Vision Credit Education, Inc.

A friend of mine recently pointed out the flawed argument held by many that the Clinton administration was responsible for the current financial crisis. He noted that the 1999 NY Times Article that blamed the crisis on government and shareholder pressures on Fannie Mae and Freddie Mac inaccurately assumed that the Community Reinvestment Act (CRA) measures were to blame.

In a word, he was right in a way. These CRA policies were designed to expand homeownership opportunities to potential homebuyers that were left out of the traditional mortgage marketplace.

Programs that worked with these potential homebuyers to teach basic financial skills were a success. Participants were educated on budgeting, saving, credit, housing costs and mortgage qualification requirements. Additionally, homebuyers continued to receive counseling and support following their purchase so that they could remain in their homes.

Special programs like these were funded by the U.S. Department of Housing and Urban Development (HUD), Fannie Mae and Freddie Mac. They relied on the skills and efforts of community nonprofit organizations in order to expand homeownership to disadvantaged groups.

To blame these CRA policies is a simple answer to a complex problem. Additionally, it fails to address the real problems that caused the current meltdown of our financial sector.

Due Diligence

I hear some professionals blaming everyone along the mortgage market chain for failing to conduct due diligence. However, the people closest to the mortgages themselves exercised the most due diligence.

They were aware of the problems that were brewing, as well as their need to quickly profit while shifting the responsibility to someone else. These are the primary areas where we went wrong:

1. Proliferation of Exotic Mortgage Products: Exploding ARMs and interest only mortgage products were only intended for a very small subset of mortgage applicants. These included high income sales professionals or other applicants expecting either a quick resale or an impending financial windfall. Most applicants steered into these loans were a poor match for the products and could never be expected to afford the payments on such loans beyond a year or two.
2. Relaxed Underwriting Standards: Lenders that approved mortgage applications based on “stated income” did not properly verify the ability of the applicants to reasonably afford the mortgage payments. Many lenders knew that the borrowers would likely default, but they approved the loans anyways and quickly resold the loans on the secondary mortgage market. Such loans were resold in packages that were often grouped into special securities that investors could buy.
3. Ineffective Mortgage Controls: Brokers profiteered by steering applicants into bad loan products that carried much higher commissions (yield spread premiums). Many brokers crossed the line even further by committing fraud. Some lied on loan applications or coached applicants on how to lie to improve acceptance of their application. The fabled NINJA loan is a direct result of such fraud. Others pressured applicants into signing mortgage documents that were for a different loan product than was discussed. Investigations of fraud and convictions for criminal activity were few, while fraudulent acts were widespread.
4. Secondary Mortgage Markets Enabled Risky Loans: Lenders could never justify keeping risky loans on their books. Such a loan portfolio carried too much risk and would ultimately cause their downfall. Instead,  they packaged these loans carefully so that the buyers would not fully understand the risky nature of much of the loans included. Additionally, Fannie Mae and Freddie Mac purchased many loans from lenders with the false expectation that reasonable care was taken to ensure creditworthiness and reasonable repayment ability of the applicants.
5. Collateralized Debt Obligations (CDOs) Facilitated Sale of Junk Mortgages to Unsuspecting Buyers: Some purchasers of CDOs fault the computer models that were supposed to help reduce the risk of such securities. However, what they failed to realize is that the whole purpose of such models was to hide bad mortgage loans in with other investments so that the buyer was unaware of the junk they were purchasing. They were simply looking to mask the risky loans so they could be unloaded to unsuspecting buyers.
6. Loan to Value Limits Expanded: Lenders assumed that home values would continue to rise at rates higher than they historically had risen. What they failed to account for is that the housing market had expanded into a massive bubble, and that it would soon burst. A conventional mortgage limits the loan to value limit to 80% of the purchase price. Other products such as FHA and other CRA backed programs allowed for up to 100%. These were not the problem. The problem arose from lenders allowing for a loan to value ratio of up to 120%. This exacerbated the negative equity situation that many distressed homeowners currently find themselves in. They cannot sell or refinance their mortgages because they owe more than the home is worth.
7. Government Guarantees: The federal government guarantees loans purchased by Fannie Mae and Freddie Mac in order to stimulate further lending activity. This promise is what contributed to the rapid expansion of Fannie Mae and Freddie Mac loan pools. As long as the loans were guaranteed, there was less concern about higher rates of default. Accordingly, lenders took greater risks knowing that these risks could be offloaded onto federal agencies and ultimately, the taxpayer. Ironically, the same government interference that increased lending also contributed to its hyperactivity and decline.

Sure it is unfair to blame the Clinton administration for causing the financial crisis through CRA expansion. That does not contain the sources of the current problem. You can blame the Clinton and Bush adminstrations, as well as members of Congress during the past 10 years for the current crisis. They failed to put in reasonable protections during the rapid acceleration of housing markets that resulted from post-911 interest rate cuts.

We can blame lenders for failing to modify loans. We can blame the government for delayed action on a bailout of Wall Street investment banks. The real blame lies on failure of our collective governments (federal and state) to provide reasonable protections for mortgage applicants. Until we enact such protections, we are sure to experience future problems of a similar nature.

Solutions

To be fair, it is necessary to provide possible solutions whenever faulting the system. These can include:

• Increased restrictions on exotic mortgage products, including a review by an unbiased third party.
• Cap of 100% loan to value on mortgage loans.
• Requirement of income documentation by applicants.
• Increased policing of mortgage originators and brokers.
• Expanded education requirements for certain low-income mortgage products.
• Cut government guarantees to a certain percentage of the total mortgage loan so that the lender bears partial risk.
• Increased penalties for fraudulent acts.

Certainly, there may be other solutions that may be effective that could be implemented. If nothing is done now, we are certainly on track to repeat mistakes of the past.

Related Link

1999 NY Times Article Predicted Financial Bailout