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Sub-Prime & Financial Markets
Meltdown |
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Part I of this 2-part
commentary takes a look at the politics that triggered Contrary to what you hear from politicians and media pundits, the sub-prime and financial meltdown of September 2008 was caused by a political screw-up, not the failure of the free market or capitalism. Specifically, it was government intervention in the free market that created the meltdown, and politicians on both sides of the aisle are responsible. Let me explain. Many American cities deteriorated in the 1970s, and this decline was thought to be caused by several things including limited credit availability to urban residents. Federally insured banks and thrifts were accused of being willing to accept deposits from minorities in low-income neighborhoods, but not willing to lend or invest there. Banks were also accused of red-lining (lending or not lending based on the geographic location and/or race of the borrower). The Community Reinvestment Act (CRA) of 1977 is a liberal piece of social legislation that was enacted to address the deteriorating condition of American cities. It was this revised and well-meaning piece of legislation, intended to reduce credit-related discrimination and expand access to credit, that prompted and pressured lending institutions to issue loans and mortgages to unqualified borrowers. Under the CRA, banks get reviewed by banking regulators every two years and are assigned a CRA Rating of “Outstanding,” “Satisfactory,” “Needs to Improve,” or “Substantial Noncompliance.” In May 1995, President Clinton issued a directive that the CRA be revised to change how banks achieve their CRA Ratings. Before Clinton’s directive, lenders only needed to show bank examiners that they engaged in outreach to low-income people in extremely economically disadvantaged areas to get a favorable CRA Rating. Outreach usually took the form of advertising in minority-oriented newspapers and having bank executives serve on the boards of local community groups. After Clinton’s directive, banks had to show that they actually issued loans to people with a low socio-economic status. Now the CRA was results-based. I think of the CRA (since Clinton’s 1995 directive) as an Affirmative Action program for mortgage lending. Like Affirmative Action, the CRA morphed from an outreach program intended to create equal opportunities to unwritten but mandated quotas. Here’s where the Association of Community Organizations for Reform Now (ACORN) comes into play. If institutions neglect to show loans to low-income individuals on their books, ACORN legally extorts lenders by protesting at their offices and/or filing or threatening to file CRA petitions with bank regulators. These petitions have the affect of stalling or preventing any significant changes to business operations that a bank wants to make (like opening a new branch or merging with another bank). ACORN protesters file petitions on CRA grounds that the lender hasn’t made enough loans to government “preferred” borrowers, nor saved enough “preferred” borrowers from foreclosure. “Preferred” borrowers to ACORN = low-income and minority borrowers. So as crazy as it sounds, in order for a CRA-regulated lender to be in compliance with the CRA and achieve that much-needed, favorable CRA rating, a lender has to issue mortgages and loans to unqualified borrowers. Without a favorable CRA rating, a lender is hard pressed to obtain regulatory approval on operational goals and objectives. Unfortunately, the lending practices of CRA-regulated institutions ended up becoming the industry norm, as non-CRA-regulated lenders also adopted the same or similar practices. As a result, more and more loans and mortgages were issued to low-income borrowers who could only afford them in the short term, thanks to their low, introductory, interest rates (teaser rates). Even though most sub-prime loans offered teaser rates that would eventually reset up, Democrat politicians publicly hailed them as key to achieving their long-time goal of affordable housing for low-income and minority individuals. Democrats are on written and video record defending Fannie Mae’s and Freddie Mac’s huge portfolios of sub-prime mortgages during the Congressional Oversight Committee hearings of 2004. This Committee convened to review Fannie’s and Freddie’s questionable mortgage and accounting practices brought to light by Mr. Armando Falcon, Jr., Director of the Office of Federal Housing Enterprise Oversight (OFHEO). This is the Agency responsible for the “safety and soundness” of Fannie Mae and Freddie Mac. Ironically, rather than inquiring about the financial practices of Fannie and Freddie during these hearings, Oversight Committee members questioned the credibility of OFHEO and Mr. Falcon, Jr. Moreover, Democrats resisted Republican’s suggestions for a stronger oversight body. Chairman of the Financial Services Committee Barney Frank even insisted that the mortgage and accounting practices of both GSEs, especially Fannie Mae, were safe and sound. Democrats showed strong, public support for sub-prime mortgages over the last decade and continued to do so until September 07, 2008, the day Fannie and Freddie went into conservatorship. Republicans were also complicit in maintaining the mortgage and accounting status quo’s at Fannie and Freddie. Although Republican Oversight Committee members did a fine job of pushing for a stronger oversight body in the 2004 hearings and even managed to get a bill out of Committee, they never took the bill to the Senate Floor for a vote. This is odd since Republicans enjoyed a Republican-majority Congress in 2004 and until 2006. Even if Democrats were not supportive of the bill, two years certainly seems like enough time to lobby for internal support among fellow Republicans for an oversight body on the same scale and level as the Office of the Comptroller of the Currency (OCC) and the Federal Reserve. Such a bill could have mitigated the sub-prime and financial markets meltdown we are now experiencing. Regulating Fannie and Freddie in a more powerful way was necessary, because their huge purchases of sub-prime mortgages encouraged lenders to continue making them; lots of them. Moreover, Republicans could have addressed the root of the problem: the CRA. They could have insisted that the CRA be revised (again) to relieve the pressure on banks to issue mortgages to marginal and unqualified borrowers. Instead, Republicans took no action for fear of being branded racist, because returning to pre-1995 performance standards (for a favorable CRA rating) would disproportionately reduce the number of mortgages granted to people of color. Needless to say, the current mortgage and financial meltdown has relieved the pressure on banks to continue issuing loans to unqualified borrowers; the CRA notwithstanding. To summarize, Democrats engaged in sins of commission by engaging in social engineering via CRA legislation. Republicans engaged in sins of omission by neglecting to reign in the mortgage and accounting practices of Fannie and Freddie with a stronger and more powerful oversight body. Now you know the politics that caused the current sub-prime and financial markets meltdown. Part II focuses on the lending practices and market events that exacerbated the crisis. |
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