up to $1 trillion in CMO's. Essentially, they were making the market for CMO's and gave the market the illusion of liquidity which essentially increases the market price.

In order for Commercial Banks to buy CMO's they needed to be rated by Moody's, Fitch, and S&P due to a 1930's law, which prevents banks from investing in securities not rated by an outside agency. As reported in the WSJ article "Let's Write the Rating Agencies Out of Our Law," 85% of the tranches of CMO's containing subprime mortgages were rated "AAA" and almost all tranches were rated as investment grade. A banks capital requirements (i.e., allowable leverage) is based on the rating of the security and the type of security. Per the article:

"For every dollar of equity that insurance companies are required to hold for bonds rated AAA, $3 is needed for bonds rated BBB, and $11 is needed for bonds rated just below investment grade (BB). For banks, the sensitivity of capital requirements to ratings is generally even more extreme."

The WSJ article, "A Silver Lining to the Financial Crisis: A More Realistic View of Capitalism," further illustrates how Commercial Banks were encouraged to hold CMO's via regulator capital requirements:

"But under the recourse rule, "well-capitalized" American commercial banks were required to spend 80 percent more capital on commercial loans, 80 percent more capital on corporate bonds, and 60 percent more capital on individual mortgages than they had to spend on asset-backed securities, including mortgage-backed bonds, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie.Specifically, $2 in capital was required for every $100 in mortgage-backed bonds, compared to $5 for the same amount in mortgage loans and $10 for the same amount in commercial loans." 

So to recap, Commercial banks bought "AAA" rated Mortgage-backed securities because they were safe and allowed the banks to further extend their capital (i.e., greater leverage). So banks were encouraged by banking regulations to buy Fannie or Freddie mortgage-backed securities because they required less capital than holding individual mortgages and commercial loans in which the bank performs its own credit risk assessment instead of the ratings agencies.

Then when the bottom dropped out of the market, Fannie stopped buying CMO's in the secondary market, which accounted for a large part of the market activity. This caused mortgage-backed securities to become illiquid (huge drop in price, because if you can't sell something it has less value). Mark-to-market accounting then required banks to devalue their holdings (on paper) because market prices dropped and in some cases the market price was based on a few "fire-sales" (kind of like appraising your house based on one foreclosure sale 5 blocks away). Then the ratings agencies, realized they screwed up, downgraded the ratings on existing mortgage backed securities being held by the banks even though nothing may have changed in the mortgage security pool backing the CMO's. This drove many banks to be further under-capitalized.

With mortgage-backed security prices in a free fall due to rating down grades and lack of liquidity, Credit Default Swaps based on these CMOs, required capital calls, i.e., more money being paid out (AIG). This was all due to the "perceived market value", i.e., regardless of actual value and actual mortgage defaults. When an investment is as opaque (less available information) as mortgage backed securities and market confidence drops, investors discount the value heavily to account for the unknown (unknown = greater risk = lower price relative to the yield).

This was manufactured and triggered by the government, Fannie Mae and Freddie Mac, and banking regulators. But of course the government points to the Wall Street Investment Banks and mortgage originators as causing the problem. It like blaming the tail for wagging the dog.

REFERENCES:
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Boston Globe: Stance on Fannie and Freddie dogs Frank
http://www.boston.com/news/politics/articles/2010/10/14/frank_haunted_by_stance_on_fannie_freddie/
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"Frank, in his most detailed explanation to date about his actions, said in an interview he missed the warning signs because he was wearing ideological blinders. He said he had worried that Republican lawmakers and the Bush administration were going after Fannie and Freddie for their own ideological reasons and would curtail the lenders’ mission of providing affordable housing."
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WSJ.com: The Future of Housing Finance
We'll never get a rational mortgage system until the government's affordable housing mandates are ended.
http://online.wsj.com/article/SB10001424052748704407804575425231311880538.html
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WSJ.com: Moving Beyond Fannie and Freddie
The experiences of other countries show there's no need for a government role in housing finance.
http://online.wsj.com/article/SB10001424052748704353504575596872063967914.html
"    Research by Edward Pinto, a resident fellow at the American Enterprise Institute who was chief credit officer of Fannie Mae in the 1980s, has shown that by 2008 half of all mortgages in the U.S.—27 million—were subprime and other high-risk loans, often with little or no down payments by borrowers. Because of their affordable- housing requirements, the GSEs bore the risk of default on 12 million of these mortgages. The Federal Housing Administration (FHA) and other government agencies insured or held an additional five million. And banks under the Community Reinvestment Act, and other mortgage providers under a Department of Housing and Urban Development program, made another 2.2 million.
    Thus, more than 19 million subprime loans were the responsibility of taxpayers, courtesy of the federal government's housing policies. The balance, slightly less than eight million loans, were securitized by Countrywide and other private issuers."

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WSJ.com: Fan and Fred and the Problem of Narrative
The GSEs don't fit the left's story about how greedy bankers caused the financial crisis. That's why they haven't been reformed.
http://online.wsj.com/article/SB10001424052748703467304575383451809694546.html
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WSJ.com: The Lesson of Basel's Bean Counters
Decades of obsession with accounting standards couldn't overcome the perverse incentives created by 'too big to fail.'
http://online.wsj.com/article/SB10001424052748704508904575192534100550538.html
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WSJ.com: Angels Out of America
How the Dodd bill harms start-ups.
http://online.wsj.com/article/SB10001424052748704671904575194483171910348.html

"Mr. Dodd's bill would change all this for the worse. Most preposterously, it would require that start-ups seeking angel investments file with the Securities and Exchange Commission and endure a 120-day review. Rare is the new company that doesn't need immediate access to the capital it raises, and a four-month delay is the kind of rule popular in banana republics that create few new businesses."
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WSJ.com: An Economy of Liars
When government and business collude, it's called crony capitalism. Expect more of this from the financial reforms contemplated in Washington.
http://online.wsj.com/article/SB10001424052748704508904575192430373566758.html

"The idea that multiplying rules and statutes can protect consumers and investors is surely one of the great intellectual failures of the 20th century. Any static rule will be circumvented or manipulated to evade its application. Better than multiplying rules, financial accounting should be governed by the traditional principle that one has an affirmative duty to present the true condition fairly and accurately not withstanding what any rule might otherwise allow. And financial institutions should have a duty of care to their customers. Lawyers tell me that would get us closer to the common law approach to fraud and bad dealing."
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WSJ.com: Staffer One Day, Opponent the Next
The revolving door can turn swiftly at the Securities and Exchange Commission.
http://online.wsj.com/article/SB20001424052702303450704575160043010579272.html
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WSJ.com: Fannie and Freddie Amnesia
Taxpayers are on the hook for about $400 billion, partly because Sen. Obama helped to block reform.
http://online.wsj.com/article/SB10001424052748704671904575193910683111250.html

"The date of the Senate Banking Committee's action is important. It was in 2005 that the GSEs which had been acquiring increasing numbers of subprime and Alt-A loans for many years in order to meet their HUD-imposed affordable housing requirements accelerated the purchases that led to their 2008 insolvency. If legislation along the lines of the Senate committee's bill had been enacted in that year, many if not all the losses that Fannie and Freddie have suffered, and will suffer in the future, might have been avoided.

Why was there no action in the full Senate? As most Americans know today, it takes 60 votes to cut off debate in the Senate, and the Republicans had only 55. To close debate and proceed to the enactment of the committee-passed bill, the Republicans needed five Democrats to vote with them. But in a 45 member Democratic caucus that included Barack Obama and the current Senate Banking Chairman Christopher Dodd (D., Conn.), these votes could not be found."
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WSJ.com: The Dodd Bill and U.S. Competitiveness
Its new taxes and regulations will make the U.S. an unattractive jurisdiction for financial companies.
http://online.wsj.com/article/SB10001424052748704117304575137980120672008.html
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WSJ.com: If You Liked Fannie and Freddie...
... You'll love Chris Dodd's latest reform proposal. It would make many more companies too big to fail and lead to far greater financial consolidation.
http://online.wsj.com/article/SB10001424052748704743404575127541719271252.html

"If passed in its current form, the bill would give the government control over the financial system in roughly the same way, and to the same extent, that ObamaCare would take over the nation's health care. There isn't a public option, exactly, but the private firms involved would be so heavily regulated that they would be effectively controlled by the government."
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WSJ.com: Most Pundits Are Wrong About the Bubble
The repeal of Glass-Steagall has helped us weather the storm.
http://online.wsj.com/article/SB122428270641246049.html

"As for the evils of deregulation, exactly which measures are they referring to? Financial deregulation for the past three decades consisted of the removal of deposit interest-rate ceilings, the relaxation of branching powers, and allowing commercial banks to enter underwriting and insurance and other financial activities. Wasn't the ability for commercial and investment banks to merge (the result of the 1999 Gramm-Leach-Bliley Act, which repealed part of the 1933 Glass-Steagall Act) a major stabilizer to the financial system this past year? Indeed, it allowed Bear Stearns and Merrill Lynch to be acquired by J.P. Morgan Chase and Bank of America, and allowed Goldman Sachs and Morgan Stanley to convert to bank holding companies to help shore up their positions during the mid-September bear runs on their stocks."
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WSJ.com: "A Silver Lining to the Financial Crisis: A More Realistic View of Capitalism"
Two familiar scapegoats for the financial crisis---deregulation and bankers' bonuses--- don't appear to be responsible for the disaster.

http://online.wsj.com/article/SB10001424052748704454304575081680480599148.html

"Regulators of banks, insurance companies and broker dealers have all incorporated the work of the ratings agencies into their regulations in myriad ways. Most importantly, bond ratings determine -- as a matter of law -- how much capital regulated institutions need in order to own the bonds.

For every dollar of equity that insurance companies are required to hold for bonds rated AAA, $3 is needed for bonds rated BBB, and $11 is needed for bonds rated just below investment grade (BB). For banks, the sensitivity of capital requirements to ratings is generally even more extreme.

The Bank for International Settlements also uses ratings to drive capital requirements, so the rating agencies have the same role in global capital markets that they have in the U.S.

For money market funds, ratings are equally critical: They are typically barred altogether from investments rated lower than AAA. In short, the ratings agencies are like a Consumer Reports for financial instruments -- but with the force of law behind their ratings. It is as if you were forbidden by law from buying an iron or a toaster unless it is rated 'Excellent.'"
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"But under the recourse rule, "well-capitalized" American commercial banks were required to spend 80 percent more capital on commercial loans, 80 percent more capital on corporate bonds, and 60 percent more capital on individual mortgages than they had to spend on asset-backed securities, including mortgage-backed bonds, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Specifically, $2 in capital was required for every $100 in mortgage-backed bonds, compared to $5 for the same amount in mortgage loans and $10 for the same amount in commercial loans."
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WSJ.com: "The Price for Fannie and Freddie Keeps Going Up"
Barney Frank's decision to 'roll the dice' on subsidized housing is becoming an epic disaster for taxpayers.
http://online.wsj.com/article/SB10001424052748703278604574624681873427574.html

"There is more to this ugly situation. New research by Edward Pinto, a former chief credit officer for Fannie Mae and a housing expert, has found that from the time Fannie and Freddie began buying risky loans as early as 1993, they routinely misrepresented the mortgages they were acquiring, reporting them as prime when they had characteristics that made them clearly subprime or Alt-A."
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WSJ.com: Let's Write the Rating Agencies Out of Our Law
By Robert Rosenkranz
http://online.wsj.com/article/SB123086073738348053.html

"Indeed, that is the entire raison d'être of the $6 trillion structured-finance business, which serves little economic function other than as a rating-agency arbitrage. Subprime mortgages (and all manner of other risky loans) held directly by financial institutions are questionable assets with high associated capital charges. Each one alone would deserve a "junk" rating. Structured finance simply piles such risky assets into bundles and slices the bundles into tranches. The rating agencies deemed some 85% of the tranches by value as AAA, and nearly 99% as investment grade -- thus turning dross into gold by a sort of ratings alchemy."
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AmericanThinker.com: Why the Mortgage Crisis Happened
By M. Jay Wells
http://www.americanthinker.com/2008/10/what_really_happened_in_the_mo.html
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Townhall.com: Frank Data: How Federal Policy Triggered the Mortgage Meltdown
http://townhall.com/columnists/CarlHorowitz/2010/05/29/frank_data_how_federal_policy_triggered_the_mortgage_meltdown
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Video of the CSPAN congressional hearings on the Fannie Mae and Freddie Mac Accounting scandal which came to light in 2004.
see: http://www.youtube.com/watch?v=_MGT_cSi7Rs
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Clinton administration's "BANK AFFIRMATIVE ACTION"
Andrew Cuomo references a Federal Reserve Report that was later discredited.
http://www.youtube.com/watch?v=ivmL-lXNy64
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IBDeditorials.com: How the Fed, Media and Academia Aided and Abetted Lending Debacle
http://www.investors.com/NewsAndAnalysis/Article.aspx?id=459798
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WSJ.com: A Mortgage Fable
http://online.wsj.com/article/SB122204078161261183.html
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WSJ.com: The Fannie Mae Gang
By Paul A. Gigot
http://online.wsj.com/article/SB121677050160675397.html
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WSJ.com: Information Haves and Have-Nots
http://online.wsj.com/article/SB122203382068860947.html
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NationalReview.com: Inside Obama’s ACORN
By Stanley Kurtz
http://article.nationalreview.com/?q=NDZiMjkwMDczZWI5ODdjOWYxZTIzZGIyNzEyMjE0ODI=
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IBDeditorials.com: Congress Tries To Fix What It Broke
http://www.investors.com/NewsAndAnalysis/Article.aspx?id=490605
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WSJ.com: Faith in Ratings
http://online.wsj.com/article/SB122212668589565225.html
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WSJ.com: The Moody's Blues
http://online.wsj.com/article/SB120303641478270219.html
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WSJ.com: AAA Oligopoly
http://online.wsj.com/article/SB120398754592392261.html
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WSJ.com: Another 'Deregulation' Myth
http://online.wsj.com/article/SB122428201410246019.html
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WSJ.com: Spitzer and Sarbox Were Deregulation?
http://online.wsj.com/article/SB122541609109386729.html
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WSJ.com: The Ratings Racket
http://online.wsj.com/article/SB121435051391301517.html
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WSJ.com: The Meltdown That Wasn't - A primer on credit default swaps, the latest Beltway scapegoat.
http://online.wsj.com/article/SB122670411909729683.html
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WSJ.com: Bad Accounting Rules Helped Sink AIG
http://online.wsj.com/article/SB122169320421449849.html
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NYTimes.com: Dear A.I.G., I Quit! http://www.nytimes.com/2009/03/25/opinion/25desantis.html
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SeattlePI.com: Activists vent at AIG executives http://www.seattlepi.com/business/404117_aigbus22.html