Government policies and the subprime mortgage crisis

The subprime mortgage crisis was a major economic downturn that began in 2007 and lasted for several years. It was caused in part by government policies that encouraged lax lending standards.

Many of these policies were implemented in the early 2000s, when the housing market was booming. The government's goal was to increase homeownership rates, especially among low-income and minority households.

Subsidies and tax incentives were provided to encourage lenders to make more mortgages available to these groups. However, this led to a surge in subprime lending, where borrowers were given mortgages they couldn't afford.

As a result, many of these borrowers defaulted on their mortgages, causing a wave of foreclosures that further destabilized the housing market.

The government policies that contributed to the subprime mortgage crisis are a complex and multifaceted issue. The Financial Crisis Inquiry Commission (FCIC) argued that government affordable housing policies were not the major cause of the crisis, but rather a minor contributor.

Many economists, including Paul Krugman and David Min, point out that the simultaneous growth of the residential, commercial real estate, and consumer credit pricing bubbles in the US and general financial crisis outside it undermines the case that Fannie Mae, Freddie Mac, CRA, or predatory lending were primary causes of the crisis.

Government policies that encouraged affordable housing goals for Fannie Mae and Freddie Mac, such as the Housing and Community Development Act of 1992, led to an increase in subprime mortgages. The 1992 legislation required that 30% or more of Fannie's and Freddie's loan purchases be related to "affordable housing".

The Community Reinvestment Act (CRA) was enacted in 1977 to encourage banks to halt lending discrimination, but its effectiveness is debated among economists. Research indicates that only 6% of high-cost loans had any connection to the law, and loans made by CRA-regulated lenders were half as likely to default as similar loans made by independent mortgage originators.

The FCIC concluded that the CRA was not a significant factor in subprime lending or the crisis, and that many subprime lenders were not subject to the CRA.

The Alternative Mortgage Transaction Parity Act of 1982 allowed non-federally chartered housing creditors to write adjustable-rate mortgages, which contributed to the subprime mortgage crisis.

In 2006, approximately 90% of subprime mortgages issued were adjustable-rate mortgages, making them a key factor in the crisis. The widespread use of these mortgages led to predatory lending and eventual defaults.

Fannie Mae and Freddie Mac, government-sponsored enterprises, purchased mortgages and guaranteed a large fraction of them in the US. However, their role in the crisis is still debated.

Depository banks had moved assets and liabilities off-balance sheet through special purpose vehicles, allowing them to take on more risk while reducing their capital requirements. This practice, along with the lack of oversight, contributed to the crisis.

Investment banks, like Lehman Brothers and Merrill Lynch, were not subject to the same capital requirements as depository banks, leading to a significant increase in debt-to-equity ratios from 2003 to 2007.

Depository banks were subject to extensive regulation and oversight prior to the crisis, but they had moved sizable amounts of assets and liabilities off-balance sheet, allowing them to take on more risk.

FDIC Chair Sheila Bair cautioned against lowering bank capital requirements, warning that banks can operate with little or no capital, and governments and deposit insurers end up holding the bag.

The Federal Home Loan Banks provide loans to banks that are backed by mortgages, and they are one step removed from direct mortgage lending, but some of the broader policy issues are similar to those of the other GSEs.

Fannie Mae and Freddie Mac, two government-sponsored enterprises, purchased mortgages, bought and sold mortgage-backed securities, and guaranteed a large fraction of the mortgages in the U.S., with a net worth of only $114 billion as of June 30, 2008.

The Alternative Mortgage Transaction Parity Act of 1982 allowed non-federally chartered housing creditors to write adjustable-rate mortgages, which were credited with replacing conventional fixed-rate, amortizing mortgages, but also led to widespread abuses of predatory lending.

The subprime mortgage crisis was a key component of the 2008 financial crisis that led to the Great Recession, and it came about after years of expanded mortgage access drove up housing demand and prices and eventually led to a real estate bubble.

Many of the purchasers of collateralized debt obligations (CDOs) were banks, which were unable to sell these CDOs as defaults started to mount, and so had less money to lend, causing the housing market to decline further.

Subprime borrowers are those who have poor credit histories and are therefore more likely to default, and lenders charge higher interest rates to provide more return for the greater risk, but the advent of interest-only loans helped to lower monthly payments so subprime borrowers could afford them.

Hedge funds played a key role in the crisis by creating demand for mortgage-backed securities by pairing them with guarantees called credit default swaps, but when the Fed started raising interest rates, those with adjustable-rate mortgages couldn't make these higher payments.

The risk was not just confined to mortgages, as all kinds of debt were repackaged and resold as collateralized debt obligations, and buyers did not know how to price them, one reason being that they were so complicated and so new.

The parallel banking system, also called the shadow banking system, became critical to the credit markets underpinning the financial system, but was not subject to the same regulatory controls, and was vulnerable because it borrowed short-term in liquid markets to purchase long-term, illiquid and risky assets.

Home equity extraction played a significant role in economic growth during the Bush administration, with free cash used by consumers from equity extraction doubling from $627 billion in 2001 to $1,428 billion in 2005.

This surge in borrowing against home value helped finance personal consumption, contributing to a significant increase in GDP. GDP grew by approximately $2.3 trillion during the 2001-2005 period, from $10.1 to $12.4 trillion.

The housing bubble built rapidly during this time, with nearly $5 trillion of total borrowing over the period. This replaced an earlier huge bubble in stocks, as economist Paul Krugman noted in 2009.

The government's GDP measure was significantly influenced by home equity extraction, with economist Niall Ferguson stating that excluding this effect, the U.S. economy grew at a 1% rate during the Bush years.

The regulatory environment played a significant role in the subprime mortgage crisis. The Financial Crisis Inquiry Commission reported that the three credit rating agencies were key enablers of the crisis, providing high ratings to mortgage-backed securities that later became worthless.

The rating agencies were paid by the companies issuing the bonds, creating an independence issue. This led to a gross error in their assessment of the securities' risk.

Regulatory influence from the federal government also contributed to the crisis. The Treasury Department's Office of the Comptroller of the Currency struck down attempts by states to prevent the growth of a secondary market in repackaged predatory loans, citing federal banking laws.

A list of deregulatory actions that contributed to the crisis includes:

The deregulation of the financial industry played a significant role in the 2007-2008 crisis. The Federal Deposit Insurance Corporation (FDIC) placed significant blame on deregulation, stating that widespread failures in financial regulation and supervision proved devastating to the stability of the nation's financial markets.

The FDIC noted that more than 30 years of deregulation and reliance on self-regulation by financial institutions had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets.

The deregulation efforts were championed by former Federal Reserve chairman Alan Greenspan and others, and were supported by successive administrations and Congresses. The financial industry spent more than $5 billion over a decade to strengthen its political clout in Washington, DC.

A dozen steps of deregulation that set the stage for the crisis include the repeal of the Glass-Steagall Act, which prohibited commercial banks from undertaking investment banking operations. The Act was repealed in 1999, allowing commercial banks to engage in investment activities.

Here are the 12 steps of deregulation that contributed to the crisis:

Enactment of a statute to restrict regulation by the SEC of financial institutions

The financial industry's efforts to deregulate the industry ultimately led to the crisis, as it allowed for excessive risk-taking and leverage.

Credit rating agencies were key enablers of the financial meltdown. The Financial Crisis Inquiry Commission reported that these agencies provided the highest safety rating to mortgage-backed securities that later became worthless.

The three main credit rating agencies, Moody's and Standard and Poor's, were paid by the companies issuing the bonds, which presented an independence issue. This led to gross errors in their assessment of risky mortgage-backed securities.

Investors relied heavily on these ratings, often blindly, and in some cases, they were obligated to use them. Regulatory capital standards were also hinged on these ratings, making them a crucial factor in the crisis.

In 1994, Congress passed the Homeowners Equity Protection Act, which gave the Federal Reserve the authority to set rules on mortgages. However, the Federal Reserve refused to exercise this authority from 1995 until last year.

The crisis has persuaded many legislators, including Rep. Barney Frank, that it's time to impose regulations on nonbank mortgage lenders.

A little accounting rule called "mark to market" played a significant role in exacerbating the financial crisis. This rule forces banks to value their assets at current market conditions.

The rule led banks to inflate the value of their mortgage-backed securities as housing costs skyrocketed, causing them to scramble to increase the number of loans they made. They then loaded up on subprime mortgages, easing up on credit requirements in the process.

The mark to market rule deflated home values during the decline, making it harder for banks to recover. In 2009, the U.S. Financial Accounting Standards Board eased the rule, allowing banks to keep the value of their mortgage-backed securities on their books.

This suspension of the rule allowed banks to avoid writing down the value of their subprime securities, which would have triggered default clauses in their derivatives contracts. The contracts required coverage from credit default swaps insurance when the MBS value reached a certain level.

Here's a list of the major deregulatory steps that contributed to the crisis:

These deregulatory steps created an environment where banks could engage in risky behavior, such as loading up on subprime mortgages, without adequate oversight. The mark to market rule, which was intended to provide transparency, ultimately contributed to the crisis by allowing banks to hide the true value of their assets.

The Bush and Clinton Administrations played a significant role in shaping the policies that contributed to the subprime mortgage crisis. The Gramm-Leach-Bliley Act of 1999, signed into law by President Clinton, repealed parts of the Glass-Steagall Act of 1933, allowing commercial banks to engage in investment activities.

This deregulation led to a significant increase in subprime lending, as banks were able to take on more risk in pursuit of higher profits. The Community Reinvestment Act of 1977, also referenced in the article, was amended by the Clinton administration to allow for more flexible lending standards, further contributing to the growth of subprime lending.

The Bush administration's policies, such as the American Dream Downpayment Initiative, also aimed to increase homeownership rates, particularly among low-income and minority households, but ultimately contributed to the crisis by encouraging subprime lending.

The Clinton Administration made significant changes to the housing market through its policies. In 1995, the National Homeownership Strategy was devised, advocating for a general loosening of lending standards for affordable housing.

This strategy was implemented by HUD under the Clinton Administration. The Clinton Administration also made changes to the CRA in 1995, which critics deemed destructive.

Under the new rules, banks and thrifts were evaluated based on various factors, including the number and amount of loans issued within their assessment areas. Some analysts believe that these new rules pressured banks to make weak loans.

The Clinton Administration set increasingly rigorous affordable housing loan requirements for Fannie and Freddie during the rest of its term.

The Bush Administration had a significant impact on the country's policies. One notable policy was the No Child Left Behind Act, which aimed to improve education by setting standards and increasing accountability.

In 2002, the Bush Administration launched the Medicare Modernization Act, which introduced prescription drug coverage for seniors. This was a major expansion of the Medicare program.

The Bush Administration also took a tough stance on immigration, passing the Secure Fence Act in 2006. This law authorized the construction of a barrier along the US-Mexico border.

The Bush Administration's foreign policy was marked by the invasion of Iraq in 2003. This decision was made in response to concerns about Iraq's alleged possession of weapons of mass destruction.