root of all evil

Conservatives, as the economy began to melt down quickly in 2008, began to target one of the programs that they truly hated, the Community Reinvestment Act. They pointed to this one program, which started back in the Carter administration, as the root of all evil. The conservative argument goes something like this — the community reinvestment act asked banks to lend more money to minorities and Americans who lived in impoverished areas. Therefore, the banks were forced to hand out riskier mortgages. This whole operation was funded through a mandate of Fannie Mae and Freddie Mac. So, with Fannie and Freddie pumping money into the mortgage financial system and bankers being “forced” to lend money to people who were obviously not qualified, there’s no surprise that these mortgages ultimately failed in a spectacular fashion.

This tale is like many tales that come out of the conservative movement. There is a shred of truth located deep within the story. Unfortunately, there is only a shred of truth. First, it is important to understand how the mortgage industry works. I thought, if I go to the bank, Friendly Bank, and I’m approved for a loan, Friendly Bank gives me the money to purchase a house. I thought that the loan stayed at Friendly Bank. I was wrong. That’s the way loans worked in the old days. Now, Friendly Bank will take my loan and do one of two things — sell the loan to another financial institution or package the loan with other loans and then sell that to a financial institution. This is where mortgage securitization comes in, along with derivatives and collateralized debt obligations and much more craziness. Fannie and Freddie worked in the secondary markets. It is true that Fannie and Freddie injected liquidity into the housing market. They are able to buy qualified loans (notice the word “qualified”) from banks and then pass those loans on to other financial institutions. “The riskiest mortgages, however — the ones that were pushing the housing bubble to dizzying heights — were simply off-limits to Fannie and Freddie.” (From Simon Johnson’s book 13 Bankers, p 145.) Fannie and Freddie were barred by law from handling these risky subprime mortgages.

When you look at the subprime mortgages that were issued at the height of the craze, between 2004 and 2006, Fannie and Freddie only sold approximately 24% of those loans. In 2006, 84% of subprime mortgages were issued by private lending institutions. These loans were then passed on to other private institutions, bypassing Fannie and Freddie. Although Fannie and Freddie Miami have wanted to get into the fray, they were unable to participate. “Private investment banks — not Fannie and Freddie — dominated the mortgage loans that were packaged and sold into the secondary mortgage market.” Over 66% of these loans stayed in the private sector.

This reason that conservatives continue to push a story that they know is not true is because the truth is very scary to them. The truth is capitalism worked the way it was supposed to work. Capitalism is about greed. Capitalism is about looking out for your own interest. This is exactly what these private investment banks did. The point of the federal government is to constrain the excesses of capitalism. Put another way, people always look for ways to make money. If there are no regulations, then people will make money any way that they can. Some will even rip off their own grandmother to make an extra dollar. Alan Greenspan and Henry Paulson (and almost everybody on the Bush financial team and unfortunately, this includes most of Obama’s financial whiz’ also) believed in self-regulating markets. They believed that the purer the market was, the better the market would regulate itself. Unfortunately, they did not factor in one of the most important things in human nature — greed and deception. No investor will always have all of the information. Financial institutions have intentionally created an atmosphere where they hold most of the cards. They only reveal the cards they want you to see; therefore, no investor is fully informed.

So, in summary, Fannie and Freddie did not cause the economic meltdown. The Community Reinvestment Act did not fuel the economic meltdown. There was a climate of deregulation, mortgage derivatives and collateralized debt obligations, which were designed to hide risk and were sold to investors as safe. These mortgage securities were stamped with triple-A ratings,duping investors into thinking that they were safe. Because the primary lender had the ability to pass off loans to someone else, there was less worry about the quality of those primary loans. There you have the cycle. You have a nearly infinite supply of investors who want low risk, yet high yield investment opportunities. These mortgage-backed securities were sold as exactly that — low risk and high yield. Unfortunately, for all of us, they were not low risk. Not even close.