Burst Expectations
A new book argues that the failure of nontraditional mortgages was key to the financial crisis.
Time to get back to the three CsThe Associated Press
In his forthcoming book, "Hidden in Plain Sight: What Really Caused the World's Worst Financial Crisis and Why It Could Happen Again," Peter Wallison, a scholar at the American Enterprise Institute and former White House counsel to President Reagan, seeks to re-inject the word “mortgage” into the narrative of the 2008 financial crisis. At the center of his narrative are what he calls nontraditional mortgages.
Two decades ago, the major lenders employed mortgage underwriting requirements for collateral, capacity and credit history – the three Cs. Collateral meant that the home buyer made a down payment, preferably of 20 percent or more of the value of the house, never less than 10 percent. Capacity referred to the maximum share of a borrower's income that could be devoted to mortgage payments and other debt service. Credit history meant that the borrower demonstrated an ability to manage credit responsibly, an ability which has come to be summarized in a credit score.
Nontraditional mortgages are those in which the lender deliberately waives one or more of the three Cs. Over a very short span of time, beginning in the late 1990s and culminating in 2007, the U.S. housing market came to be dominated by such mortgages.
Wallison's thesis is that policymakers in Washington underestimated the significance of the surge in nontraditional mortgages. What is perhaps even more deplorable is the way that these mortgages continue to be downplayed in the mainstream narratives of the crisis and in the policy responses that followed.
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Political Cartoons on the Economy ]Wallison's own narrative may be summarized as follows:
- Government encouraged the growth in nontraditional mortgages. In the decades leading up to the crisis, government officials produced reports and statements criticizing lenders for sticking to the three Cs. They issued lending quotas to Freddie Mac, Fannie Mae and large commercial banks. To meet those quotas, those lenders had to turn to nontraditional mortgages.
- The high volume and low quality of nontraditional mortgages was never disclosed properly. Fannie Mae and Freddie Mac instead reported that their portfolios included only one or two percent of “subprime” loans. Later, Wallison's colleague Ed Pinto found that many of the loans that Freddie and Fannie classified as standard were in fact substandard loans that defaulted at much higher rates than conventional mortgages. Meanwhile, in the private sector securities market that Wall Street had cultivated, investors were surprised to see the extreme low quality of the underlying mortgages revealed. With investors quickly losing faith in what they were buying and trading, that mortgage securities market collapsed.
- The period from about 1995 to 2007 saw the longest, largest housing bubble in American history. This was fueled in part by the surge in nontraditional mortgages. When this bubble collapsed, such mortgages defaulted in large numbers. Wallison points out that the housing bubbles that took place in other countries were not as damaging, because other countries had not relied on nontraditional mortgages and thus their mortgage default rates remained relatively low. It was loss of confidence in the mortgage instruments issued in the U.S. that caused problems for financial institutions around the world.
- During the crisis, government failed to reassure investors and instead lurched from an unnecessary bailout of Bear Stearns to permitting the failure of Lehman Brothers, by which point the markets were not prepared for anything other than another bailout.
- After the crisis, Congress photo-shopped the narrative, using as instruments the Financial Crisis Inquiry Commission and the Dodd-Frank Act. Congress mandated regulation of practices that played no role in the crisis, either because legislators wanted to mislead the public or were themselves misled. Meanwhile, they did not confront the issue of what do about Freddie Mac and Fannie Mae, and they left the door open for the return of nontraditional mortgages. Indeed, Melvin L. Watt, the recently appointed regulator of Freddie Mac and Fannie Mae, is once again calling for the loosening of underwriting standards.
I do have a few quibbles with Wallison's forthcoming book:
First, while nontraditional mortgages were a big part of the story, they were not the whole story. The problems were compounded by extreme leverage at Freddie, Fannie, the big banks and Wall Street firms. I am certain that Wallison would agree that all of these firms had way too much debt and too little equity, but this issue gets little play in the book.
Second, Wallison correctly points out that market value accounting has pro-cyclical characteristics, and this makes it problematic during a crisis. That is, as asset prices fall, firms must mark down their balance sheets, forcing them to sell assets to meet regulatory requirements, causing asset prices to fall further. However, I disagree with any suggestion that regulators abandon market value accounting, which would amount to putting on a blindfold concerning the bank's true condition. Instead, I would stick with market value accounting, and instead encourage some short-term forbearance that would permit banks to stay under-capitalized during brief periods of market turmoil. This, too, might be a risky approach for regulators to take, but at least the risks could be better measured and understood.
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Put the Market Back in Real Estate ]Finally, Wallison says that prior to 1995, Countrywide Funding Corp. was “just another subprime lender.” In fact, Countrywide had been for a number of years one of the leading originators of loans conforming to Freddie Mac and Fannie Mae standards. Because he is going to be attacked by partisans who will seize on every mistake they can find, he has to be more careful than this.
On the whole, I think that Wallison makes a good case. Indeed, “Hidden in Plain Sight” bears out a pessimistic prediction I made five years ago. In August 2009, I commented on a speech that then-Federal Reserve Chairman Ben Bernanke had just given that “’panic’ appears 14 times during the speech. The phrase ‘house prices’ appears just twice, and the phrase ‘mortgage defaults’ appears just once.” Two months later, concerning the use of the word “mortgage” in the crisis narrative, I predicted, “The use of the M word will be highly correlated with ideology. Toward the right, the M word will be used a lot. Toward the left, the M word will be used less. Instead, we will hear lots of G words – global imbalances, Gramm-Leach-Bliley, greed, and so on.”
Indeed, the gulf remains wide between Wallison and his opponents, who refuse to ascribe any blame for the crisis to Freddie Mac, Fannie Mae and other misguided government interventions in mortgage lending. A fair-minded person should at least read Wallison's book before committing wholeheartedly to an opposing narrative.