Who to Blame for the Financial Crisis

Homeowners, mortgage lenders, consumers, bankers, political leaders, corporate chiefs and more.


U.S. home prices grew by an average of 3 percent per year from 1945 to 2001. During the next five years, they rose at an estimated 16 percent annually. That includes homes that took on mortgages to extract equity, helping to reduce the equi­ty content in U.S. housing from nearly 70 percent in 1965 to 43 percent in 2007.

At the same time, Freddie and Fannie wriggled out of tighter regulation by donating thousands of dollars to political action committees.

The disastrous subprime market was thus the creature not so much of Wall Street as of our political leaders, who created the subprime market by pressing banks to make riskier loans and then virtually compelling Fannie and Freddie to liquefy these toxic assets by putting more and more of them on their own balance sheets. Fannie and Freddie had been buying risky loans since 1993 to meet the "affordable housing" requirements established by Congress. No one in successive administrations effectively monitored the consequences, especially the workings of the 1977 Community Reinvestment Act, which was designed to make loans available in poorer communities. Obsessed by this political objective, Democrats would not support regulations suggested by the Republicans in the Senate Banking Committee in 2005 that would have established more auditing and oversight.

The result? At the end of 2008, these two agencies held or guaranteed about 10 million subprime and alt-A mort­gages through mortgage-backed securities. These hazardous loans had a principal balance of $1.6 trillion. These are the loans that began to default at unprecedented rates in 2008 and 2009 and forced the government to take control of Fannie and Freddie, which then continued to buy dicey mortgages to minimize the housing crisis.

More troubling, Peter Wallison's report in the Wall Street Journal on research by Edward Pinto, a former chief credit officer at Fannie Mae, says that "from the time Fannie and Freddie began buying risky loans . . . they routinely misrepresented the mortgages . . . as prime when they had characteristics that made them clearly subprime or alt-A." According to Wallison, "Of the 26 million subprime and alt-A loans outstanding in 2008, 10 million were held or guaranteed by Fannie and Freddie, 5.2 million by other government agencies, and 1.4 million were still on the books of the four largest U.S. banks." And 7.7 million subprime and alt-A housing loans were in mortgage pools supporting mortgage-backed securities issued by Wall Street banks.

Where were the rating agencies when this house of cards was being built? Most of the loans were rated AAA. But what did that mean?

The raters went merrily along assuming that any losses incurred from defaults would be within the historical range. But the assumptions were false, in part because of irrational exuberance and in part because of the mislabeling of defaults and actual losses after foreclosures exceeded all prior experience. Everybody was incurring unprecedented losses and deficits, but the rating agencies and regulators seemed to have lost touch with reality.

In the meantime, while the party was on, some 75 percent of the interest-­only or negative amortization loans that didn't require near-term principal payments were packaged into securities. The banks sold these and other complex financial products as securities worldwide to monetize a lending binge of consumer loans of all flavors: mortgages, home equity lines, credit cards, auto loans, student loans, and commercial real estate. Many mortgages were too large in relation to the real value of the homes, and some were taken out to support lifestyles by drawing down the equity in the homes. When the housing bubble burst and homeowners could no longer service the mortgages, the default rate soared to levels never before experienced or contemplated—way beyond the 1 percent to 2 percent during good times or even the 6 percent to 7 percent during recessions, to levels of nearly 10 percent for fixed rate mortgages, more than 25 percent for subprime adjustable rate mortgages, and almost 60 percent for option adjustable rate mortgages.