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The Subprime Lending Debacle: Competitive Private Markets Are the Solution, Not the Problem, Cato Policy Analysis No. 679

The Subprime Lending Debacle: Competitive Private Markets Are the Solution, Not the Problem, Cato Policy Analysis No. 679

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Published by Cato Institute
The United States’ market-government hybrid mortgage system is unique in the world. No other nation has such heavy government intervention in housing finance. This hybrid system nurtured the excessively risky loans, financed with too much leverage, that fueled the U.S. housing bubble of the last decade and resulted in the systemic collapse of the global financial system.



The responsibility for the massive failures of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, at the center of American housing finance and the private securitization system that supports housing finance, falls directly on regulators and indirectly on their political overseers. Private and GSE prudential regulators were given politically determined social lending goals that ultimately trumped prudential regulation, forcing the GSEs to fund subprime lending in competition with private label securitizers. The result was the extension of lower and lower quality loans, creating a race-to-the-bottom between the GSEs and private mortgage providers, all while regulators and politicians looked on approvingly. The financial crisis resulted when many of those loans turned sour in the latter part of the last decade.

We find no evidence that the United States housing market has unique characteristics requiring a hybrid GSE system, thus we conclude that the system and the political risks it is subject to are unnecessary. Any U.S. housing finance policy that does not safeguard prudential regulation from political influence by separating housing subsidy from finance and eliminating government- induced distortions will result in another systemic failure. To re-privatize the GSEs while maintaining their political goals, or to create new, specially chartered enterprises that pursue those goals, would exacerbate systemic risk.
The United States’ market-government hybrid mortgage system is unique in the world. No other nation has such heavy government intervention in housing finance. This hybrid system nurtured the excessively risky loans, financed with too much leverage, that fueled the U.S. housing bubble of the last decade and resulted in the systemic collapse of the global financial system.



The responsibility for the massive failures of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, at the center of American housing finance and the private securitization system that supports housing finance, falls directly on regulators and indirectly on their political overseers. Private and GSE prudential regulators were given politically determined social lending goals that ultimately trumped prudential regulation, forcing the GSEs to fund subprime lending in competition with private label securitizers. The result was the extension of lower and lower quality loans, creating a race-to-the-bottom between the GSEs and private mortgage providers, all while regulators and politicians looked on approvingly. The financial crisis resulted when many of those loans turned sour in the latter part of the last decade.

We find no evidence that the United States housing market has unique characteristics requiring a hybrid GSE system, thus we conclude that the system and the political risks it is subject to are unnecessary. Any U.S. housing finance policy that does not safeguard prudential regulation from political influence by separating housing subsidy from finance and eliminating government- induced distortions will result in another systemic failure. To re-privatize the GSEs while maintaining their political goals, or to create new, specially chartered enterprises that pursue those goals, would exacerbate systemic risk.

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Published by: Cato Institute on Jun 16, 2011
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Executive Summary 
The United States’ market-government hybridmortgage system is unique in the world. No othernation has such heavy government interventionin housing finance. This hybrid system nurturedthe excessively risky loans, financed with toomuch leverage, that fueled the U.S. housing bub-ble of the last decade and resulted in the systemiccollapse of the global financial system.The responsibility for the massive failures of thegovernment-sponsored enterprises (GSEs) FannieMae and Freddie Mac, at the center of Americanhousing finance and the private securitizationsystem that supports housing finance, falls di-rectly on regulators and indirectly on their politicaloverseers. Private and GSE prudential regulatorswere given politically determined social lendinggoals that ultimately trumped prudential regula-tion, forcing the GSEs to fund subprime lendingin competition with private label securitizers. Theresult was the extension of lower and lower quality loans, creating a race-to-the-bottom between theGSEs and private mortgage providers, all while reg-ulators and politicians looked on approvingly. Thefinancial crisis resulted when many of those loansturned sour in the latter part of the last decade.We find no evidence that the United Stateshousing market has unique characteristics re-quiring a hybrid GSE system, thus we concludethat the system and the political risks it is subjectto are unnecessary. Any U.S. housing finance pol-icy that does not safeguard prudential regulationfrom political influence by separating housingsubsidy from finance and eliminating govern-ment-induced distortions will result in anothersystemic failure. To re-privatize the GSEs whilemaintaining their political goals, or to createnew, specially chartered enterprises that pursuethose goals, would exacerbate systemic risk.
The Subprime Lending Debacle
Competitive Private Markets Are the Solution, Not the Problem
by Patric H. Hendershott and Kevin Villani
No. 679June 20, 2011
 Patric H. Hendershott is a part-time chair in real estate economics and finance at the University of Aberdeen,Scotland. Previously he taught economics and finance at Purdue University and Ohio State University from1969 to 1999. Kevin Villani is a consultant and former Freddie Mac chief economist.
 
Introduction
In the last decade, much of the developedworld experienced large increases in housingprices. The subsequent collapse of this hous-ing bubble sparked the 2007–2008 financialcrisis and ensuing recession.Though the bubble was worldwide, it playedout differently in the United States than else-where. Many of the mortgages underlying theU.S. bubble were “subprime”—that is, they wentto homebuyers with shaky credit histories orhomebuyers who were borrowing more money than they could easily repay over the course of the mortgage. The reason so many subprimeloans were issued in the last decade is that theUnited States’ more liberal down payment re-quirements and underwriting standards, facili-tated for decades by federal housing policies, hadlong ago accommodated more qualified buyers,and lenders turned to the less-qualified in orderto continue their business. So from mid-2004through mid-2007, over a million borrowers satacross the table from lending officers, signingloan documents and accepting over a trilliondollars in loans that neither the borrower northe lender expected to be repaid.In 2009 Congress created the Financial CrisisInquiry Commission (FCIC) to investigate thecauses of the crisis. Congress modeled the FCICafter the Pecora Commission of 1933 and, likeits predecessor, Congress intended for the FCICto find that “Wall Street greed” was to blame.The commission dutifully reached that conclu-sion in its final report, claiming that borrowerswere victimized by irresponsible lenders. But be-cause that did not result in an actionable policy agenda, the FCIC also promoted the narrativethat other independent and complex causescontributed to the crisis, all of which are ame-nable to mitigation through more governmentintervention in housing markets.Disappointingly, the FCIC report gave littleattention to one independent cause that really did contribute heavily to the financial crisis: de-cades of government policies to increase home-ownership rates. Included in those policies isthe creation and direction of the government-sponsored enterprises (GSEs) Fannie Mae andFreddie Mac, the home-finance giants at the cen-ter of the U.S. mortgage system. The report didacknowledge that the behavior of the GSEs wasone of many independent market and regula-tory failures, but it went on to extol the supposed virtues of the GSEs instead of questioning theirnecessity. There was not much new in this discus-sion, and three of the four Republican appointeesto the FCIC dissented to the commission’s finalreport, putting less emphasis on the greed narra-tive and narrowing somewhat the list of complexcauses of the financial crisis.The Obama administration’s own report toCongress on the crisis, entitled “Reforming Amer-ica’s Housing Finance Market,” offers much thesame narrative as the FCIC report, blaming thesubprime lending crisis on poor consumer regu-lation, inadequate financial institutions, com-plex securitization, inadequate capital, and inad-equate loan servicing. The report is a frustratingmélange of promising ideas for reform and dis-couraging calls to repeat the policy mistakes of the past. It implicitly rejects the notion that socialhousing goals played a role in the financial crisisand does not specifically recommend their elimi-nation, but it supports greater transparency andtargeting of affordable housing support. It makesno mention of reforming the U.S. Departmentof Housing and Urban Development (HUD),which oversees U.S. housing policy, and it implic-itly rejects the notion that housing finance regu-lation has become politicized and recommendsa doubling-down on the regulatory regime withno change in political oversight, but it supports a robust private market for housing finance. Whileit supports a winding down of Fannie Mae andFreddie Mac, it proposes alternative guaranteemechanisms in times of “crisis” and for “targeted”borrowers that go well beyond the governmentbacking and social mission initially conferred onFannie and Freddie. It argues that governmentinsurance programs to support “affordable hous-ing” and “catastrophic” protection should be ac-tuarially sound and priced to market, but it doesnot say how the subsidies necessary to make in-surance affordable will be funded.Why does the United States even have GSEs,when no other market economy has them?Their existence is grounded in a “third-way” eco-
2
Why does theUnited Stateseven have GSEs,when no othermarket economy has them?
 
nomic theory—a theory that supports neither a relatively unfettered market in housing financenor heavy government involvement in the formof broad, explicit on-budget subsidies for hous-ing. This third-way theory asserts that housingfinance markets do not function well withoutextensive, pervasive prudential regulation. Fur-ther, government-imposed social lending goalsare needed to meet the shortage of “affordable”housing loans, mitigate racial discriminationby lenders against prospective borrowers, andboost the availability of cheap fixed-rate mort-gage credit. The FCIC and Obama administra-tion reports implicitly support this narrative,attributing systemic regulatory failure to ideo-logical bias and implying that lenders and inves-tors are systemically racially biased, incompe-tent, ignorant, irrational, and panicky.The FCIC report spends only 10 of its 662pages addressing social lending mandates, con-cluding that “these (housing) goals only con-tributed marginally to Fannie’s and Freddie’sparticipation in those (risky) mortgages.”
1
TheObama administration report also finds nofault with these goals, only shareholders’ reck-less pursuit of profit in meeting them. But notall FCIC members agreed. Peter Wallison wrotean independent dissent to the FCIC report, argu-ing that these goals alone explain why the GSEswould reduce and virtually eliminate down pay-ments—bypassing private mortgage insurance—and weaken underwriting guidelines.Private-label mortgage-backed securitiza-tion financed many of the subprime loans. Mostof these were securitized by large investmentbanks—which, in the wake of the financial cri-sis, all merged to become more stable universalbanks—that most believe are “too big to fail.” Thepolitical distortions enabling private-label securi-tization were quite similar to those of GSEs, butthis market would likely not have gotten startedwithout GSE leadership in laxity and massivesupport of the housing price bubble.If the third-way narrative is correct, then gov-ernment intervention promotes competitionamong actuarially sound firms. But excessiveprotection reduces competition. If social lendingquotas are just an attempt to deliver off-budgetcross-subsidies from lower-risk mortgage borrow-ers (who pay their implicit mortgage insurancepremiums and seldom default) to higher-riskborrowers, then competition from unconstrainedproviders must be suppressed or else it will resultin too much money being lent to too many high-risk borrowers. This leads to politically manipu-lated and protected crony capitalist enterprisesand/or government monopolies. Moreover, theimplications go well beyond mortgage finance toother mandatory government-run financial pro-grams, e.g., Social Security “pensions” and Medi-care “health insurance.”The implicit third-way conclusion that U.S.mortgage markets work so much worse thanthose in all other market economies as to war-rant a higher level of government control andlegal mandates is shocking. This paper exam-ines that government intervention, explaininghow it increased over the last quarter-century inpursuit of high-minded homeownership goals.This paper argues that policymakers, in pur-suit of those goals, pushed the GSEs to extendriskier and riskier loans, and that private-labellenders also turned to risky mortgages after thepool of qualified prospective borrowers becameextremely shallow as a result of previous govern-ment efforts to broaden homeownership. Theresult was a housing finance market heavily slanted toward making poor-quality, actuarially unsound loans—a situation that would inevita-bly end in a financial crisis.
Social Lending Goals andthe Antecedents of the Crash
Social lending goals for housing in the UnitedStates date back at least to the Home MortgageDisclosure Act (HMDA) of 1975 and the Com-munity Reinvestment Act (CRA) of 1977. TheHMDA and CRA purportedly reflected a con-cern that bankers were not lending enough inthe local communities or neighborhoods, whichwere typically characterized by ethnic and/orracial concentrations. Lending goals for FannieMae were introduced about the same time andfor the same purpose.The theory behind these goals was that therewas a sufficient supply of creditworthy borrowers
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The politicaldistortionsenablingprivate-labelsecuritizationwere quitesimilar to thoseof GSEs, butthis marketwould likely not have gottenstarted withoutGSE leadershipin laxity andmassive supportof the housingprice bubble.

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