Did lack of regulation create the subprime mortgage
crisis? I’m asked this all the
time. The short answer: Of course not. Nowhere close. Not a
chance. Here’s the long answer.
What regulations have we had? The mortgage originator—your local bank or mortgage broker—was
under regulations not to discriminate and to inform you of your interest
rate. Those papers you signed without
reading? Many of them were “Truth in
Lending” disclosures designed to protect you from getting into something you
didn’t understand. However, if you
didn’t read them, maybe they didn’t protect you.
But you were not the one lending money to a borrower
incapable or unwilling to pay the money back.
That was your banker. He was not
regulated because he didn’t have any risk.
He immediately turned around and sold your loan, along with a thousand
other loans, to a Wall Street investment bank, which formed the many mortgages
into a mortgage backed security or a “collateralized debt obligation.”
There were no regulations protecting Wall Street investment
bankers from lending deadbeats money.
The idea is that they are smart enough, sophisticated enough, to take
care of themselves. (That turned out to
be a bad idea, but it was the idea behind the lack of regulation.)
How did these rich, sophisticated investors make such a huge
mistake? First they experimented. They tried small variations from the old
traditional loans. Variations like
adjustable rate mortgages. Low-down-payment
mortgages. No documentation
mortgages. (How else would strippers
who make their living from tips be able to borrow money?)
These experiments worked well. Surprisingly well.
Why? Because it was a rising
real estate market. Borrowers who were
unable to make their payments simply sold their homes at a profit. No big deal, and no default or foreclosure
on the mortgage.
The crucial mistake that Wall Street made was extrapolating
from the good times to the bad times.
They assumed that these subprime mortgages would be good all the time
because they had been good in the rising house market. Oops.
Would more regulation have helped? Maybe we could have protected Wall Street investment bankers from
themselves. Maybe with good regulations
they would not have to give up their summer homes in the Hamptons. Maybe.
In reality, regulatory policy has worked in the opposite
direction. The government wanted more
risky loans made, not less. For
example, the Community Reinvestment Act pressured banks to make loans in poor
neighborhoods. Banks (and I was a
banker under the CRA) figured that making some bad loans was just another tax.,
a cost of doing business as a regulated company. In 1995, the Clinton administration revised the CRA to increase
pressure on banks to make more loans to risky borrowers. In 1997, the first pool of subprime
mortgages was securitized (by Bear Stearns!)
The law regulating Fannie Mae and Freddie Mac was rewritten
to reduce their capital requirements, meaning they would become riskier. Some critics were concerned about the risk,
but here’s what the distinguished Congressman Barney Frank had to say at the
time:
''These two entities — Fannie Mae and Freddie Mac — are
not facing any kind of financial crisis,'' said Representative Barney Frank of
Massachusetts, the ranking Democrat on the Financial Services Committee. ''The
more people exaggerate these problems, the more pressure there is on these
companies, the less we will see in terms of affordable housing.''
New York Times,
September 11, 2003
At the height of the real estate boom, the United States set
record home ownership rates.
Politicians, including President Bush, bragged about their success at
getting Americans into their own homes.
As recently as August 2007, the President bragged that he was helping
Americans get homes with lower down payments and higher loan limits. He also signed a lay making it easier for
homeowners to walk away from their mortgage obligations.
Would more regulation have reduced the number of bad loans
made? Most likely, more regulation
would have increased the problem.