The Nature and the Origin of the Subprime Mortgage Crisis

There has been a long term American policy of promoting home ownership. This entailed making the financing of home purchases as easy as possible. Various financial institutions were set up over time to make the securing of a mortgage quick and convenient. There once were Savings and Loan Associations that were savings institutions which could only invest in home mortgages. Fannie Mae (the Federal Nation Mortgage Association FNMA) was set up in 1938 to provide a secondary market for home mortgages. This meant that if a bank granted a mortgage to someone and later the bank needed funds the bank could readily sell the mortgage to Fannie Mae. However, in order for lending institutions to have access to the secondary mortgage market of Fannie Mae they had to abide by Fannie Mae's rules.

In the past Fannie Mae prohibited the lenders it was dealing with to engage in the practice of red lining. Red Lining meant that a bank would refuse to finance a home purchase in neighborhoods it consider high risk even if the prospective borrowers were themselves good credit risks. In part, this was because the bank did not want, in the event of default and foreclosure, to become the owner of property in a risky neighborhood. The deeper roots of the problem go back to the Community Reinvestment Act of 1977.

In the 1990's under the administration of Franklin Raines, a Clinton Administration appointee, Fannie Mae began to demand that the lending institutions that it dealt with prove that they were not redlining. This meant that the lending institutions would have to fulfill a quota of minority mortgage lending. This in turn meant that the lending agencies would have to lower their standards in terms of such things as down payments and the required incomes. These subprime borrowers would be charged a higher interest rate. Having put the lending agencies into the position of granting subprime mortgages Fannie Mae then had to accept lower standards in the mortgages it purchased. That set the ball rolling. If a bank granted a mortgage to a borrower that was not likely to successfully pay off the mortgage then all the bank had to do was to sell such mortgages to Fannie Mae. The banks typically earned a loan origination fee when the mortgage was granted. The lending agencies could then make substantial profits dealing in subprime mortgages.

Because Fannie Mae and Freddie Mac made a market for subprime mortgages the lenders did not have to worry about of the soundness of the mortgage contract they wrote. Thus the lenders could write the mortgages as adjustable interest rate mortgages knowing full well that an upturn in the interest rates could easily throw the borrower into insolvency. For example, when the interest rate is 6 percent the mortgage payment for a 30-year $200,000 mortgage is $1199 per month. If the interest rate goes up to 7 percent the mortgage payment would increase by $131 per month, an 11 percent increase. For many of the subprime borrowers living on the edge of insolvency this would be enough to push them over the edge. The guilt for the subprime mortgage financial crisis lies both with the lenders who knowingly put borrowers into booby trapped mortgages and the management of Fannie Mae and Freddie Mac for making a market for such booby trapped mortgages thus giving the lenders the incentive for writing them.

The subprime borrowers were charged a higher interest rate to compensate for the higher risks. Obviously the borrower that could not qualify for the mortgage at the lower rate was going to be more of a risk at the higher rate. It seems that everyone but the dimwits running Fannie Mae (into the ground) understood intuitively that a poor risk for a mortgage cannot be made a better risk by charging a higher interest rate. Here are some illustrations of the point.

The graph below shows the relationship between expected rate of return and risk, called the market line, that separates the good investments from the bad investments. The dot shows a subprime mortgage.

The dot being below the market line indicates that it given its risk and return it is not a good investment. No rational investor would invest in it. The next graph shows the attempt to make it a good investment by increasing the interest rate; i.e., to move the dot from point 0 to point 1. But the increase in the interest rate increases the risk of default, so the movement is from point 0 to point 2. Given the increase risk the dot is even farther below the market line and is an even worse investment than at point 0.

There is the experience of the junk bond market that collapsed once investors realized that the higher rate of interest on the junk bonds was not sufficient to compensate for their higher risk.

The presumption was that although there would be a higher default rate at the higher interest rates there would be some lenders large enough to pool these mortgages and even with their higher default rates make a higher rate of return. This was the logic behind junk bonds market created by Michael Milken at Drexel Burnham Lambert. In the case of the junk bonds the higher interest rates were not enough higher to compensate for their higher risk and the junk bond market collapsed. A similar sort of thing occurred with the subprime mortgages. Fannie Mae and Freddie Mac pooled the subprime mortgages and then created securities which were sold around the world. When the subprime borrowers defaulted on their mortgage payments that led to the real estate market being flooded with houses for sale. The subsequent decline in housing prices then led even prime borrowers to walk away from mortgages where the mortgage debt exceeded the market value of the property. Fannie Mae and Freddie Mac were inundated by default claims from the mortgage default insurance they had provided. When Fannie Mae and Freddie Mac were declared bankrupt by their managers there was an instantaneous loss in value for not only the subprime mortgages but also the prime mortgages. Fannie Mae and Freddie Mac had provided default insurance on approximately one half of all American home mortgages. Thus the bankruptcy of Fannie Mae and Freddie Mac could have led to the bankruptcy of any major holder of mortgages or securities based upon mortgages.

In 1968 Fannie Mae was turned into a private company in large part because Congress wanted to separate Fannie Mae from its own budget accounting. Fannie Mae up until that time had had a virtual monopoly in the secondary mortgage market. Having privatized Fannie Mae it was appropriate for the Federal Government to create competition in the secondary mortgage market. It did this in 1970 when it created the Federal Home Loan Mortgage Corporation (FHLMC). Since the FNMA had the euphonic nickname of Fannie Mae the FHLMC was given the catchy but illogical name of Freddie Mac. Freddie Mac was intended for expanding the secondary mortgage market.

Fannie Mae and Freddie Mac both not only purchased mortgages they also provided payment insurance, for a fee, for other mortgages. They also created pools of mortgages and issued securities based upon the revenue received. This procedure was called securitization and the securities created were called collateralized debt obligations, CDO's. Such securities allowed investors to invest in the mortgage market by diversifying the risk. If such investors purchased a single mortgage there would have been too much risk concentrated in that single mortgage but if they, in effect, purchase one percent of a hundred such mortgage their risk would be diversified.

Not only did Fannie Mae, Freddie Mac and other institutions create diversification through securitization but they created securities that partitioned the risk. One security would have first claim to the mortgage payments, another second claim; i.e., that security would receive payments only after the first claim security's obligations had been met. And so on down the line. The security last in line was the most risky and came to be known as toxic waste. Thus this partitioned securitization created some securities that were riskier than the original mortgages. It was difficult to ascertain what values the various securities should have.

The market could be relied upon to eventually establish appropriate values. But in the short run the market would punish buyers who paid too much for a security by imposing losses that would take those buyers out of the market. However if buyers erroneously believe that even in the short run the market prices are appropriate values then process of finding appropriate prices for the securities is delayed.

In the case of the graduated risk, mortgage-backed securities the market worked perversely in the short run. The prices established for those securities made it seem that a profit could be made by buying mortgages and using them to create mortgaged-backed securities. Thus a demand was created for mortgages, even subprime mortgages. Not only did it seem that a profit could be made in securitization of even subprime mortgages, profits were being made. Securitizers like Fannie Mae and Freddie Mac were being drawn into the process from the apparent profitability of the process, thus justifying their creation of a market for subprime mortgages. It was as though the U.S. Treasury started buying pyrite (fool's gold) as well as real gold. The fact that the Treasury was buying pyrite resulted in private companies also buying pyrite and thus the price of pyrite would increase. The Treasury then seeing the value of its stocks of pyrite increasing would then believe that the original decision to buy pyrite was justified and thus buy more.

In the case of the subprime borrowers they were charged higher interest rates and were required to pay for default insurance. This higher burden increased the risk of default. The subprime mortgages became bad investments and no amount of securitization would alter this aspect. But the process of producing graduated risk securities backed by the subprime mortgages disguised the fact that they were bad investments. The perceived status of Fannie Mae and Freddie Mac as quasi-governmental institutions enabled them to sell their toxic product world-wide.

Although some people erroneous attribute the financial crisis to this mortgage default insurance and/or to securitization, these practices are perfectly legitimate and appropriate for financial markets. The problem arose because Fanny Mae and Freddie Mac were the key institutions in providing mortgage default insurance and in buying subprime mortgages. There were abuses of the derivative instruments that should have been punished by the market but were not because the perpetrators were ultimately bailed out.

The primary abuse was that banks bought credit default swaps (CDS) from parties who could not possibly make good on their agreements. The banks wanted such insurance to remove the risk associated with the mortgages and mortgage-backed securities which they had purchased. Removing the risk allowed the banks to invest more deeply in such securities. The sellers of such insurance did so because they received a premium now for a future obligation. It was rational although fraudulent for those sellers of CDS's to do so even though they could not make good on the future obligations. It was up to the banks to ascertain whether they were transferring the default risk to another party or simply changing their default risk into counter-party risk. If the CDS's had been legally insurance then the state and federal insurance regulators would have had a say in their regulation, but the CDS contracts were written in such a way that they did not technically qualify as an insurance contract. The CDS contracts might also have come under the regulation of the Commodity Futures Trading Commission (CFTC) of the Federal Government, but there was an act of Congress passed and signed into law in the year 2000 by William Clinton which specifically excluded CDS's from regulation by the CFTC.

It was in the late 1990's, as shown below, under the urging of the Clinton Administration that Fannie Mae and Freddie Mac began to operate as social welfare agencies instead of financial institutions. The insurance premiums on subprime mortgages were too low for the risks involved. No rational buyer would have purchased those subprime mortgages except at a drastic discount; Fanny Mae and Freddie Mac did purchase them. No amount of securitization could alleviate the fact that the subprime mortgages were not good investments. The practice of securitization and the credibility of Fanny Mae allowed the bad investments of the U.S. subprime mortgages to be spread throughout the world.

There was also a flawed view of the nature of risk in the mortgage market involved in the crisis. Securitization was based upon the notion that the risks of default for the different mortgages were independent. When housing prices fall there are some borrowers who find the market value of their property is less than the amount of debt outstanding and they decide to walk away from their debt obligations. No amount of diversification will reduce this risk. The default, foreclosure and resale of the properties then feed back into the mortgage market further increasing the risk. See Market Risk for more on this topic.

An article by Steven A. Holmes from the September 30, 1999 edition of the New York Times describes how the process began that culminated in the financial crisis of September 2008. The article reveals how much wishful thinking there was on the part of government officials that financial institutions could be run like social welfare agencies and how they were forewarned of their folly yet they went ahead and did it.

Fannie Mae Eases Credit To Aid Mortgage Lending

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.

The September 1999 New York Times article continues:

"Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements," said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. "Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market."

That is the end of the quotation in the article of Franklin Raines comments. Steven Holmes' article continues:

Demographic information on these borrowers is sketchy. But at least one study indicates that 18 percent of the loans in the subprime market went to black borrowers, compared to 5 per cent of loans in the conventional loan market.

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

The Savings and Loan Associations were part of what was known as the thrift industry, which included credit unions as well as savings and loan associations. The New York Times article makes reference to the collapse of the thrift industry in the 1980's.

"From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry."

The article then goes on to give some of the details of mortgage industry's operation.

Under Fannie Mae's pilot program, consumers who qualify can secure a mortgage with an interest rate one percentage point above that of a conventional, 30-year fixed rate mortgage of less than $240,000 -- a rate that currently averages about 7.76 per cent. If the borrower makes his or her monthly payments on time for two years, the one percentage point premium is dropped.

Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings.

Fannie Mae officials stress that the new mortgages will be extended to all potential borrowers who can qualify for a mortgage. But they add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings than non-Hispanic whites.

The 1999 article goes on to give some of the statistics of the performance of Fannie Mae program to extend mortgage lending to minorities.

Home ownership has, in fact, exploded among minorities during the economic boom of the 1990's. The number of mortgages extended to Hispanic applicants jumped by 87.2 per cent from 1993 to 1998, according to Harvard University's Joint Center for Housing Studies. During that same period the number of African Americans who got mortgages to buy a home increased by 71.9 per cent and the number of Asian Americans by 46.3 per cent.

In contrast, the number of non-Hispanic whites who received loans for homes increased by 31.2 per cent.

Despite these gains, home ownership rates for minorities continue to lag behind non-Hispanic whites, in part because blacks and Hispanics in particular tend to have on average worse credit ratings.

In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae's and Freddie Mac's portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups.

The change in policy also comes at the same time that HUD is investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants.

The Accounting Scandal at Fannie Mae

In May of 2006 the Office of Federal Housing Enterprise Oversight (OFHEO) issued the report on its three year investigation of the Federal National Mortgage Association (Fannie Mae). The acting director of OFHEO, James B. Lockhart, said

Our examination found an environment where the ends justified the means. Senior management manipulated accounting, reaped maximum, undeserved bonuses, and prevented the rest of the world from knowing.

The reported charged that the reported earnings from 1998 to mid-2004 were bogus values generated by erroneous accounting practices. These fraudulent earnings then were used to justify enormous bonuses for the senior management. The extent of the fraudulent accounting profits was a mind-boggling $11 billion. The sizes of the undeserved bonuses were not just millions of dollars, or even tens of millions of dollars. Instead they were hundreds of millions of dollars.

The report said,

The conduct of Mr. Raines, CFO Timothy Howard and other members of the inner circle of senior executives at Fannie Mae was inconsistent with the values of responsibility, accountability, and integrity. […] Those individuals engaged in improper earnings management in order to generate unjustified levels of compensation for themselves and other executives.

The manipulations not only involved raising the level of reported earnings but also reducing the variability of earnings to give the impression to the public that Fannie Mae's business operations were less risky than they actually were.

As a result of the findings Fannie Mae was fined $400 million. The major portion of this fine, $350 million, was levied by the Security and Exchange Commission to compensate the people who bought stock in Fannie Mae on the basis of these false accounts.

Fannie Mae was enjoined to limit its holdings and insurance of mortgages at $727 billion and meanwhile correct its accounting procedures and risk management practices. The chief executive of Fannie Mae, Franklin Raines, and its chief financial officer, J. Timothy Howard, were allowed to resign from the organization. The report suggested that Fannie Mae consider retroactively firing Raines and Howard. This would deny them retirement benefits.

Freddie Mac had undergone a similar probe concerning improper accounting procedures before the investigation of Fannie Mae.

After about ten years of the operation of Fannie Mae and Freddie Mac under social objectives, including making top management rich, rather than financial probity the enormous institutions were nearing collapse in 2007. Below are shown the financial statistics for both Fannie Mae and Freddie Mac.

These were the statistics for 2007. The statistics for 2008 are not yet available, but the financial conditions obviously worsened.

Summary

The subprime mortgage crisis had its origin in the program the directors of Fannie Mae initiated in the late 1990's to pursue social welfare goals rather than maintain financial viability. Lenders were strongly encouraged to reduce the requirements for mortgage below what had been found to be the minimum adequate levels. Having pushed the lenders into the subprime mortgage market Fannie Mae made the financially infeasible feasible by being willing to buy such subprime mortgage and to grant default insurance on such mortgages. When Fannie Mae effectively went bankrupt the lenders who had written such subprime mortgages found that there was no longer a market for them and thus they were stuck with them. Also those lenders who had obtained default insurance now find that insurance is useless if Fannie Mae cannot pay off on the defaulted mortgages. The lenders should have been aware that there is a risk with any insurance company that it might not be willing and able to pay off on claims. The supposed guarantee of Fannie Mae obligations by the Federal Government removed any concern of businesses with the risk of counter-party default. It is unwise to encourage such behavior.

On May 6, 2009 the Center for Public Integrity published a study entitled Who's Behind the Financial Meltdown. The six member team of journalists preparing the study surveyed government data on millions of subprime mortgages issued between 2005 and 2007. Some of their major findings were

• Nine of the top 10 lenders were based in California, including all of the top five: Countrywide Financial Corp., Ameriquest Mortgage Co., New Century Financial Corp., First Franklin Corp., and Long Beach Mortgage Co.
• Altogether 56 percent of the $1.38 trillion of subprime mortgages in the study period were written by California firms.
• Some lenders allowed borrowers to state their incomes without providing documentation.

There are plenty of parties to blame for the subprime mortgage crisis, but a large share of that blame rests with Franklin Raines, Timothy Howard and the other members of the inner circle of Fannie Mae. The lenders would not have written the flawed mortgages with their bobby-trapped conditions if they could not have counted on selling them to Fannie Mae or getting default insurance from such sources. And finally scuttling Fannie Mae in September of 2008 before it was technically bankrupt produced a shocked surprise for the stock market that produced the panic selling and the collapse of stock prices.