January 28, 2009

Excerpt: ‘The True Scope of the Housing Bust’ — Fan and Fred Did It

Filed under: Business Moves,Economy,Taxes & Government — Tom @ 2:15 pm

An interview last week by Chip Hanlon of Safehaven (HT The Independent Institute’s Beacon Blog) of Fannie Mae’s first Chief Credit Officer, Edward Pinto, is probably the best explanation out there, so read the excerpts after the jump (if you’re on this blog’s home page), and go and save the whole thing:

Chip: ….. we’ve heard a lot over the past few months, first with the takeover of Fannie and Freddie, and now the big (Fan and Fred) bailout package that was passed last week. We’ve heard a lot about this problem being caused by Wall Street greed. Isn’t Wall Street the prime culprit?

Edward: No. It’s not. …. Fannie Mae started it. Freddie Mac sort of had to follow suit. And Freddie Mac was always sort of the junior partner; they were always pretty much smaller than Fannie. So they pretty much followed suit.

Fannie Mae, starting in the late 1980s, early 1990s, decided that in order to protect its charter from attack by Congress, and Congress is the only entity that can change its charter. The president has no power; Fannie Mae has no power.

Chip: OK.

Edward: Congress is the only entity. It’s a congressionally granted charter. The only way to protect their charter and the provisions under it that were very, very valuable – the high leverage, the high portfolio that they could do, the implicit government guarantee, the exemption from taxes, the exemption from SEC oversight – these were all part of their charter.

And in order to protect that, the decision was made to embrace the charter and the strategy for protecting it was affordable housing. And Congress embraced that strategy with a vengeance.

Chip: Getting into it for the first time.

Edward: In 1992, put in a provision requiring Fannie and Freddie to do affordable housing in a certain percentage to be set by HUD. So now they had HUD setting the goals. And HUD has been a disaster when it comes to affordable housing.

Chip: And thus our first slide into this mess.

Edward: That’s the first slide into this mess. And that goes on for the next 15 years. But the second thing that happened, that was going on at virtually precisely the same time …. roughly that Fannie Mae is deciding to embrace this mission of affordable housing to protect their charter, it had cleared the way of all competition to whatever part of the market it wanted to control. It had beaten back every private competitor.

Solomon Brothers in the late ’80s had endeavored to do something that Fannie Mae viewed as a threat. And Fannie Mae was able to defeat Solomon Brothers and get them to back off from that permanently.

Likewise GE Capital, through some of its subsidiaries, was trying to develop programs a develop businesses that might compete with Fannie and Freddie, and they were defeated. This happened a number of times.

The reason they were able to be defeated was these charter advantages. Fannie and Freddie had tremendous leverage. On their portfolio business, they could lever approximately 40:1. On their MBS business, they were able to lever 180:1 approximately.

Chip: [laughs]

Edward: And as the listeners would know, those are fantastic leverage levels. These companies have always been relatively minimally capitalized in terms of levels of capital. And it was that leverage compounded with the ability of that leverage to finance or support huge portfolios in both companies that threw off huge amounts of money and profits that could be used to subsidize affordable housing, which would benefit their supporters in Congress. Which would keep them from changing the rules to either reduce their portfolio size, put in a strong regulator, or raise their capital requirements.

Any one of those three things, just any one of them, would have endangered the ability of Fannie and Freddie to support affordable housing at the level that Congress wanted it.

Chip: So Congress created this mess with its desire to essentially throw caution to the wind, in the name of doing something good, and now they rail against Wall Street and fail to name themselves as movers in this issue.

Edward: Exactly. If you recall, in the late ’80s, the Congress was always complaining about there isn’t enough discretionary spending. We don’t have enough. We’re getting squeezed, we’re getting squeezed. Well, HUD and affordable housing was in the discretionary spending bucket.

So in effect Congress decided, well, if we can’t get it through spending that’s on-budget, what if we get to it with spending that’s off-budget. And Fannie and Freddie could put trillions into this. In fact, in 1994, Fannie Mae announced its first trillion-dollar affordable housing initiative, by Jim Johnson.

And then it was followed in 2001, I believe it is, that Frank Raines had a follow-on, a cumulative $2 trillion program. And Freddie Mac had a companion $2 trillion program that year. These were multi-year programs. But I’ve now named $5 trillion of initiatives.

That swamped anything Congress could have done through HUD.

Chip: Right. And only a government-ordained institution could go on and make such messy loans, throwing credit standards to the wind, in a way that no private institution that actually cared about getting its capital back would ever do. Correct?

Edward: Exactly.

Chip: ….. Boy, it sounds like it took on this billowing effect that it was almost taking on some characteristic of a Ponzi scheme in its growth. It makes you wonder that, as bad as we all think this situation is, that underneath it’s probably much, much worse. A truly epic situation.

Chip: ….. Some would say all this has been worth it – or maybe they wouldn’t say that now, but it was always the case, because the case was, well, many of these loans helped further the goal of affordable housing. But in fact it’s done nothing of the sort, right?

Edward: It’s absolutely done nothing of the sort. In fact, when I was at Fannie Mae, I worked with Gail Cincotta who was the founder of National People’s Action, which is a community group very much like ACORN, much, much smaller.

And she was instrumental in getting the CRA Act, the Community Reinvestment Act, passed. And she really hated FHA and HUD and the tremendous default rates that they had and what it was doing to default rates in Chicago, Detroit, St. Louis, all around the country. And she’s on record in front of Congress talking about this for many years.

Chip: So an affordable housing advocate who actually wanted solid lending standards.

Edward: She wanted solid lending. She wanted lenders to have skin in the game. And her vision of CRA was you’d have lenders that actually were lending their money, not HUD lending the taxpayer’s money. Lenders lending their own money, and they would keep track of this.

When Fannie Mae got involved, I put that same requirement in, that the lenders had to keep skin in the game, had to take that first loss, had to participate fully in that first level of losses. And the idea being that that would keep them attentive and the programs would be successful.

Chip: Common sense again.

Edward: Common sense lending for affordable housing. That requirement was changed in one or two months after I left Fannie Mae, it was changed. Because that then enabled a huge expansion very quickly of the affordable housing programs.

The way I’m describing, it takes time. You can’t announce a trillion-dollar program and do it that way. You have to do it transaction by transaction, bank by bank, and look at each transaction and look that it’s properly put together. But that takes time. People didn’t want to take the time to do that. They wanted to do it the easy way, the fast way.

As you know, when you start making credit decisions that are based on political expedience and loose lending, it may take five or ten years for the problems to actually surface. They’re just sort of sleeping. Housing prices are going up, which they were for the most part of the ’90s. Particularly starting in about ’93, all the way to 2005 or 2006.

Well, a rising tide raises all ships, and it basically masked what was going on with the loose lending. But the balloon can only keep blowing up for so long. Ironically, as Fannie and Freddie were feeding this market, house prices started going up even faster. And so Fannie and Freddie and were under even more pressure to do affordable housing because housing was becoming more unaffordable. Think about that.

Chip: Wow, that’s unbelievable. We’re running little long here, so one last question or thought here. And that’s the question of where we’re heading. I look at what’s taking place in Washington, DC, today and it doesn’t give me one bit of comfort. In fact it makes me feel like we’re trying to build a similar mess once again.

Sadly, as you will see in the full interview, they are.

The discussion excerpted here shows that Fan and Fred brought down the housing market by in essence forcing its standards on everyone else. Those trying to pin the blame elsewhere have nowhere to hide, period.

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UPDATE: Some other interesting background from January 2005 at CNN.

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