The Dissent of
The question I have been most frequently asked about the Financial Crisis Inquiry Commission (the “FCIC” or the “Commission”) is why Congress bothered to authorize it at all. Without waiting for the Commission’s insights into the causes of the financial crisis, Congress passed and the President signed the Dodd-Frank Act (DFA), far reaching and highly consequential regulatory legislation. Congress and the President acted without seeking to understand the true causes of the wrenching events of 2008, perhaps following the precept of the President’s chief of staff —“Never let a good crisis go to waste.” Although the FCIC’s work was not the full investigation to which the American people were entitled, it has served a useful purpose by focusing attention again on the financial crisis and whether—with some distance from it—we can draw a more accurate assessment than the media did with what is oft en called the “first draft of history.”
To avoid the next financial crisis, we must understand what caused the one from which we are now slowly emerging, and take action to avoid the same mistakes in the future. If there is doubt that these lessons are important, consider the ongoing efforts to amend the Community Reinvestment Act of 1977 (CRA).
Like Congress and the Administration, the Commission’s majority erred in assuming that it knew the causes of the financial crisis. Instead of pursuing a thorough study, the Commission’s majority used its extensive statutory investigative authority to seek only the facts that supported its initial assumptions—that the crisis was caused by “deregulation” or lax regulation, greed and recklessness on Wall Street, predatory lending in the mortgage market, unregulated derivatives and a financial system addicted to excessive risk-taking. Th e Commission did not seriously investigate any other cause, and did not effectively connect the factors it investigated to the financial crisis. Th e majority’s report covers in detail many elements of the economy before the financial crisis that the authors did not like, but generally failed to show how practices that had gone on for many years suddenly caused a world-wide financial crisis. In the end, the majority’s report turned out to be a just so story about the financial crisis, rather than a report on what caused the financial crisis. Pages 443-444
If the Commission’s investigation had been an objective and thorough investigation, many of the points I raise in this dissent would have been known to the other commissioners before reading this dissent, and perhaps would have been influential with them. Similarly, I might have found facts that changed my own view. But the Commission’s investigation was not structured or carried out in a way that could ever have garnered my support or, I believe, the support of the other Republican members.
One glaring example will illustrate the Commission’s lack of objectivity.
In March 2010, Edward Pinto, a resident fellow at the American Enterprise Institute (AEI) who had served as chief credit officer at Fannie Mae, provided to the Commission staff a 70-page, fully sourced memorandum on the number of subprime and other high risk mortgages in the financial system immediately before the financial crisis. In that memorandum, Pinto recorded that he had found over 25 million such mortgages (his later work showed that there were approximately 27 million). Since there are about 55 million mortgages in the U.S., Pinto’s research indicated that, as the financial crisis began, half of all U.S. mortgages were of inferior quality and liable to default when housing prices were no longer rising. In August, Pinto supplemented his initial research with a paper documenting the efforts of the Department of Housing and Urban Development (HUD), over two decades and through two administrations, to increase home ownership by reducing mortgage underwriting standards.
This research raised important questions about the role of government housing policy in promoting the high risk mortgages that played such a key role in both the mortgage meltdown and the financial panic that followed. Any objective investigation of the causes of the financial crisis would have looked carefully at this research, exposed it to the members of the Commission, taken Pinto’s testimony, and tested the accuracy of Pinto’s research. But the Commission took none of these steps. Pinto’s research was never made available to the other members of the FCIC, or even to the commissioners who were members of the subcommittee charged with considering the role of housing policy in the financial crisis. Accordingly, the Commission majority’s report ignores hypotheses about the causes of the financial crisis that any objective investigation would have considered, while focusing solely on theories that have political currency but far less plausibility.
This is not the way a serious and objective inquiry should have been carried out, but that is how the Commission used its resources and its mandate. Page 447
Three specific government programs were primarily responsible for the growth of subprime and Alt-A mortgages in the U.S. economy between 1992 and 2008, and for the decline in mortgage underwriting standards that ensued.
1. The GSEs’ Affordable Housing Mission.
In 1992, Congress enacted Title XIII of the Housing and Community Development Act of 19926 (the GSE Act), legislation intended to give low and moderate income7 borrowers better access to mortgage credit through Fannie Mae and Freddie Mac. Th is effort, probably stimulated by a desire to increase home ownership, ultimately became a set of regulations that required Fannie and Freddie to reduce the mortgage underwriting standards they used when acquiring loans from originators. Pages 452-453
2. The Community Reinvestment Act.
In 1995, the regulations under the Community Reinvestment Act (CRA)10 were tightened. As initially adopted in 1977, the CRA and its associated regulations required only that insured banks and Savings & Loans reach out to low-income borrowers in communities they served. The new regulations, made effective in 1995, for the first time required insured banks and S&Ls to demonstrate that they were actually making loans in low-income
communities and to low-income borrowers.
In 2007, the National Community Reinvestment Coalition (NCRC), an umbrella organization for community activist organizations, reported that between 1997 and 2007 banks that were seeking regulatory approval for mergers committed in agreements with community groups to make over $4.5 trillion in CRA loans. A substantial portion of these commitments appear to have been converted into mortgage loans, and thus would have contributed substantially to the number of subprime and other high risk loans outstanding in 2008. For this reason, they deserved Commission investigation and analysis. Unfortunately, as outlined in Part III, this was not done.
Accordingly, the GSE Act put Fannie and Freddie, FHA, and the banks that were seeking CRA loans into competition for the same mortgages—loans to borrowers at or below the applicable AMI. Page 454
3. Housing and Urban Development’s (HUD) Best Practices Initiative.
In 1994, HUD added another group to this list
when it set up a “Best Practices Initiative,”… As shown later, this program was explicitly intended to encourage a reduction in underwriting standards so as to increase access by low income borrowers to mortgage credit.
It also created ideal conditions for a decline in underwriting standards, since every one of these competing entities
was seeking NTMs not for purposes of profit but in order to meet an obligation imposed by the government. The obvious way to meet this obligation was simply to reduce the underwriting standards that impeded compliance with the government’s requirements.
Indeed, by the early 1990s, traditional underwriting standards had come to be seen as an obstacle to home ownership by LMI families. In a 1991 Senate Banking Committee hearing, Gail Cincotta, a highly respected supporter of low-income lending, observed that “Lenders will respond to the most conservative standards unless [Fannie Mae and Freddie Mac] are aggressive and convincing in their efforts to expand historically narrow underwriting.”
In this light, it appears that Congress set out deliberately in the GSE Act not only to change the culture of the GSEs, but also to set up a mechanism that would reduce traditional underwriting standards over time, so that home ownership would be more accessible to LMI borrowers. For example, the legislation directed the GSEs to study “The implications of implementing underwriting standards that—
(A) establish a downpayment requirement for mortgagors of 5 percent or less;
(B) allow the use of cash on hand as a source of downpayments; and
(C) approve borrowers who have a credit history of delinquencies if the borrower can demonstrate a satisfactory credit history for at least the 12-month period ending on
the date of the application for the mortgage.” None of these elements was part of traditional mortgage underwriting standards as understood at the time. Page 455
By 2008, the result of these government programs was an unprecedented number of subprime and other high risk mortgages in the U.S. financial system. Page 456
As Table 1 makes clear, government agencies, or private institutions acting under government direction, either held or had guaranteed 19.2 million of the Non-traditional mortgage (NMT) loans that were outstanding at this point. By contrast, about 7.8 million NTMs had been distributed to investors through the issuance of private mortgage-backed securities, or private-mortgage-backed securities (PMBS), primarily by private issuers such as Countrywide and other subprime lenders.
The fact that the credit risk of two-thirds of all the NTMs in the financial system was held by the government or by entities acting under government control demonstrates the central role of the government’s policies in the development of the 1997-2007 housing bubble, the mortgage meltdown that occurred when the bubble deflated, and the financial crisis and recession that ensued. Page 456
The Commission majority’s report focuses almost entirely on the 7.8 million PMBS, and is thus an example of its determination to ignore the government’s role in the financial crisis.
One of the many myths about the financial crisis is that Wall Street banks led the way into subprime lending and the Government Sponsored Enterprises (GSE’s Fannie Mae and Freddie Mac) followed. The Commission majority’s report adopts this idea as a way of explaining why Fannie and Freddie acquired so many non-traditional mortgages (NTMs). This notion simply does not align with the facts. Not only were Wall Street institutions small factors in the subprime private mortgage backed securities (PMBS) market, but well before 2002 Fannie and Freddie were much bigger players than the entire PMBS market in the business of acquiring NTM and other subprime loans. Table 7, page 504, shows that Fannie and Freddie had already acquired at least $701 billion in NTMs by 2001. Obviously, the GSEs did not have to follow anyone into NTM or subprime lending; they were already the dominant players in that market before 2002. Table 7 also shows that in 2002, when the entire PMBS market was $134 billion, Fannie and Freddie acquired $206 billion in whole subprime mortgages and $368 billion in other NTMs, demonstrating again that the GSEs were no strangers to risky lending well before the PMBS market began to develop. Page 463
Even today, there are few references in the media to the number of NTMs that had accumulated in the U.S. financial system before the meltdown began. Yet this is by far the most important fact about the financial crisis. None of the other factors offered by the Commission majority to explain the crisis—lack of regulation, poor regulatory and risk management foresight, Wall Street greed and compensation policies, systemic risk caused by credit default swaps, excessive liquidity and easy credit—do so as plausibly as the failure of a large percentage of the 27 million NTMs that existed in the financial system in 2007. Page 465
The Commission never attempted a serious study of what was known about the composition of the mortgage market in 2007, apparently satisfied simply to blame market participants for failing to understand the risks that lay before them, without trying to understand what information was actually available…Until Fannie and Freddie were required to meet HUD’s AH goals, they rarely acquired subprime or other low quality mortgages. Indeed, the very definition of a traditional prime mortgage was a loan that Fannie and Freddie would buy. Lesser loans were rejected, and were ultimately insured by FHA or made by a relatively small group of subprime originators and investors.
Although anyone who followed HUD’s AH regulations, and thought through their implications, would have realized that Fannie and Freddie must have been shifting their buying activities to low quality loans, few people had incentives to
uncover the new buying pattern. Investors believed that there was no significant risk in MBS backed by Fannie and Freddie, since they were thought (correctly, as it turns out) to be implicitly backed by the federal government. In addition, the
GSEs were exempted by law from having to file information with the Securities and Exchange Commission (SEC)–they agreed to file voluntarily in 2002–leaving them free from disclosure obligations and questions from analysts about the quality of
their mortgages. Page 466
Indeed, the Commission’s entire investigation seemed to be directed at minimizing the role of NTMs and the role of government housing policy. Page 469
Parenthetically, it should be noted that the Commission’s staff focused on Bear because the Commission’s majority apparently believed that the business model of investment banks, which relied on relatively high leverage and repo or other short
term financing, was inherently unstable. Th e need to rescue Bear was thought to be evidence of this fact. Clearly, the five independent investment banks—Bear, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs—were badly damaged in the financial crisis. Only two of them remain independent firms, and those two are now regulated as bank holding companies by the Federal Reserve. Nevertheless, it is not clear that the investment banks fared any worse than the much more heavily regulated commercial banks—or Fannie and Freddie which were also regulated more stringently than the investment banks but not as stringently as banks. Page 478
The Commission majority did not discuss the significance of mark-to-market accounting in its report. This was a serious lapse, given the views of many that accounting policies played an important role in the financial crisis. Page 480
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