Posts Tagged ‘Savings and Loan’

A primer on the mortgage crisis

Thursday, September 18th, 2008

I am no finance expert, but I was explaining to my wife how this mortgage meltdown occurred and I thought a few others might be interested. I bought my first home in 1969. It was in South Pasadena and I paid $35,000 for it, with a $3500 down payment and a $3500 second trust deed taken back by the seller who had already moved into a new home and was motivated. Thus, I paid 20% down and Home Savings and Loan took the mortgage at 6% interest. For the next four years, I paid $204 per month on my mortgage and $35 per month to the second trust deed holder until I paid the second off two years later. In those days, Savings and Loan institutions, like the one in “It’s a Wonderful Life,” took in deposits at 4% interest paid and loaned money at 6% to home buyers. They kept their own loans in-house and collected the payments as their income. Like the S&L in the movie, they had borrowed “short” and loaned “long” so they were susceptible to runs.

The Savings and Loan debacle of the 1980s ended that era. A summary by someone who knows a lot more about this than I do is here. That, however, does not explain the mortgage mess.

The S&Ls were destroyed by inflation in the 1970s and 80s. By 1979, interest rates on houses were as high as 21% and savers had abandoned the S&Ls to invest in trust deeds (as I did) or in high interest bonds. I had US Treasury bonds that carried a coupon rate of 16% and, when bought at a discount, carried an interest rate of 18%. That was US Treasury paper ! The S&Ls depositors fled to higher yields and the action by Congress in freeing the interest rates they could pay was too late. Worse, it raised the total deposit cap that was insured by the Federal Savings and Loan Insurance Corporation, or FSLIC, to $100,000 from $20,000. There was no reason to do that and it was not debated. It was just added by the House Banking Committee chairman, Fernand St Germain. The result was the savings and loan scandal of the 1980s. After that, a new model was necessary for home loans. It was not an improvement.

As I explained the current mortgage process this morning, I tried to use simple examples for clarity. In my example of the 1969 purchase of my first home, the mortgage company serviced the loan, collecting my payments. It was in their interest to verify my creditworthiness as, if I defaulted, they would have to foreclose and take possession of my house. In the 1960s, houses kept their value but, in 1973 when I sold that house after moving to Orange County, I sold it for what I had paid. There was no appreciation. Considering that I had made improvements, I lost money. Why I didn’t keep it and rent it to someone else is another story? I should have but I was starting a new medical practice and didn’t want to manage a rental property 60 miles away. That was a bad decision as it was sold for $595,000 15 years later.

When I bought my house in 1991, the one I still own, the loan was handled by a mortgage broker. This was an innovation since 1969 and was at the root of the present crisis. Loans were no longer carried by the origination lender but were quickly sold to other investors. The broker made his money from the origination fees and the “points” paid by the borrower. This was just as true of banks, like Washington Mutual, as brokers. I refinanced my house a couple of years ago and made payments to WaMu for about six months. Then I received a notice that the loan was now owned by Wells Fargo. This resale market for mortgages had one bad feature and one good one. The bad feature was that the originating lender did not have to live with the decision to loan me money forever. Once they sold the loan, the problems that arose in the future, if any, were not their problems.

The good feature, and the bad, were a result of the Federal National Mortgage Association, Fannie Mae, and its sister organization, Federal Home Loan Mortgage Corporation, Freddie Mac, which buy residential mortgages from banks and brokers. They have criteria for those loans, and those that meet them are called “conforming.” Because Fannie Mae and Freddie Mac have been perceived as guaranteed by the government, the interest rates were lower for conforming loans.

The resulting mess is a consequence of moral hazard. The classic example of moral hazard is in insurance where the existence of insurance may cause the insured to behave in a less careful manner. That is exactly what happened here. If the lender was loaning his own, or his company’s, money, he had an awareness of the risk of default and an interest in minimizing that risk. The result was good judgment in lending. Once that risk was reduced or removed, by selling the mortgage to someone else, it became the problem of the buyer to assess risk. Fannie Mae and Freddie Mac were responsible for the risk in the loans they bought.

Then another factor entered the equation, the Congressional mandate. Congress, and especially the Democratic party, decided that lending standards were too restrictive toward minorities and the poor.

The Clinton administration has turned the Community Reinvestment Act, a once-obscure and lightly enforced banking regulation law, into one of the most powerful mandates shaping American cities—and, as Senate Banking Committee chairman Phil Gramm memorably put it, a vast extortion scheme against the nation’s banks. Under its provisions, U.S. banks have committed nearly $1 trillion for inner-city and low-income mortgages and real estate development projects, most of it funneled through a nationwide network of left-wing community groups, intent, in some cases, on teaching their low-income clients that the financial system is their enemy and, implicitly, that government, rather than their own striving, is the key to their well-being.

That was the lead paragraph from the article, in 2000. This was all predictable. Moral hazard plus Congressional mandates. If I were a Democrat, I might say that the Congress was in Republican hands from 2000 to 2006. Very true. There is blame enough for both parties. Real estate developers and construction interests loved the new rules. They tend to be Republican. There were a few who tried to stem the tide.

From David Frum today:

By JOHN D. MCKINNON The Wall Street Journal; July 12, 2008; Page A8

WASHINGTON — Peter Wallison saw Fannie Mae’s troubles coming 25 years ago.

In the early 1980s, he was a top official in the Reagan Treasury Department. And Fannie Mae, at least by some measures, was insolvent, thanks to the economic storms that were then roaring through the savings-and-loan industry.

But getting anyone to do anything about the congressionally chartered mortgage company and its unusual vulnerabilities proved futile, even after Mr. Wallison began writing books warning that it and sister company Freddie Mac could take advantage of their government ties and relative lack of regulation to grow too large.

Fannie and Freddie applied pressure to try to silence Peter.

Almost immediately, he said, he experienced political pressure of the sort that—until now—has made Fannie Mae largely invulnerable to new legislative oversight and left it under the supervision of a weak financial regulator.

At the time, he sat on the board of a mortgage-insurance company that did extensive business with Fannie Mae. When the company’s officials noticed that they weren’t being chosen to insure some mortgage pools, Fannie officials told them it was because of Mr. Wallison’s new project at AEI, he said.

John McCain tried pass legislation.

For a decade reformers have tried to persuade Congress that they were allowing a serious risk to the government’s credit to develop in Fannie Mae and Freddie Mac, but few lawmakers would take action.

One of the reasons for this was the extraordinary power of Fannie and Freddie. They not only spent close to $150 million in lobbying over the last decade, but they also got their constituents—the securities industry, the homebuilders and the realtors—all powerful industries that depend on Fannie and Freddie’s largesse—to support their sole legislative objective: the defeat of any attempt to control their growth. Congress, as usual knuckled under to the special interest.

However, a very small number of lawmakers saw this problem for what it was, and were willing to stand up to the power of Fannie and Freddie—and I am proud to say that John McCain was one of them. In 2005, he joined a small group of Republican Senators to cosponsor the Federal Housing Enterprise Regulatory Reform Act, the strongest legislation introduced up to that time to control Fannie and Freddie. In a statement, he noted that “For years I have been concerned about the regulatory structure that governs Fannie Mae and Freddie Mac…and the sheer magnitude of these companies and the role they play in the housing market…If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie and Freddie pose to the housing market, the overall financial system, and the economy as a whole.”

These were prophetic words, given what we know now, but they did not spring from a sudden conversion in that year. Three years earlier, McCain had introduced legislation—co-sponsored with the House Democratic leader Dick Gephardt—to create a Corporate Subsidy Reform Commission. The purpose of this group was to eliminate what McCain called “corporate welfare.” In a statement at the time, he noted that “There are more than 100 corporate subsidy programs in the federal budget today, requiring the federal government to spend approximately $65 billion a year…These programs provide special benefits or advantages to specific companies or industries at the expense of hard-working taxpayers. In years past, Congress has insisted that it would eliminate the existence of this corporate welfare, but virtually no such program has been eliminated…This bill aims to remove the special treatment given to politically powerful industries…”

In other words, as far back as 2002, John McCain realized that underlying what would ultimately become the Fannie and Freddie crisis was the willingness of Congress to provide financial support to private corporations. And he was willing to take on powerful interests to stop this process. If his bill had resulted in action at that time, the unprecedented steps that the Secretary of the Treasury and Congress had to take in the last two weeks would not have been necessary.

What do we do now ? The leaders of the financial world don’t know what to do. Harry Reid says no legislation is planned because they don’t know what to do.

I guess we will just have to elect McCain.

As usual, Herr Olbermann is wrong in his comments about one of McCain’s suggestions about how to deal with the crisis.

UPDATE: This comment from another blog on the subject of the AIG collapse is interesting. It ties the thread from Fannie Mae to all the other turmoil.

Question: What started this mess?

Answer: The housing “bubble” burst.

Question: How did that cause this problem?

Answer: Most mortgages are bundled and sold as fixed income securities (bonds). Once default rates went through the roof and housing values fell, the value of these bonds could not be determined.

Question: Why is that a problem?

Answer: When the value of a bond is unknown, no one wants to buy it.

Question: Why is that a problem?

Answer: Because a bond that you can’t get a bid on is pretty much worthless as an asset.

Question: And why is that a problem?

Answer: Because most financial firms are required to “mark to market” what they own. And a security that you can’t get other people to buy is valued at zero.

Question: Can’t you take an educated guess?

Answer: That’s what most firms are doing, but a guess is just a guess, not anything more precise. And if you are dealing with a firm that could be worth billions or could be billions in the hole, would you give them a loan? No. I didn’t think so. Ergo, there goes Lehman Brothers and Bear Stearns.

Question: And who began this mess?

Answer: Who are the world’s biggest bundlers and sellers of mortgage backed securities? Fannie Mae and Freddie Mac. They set the standards for mortgages. They relaxed lending standards to help the “poor” obtain home ownership. They hired lobbyists and gave millions to every politico who would take it to prevent a crackdown on their lending practices and the amount of leverage they were using. They went to incredible leverage levels to make their earnings numbers so that their politically appointed leaders could collect millions and hundreds of millions in salary and bonus.

Fannie and Freddy were the underwater earthquake that’s now creating this financial tsunami because the mortgage backed securities market involves trillions of dollars spread throughout the globe. History will show that a relatively few Democrat political hacks looking to line their own pockets may have cause the most massive financial panic in history.
9.19.2008 7:24am

UPDATE #2 This post on the Global Labor blog strikes me as wise and somber. It should be read. That link is now updated.

UPDATE #3: This Bloomberg piece has blown the lid off this story. The author is already getting threats. Guess from who ?

What does the Fannie Mae collapse have to do with 9/11 ?

Monday, July 14th, 2008

UPDATE #2: The Wall Street Journal also offers a suggestion on what to do now. Place them in receivership and restructure the management. That is another way of saying to get the politicians out of the boardroom and executive suite. Run them like businesses. Combined with the energy crisis, and considering who has been controlling them, this could be another issue for the GOP in the fall. If they can work up the right narrative. And that’s a big if.

UPDATE: The Wall Street Journal comments on Why Fannie Mae and Freddie Mac were immune to critics even back in the Reagan Administration.

Mr. Wallison, who went on to become White House counsel, decided to devote himself to exposing the potential risks posed by the mortgage giants after he retired from law practice and joined the conservative American Enterprise Institute in 1999.

Almost immediately, he said, he experienced political pressure of the sort that—until now—has made Fannie Mae largely invulnerable to new legislative oversight and left it under the supervision of a weak financial regulator.

At the time, he sat on the board of a mortgage-insurance company that did extensive business with Fannie Mae. When the company’s officials noticed that they weren’t being chosen to insure some mortgage pools, Fannie officials told them it was because of Mr. Wallison’s new project at AEI, he said.

The original WSJ article is behind the subscription wall.

We are seeing a meltdown in the mortgage market as it was reconstituted after the S&L crisis of the 1980s. One of the two huge “market makers” for home mortgages is Fannie Mae or Federal National Mortgage Association. It was originally founded in the Depression to assist in increasing home ownership and decreasing foreclosures, many of which involved people who had little debt on their homes but no income to pay the interest. In 1968, it was rechartered and began to buy “conforming” mortgages from originating banks and S&Ls, then bundle them into bonds containing many mortgages, and sell them in a secondary market that gradually grew.

In 1969, when I bought my first home for $36,000. The minimum down payment was 20%. The loan was made by Home Savings and Loan at an interest rate of 4% and my house payment was $204/ month. The seller, who had already bought another house, was willing to take back a 10% second TD of $3500, on which I paid $35/month until I paid it off two years later. The primary trust deed was held by Home S&L in their own portfolio so they had an interest in determining that I was a good risk. In those days, the S&Ls loaned money at 4% or so and borrowed it from depositors at 2.5 to 3%. It was considered a safe, although rather dull, business. The profit was the difference and they were bared from riskier investments.

Then came Jimmy Carter and interest rates of 18%. At first, inflation took off as spending was high and the economy was stuck in what was called “stagflation.” The bear market of 1974 halved the value of the stock market. The 1960s bull market was over. People who had their savings in S&L accounts watched as inflation ate them up. They were collecting interest of 3% and inflation was 12%. They did the rational thing and withdrew their savings. They found unusual investments for them. My partner and I invested our pension account funds in second trust deeds that were steered to us by a real estate broker we knew and who made sure that we only bought good loans. These paid as much as 18% for two or three years. I also bought Treasury bonds that paid 16% coupon rate and I bought them at a discount so the real return was 18%. That was good money.

Others bought gold although it was still illegal until 1974. The inflation led to a flurry of decisions to avoid the dollar including buying antiques and crystal art pieces. It also led to the first inflation of home prices. The S&Ls were in serious trouble but it all came to a head when, in 1980, Fernand St. Germain, chairman of the House Banking Committee, lit the match that burned the S&Ls down.

One night in 1980, Representative Fernand St Germain (D-Rhode Island), whose $10,000-to-$20,000-a-year restaurant and bar tab was paid for by the S&L industry’s chief lobbyist, proposed raising federal insurance on S&L savings accounts from $40,000 to $100,000- even though the average size of an S&L account was $6,000. He waited until after midnight, when only eleven representatives were still on the floor of the House; they approved his proposal unanimously.


But St Germain was just getting warmed up. In 1982, he cosponsored a bill that removed all controls on what S&Ls could charge for interest and released them from their century-old reliance on home mortgages.
Around the same time, the Reagan administration ended the requirement that S&Ls lend money only in their own communities, allowed them to offer 100% financing (i.e. no down payments), let real estate developers own their own S&Ls, and permitted S&L owners to lend money to themselves.


These changes were like taping a sign to the S&Ls’ backs that read, “Defraud me.” In fact, it’s widely rumored that Mafia lawyers and accountants carefully monitored the progress of this bill as it worked its way through Congress, ready to pounce the moment it became law.

I don’t agree with the conspiracy theory here but the facts are correct and the reader can draw his or her own conclusion.

The result was disaster by 1985. My ex-wife worked for the Resolution Trust Commission managing bankrupt S&Ls and selling off their assets. She had a background in mortgage banking and told me some amazing stories. The self dealing and criminal behavior was astonishing.

The recovery of the housing market was nursed by Fannie Mae and Freddie Mac, both of which restructured the entire mortgage industry. No longer did local banks and S&Ls loan their own money to worthy borrowers, collecting the payments and amortizing the loan over 20 or 30 years. They “packaged” the loan and resold it to one of the big national bundlers like Fannie Mae. Sometimes the loans were sold to private investors.

Things did not begin to heat up again until the end of the Clinton Administration. The internet stock bubble left a lot of people with money to invest but few good opportunities. Many had taken their money out of the stock market after making plenty of money. Secondly, after 9/11, the Bush Administration was determined to avoid a recession brought on by the huge capital loss of the WTC collapse. The Panic of 1907 was precipitated by the San Francisco Earthquake and the huge losses to insurance companies. The Great Depression was partly a reaction to the default of war loans from World War I and the reparations demanded of Germany. There was fear that another severe financial panic would follow 9/11. In fact, that may have been a large part of the plan by Osama bin Laden. As a result, the banks had a lot of money to lend and they soon ran out of worthy borrowers. What to do ? Lend it to people with less than sterling credit. After all, houses were going to keep going up in price, weren’t they ?

Enter the chislers and scammers. Some of whom were former Clinton Administration members who got themselves appointed to the boards of the two big mortgage lenders. Did they have a broad background in mortgage banking ? No. They were politicians, like Jim Johnson who recently left the Obama campaign where he had been serving as the co-chair to vet potential VP nominees. What was his background ? Politics, not finance.

James A. Johnson is a United States Democratic Party political figure. He was the campaign manager for Walter Mondale’s failed 1984 presidential bid and chaired the vice presidential selection process for the presidential campaign of John Kerry. In the 2008 election, he is a member of the vice-presidential selection process for the presumptive Democratic nominee, Senator Barack Obama.

From 1991 to 1998, he served as chairman and chief executive officer of the Federal National Mortgage Association (Fannie Mae), the quasi-public organization that guarantees mortgages for millions of American homeowners. Previously, he was vice chairman of Fannie Mae (1990-1991) and a managing director with Lehman Brothers (1985-1990).

Franklin Raines at least had some financial background. His tenure at Fannie Mae, however, did not inspire confidence. For a while it looked like he might be indicted. Then the Democrats took over Congress and all was forgiven.

Jamie Gorelick, former Clinton Deputy Attorney General, however, had no background in finance. She is a lawyer. She did very well for herself, though. Now we are at the next big crisis and Fannie Mae is in trouble. Where is Gorelick ? Back at her law firm. What is the connection between Fannie Mae and 9/11 ? The link is Jamie Gorelick. What a career !

She helped bring the attack on 9/11 by blinding the intelligence agencies, then she profits from the easy money that follows the attack. She still has a few fingers in the pot, as you will seen in the Volkh piece. You can tell it’s all politics because the defenders are out already. Thank God for Mickey Kaus.