Sunday, November 2, 2008

How Did the Financial Meltdown Happen?

Myths and Facts about the Financial Crisis

The conservative spin machine went into overdrive after the financial crisis exploded the claim that unregulated markets always work best. Talking points fed to sympathetic columnists and reporters told an alternate, racially tinged tale: poor people were to blame. In the mythos they created, the Community Reinvestment Act forced banks to “loosen underwriting standards” and to lend to the poor and those with poor credit, forcing Fannie Mae and Freddie Mac, the “800 pound gorilla in the room,” to careen down the path of bad loans, dragging other lenders with them. Incredibly, conservatives blame insufficient regulation of Fannie and Freddie, and cite the Clinton administration as the architect of the mortgage industry’s collapse.

Of course, none of this stands up to scrutiny. Here’s a guide to the most widely spun myths:

Myth #1: De-regulation had nothing to do with this crisis

The Facts
Conservative de-regulation left Wall Street with no cop on the beat. Bush’s conservative appointees rolled back regulation and oversight of banks, insurers, lenders, and credit raters. - The explosion in subprime loans after 2000 were made by unregulated mortgage companies, and the vast majority of them were issued to higher income borrowers, not low- to moderate-income borrowers. - The Gramm-Leach-Bliley Act of 1999 (GLBA) dismantled Depression-era law that had prohibited bank holding companies from owning other financial companies such as investment, commercial banking, and insurance companies. GLBA ignited a wave of mergers and hampered government regulators charged with preventing conflicts of interest and risky financial behavior.

Myth #2: Private lenders were pressured into giving out risky loans

The Facts
Private lenders—not the government-backed Fannie and Freddie—issued the vast majority of subprime loans, and to low- and moderate-income borrowers in particular. Fannie and Freddie did not guarantee and securitize large quantities of subprime loans. - In fact, Fannie Mae actually lost market share because it chose not to “participate in large amounts of these non-traditional mortgages in 2004 and 2005” because it “determined that the pricing offered for these mortgages often was insufficient compensation for the additional credit risk associated with these mortgages.” As economist Dean Baker stated, “Fannie and Freddie got into subprime junk and helped fuel the housing bubble, but they were trailing the irrational exuberance of the private sector….In short, while Fannie and Freddie were completely irresponsible in their lending practices, the claim that they were responsible for the financial disaster is absurd on its face—kind of like the claim that the earth is flat.” - In testimony before the House Committee on Oversight and Government Reform, Lehman Brothers CEO Richard Fuld acknowledged that Fannie and Freddie’s role in Lehman’s demise was “de minimis,” or so small that it does not matter.

Myth #3: Fannie Mae and Freddie Mac Caused the Crisis

The Facts
While some are attempting to scapegoat Fannie Mae and Freddie Mac, economist Dean Baker recently stated that while Fannie and Freddie “got into subprime junk and helped fuel the housing bubble,” they were “trailing the irrational exuberance of the private sector” and actually lost market share to private subprime lenders in the years 2002-2007, when “the volume of private issue mortgage backed securities exploded.” - In a 2006 Securities and Exchange Commission filing (available here) covering its activities in 2004, Fannie Mae stated: “We did not participate in large amounts of these non-traditional mortgages in 2004 and 2005.” In the report, Fannie Mae also noted the growth of subprime lending and reported, “These trends and our decision not to participate in large amounts of these non-traditional mortgages contributed to a significant loss in our share of new single-family mortgage-related securities issuances to private-label issuers during this period.” - Additionally, Lehman Brothers CEO Richard Fuld testified before the House Committee on Oversight and Government Reform on October 6, 2008, that Fannie and Freddie’s failure played a minimal role in Lehman’s demise.

Myth #4: The 1977 Community Reinvestment Act is to blame for the current financial crisis

The Facts
Several media figures have attempted to connect the financial crisis to the Community Reinvestment Act (CRA), originally passed in 1977 and since amended. However, according to housing experts, a large number of subprime loans were not made under the CRA, which applies only to depository institutions. Additionally, a study released earlier this year by a law firm specializing in CRA compliance estimated that in the 15 most populous metropolitan areas, 84.3 percent of subprime loans in 2006 were made by financial institutions not governed by the CRA.

However, the claim that the CRA is responsible for the current crisis ignores several crucial facts: - The CRA does not cover independent mortgage companies, which issued the vast majority of the loans underlying the crisis. The act applies only to depository banks and thrifts (savings and loan associations) that are federally insured. According to University of Michigan law professor Michael Barr in testimony before the House Financial Services Committee, just 20 percent of the subprime mortgages since the late 1990s were issued by CRA-covered lenders. Thus, 80 percent subprime loans were made by lenders not regulated by the CRA. - The CRA actually created more responsible lending. San Francisco Federal Reserve Bank President Janet L. Yellen rejected the “tendency to conflate the current problems in the subprime market with CRA-motivated lending,” and noted “that the CRA has increased the volume of responsible lending to low- and moderate-income households.” - The act was passed in 1977, well before the subprime loan bonanza occurred. In fact, the Bush administration’s weakening of the CRA coincided with the subprime boom. - Banks did not engage in an orgy of reckless subprime lending to meet CRA obligations; they did so for they same reason they always do: to make money. Only this time, deregulation allowed them to get paid not just for making the loans, but for turning them into securities and trading them (see below).

Myth #5: Progressives have opposed strengthening oversight over Fannie and Freddie

The Facts
Several media figures have accused progressives in Congress of opposing stronger oversight of two mortgage giants, Fannie Mae and Freddie Mac. In fact, Rep. Barney Frank (D-MA), chairman of the Financial Services Committee, and his predecessor, Rep. Michael Oxley (R-OH) made efforts to enhance regulatory oversight on Fannie Mae and Freddie Mac, including the Federal Housing Finance Reform Act of 2005 and sponsoring the Federal Housing Finance Reform Act of 2007. Both of these bills called for a new agency to oversee and regulate Fannie Mae and Freddie Mac.

Myth #6: Congress funded ACORN in the bailout package

The Facts
Numerous media figures reported that Congress tried to steer money to ACORN in the recent housing bailout bill. In fact, neither the draft proposal nor the final version of the bill contained any language mentioning ACORN. Those making the false claim were misrepresenting a provision—since removed—that would have directed 20 percent of any profits realized on troubled assets purchased under the plan into two previously established funds: the Housing Trust Fund and the Capital Magnet Fund, which, under the law authorizing them, distribute funds through state block grants and through competitive application processes, respectively.

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