Government policies promoting subprime risk-taking by government-sponsored enterprises (GSEs, e.g., Fannie Mae and Freddie Mac) dominating the residential mortgage market so as to increase home ownership by those who could not otherwise afford it are the most likely “cause” of the financial crisis of 2008.1 We place cause in quotation marks because causation has always been and is likely to continue to be notoriously hard to prove in a strict statistical sense. We highlight the careful and detailed evidence presented in Peter Wallison’s recent book, Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again. Wallison’s (Reference Wallison2015) evidence is consistent with the hypothesis that mortgage public policies intended to increase home ownership by those who could not otherwise afford it is the most likely “cause” of the financial crisis of 2008.
Figure 2.1 highlights the dramatic increase in inflation-adjusted real estate prices (measured by the Case-Shiller Home Price Index) during 1995–2005. Prior to this period, for more than a century, namely, from 1890 to 1995, inflation-adjusted real estate prices, while exhibiting volatility from year to year, were basically unchanged.
Figure 2.1 (A) Real Standard & Poor’s (S&P) 500 Index and real Case-Shiller Home Price Index, 1890–2013. This panel highlights the dramatic increase in inflation-adjusted real estate prices (measured by the real Case-Shiller Home Price Index) during 1995–2005. Prior to this period, for more than a century, namely, from 1890 to 1995, inflation-adjusted real estate prices, while exhibiting volatility from year to year, were basically unchanged.
(B) Real S&P 500 Index and real Case-Shiller Home Price Index, 1960–2013.
Figures 2.2 and 2.3 highlight the growing and important role of GSEs in the US residential mortgage debt market during 1992–2008. Why did the GSE’s role in the US residential mortgage debt market increase so significantly during 1992–2008?
Figure 2.2 (A) The growing and important role of Fannie Mae and Freddie Mac in the US residential mortgage debt market during 1992–2008.
(B) The growing and important role of Fannie Mae and Freddie Mac in the US residential mortgage debt market during 1992–2008.
Figure 2.3 (A) Total holdings of US mortgages by type of financial institution.
(B) Market- and bank-based holding of home mortgages. Market-based holdings refer to the holdings of GSE mortgage pools, private-label mortgage pools, and GSE holdings. Bank-based holdings refer to holdings of commercial banks, savings institutions, and credit unions. Market-based suppliers of credit have become increasingly important during 1995–2008.
The US Congress passed the Federal Housing Enterprises Financial Safety and Soundness Act in 1992 (the GSE Act) with the worthy goal of helping low-income families buy homes. The GSE Act initially established a goal for Fannie Mae and Freddie Mac – that at least 30% of all mortgages they bought needed to be from borrowers/homeowners who were at or below the median income level of the area in which they lived. The thinking was that the liquidity provided to banks and other mortgage originators would enable and encourage them to extend mortgage loans to low- and moderate-income homebuyers (whose incomes were below the median income for the area).
Prior to 1992, most mortgages were prime mortgages, that is, mortgages offered to homebuyers who had good credit histories, were able to put 10% to 20% as down payment on the house, and whose loan-payment-to-income ratios were below 33% (after the mortgage was closed). Families/individuals unable to meet these underwriting criteria were usually unable to buy a home. The aforementioned underwriting criteria had been developed by mortgage originators over several decades and reflected the payment and default experiences they had with their borrowers. In other words, these underwriting standards would lead to a sustainable mortgage market and had done so up to that time. Government policies that required Fannie Mae and Freddie Mac to ensure that a certain percent of all mortgages they bought were from borrowers/homeowners who were at or below the median income level of the area would eventually put pressure on mortgage originators to lower these underwriting standards. If these mortgage originators could readily sell these subprime mortgages (which did not meet the aforementioned underwriting standards) to Fannie or Freddie, then the mortgage originators would not be concerned with lowering the underwriting standards. Of course, Freddie and Fannie owned the credit risk of those mortgages to the extent that they decided to retain those mortgages in their portfolios. Finally, if the US Treasury had to bail out Freddie and Fannie from insolvency (due to losses from these subprime mortgages), then the credit risk of these subprime mortgages would ultimately be borne by US taxpayers.
Figure 2.4 illustrates the GSE housing goals for low- and moderate-income borrowers during 1996–2008 and the performance of Fannie Mae and Freddie Mac with respect to these goals. The GSE housing goal for low- and moderate-income borrowers was 40% in 1996 and was rapidly increased to 56% by 2008. Fannie and Freddie were able to meet or exceed these goals for every year except for 2008. Figure 2.5 illustrates subprime mortgage originations during 1996–2008 and subprime’s share of the entire mortgage market. The years 2000–6 witnessed a rapid increase in subprime mortgage originations. Coincidentally, the GSE housing goal for low- and moderate-income borrowers was 42% in 2000 and was rapidly increased to 53% by 2006. The increase in the GSE housing goals for low- and moderate-income borrowers and the increase in subprime mortgage originations during 2000–6 are consistent with the following argument: government housing policies reflected in GSE housing goals for low- and moderate-income borrowers likely fueled the subprime mortgage originations during 2000–6.2
Figure 2.4 Enterprise housing goals and performance. GSE housing goals for low- and moderate-income borrowers during 1996–2008 and the performance of Fannie Mae and Freddie Mac with respect to those goals. The GSE housing goal for low- and moderate-income borrowers was 40% in 1996 and was rapidly increased to 56% by 2008. Fannie and Freddie were able to meet or exceed these goals for every year except for 2008.
Figure 2.5 Subprime mortgage originations. The years 2000–6 witnessed a rapid increase in subprime mortgage originations and the securitization of these mortgages.
Subprime mortgage products were initially intended for low- and moderate-income borrowers who did not have good credit histories and/or were unable to put 10% to 20% as down payment on a house and/or whose loan-payment-to-income ratios were above 33%. However, over time, prospective homebuyers who were not in the low- and moderate-income categories and who could qualify for a prime mortgage for a (less expensive) home started using subprime mortgage products to purchase more expensive homes or put less money down. Consider a prospective homebuyer who had $30,000 as a down payment. He or she could purchase a home valued at up to $300, 000 and still qualify for a prime mortgage because his or her down payment would be more than 10%. However, if the homebuyer chose to put down only 5% as a down payment, then he or she could purchase a home valued at $600,000. Of course, the mortgage for the $600,000 house would be subprime. According to the US Department of Housing and Urban Development (HUD), 37% of mortgage loans bought by Fannie Mae in 2007 and 32% of mortgage loans bought by Freddie Mac in 2007 were made to borrowers above the median income level who put down less than 5% as a down payment (see HUD 2008). Also, in 2007, the National Association of Realtors reported that 45% of first-time homebuyers put no money down; furthermore, of those who did put down a payment, the median amount was 2% of the purchase price (USA Today, July 17, 2007). Additionally, Barth et al. (Reference Barth, Li, Phumiwasano and Yago2008) document that “during the period January 1999 through July 2007, prime borrowers obtained thirty-one of the thirty-two types of mortgage products … obtained by subprime borrowers.” This evidence suggests that GSE housing goals for low- and moderate-income borrowers led to lowering of mortgage underwriting standards not just for low- and moderate-income borrowers but also for all borrowers.
Role of Big Banks in the Financial Crisis
The big banks played two important roles related to the financial crisis. First was their large and growing role in the issuance of mortgage-backed securities (MBSs), especially during 2004–6 (see Figure 2.6). MBSs issued mostly by big banks were known as private-label securities (PLSs). As Figure 2.6 indicates, PLSs were more than 50% of the issuance of MBSs for each of the years 2004, 2005, and 2006. More important, PLSs for each of the years 2005 and 2006 were valued at more than $1 trillion. The ability of the big banks to issue such a large volume of securities enabled them to earn significant fees. However, more important than these fees was the phenomenon of these big banks investing massively for their own portfolio in the top-rated (AAA) tranches of the MBSs they were issuing. A question arises: Why were these big banks investing in the (top-rated AAA tranches of the) MBSs they were issuing?
Figure 2.6 Distribution of MBS issuances by issuer. PLSs (MBSs issued by mostly big banks) were more than 50% of the MBS issuance for each of the years 2004, 2005, and 2006. PLSs are denoted by the unshaded part in each vertical bar in the figure.
Historically, banks have been intermediaries between depositors and borrowers. However, the process of securitization changed the role of banks to intermediaries between investors. Banks would pool mortgages into MBSs. MBS owners would receive the principal and interest from the underlying mortgages. MBSs were structured into tranches based on risk. The most risky tranche offered the highest return but would be the first to have its promised payments defaulted if the principal and interest payments from the underlying mortgages were insufficient. The least risky tranche offered the lowest return but, correspondingly, would be the last to have its promised payments defaulted if the principal and interest payments from the underlying mortgages were insufficient. These tranches would be rated, and the least risky tranche would almost always receive the AAA rating. These tranches would be sold to institutional investors in the United States and abroad. Figure 2.7 illustrates the growing importance of securitizations during 2004–6 and the increasingly dominant role of subprime mortgages in these securitizations.
Figure 2.7 Subprime originations and securitization rate. The subprime originations and securitization rate of the subprime mortgages was growing in importance during 2004–6.
During 2004–7, most of the large banks started investing (holding as assets in their balance sheets) heavily in the AAA-rated tranches of the MBSs they (or other big banks) had securitized. These banks would borrow short term, often overnight, at close to the London Interbank Offered Rate (LIBOR) and use the funds to invest in the AAA-rated tranches. The banks would invest mostly in the AAA-rated tranches because regulatory guidelines/requirements required them to not hold additional (equity or retained earnings) capital if the additional investment was in safe AAA securities. The yield on the AAA-rated tranches was more than the LIBOR: the banks would book the difference as profit. Just because the banks booked it as “profit” did not make it so! These “profits” were not profits in the traditional net-present-value sense but were merely an accounting artifact of the difference between the AAA tranche yield and the LIBOR. As is taught in any Finance 101 class in this country and across the globe, if security A offers a higher expected return than security B, then A is riskier than B. Borrowing at the LIBOR and investing in AAA-rated tranches did not mean that the risk of the AAA-rated tranches had been eliminated (or reduced to the level implied by the LIBOR). Somebody had to bear the risk of these AAA-rated tranches – they were the bank’s bondholders and stockholders and, ultimately, US taxpayers. Indeed, this risk was not notional.
As the US real estate market stalled and then real estate prices started heading downward during 2005–8, homeowners (who had little or no equity in their homes) began defaulting on their mortgages. Table 2.1 documents that subprime loans were defaulting at extremely high rates: 35% and 34% default rates 18 months after origination during 2006 and 2007, respectively; more important, a very high percentage of subprime mortgages originated during 2004–7 were sold to the big banks (private securitizers) for securitization purposes. Ultimately, these defaults by homeowners led to defaults of the AAA-rated tranches, leading to substantial losses by the big banks that had invested in these tranches. In many cases these losses were large enough to potentially lead to bank insolvency. Banks and their allies publicly argued that their insolvency would severely and adversely affect the US financial system and the economy. Whether or not insolvency of some of these big banks would have been catastrophic for the country is debatable; regardless, the banks and their allies were able to convince the key policymakers in the United States – hence the “need” for US taxpayer bailout of these banks. Tsesmelidakis and Merton (Reference Tsesmelidakis and Merton2012) estimate the value of the implicit guarantees that led to massive wealth transfer (via the taxpayer-funded bailout) from US taxpayers to bank shareholders and debtholders as $365 billion during October 2008–June 2009. Acharya, Anginer, and Warburton (Reference Acharya, Anginer and Warburton2015) estimate that these implicit guarantees afforded the big banks a funding advantage of 30 basis points during 1990–2012. More recently, Gandhi, Lustig, and Plazzi (Reference Gandhi, Lustig and Plazzi2016) provided evidence of the implicit guarantees provided by US taxpayers to the big banks. This documented large wealth transfer from US taxpayers to the big-bank investors makes this an important issue in the ongoing national debate on the economy.
Table 2.1 Loan Characteristics at Origination
| Prime loans | Subprime loans | |||||||
|---|---|---|---|---|---|---|---|---|
| 2004 | 2005 | 2006 | 2007 | 2004 | 2005 | 2006 | 2007 | |
| Percent default in first 12 months | 2% | 2% | 4% | 5% | 11% | 16% | 24% | 25% |
| Percent default in first 18 months | 4% | 8% | 8% | 7% | 16% | 24% | 35% | 34% |
| At 12 months since origin | ||||||||
|---|---|---|---|---|---|---|---|---|
| Loan sold to GSE | 74% | 71% | 72% | 83% | 4% | 6% | 9% | 40% |
| Loan sold to private securitizer | 19% | 24% | 23% | 11% | 91% | 92% | 89% | 55% |
| Loan held on portfolio | 7% | 6% | 5% | 6% | 5% | 2% | 3% | 5% |
Regarding the “profits” (difference between the AAA tranche yield and the LIBOR), the banks were booking – this was the source of substantial compensation to bank employees (and their managers) involved in the securitization process and related transactions. Some of this compensation involved cash bonuses. Perhaps more important – to the extent that bank analysts were unable to discern the source of the bank’s higher earnings (via the “profits”) – bank stocks were overvalued.3 Bank managers could sell these overvalued shares and/or exercise their options to take money off the table before the analysts and other market participants realized the source of these “profits.” As we will see in the following chapters, most managers of the big banks did just that.
