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Words of the Day: De-regulation and Greed.

This story is inspired by this post (thank you Minerva).  We are hearing a rapid drum beat coming from conservative pundits blaming “minorities and risky folks”, the Community Reinvestment Act of 1977 and Democrats for supporting Fannie Mae/Freddie Mac for the current financial crisis.  As for “blaming minorities and risky folks”, it is laughable to think that an economically challenged group of people in this country would bring down financial conglomerates like Bear Stearns and AIG but unfortunately this propaganda campaign is insidious and serves to divide people along racial lines.  The Community Reinvestment Act is over thirty years old and did not contribute to the irresponsible lending practices of mortgage lenders and brokers.  Fannie and Freddie were victims of greed by their corporate leadership

The current financial crisis was caused by de-regulation and corporate greed.  The blame can be shared by plenty of people in Washington and Wall Street.  Unfortunately, we are the ones who will ultimately pay the price of this fiasco. 

Community Reinvestment Act of 1977

The purpose of the Community Reinvestment Act of 1977 (CRA) is to encourage federally insured depository institutions, particularly banks and savings and loan associations, to serve the credit needs of the communities they serve, including low- and moderate- income neighborhoods, but “consistent with safe and sound banking operations”.  CRA attempts to prohibit “redlining” – a practice where banks refuse to lend money in certain areas regardless of the credit worthiness of potential borrowers.  It attempts to balance the credit needs of communities with sound lending practices.  CRA is thirty-one years old.

Most of the subprime loans were made by firms that were not regulated by CRA.  Michael Barr, law professor at University of Michigan, testified before the House Committee on Financial Services that:

50% of subprime loans were made by mortgage lenders not subject to federal supervision and another 30% were made by affiliates of banks which were not subject to routine supervision or examinations.

Bank of America, Wells Fargo, and many other banks had subprime lending subsidiaries that were not covered by CRA.  Companies like Countrywide Mortgage Company and Ameriquest Mortgage Company, who developed a niche in subprime lending, were not subject CRA

CRA-banks must pass “safety and soundness” tests performed by various banking regulators.  The “safety and soundness” tests discourage CRA-banks from making risky loans.  CRA does not require depository institutions to make risky loans.  A study by the law firm Traiger & Hinckley found that CRA financial institutions were less likely to make the subprime loans that fueled this financial crisis.

Timeline of De-Regulation

1999 – Gramm Leach Bliley Act (GLBA)– (in part named after Sen. Phil Gramm) effectively repeals key provisions of the Glass-Steagall Act of 1933 and allows commercial banks and investment banks to merge and allows banks to offer commercial banking, investment and insurance services.  As a result of GLBA, banks integrated investment, banking and insurance services into one big holding company such as Citigroup or Bank of America.  The profit objectives of banking and insurance, typically conservative ventures, competed with the profit objectives of investment banking divisions which are to achieve higher returns (possible higher risk).

The competing profit objectives posed a challenge to CEOs: do they go for higher returns (good for shareholders and bonuses) or do they settle by balancing risk and return.  Some CEOs of large financial conglomerates chose higher riskier returns over more conservative business practices such as controlling risk.  Many financial conglomerates, like Lehman Brothers, actually owned subprime lending subsidiaries.

2000 – Commodity Futures Modernization Act (CFMA) – (co-sponsor Sen. Phil Gramm) besides creating the “Enron Loophole” it essentially created the $58 trillion unregulated market for credit default swaps(CDS).  Yes, those same nasty CDS that contributed to AIG’s and Lehman’s collapse.  Are these CDS what Secretary Henry Paulson and Fed Chairman Bernanke really worried about?  CFMA allowed financial conglomerates and others to trade these CDS without regard to how much risk or capital was at stake.

2003 – Office of the Comptroller of the Currency, an obscure office in the U.S. Treasury Department, issued a formal opinion letter preempting the State of Georgia’s predatory lending laws and promulgated rules exempting national banks from state predatory lending laws and consumer protection laws.  As a result, several states, such as Georgia and California, either gutted, repealed or shelved predatory lending laws.  The absence of scrutiny by state regulators meant that predatory lenders were allowed to continue unabated because the federal government either didn’t have the resources or desire to crack down on predatory lending.

2004 – SEC ruling lifted net capital requirements for brokerage units of investment banks.  Goldman Sachs, led by Henry Paulson (now Treasury Secretary), and four other investment banking firms lobbied heavily for this change.  The purpose of the net capital requirement rule was to provide a cushion for investment losses incurred by a brokerage unit particularly during market crashes.  The SEC’s ruling on April 28, 2004, allowed billions of dollars once held in reserve in case of market crashes to flow up to the parent of the brokerage units so they could invest more into mortgage backed securities (MBS).  The impact of this overlooked SEC ruling was immediate.  At Bear Sterns debt to equity ratios increased sharply to 33%, meaning for every $33 of debt there was $1 of equity.

But wait it gets better.  The investment banking firms convinced the SEC to allow them to use their own risk models to assess the riskiness of their investment portfolios and not some independent auditor or regulator.  The ruling allowed the investment banks to self-regulate themselves when it came to risk.  This would be laughable if it wasn’t for $700 billion bailout that we are paying for.

During the timeline stated above (1999-2004), the dominate policy theme in Washington was less regulation the better.  But better for whom – certainly not us.  Financial conglomerates and their Washington benefactors certainly were better off as a result of de-regulation.  Now, we are paying the price.

Fannie Mae and Freddie Mac

From Fannie Mae:

Fannie Mae provides stability, liquidity, and affordability to the nation’s housing finance system under all economic conditions. We exist to expand affordable housing and bring global capital to local communities in order to serve the U.S. housing market.

Fannie and Freddie were government sponsored entities which meant that their corporate charters were created by Congress.  However, both Fannie and Freddie were publicly traded companies owned by shareholders.  Prior to the recent government takeover of Fannie and Freddie, the Office of Federal Housing Enterprise Oversight (OFHEO) was responsible for

“ensuring the safety and soundness of Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).”

The OFHEO, created in 1992, was a federal regulatory agency – an “independent office” within the Department of Housing and Urban Development (HUD).  The budget for OFHEO was funded by assessments from Fannie Mae and Freddie Mac.  The President appointed and senate approved the Executive Director of OFHEO.

Fannie and Freddie have had troubling recent histories: from accounting scandals to extremely high executive compensation plans.  Fannie and Freddie spent $170 million between 1998 and 2008 to gain access to politicians in Washington.  Their investment paid off – Congress did not pass any legislation that would have further regulated Fannie and Freddie. 

The original intent and mission of Fannie and Freddie were very admirable: to expand affordable housing and homeownership particularly with low- and moderate- income families.  But the executives at Fannie and Freddie had horribly strayed from the intended missions of these two institutions.  These executives pursued higher returns for shareholders and higher bonuses for themselves.

Ultimately, Fannie and Freddie’s failure was the result the action of its executives.  Daniel Mudd, Fannie’s CEO, in a memo to its board from January 2007 said

one of Fannie Mae’s achievements in 2006 was expanding its involvement in the market for subprime and other nontraditional mortgages. He called it a step “toward optimizing our business.”

They failed to appreciate the risks inherent in their portfolios.  The desire for higher profits and increased market share destroyed Fannie and Freddie.  Now, Fannie and Freddie are our problems.

Before, those conservative pundits blame those “minorities and risky folks” and subprime loans consider this:

About 3 million U.S. borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of subprime loans outstanding, according to Inside Mortgage Finance, a trade publication in Bethesda, Maryland.

Alt-A mortgages are considered better than subprime.  Alt-A borrowers are supposed to have better credit scores than subprime borrowers.  The Alt-A loans are often referred to as “low-doc” or “no-doc” loans because borrowers do not provide documentation to prove income or assets.  These loans were very popular in California, Las Vegas and Florida where it was expected that real estate values would continue to increase.  Lenders were lending based on credit history and loan-to-value ratios (loan amount compared to fair market value of real estate).  They essentially ignored the borrowers ability to repay the mortgage loan. 

Guess who had a niche in “Alt-A” loans:  failed IndyMac Bank.

Guess who owned the nations largest “Alt-A” loan originator:  Lehman Brothers through Aurora Loan Services.

Glass-Steagall Act of 1933 was a result of a financial crisis in the commercial banking industry.  Jump ahead 75 years – financial crisis in the commercial banking industry.  We never learn from history Those advocating de-regulation either never learn from history or don’t care.