Arnold Kling typed up a draft testimony on what caused the mortgage/financial crisis:
Forty years ago, depository institutions handled mortgage credit risk very differently than they do today. Back then, the depository institution, which was typically a savings and loan association, held mortgages that were underwritten by its own employees, given to borrowers and backed by homes in its own community. These were almost always 30-year, fixed-rate loans, with borrowers having made a significant down payment, often 20 percent of the price of the home. Call this approach to mortgage lending “Method A.”Today, mortgage loans held by depository institutions are often in the form of securities. These securities are backed by loans originated in distant communities by unknown borrowers, underwritten by mortgage brokers or other personnel not employed by the depository institution. The loans are often not 30-year fixed-rate loans, and the borrowers have typically made down payments of 5 percent or less, including loans with no down payment at all. Call this approach to mortgage lending “Method B.”
If you compare the two methods using common sense, then Method B does not pass a simple sanity check. In fact, the current financial crisis consists of banks that are up to their necks in Method B.
Method A suffered a breakdown in the 1970′s, because inflation was allowed to get out of control. The 6 percent mortgage interest rates that were commonly charged by savings and loans became untenable when inflation and interest rates soared to double-digit levels. The savings and loan industry went out of business. Whether Method B could survive a similar shock is unclear. The right lesson to learn from the 1970′s was not that we should use Method B. The right lesson to learn is that we should not let inflation get out of hand.
To survive against Method A, Kling notes, Method B requires government favors and subsidies. It always has, and it always will:
The secondary mortgage market began in 1968, when the United States formed the Government National Mortgage Association (GNMA). GNMA pooled loans originated under programs by the Federal Housing Administration (FHA) and the Veterans Administration (VA) and sold these pools to investors. The purpose of this, as with the quasi-privatization of the Federal National Mortgage Association (Fannie Mae) that took place that year, was to take Federally guaranteed mortgage loans off of the books. President Johnson, fighting an unpopular war in Vietnam, wanted to save himself the embarrassment of having to come to Congress to ask for larger and larger increases in the ceiling on the national debt.Thus, the first steps toward mortgage securitization were taken in order to disguise financial reality using accounting gimmicks. It has been the same ever since.
In the early 1980′s, the savings and loan industry was imploding. The savings and loans held many mortgages that had lost value, due to inflation and high interest rates. Under the accounting rules prevailing at the time, they could record the mortgages at their original book values–as long as they did not sell them. The S&L’s were stuck. If they did not sell mortgages, they would lack the cash to pay depositors. If they did sell mortgages, they would have to recognize losses, and regulators would shut them down.
The solution was a program called Guarantor at Freddie Mac and Swap at Fannie Mae. Under this program,, an S&L paid Fannie or Freddie a fee to pool loans into securities, which were retained by the S&L. The S&L could then use the securities as collateral to obtain loans. The key to the whole operation was an accounting ruling that allowed the S&L’s to maintain the fictional book values of the mortgages held as securities,, even though lenders were using much lower market values when providing the collateralized loans to the S&L’s. This accounting ruling came from fierce lobbying by Wall Street, which wanted to broker the loans to the S&L’s.
Freddie Mac, Fannie Mae, and Wall Street extracted large fees from this program. Ultimately, most of the S&L’s failed, with losses borne by taxpayers. The Guarantor and Swap programs increased the cost, both directly by transferring wealth out of the S&L’s and indirectly by allowing defunct S&L’s to remain in business and continue gambling with other people’s money.
Following the demise of the S&L’s, regulators established capital requirements and other rules that made Method A lending very expensive relative to Method B lending. Freddie Mac and Fannie Mae were given freedom to leverage their guarantee at much higher ratios of assets to capital than were Method A lenders. In fact, the capital regulations even told banks that holding private mortgage securities under Method B was less risky and therefore required less capital than Method A lending. The result was that Method B came to dominate the American mortgage market. Had the playing field been level, Method A would have remained in place, and Method B likely would never have gotten started.
Rad the whole thing.