What really happened and how do we really fix it? Posted by mitcka at 10/21/08 02:56 PM

You may think that the mortgage crisis was caused by people getting loans they didn't deserve, shouldn't have gotten, and couldn't afford--with government help. This commentary in the Wall Street Journal blames the crisis on federal policies such as the Community Reinvestment Act.

That turns out to be wrong.

The Community Reinvestment Act (passed in 1977) encouraged lenders to lend responsibly in areas previously underserved by banks, like rural and inner city areas.

Recent studies cited in the Washington Post are already proving that CRA-regulated lenders made few risky loans and were far more likely to keep those loans in their portfolios--taking long term responsibility for the risks they did take.

Traiger & Hinckley, a New York-based law firm that represents lenders complying with CRA regulation, took a look at whether the law encouraged irresponsible lending.

"CRA banks were significantly less likely than other lenders to make a high-cost loan," the law firm's report found. When CRA banks did originate high-cost loans, the average APR (annual percentage rate) was appreciably lower than the average APR on high-cost loans originated by other lenders.

Further, CRA banks were more than twice as likely as other lenders to retain originated loans in their portfolio, said Warren Traiger, a partner at Traiger & Hinckley.

"If more lenders were covered by CRA, the crisis would have been mitigated," Traiger said in an interview.

The vast majority of risky loans were made by lenders not even subject to CRA, according to expert testimony before Congress earlier this year.

That's not to say there were not market failures, or that the government didn't have a hand in those failures. Largely in this decade, there have been several key changes that lead housing markets in such ritzy places as San Diego and Las Vegas to overheat.

1. Mortgage lending began to generate fees to multiple parties, most of whom had little or no risk if the loan was never repaid. Mortgage brokers, lenders and investment houses got fees when loans were made and sold, keeping the fees and moving the risk on to the ultimate investor (often us, in our retirement or pension funds). Because lenders made their money on the fees instead of on repayment, this created an incentive to make loans without careful scrutiny of the ability to repay them and encouraged complicated and even deceptive loan product designs.

2. 2000 the Commodities Futures Modernization Act assured Wall Street that it could trade in "swaps" without regulatory oversight.

3. 2004 the SEC waives leverage rules that once limited the amount of debt the big firms like Goldman Sachs could pile up in search of ever greater profits. Leverage is a primary reason we have a world wide meltdown rather than merely a burst housing bubble.

4. 2004 SEC creates program of "voluntary supervision" of major Wall Street firms. Last month, the SEC chairman shut the program down, conceding that it didn't work, after an internal audit report found it "fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily."

Add to this deregulatory frenzy, a commitment by the Fed to keep interest rates very low over several years (a factor whose importance can't be overstated), and you have the makings of a really big bubble.

There's an important outcome common across most of the key changes that got us into this crisis: the people who make the loans in the first place (and earn big, up front fees) no longer have to accept the long term risk of default. Mortgage brokers who sell for fees, and banks who securitize and sell the risk to someone else, and investment firms who slice and dice that risk and sell it off again each have an incentive to make the most they can right now while someone else deals with any headaches that might arise later. Ultimately that someone else was the taxpayer.

Oregon economics professor Mark Thoma gives us this excellent, common sense description of the real problem. A good analysis can start us towards a real solution.

If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans.

The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.

Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.

A solution to this is to give each person in the chain a stake in the future outcome of the mortgage.

This means making sure borrowers can repay their loans, limiting abusive loans structured to fail (like a low teaser rate designed to go up a lot), and making sure that everyone in the mortgage food chain has skin in the game. Everyone who gets a fee should be at risk of losing it if the loan isn’t repaid. Then, we must also make sure regulators aren’t asleep at the wheel and we must rein in corporate leveraging so that small problems don’t become global ones. There's a lot to do. We better get to it!

comments (15)

1 Posted by Roger Bury at 10/30/08 06:27 PM

Is it possible for Consumers Reports to get back to product reviews and stop the left wing propaganda? I like the product reviews. I am an adult and I don't need you to tell me how to think.

2 Posted by Chip at 10/30/08 06:36 PM

Everything said here is true, but it certainly isn't the whole truth. There is a horrible trend that has developed in this country to blame business for poor judgement, and to pity the individual as the victim. Individual responsibility is disregarded. That in itself explains a lot of the problems in this country.

I remember several years ago hearing ads on the radio for 110% interest-only mortgages. I thought "What kind of a fool would overextend himself like that." If you won't watch out for yourself, you have no right to expect someone else to do it for you.

Such people are just as responsible for this mess as the brokers, and many will keep their houses and not be held responsible for much of the cash that has disappeared.

Fannie and Freddie were rigged games, rigged by both political parties. Barney Frank blockaded efforts to regulate them.

Efforts by Consumer Reports to further politcize the issues, rather than solve them, hurts us all in the long run.

3 Posted by A. Schrut, M.D. at 10/30/08 10:12 PM

I trust Consumers, who investigate carefully and are objective in what they do.

This goes for their views of the mortgage crisis and its aftermath.

4 Posted by SRM at 10/30/08 11:45 PM

If folks like Roger don't want to read the important information on this site, he just needs to stop coming here and stay on the product review web page. That's the neat thing about the internet, we have the freedom to type in any URL we want and don't have to type in the URL's we don't like. I suspect such folks would be more comfortable with the right-wing spin on Bill O'Reilly's webpage.

I can't wait for Obama to take the reigns from Bush and his failed economic policies and oversight (or lack thereof). Obama will look after the majority of Americans, those of us in the middle class who were dismissed by Bush's focus on his "have more's." Obama will appoint regulators who actually believe their job is to regulate the banks and other big financial entities. GO OBAMA.

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5 Posted by Claude Laniado at 10/31/08 12:03 AM

check out

1) documentary IOUSA on the financial crisis and how we got there and the corruption
2) check out Hal Turner's video on what the US government is planning to do(while the value of the dollar is going down to zero in the next couple of months and the amero dollar we'll be taking it's place..not sure how mich of this is true...but it is certainly a problem to investigate further before it is too late..

http://video.google.com/videoplay?docid=1954933468700958565&hl=es

6 Posted by jim at 10/31/08 08:47 AM

all this bailout is crazy , in a few years it will happen again. how about putting a few billion back in s.s. that they borrowed ( stole). we need to clean out washington .nothing with our government, just the clowns running it . they all need to take a course in economics

7 Posted by Mark at 10/31/08 10:51 AM

I just read an article that bailout money that the government is giving the banks will go to yera end bouses. Where's the regulation?!!! How arrogant can these CEO's get?!!! This needs to be stopped immediately. There has to be strict accounting for this money.

8 Posted by Geraldine Allen at 10/31/08 10:58 AM

One commenter "cleverly" said he/she doesn't need to be taught "how to think." I beg to differ. I'm 86 and being widowed and living alone for the past 7 years, I've had time to use my energy to learn about our country and myself. I am educated at the master's degree level, but I've learned that I'm woefully uninformed on American history and especially am I ignorant of economic and financial problems.
Paul Krugman's editorials are to my searching mind like water to someone dying of thirst. Other writers are helpful also, but his layman's assessment of current problems helps me realize that I CAN come to understand economics and finance WITHOUT
POLITICAL OR IDEOLOGICAL BIAS! God help us all in this country if we can't learn to educate ourselves and consider the whole country, everybody, poor as well as rich and all of us in between who are so fast dropping into poverty.

9 Posted by Brian at 11/01/08 07:35 AM

So much bogus information coming out! The bottom line is that the Politicians rewarded certain political players to be put in charge of Freddy Mack and Fannie May and forced institutions to give Mortgage Loans to people who had no ways or means to even pay off these mortgages. People who were not even U.S.A. citizens were given loans that should only go to Citizens who have earned this right. We have socail break-down of Common Sense for extremist political self interests. Be careful about swallowing all the lies and deceit that are in the mainstream newsmedia and many political self interest and special interest groups. Our political system is corrupted by many politicians for the sake of power and the almighty dollar. And this so called melt down is one more symptom. We need to vote out the corrupt and don't trust the smooth talking candidates without close scrutiny of their points.

10 Posted by Brian at 11/01/08 07:36 AM

Help us!

11 Posted by James Johnson at 11/01/08 02:50 PM

Boost economy with trillions of dollars by reducing credit card interest to a maximum of 10% APR or lower. The financial institutions got us started in this mess with bait and switch schemes, like low introductory rates on credit cards and ARM mortgages, than increasing rates until foreclosure. They now have the real estate to resell and make even more money, but Wall Street wizard tried to get rich too and kept reselling the securities as AAA class.

12 Posted by george reeves at 11/01/08 04:12 PM

Many Anericans, even among the most formally educated, don't know how to buy a house, evaluate the costs of interest, mortagage payment plans, insurance requirements, maintenance and improvement and furnishing costs as a percentage of their income not only during the "teaser" period but also over a long term. They don't read nor understand the underlying documentation.

All most think of is that 1) I need a tax deduction and 2) the presumed increase market value will cover any errors and I can always sell.

Since the investment in a principal home is probably the largest financial decision that most will make during their lifetime, a formal high school level, or community college for credit course should be required that focuses on basic home ownership including the use of other personal debt since as credit cards, home equities, leasing, appliance and auto finance, etc. Nothing theoretical. Practical day to day stuff.

We'd avoid a lot of problems.

13 Posted by Nina Bell at 11/02/08 11:52 AM

It is a disgrace for CEOs to receive a bonus after their company requires government help to stay afloat. Citizens should not pay for mistakes made by companies, nor should the government, which winds up being the same.

14 Posted by Chas at 11/03/08 09:44 AM

When i bought my first house, you needed 20% down to get a conventional loan. If less than that, one could get an FHA of GI or whatever you qualified for with as little as 5% down or less for GI. As time has gone on, it seems that the ultimate goal was to have bigger and bigger houses to give the impression that you had 'arrived'.The same with SUVs and ubber luxury sedans. Personally, my feeling is this; If you are living beyond your means for whatever reason, you will crash and you have no one to blame but the guy who looks back at you in the mirror. You got there without help,now get help to work you way out of trouble and then learn from the experience and don't repeat.

15 Posted by Think Twice at 11/05/08 07:55 PM

News you can trust; just like the product reviews.