Matt Yglesias

39 Responses to “Blame-Shifting”

1. James Says:
   October 2nd, 2008 at 2:31 pm

   I am so tired of this conservative canard. The CRA, Fannie Mae and Freddie Mac contributed nothing to this mortgage problem. I will explain one more time.

   The mortgage meltdown came about because of lending industry deregulation, led by Republicans with some Democratic help. Before 1995, profitable and performing loans were the same. Deregulation led to fragmentation of the industry which then gave a financial incentive to all people in the mortgage origination-to-sale-to-security chain to create profitable as opposed to performing loans, which are loans that people pay every month. In 1995 the Republicans in control of Congress changed the FRB’s RESPA anti-kickback rules for mortgage brokers, thereby allowing lenders to pay brokers a yield spread premium (also called a par plus payment). In a nutshell, this is a payment made by the lender to the broker if the broker originates a loan that is a higher than par rate for that borrower. For example if a broker has an “A” rated borrower based on his loan application, and now his FICA/Fair Isaac score, that qualifies for the lender’s best 6% loan, the lender will pay the broker a premium if the broker can lock and close that “A” borrower into a higher 8% loan. That 8% loan has more value to the lender than a regular 8% loan because an “A” borrower, who is less likely to default, is paying an interest rate that a “B” borrower would pay, who is more at risk of default. In the 1990s consumer lawyers around the country argued that this payment was a kickback for the referral of business, the higher par loan, made illegal under RESPA because the broker does no more work to close the loan at 6% than he does at 8%. The broker is being paid by the lender to refer the lender the higher than par rate loan, which is an illegal kickback for the referral of business. The mortgage industry got Congressand the FRB to change this anti-kickback rule so that consumers had to prove the overall broker compensation was unreasonable, an impossible task because most states allowed lenders to charge up to 10% of the loan amount for his commission. The non bank lenders led by Countrywide, Ameriquest, Home Eq., etc., saw this as a means to eliminate offices, and the overhead and management issues of having an office in every city. These lenders, Countrywide being the most famous, created a nationwide network of brokers who they would pay yield spread payments for originating higher than par loans. Countrywide would get short term money to fund the loans, which had to be “qualifying loans” for Fannie and Freddie to buy, then turn around and sell them on the secondary market. The broker would qualify the borrower by giving him an adjustable loan with a 1 year discounted teaser rate and qualify the borrower at the lower monthly payment. So, for a simplified example, an “A” borrower goes to a mortgage broker and says “I need a $100,000.00 loan”. Since he is an “A” borrower he qualifies for 6%, but the broker would search for the lender who would pay him the highest yield spread, usually Countrywide and tell the borrower: “all you can get is a 8% loan, but I can discount that to 4% for the first year and qualify you.” The broker would also tell the borrower to pay down non-secured debt so the lender would qualify him for the loan i.e. the credit cards and car loan, thus driving up the total principal and their yield spread payment. Now the $100,000.00 6% loan is at $125,000.00 and 8% – barely affordable until discounted for the 1st year to say 4%. At closing Countrywide would draw $125,000.00 on its short term line of credit, and fund the loan, paying the broker the yield spread. Countrywide would then sell these qualifying loans in the secondary market. The loan was “teased” to 4% for the 1st year so the borrower qualified under that lower rate. The broker would tell the borrower “Do not worry about the increase, just come back when the loan increases and I will refi you.”

   Allowing interstate banking, then Gramm-Leach-Bliley that eliminated the wall between investment banks, deposit banks, and insurance companies, with a boost from the parity statute created a huge pool of money to lend which did not have to be “qualifying” loans, or loans that had to meet minimum underwriting guidelines so they were eligible for purchase by Fannie/Freddie. Now deregulated, the Countrywides of the world did not have originated mortgages as qualifying loans eligible for purchase by Fannie or Freddie because the newly deregulated investment banks would buy them. This allowed Countrywide to take this pool of loans, a mixture of “A” “B” “C” and “D” grade borrowers and go to someone like Merrill Lynch and say “I have 1,000 loans average $125,000.00 each with an average 10% yield over 30 years with a present value of $150,000.00, (now consisting of 100% LTV loans and very risky borrowers who could default when the loans adjusted). I will sell you the loans for $140,000.00.” When Merrill bought, Countrywide would then pay back its credit line and just made $15,000.00 per loan less its yield spread less its costs of money for 1,000 loans, or lets say $10,000.00 per loan which is $10 million. Meanwhile Countrywide kept the servicing rights for these loans which also generated another income stream for Countrywide. Merrill Lynch before deregulation was prohibited from entering the mortgage business. Gramm’s bill made the investment banks an unregulated lender, with an income stream from Countrywide as the servicing agent. Merrill would then securitize and sell the pool of loans to Bank of America as Trustee (after buying Countrywide and Merrill Lynch, BOA has a vertical monopoly in the mortgage business from Countrywide’s network of brokers, to BOA’s ability to short term fund the broker’s loans, to Countrywide’s mortgage servicing business to Merrill Lynch who would securitize the pool, to BOA who acts as Trustee for the securitized loans), as a non-regulated security. BOA in essence sold shares of stock in the pool of mortgages. The rating of these pools of loans was privatized, which means that a company like Moody’s was given the rating task. Moody’s had no idea how to rate a pool of loans which had a mix of “A” through “D” loans, all with greater degrees of risk of default because these borrowers were now paying slightly higher interest rates than they would be expected to pay, and would probably not pay when the rates changed. Moody had no idea if the homes, the collateral, were properly appraised and had sufficient equity to cover a default. Moody’s essentially saw a pool of loans with “A” to “D” borrowers with 15%-20% of the pool as “A”, and so rated the pool as AAA which was its highest degree of safety. In other words, Moody’s rated a pool of largely junk loans as AAA rated securities, which entities like Bank of America, as Trustee for “ABC” asset backed securities bought and sold as great investments. (As I understand it they later divided these pools into tranches or 3 different degrees of safety and sold them accordingly).

   No one had a financial incentive to make sure the originator closed a performing loan – a loan that the borrower would pay back, and if not, that the collateral had sufficient equity to pay back the principal. The Broker and Countrywide as originator, only had an incentive to close profitable loans – loans they could sell. They could care less if the loans were performing loans. Everything was “sellable” as long as the pool was sold before too many of the loans started to default. They were very likely sold before any default because mortgages are paid in arrears and closing agents collected the 1st fragmented month’s interest at closing. So the first payment was not even due until anywhere from 30 to 60 days after closing – a window in which the mortgages were often sold twice.

   There were no underwriting rules because the originators and lenders, Countrywide and Merrill, were unregulated, and did not have to sell to Fannie/Freddie, so the loans were also non-qualifying. The industry then began to originate non-income qualifying loans i.e. stated income. Many people gave the correct income info to the broker, who then submitted an application to the lender with false income information. These loans were justified because of the values of the properties. The brokers would get friendly appraisers to give a high-ball appraisal then submit the loan package. The appraiser would either give the broker a higher appraisal or he would lose that broker’s business. This was the first wave of foreclosures that went through the courts. These sub-prime loans defaulted because they were based on one or all or a combination of these factors: 1) borrowers who qualified for lower (teased, discounted rates, or interest only loans); 2) inflated income by the broker who wanted to close the loan and get paid; 3) high-ball appraisals, 4) and all the borrowers were paying higher interest than they should have paid after their discount expired because of the yield spread.

   Around 2001/2002, we are 2/3 years post-deregulation. The non-deposit banks like Merrill and Lehman and Goldman were buying up all of the non-qualifying mortgages from the Countrywides that sprung up across the country, securitizing them and selling the securities, completely cutting Fannie/Freddie out of this lucrative business. The loans were all non-qualifying because they were more profitable than qualifying loans sold to Fannie/Freddie. No one was selling to Fannie/Freddie because brokers were originating “non-qualifying” loans that Fannie and Freddie could not buy – they were too risky. As quasi public companies, Fannie and Freddie had to drop their qualifying standards via regulatory changes. Fannie and Freddie then lowered their “qualifying” standards so they could buy these otherwise non-qualifying mortgages and join the securitized gravy train. If they did not, the now deregulated investment banks would force Fannie/Freddie out of the mortgage business and into bankruptcy. The Republican majorities in the Senate and House along with a Republican president were more than glad to deregulate Fannie and Freddie so they could compete with the unregulated investment banks. So Fannie and Freddie wound up with a lot of these toxic mortgage pools. They publicly sold the idea as “the ownership society” so more minorities and poor could own a home. The fact that these loans also helped meet CRA guidelines for the regulated banks that originated loans, the only entities covered by the CRA, was purely coincidental.

   The next wave we will see is because deregulation compounded the problem by allowing lenders to devise and close the 4 option mortgage. This mortgage allows a borrower to elect to pay on 1 of 4 options each month: 1) ½ of the interest that was due on the loan with the remaining ½ put on the back end of the loan. At the end of a fixed period, usually 3 or 5 years the borrower would have to amortize the full mortgage principal plus back end interest at whatever the rate was; 2) interest only; 3) amortize over 30 years; 4) amortize over 15 years. The Countrywide broker now could qualify a borrower if his income allowed him to pay ½ of the interest on a 30 year mortgage. This opened up a whole new category of borrower who could not otherwise qualify for a 30 year amortized loan. The broker would sell this 4 option mortgage to the consumer by telling him “just come back in 3 years or 5 years when the loan adjusts and we will refinance you because the house will go up in value” The broker used the same appraiser to over-appraise the value. Here is an example of how that loan works. A $100,000 10% mortgage would require $10,000 per year interest or about $850.00 per month. The broker would qualify the borrower at $425.00 per month which is ½ of the interest. After 3 years, the $100,000 principal is now $115,300.00 and costs about $1,200.00 per month to fully amortize over 27 years. The borrower’s payment almost triples. These are the loans that we are starting to see come through the foreclosure division. We will see this wave for a few years.

   You have to remember, too, these are amateur borrowers who have maybe 1 or 2 mortgages in their lifetime, relying on professional lenders who are closing 1 or 2 mortgages a week. The borrower usually relies on the lending professional to give good advice because the borrower thinks the broker is working for the borrower when he is not.

   The present free market of mortgage lending creates a climate where no one has an incentive to close a performing loan, just a profitable loan. This is the Republican free market working perfectly to cause this problem and why it needs to be strictly controlled. The Broker is working to maximize his yield spread payment. The incentive for the broker is to close as many loans to maximize his profit. He has no stake in getting the best loan for the borrower nor in making sure the loan will perform as long as he gets paid. If he worked as a loan officer for a bank that kept the loan and he closed too many loans that defaulted he would be fired. Countrywide had an incentive to pay brokers large yield spread premiums and originate as many loans as possible, then sell the loans as fast as possible. They did not care if the loan performed, so they closed an eye to the bad underwriting that went on and in fact encouraged its employees to qualify everyone – who cares at Countrywide as long as the loan is sold before it defaults. If Countrywide were a bank that kept the loan, a performing loan is paramount to keep them from failing. Merrill Lynch does not care if the loan performs as long as the pool is AAA rated and can be sold. This is why we are where we are. Government regualtion of the Merrills of the world would not allow a pool of in essence junk mortgages to be sold as AAA securities. The CRA and Fannie Mae Freddie Mac did not cause this problem. Deregulation is the cause of the problem.

2. RKU Says:
   October 2nd, 2008 at 2:36 pm

   Well, I’m pretty skeptical about whether the CRA has much to do with the Financial Meltdown, but I think there’s more of a case for illegal immigrants and Freddie/Fannie.

   After all, illegals seems to comprise a pretty huge fraction of the construction workers building all those new houses, especially in the states with the biggest Bubbles like CA. Without them, the cost of building would have been enormously larger, putting pressure on the profit margins of home-builders, meaning they probably wouldn’t have over-built so much on spec.

   Also, immigration in general certainly increased the competition for houses, thereby driving up prices. For example, if our population were stable or falling, a Housing Bubble would be extremely unlikely.

   And I think that everyone admits that Fannie/Freddie played a huge role over the decades in driving up home-ownership and housing prices. After all, this used to be one of their biggest bragging points…but now is less so!

3. DHN Says:
   October 2nd, 2008 at 2:38 pm

   Where did the money go?

   “We gave it all away to the colored people.”

   Yeah, that’ll fly.

4. Bob Oso Says:
   October 2nd, 2008 at 3:03 pm

   RKU,

   Seriously? Illegals caused builders to overbuild? It had nothing to do with the cheap loans that builders and homebuyers could get? All those illegals buying up houses caused the bubble? Get real.

5. roac Says:
   October 2nd, 2008 at 3:08 pm

   I got almost all the way through RKU’s post before my NOT IRONY warning light started flashing.

   The claim is that (1) Immigrants fueled the boom by working for practically nothing, and then (2) bid up the price of housing with all the money they had made.

   One thing that is not falling is the level of dumb.

6. bcg Says:
   October 2nd, 2008 at 3:11 pm

   I think there’s something wrong with saying that it doesn’t matter what the government may have done pre-Bush to conceive this disaster, even if Bush’s administration failed in their duty to abort it. Saying, “Bush should have stopped it, period. Don’t look in the past to see who else made mistakes, it was all Bush,” is more than a little intellectually dishonest.

7. roac Says:
   October 2nd, 2008 at 3:20 pm

   bcg: Certainly if other administrations made mistakes that contributed to the debacle, they bear part of the responsibility.

   What mistakes did they make, and how did they contribute? Show your work.

8. Jeffrey Davis Says:
   October 2nd, 2008 at 3:27 pm

   bcg,

   An understanding of necessary and sufficient causes: don’t apply for a sub-prime mortgage without it.

9. JohnH Says:
   October 2nd, 2008 at 3:31 pm

   So let’s see: (1) there wouldn’t have been a pyramid of diced and sliced subprime loans if there hadn’t been subprime loans, (2) there wouldn’t have been subprime loans if the banks hadn’t wanted to loan to more people than could afford prime loans, and (3) there wouldn’t be such people if they weren’t poorer than the GOP base. We conclude that (a) we should have regulated and restricted such loans, (b) we should have done something to reduce poverty, or (c) we should blame poor people and punish them accordingly. You guess which. Heck, I’m all for rounding them up and shooting them.

10. James Robertson Says:
    October 2nd, 2008 at 3:36 pm

    Those are all things created by and regulated by the people running the country, Matt. Do you take extra-stupid pills when it looks like some of the blame might land on Democrats?

11. Don Williams Says:
    October 2nd, 2008 at 3:38 pm

    As some of you may recall, I’m strongly opposed to our current high levels of immigration –because I think it depresses wages and prevents our lower income citizens from ever getting a leg up. The same lower income citizens who fight our country’s wars.

    But from what I’ve seen, immigration has both lifted our GDP and our housing values. In my area, at least, middle class to upper middle class immigrant professionals have bought a lot of houses at high prices. I think the market overall would have fallen (well before now ) without those buyers.

    Plus, if you look at US GDP growth, it has largely paced the population growth –growth which in turn has largely been from immigration. More people equals more money.

    I think that at the bottom line level, existing citizens are hurt –because even though total income rises as population rises, Per Capita income and wealth often fall. Because our resources(land,water, roads,etc) are shared among more people.
    Certainly we are suffering major environmental degradation from population growth — as well as stomach-churning atrocities like factory farming.

    But the burden of Social Security and Medicare obligations are lighter if shared among a larger group of young taxpayers.

    So the tradeoffs are complex — and usually not discussed in an honest fashion.

12. Scott Spearman Says:
    October 2nd, 2008 at 3:59 pm

    I love THIS DEBUNKING from a smart guy in the financial services industry, Barry Ritholtz. He also wrote THIS article in Barron’s that describes in what sense government is at fault.

    Scott

13. calscientist Says:
    October 2nd, 2008 at 4:28 pm

    Rush Limbaugh has upped the ante on all of this nonsense. Fannie Mae and Freddie Mac were untouchable to Dems you see because THEY WERE ABOUT REPARATIONS! Look to the bottom of the link of this transcript page. See how he deftly takes Obama, the housing crisis, and racist rants on reparations and ties them together in one neat bundle? What a man! What a drug addled gasbag!

14. Jim Says:
    October 2nd, 2008 at 4:40 pm

    Where are all of these minorities living large with their mortgages? Blacks make up 13% of the US population. How many of those own houses? And how many of those got mortgages through CRA?

    This talking point doesn’t make sense for about 40 different reasons.

15. James Robertson Says:
    October 2nd, 2008 at 4:57 pm

    The only ones I hear bringing up race are Democrats, as a way to fend off partial blame. Loans were granted to people who couldn’t possibly repay them, and the vast majority of those recipients were probably white. So what? They still couldn’t afford them, and Fannie, Freddie, and a bunch of people in government – including Barney Frank and Chris Dodd in particular – are to blame. Sure, the administration should have tried to call BS on this years ago. In fact, in 2003, the administration made a few weak attempts to make such a call – but it was demogogued by people like Frank. Same thing back in the 90’s, when a few people (in and out of government) wondered whether the free money theory of lending made sense.

    This is a bipartisan mess.

16. calscientist Says:
    October 2nd, 2008 at 5:11 pm

    James Robertson Says:
    October 2nd, 2008 at 4:57 pm

    The only ones I hear bringing up race are Democrats, as a way to fend off partial blame

    Uh, you are not listening very well. Take a look at the link I have to Limbaugh, and look up ENDLESS columns/etc (Krauthammer, …) trying to pin this on Dems and their concerns for minority home ownership.

17. James Robertson Says:
    October 2nd, 2008 at 5:18 pm

    calscientist – “low income” is not a match for “minority”. Most of the screaming I hear is the rational observation that we just got done having a party where we handed money that could never be repaid to a bunch of lower income people who themselves should have realized that the light they saw was an oncoming train. Heck, it wasn’t limited to lower income people, for that matter. When my wife and I were house shopping a decade ago, our real estate agent attempted to convince us that we should get a mortgage 2-4x what we were comfortable with. People all across the income spectrum have been being upsold on things they couldn’t afford.

18. calscientist Says:
    October 2nd, 2008 at 5:23 pm

    James Robertson Says:
    October 2nd, 2008 at 5:18 pm

    calscientist – “low income” is not a match for “minority”. Most of the screaming I hear is the rational observation that we just got done having a party where we handed money that could never be repaid to a bunch of lower income people who themselves should have realized that the light they saw was an oncoming train. Heck, it wasn’t limited to lower income people, for that matter.

    When Rush says reparations is that low income? These are dogwhistles James, and Limbaugh is simply being more explicit than the others.

19. Glaivester Says:
    October 2nd, 2008 at 5:52 pm

    Sure, the administration should have tried to call BS on this years ago. In fact, in 2003

    Huh? Bush was at the forefront of claiming that we needed to eliminate things like down payments in order to expand housing.

    CAP’s Michael Ettlinger takes on various conservative efforts to shift blame for the financial crisis off of the people running the government…

    Actually, the attempt is largely to take the blame off of the free market and put it onto the government, thank you very much.

    JohnH: No one is blaming poor people or minorities for the housing crisis. They are blaming the policies aimed at them. There has been a big push in recent years to get more people to have their own house rather than renting, and that has contributed to the housing bubble and to the related investment bubble in derivatives, hedge funds, etc.

    Also, what no one is mentioning is that Federal-Reserve backed fractional reserve banking with legal tender fiat money is in itself a form of regulation. Government through the Federal Reserve financed the bubble. Moreover, government’s implicit proise of bailouts created an environment where people were willing to take more risks because the government would cover their losses. So the idea that the government is only to blame for this for what it didn’t do (i.e. regulate more) and not what it did do (fund, insure, and encourage a massive surge in housing) is ludicrous.

20. oderb Says:
    October 2nd, 2008 at 5:58 pm

    Peter Wallison makes what seems to me a persuasive case that Freddie and Fannie were a big part of the problem. I’d be interested in seeing what folks with more understanding than I have think of his argument.

21. oderb Says:
    October 2nd, 2008 at 5:58 pm

    http://www.aei.org/publications/pubID.28704/pub_detail.asp

22. mikelotus Says:
    October 2nd, 2008 at 7:17 pm

    Nice try oderb, let’s try this instead: http://www.nytimes.com/2008/08/23/business/23nocera.html

23. James Robertson Says:
    October 2nd, 2008 at 7:30 pm

    calscientist – it’s not blaming the recipients to point out that the policies aimed at them were ultimately harmful. Not to mention that I couldn’t care less what Limbaugh says. Right here, I’m commenting on Matt’s inability to recognize that Democrats had a hand in this.

24. James Says:
    October 2nd, 2008 at 7:35 pm

    Brad Delong does a good job of debunking the CRA/ minority lending caused the meltdown myth:

    http://delong.typepad.com/

    J. Bradford DeLong is a Professor of Economics at U of Cal. at Berkeley MA and PhD from Harvard, his CV is on his site.

    This link discusses the statistics that show CRA loans were no more at risk of default than conventional or qualifying loans:
    In fact it examines the data which shows they have no greater default rate than other loans: chttp://www.allbusiness.com/personal-finance/real-estate-mortgage-loans/677967-1.html

25. James Says:
    October 2nd, 2008 at 7:36 pm

    Sorry here is the link:
    http://www.allbusiness.com/personal-finance/real-estate-mortgage-loans/677967-1.html

26. roac Says:
    October 2nd, 2008 at 7:37 pm

    If the accusation being directed at Fannie and Freddie hinges on greed, doesn’t that put the focus on the decision to privatize them, and thereby infuse them with the profit motive? Just asking; still trying to understand.

27. Aatos Says:
    October 2nd, 2008 at 7:43 pm

    Right, well if life were that hidden camera footage where the Black man gets quoted a higher interest rate rate than a White man, even though the White man has less income and a lower credit score, then these conservatives would be the ones hiding their face in their forearms and slamming the door on the camera crew.

28. MsAnne Says:
    October 2nd, 2008 at 7:43 pm

    James – first poster – excellent description. As the arguments for who’s to blame evolve, I can’t forget my own personal experience with the mortgage industry. I guess I didn’t realize how wise-spread this type of lending was.

    “The present free market of mortgage lending creates a climate where no one has an incentive to close a performing loan, just a profitable loan. This is the Republican free market working perfectly to cause this problem and why it needs to be strictly controlled. The Broker is working to maximize his yield spread payment. The incentive for the broker is to close as many loans to maximize his profit. He has no stake in getting the best loan for the borrower nor in making sure the loan will perform as long as he gets paid.”

    I applied for a mortgage, my first ever, in 2005. The type of loan you describe in your last paragraph, one with no income verification, or verification based upon Math I never understood was what was being pushed in my direction. We lived in Woodsy Mountain Resort, NH where property prices were greatly out of step with income, since the “boom” had allowed so many city folks to drive prices up buying second homes on their prosperity and steroid-enhanced equity in their primary homes. Greedy real estate agents also bolstered the confidence of young and inexperienced folks like myself with young families (I was pregnant at the time) and convinced them to buy more house than they could afford. Trying to get into the market at all required this type of loan for us based upon the disparity between income and real estate prices. All those same arguments were thrown at us – more equity in 5 years, better credit in 5 years, more income in 5 years etc…. Fortunately, I have prudent, wise, and fiscally responsible parents who advised me through the process. When I sat down with my dad (who is a real estate investor, and spent his early career days right out of college as a mortgage loan officer) and described the product to him and showed him the paper work – he was astounded. Bottom line – I decided to walk away from the market since renting was less expensive than owning in 2005. Sure glad I had someone to educate me and advise me, or else, I’d be a statistic.

    The system relied on low-information folks to eat these arguments up. And now, here we are. This is a market failure of a pretty tall order. I’m not a fan of government intervention and have only a limited academic knowledge of economics. My rule of thumb as a voter is that once a good crosses the line between private and public, I’m willing to finance it with my tax dollars or support legislation that will limit the liability to tax payers. In my limited knowledge opinion, that’s what we have here with this bailout: A private good turned public through market failures and not enough regulation to limit tax-payer liability.

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