Since the post-Civil War era, the median cost of a new single family house has hovered around $100,000 in constant 1975 dollars, and with the exception of the Great Depression, housing bubbles and deflations have been asynchronously localized to metropolitan or area markets. Then in 1977, Congress passed The Community Reinvestment Act[1], a law designed to encourage commercial banks and savings associations to reduce discriminatory credit practices against low-income neighborhoods[2]. The Act requires the appropriate federal financial supervisory agencies to encourage regulated financial institutions to meet the credit needs of the local communities in which they are chartered, consistent with safe and sound operation (§802.). To enforce the statute, federal regulatory agencies examine banking institutions for CRA compliance, and take this information into consideration when approving applications for new bank branches or for mergers or acquisitions (§804)[3].
Lending is how banks make their money. They are in constant arbitrage, pitting the interest they pay against the interest they charge so as to show a profit at the end of the day. Given this, it is reasonable to assume that they have sound fiscal reasons for not loaning money when the opportunity arises. With this Act, Congress is telling banks to play the part of brokerage houses in the 1920s – artificially cheapen the price of housing (through counter-fiscal interest rates or other loan terms) so as to include a class of buyer not qualified under traditional circumstances[4].
Even so, penetration into these neighborhoods was slow – most candidate properties were woefully sub-standard, or most candidate buyers were ineligible even under relaxed requirements – and regulators were nagging. “Subprimes”, as CRA-compliant loans were being called, were presenting problems, and banks were being squeezed on applications for branches, mergers and acquisitions. So banks began approving alternative mortgage products. Interest only mortgages provide an introductory period during which monthly payments cover only loan interest (“teaser rates”), after which payments are reset to a higher amount to also cover the loan’s principal. Negative amortizing mortgages (NegAms) allow borrowers to pay teaser rates less than current interest due and result in a higher loan balance and higher future payments. Adjustable rate mortgages (ARMs) reset the interest rate with changes in market interest rates and therefore can result in higher or lower monthly payments depending on market conditions[5]. Progress was still slow, so they went to low-doc and no-doc loans (so called “liar loans”) whereby applicants were required only abbreviated documentation (of income, existing debt, etc), or no documentation at all.
Although clearly in violation of §802’s “consistent with safe and sound operation” language, all was done in full view of regulators so as to demonstrate CRA compliance.
In an attempt to mitigate risk on these loans, banks began offering subprime qualifications into middle- and upper-middle-class neighborhoods (a sounder class of borrower), and packaging subprimes into mortgage backed securities (MBS) that could be traded in the derivatives market. Whereas subprime and other risky mortgages were still relatively rare before the mid-1990s, their use increased dramatically during the subsequent decade. In 2001, newly originated subprime and home equity lines (second mortgages) totaled $330 billion and amounted to 15% of all new residential mortgages. Just three years later these mortgages accounted for almost $1.1 trillion in new loans and 37% of residential mortgages. Their volume peaked in 2006 when they reached $1.4 trillion and 48% of new residential mortgages
. Over a similar period, the volume of MBS’s collateralized by subprime mortgages increased from $18.5 billion in 1995 to $507.9 billion in 2005[7].
Two things were happening inside this sequence of events that exacerbated the inherent hazard. During the good times of the second half of the 1990s, house prices ran ahead of inflation and wages (as they are wont to do); and the dot-com bust in 1999 - 2000 saw interest rates drop to mitigate the resulting downturn. While standing still, in other words, a prospective borrower qualified for a costlier home than a year earlier. According to 2006 Census estimates, the homeownership rate increased from the pre-subprime rate of 64.7% in 1995 to 68.8% in 2006. Looser credit standards allowed an additional 4.6M American households and families to become homeowners than might otherwise have been the case without these mortgage market innovations
. This period saw the rise of the McMansion. It was capping an era of ever-increasing home prices where, once again, it was conventional wisdom that home prices would always rise. This led to a mindset where everyone – sellers, buyers, banks, investors, regulators, legislators – assumed the current arrangement had spread risk to the point of elimination. Catastrophe was inevitable.
[1] PL 95-128, title VIII, 91 Stat 1147, 12 USC § 2901 et seq.
[2] Ben S Bernanke, Prepared Speech, The Community Reinvestment Act: Its Evolution and New Challenges, Chairman of the Federal Reserve System. before the Community Affairs Research Conference, March 30 2007, Federal Reserve System, available at:
http://www.federalreserve.gov/newsevents/speech/Bernanke20070330a.htm
also The Community Reinvestment Act: Thirty Years of Accomplishments, but Challenges Remain, February 13, 2008. This hearing before the full House Committee on Financial Services examined the impact of CRA on the provision of loans, investments and services to under-served communities. In addition to exploring CRA’s success, the hearing hoped to examine challenges that prevent the law from being more effective for the future.
[3] The Community Reinvestment Act, Federal Reserve Bank of St Louis, available at:
http://www.stlouisfed.org/community/about_cra.html
[4] According to standard risk/reward formulae for balancing prudent interest for risky loans, these banks would be up against usury laws to charge what logic dictates to issue mortgages into many of these areas and to many of these buyers.
[5] Edward Vincent Murphy, Subprime Mortgages: Primer on Current Lending and Foreclosure Practices, Congressional Research Service Report for Congress, March 19 2007, p. 3.
Inside Mortgage Finance, website, available at:
www.imfpubs.com
[7] [E:-Drive/Economics] Darryl E Getter, Mark Jickling, Marc Labonte, and Edward Vincent Murphy, Financial Crisis? The Liquidity Crunch of August 2007, Congressional Research Service Report for Congress, September 21 2007, p. 3, available at:
http://assets.opencrs.com/rpts/RL34182_20070921.pdf
US Census Bureau, 2006 American Community Survey, Table S1101, available at:
http://factfinder.census.gov/servlet/STTable?_bm=y&-qr_name=ACS_2006_EST_G00_S1101&-geo_id=01000US&-ds_name=ACS_2006_EST_
Posted
03-11-2010 20:58
by
Eagle Watch