Meme Watch: FNMA, FHLMC, and CRA Caused the Great Recession
What caused the economic meltdown of 2008? One meme holds that Fannie Mae and Freddie Mac, plus the Community Reinvestment Act (CRA), “forced” banks to offer mortgages to people who had nether the ability to pay back those loans, nor the intention of doing so. Unsurprisingly, the loans went bad when the housing bubble burst, and the banks were left holding the bag.
How true is this meme? Let’s examine it together, shall we?
I’m not going to describe what led to the 2008 world financial collapse. I am, however, going to explore the meme that the collapse was caused by the CRA, Fannie, and/or Freddie.
Did the CRA Do It?
Let’s start by looking at the CRA. The law does not require anyone to lend to anyone. It certainly doesn’t require banks to lend to poor people. It’s not about income; it’s about geography.
Prior to 1977, large banks would open branches in places where the bank didn’t intend to do much business, other than charging people transaction fees. In other words, non-local banks would take money out of communities, while putting little to none back in the form of issued loans, and would thus be a factor reducing the wealth of those communities. In these neighborhoods, large non-local banks would institute high fees for auto loans, transactions, credit cards, check cashing, or overdraft protection — while at the same time limiting business loans, homeowner’s loans, or mortgage loans (or charging high fees and high rates for those as well). The practice of declining to invest in certain neighborhoods is known as redlining.
The CRA’s intent was to slow down, stop, or reverse these discriminatory and predatory banking practices. The Act required banks that wanted to operate in a given community to lend to people and businesses in that community, rather than merely leaching money out of it. They were required only to issue loans consistent with safe and sound operation, as defined by the broader banking laws. Note that no banks were“forced” to do anything; any bank could decline to operate in any communities it wished. The choice was left up to the banks. Note, also, that no banks were“forced” to issue unsound loans within the communities in which they operated.
Had the CRA been responsible for the housing boom and subsequent bust, one would have expected to see the biggest increases in housing prices during the boom, and the highest default rates, to have occurred in CRA neighborhoods, such as Compton or Harlem. But they were in the suburbs and exurbs, areas in which the CRA necessarily has zero impact. Three quarters of subprime loans issued from 2004 to 2007 were issued by companies that didn’t have a single branch in a single CRA neighborhood. According to the Financial Crisis Inquiry Commission, only six percent of subprime loans were made to CRA-qualified borrowers. And that six percent had half the default rate of otherwise identical loans outside of CRA territory.
It is also true that no one forced the borrowers to take out the loans. Of course, America has a history of long-term rising wages and real estate values. The vast majority of Americans — from the lenders to the borrowers to investment counselors — were convinced that home ownership was a good investment. Without doubt, owning a home had long been a key part of getting ahead, and even a comfortable retirement, for generations of Americans. Less-wealthy people dreamed that they might one day participate in the growth of America, and owning a house was seen as the surest way to do that. President George W. Bush spoke of this often, such as this quote from a 2002 speech in Atlanta:
And part of economic security is owning your own home. Part of being a secure America is to encourage homeownership.
So, yes, it was generally accepted that home ownership was an important component in economic security, and thus desirable for all Americans. But this has nothing to do with the CRA.
Fannie and Freddie
What were Fannie Mae and Freddie Mac’s involvements? To answer that, one must first understand the mission of the Federal National Mortgage Association (FNMA, or “Fannie Mae”) and the Federal Home Loan Mortgage Corporation (FHLMC, or “Freddie Mac”):
The Federal National Mortgage Association (FNMA; OTCBB: FNMA), commonly known as Fannie Mae, was founded in 1938 during the Great Depression as part of the New Deal. It is a government-sponsored enterprise (GSE), though it has been a publicly traded company since 1968. The corporation’s purpose is to expand the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities (MBS), allowing lenders to reinvest their assets into more lending and in effect increasing the number of lenders in the mortgage market by reducing the reliance on thrifts.
Since it is an outgrowth of Roosevelt’s New Deal, conservatives have hated Fannie Mae since its creation. The current attempt to blame the economic collapse on Fannie Mae is nothing more than a continuation of that hatred. Freddie Mac was created in 1970, in part to provide competition to Fannie Mae, and in part “to expand the secondary market for mortgages in the US,” thus also securitizing those mortgages.
“Securitizing mortgages” means bundling them together and backing them with funds from some other source. Until the growth of the derivatives market, this often took the form of mortgage insurance, which covers lost principal in the event of a default. In the case of a GSE-backed mortgage, the GSE would cover lost principal, keeping the lending bank from losing money on the mortgage. In order to limit the possible exposure that the federal government would have, the GSEs have formal guidelines for acceptable risk. Loans that meet these guidelines are commonly referred to as “conforming loans”.
As the first decade of the millennium went on, the amount of subprime lending financed by Fannie and Freddie actually decreased, while all of the growth, and more, in subprime occurred in the private mortgage industry. Why is this?
Around 2002, banks discovered that offering mortgages could be highly profitable even if the loan went into default. In a fashion derived from Freddie Mac’s MBSes, private financial institutions began bundling private mortgages into packages called Collateralized Debt Obligations (CDOs). Unlike Freddie’s MBSes, though, the mortgages in the private CDOs did not have to meet the GSE standards. The private CDOs, then, were made up mostly of non–conforming loans.
These CDOs, like Freddie’s MBSes, had the advantage of spreading default risk, in much the same way that mutual funds spread the risk associated with single stocks. But a CDO based on subprime mortgages would have higher risk than one based on prime mortgages. The GSEs’s MBSes cover that risk and make the subprime CDOs more attractive. In order to compete, then, these private mortgage CDOs were insured, not by Fannie or Freddie, or by the federal government, but rather by CDO insurance in the form of credit default swaps, or CDSes, issued by AIG. Because CDOs were protected by default via the CDSes, they were considered AAA-grade investments. With greater returns than alternative AAA-grade investments, these CDS-backed CDOs were very attractive to investors.
The investors in these CDOs were other institutions, including other banks, investment firms, pension funds…and Fannie Mae and Freddie Mac, who, as publicly-traded companies, were looking for opportunities to increase profit. Since many other financial institutions were investing in CDS-backed CDOs at the time, and registering record profits as a result, the GSEs had tremendous pressure by their shareholders to do the same, and so they jumped on the bandwagon.
The sudden interest in investing in these CDOs encouraged banks and mortgage-only houses to make more of these subprime loans, and even to misrepresent them on the resale market. After all, they rationalized, they’re insured anyway, so what’s the harm? And, by selling mortgages to CDO bundlers, the originating bank carried little risk, while making a profit on reselling the loans to someone else. Nothing (certainly not the CRA, either of the GSEs, or any law) forced these banks to create variable-rate mortgages, or mortgages with teaser rates, or negative-amortization mortgages. Nor were they forced to issue mortgages to people who couldn’t document their income. No one forced CDO bundlers to buy CDS coverage for high-risk loans, recasting the CDO as AAA-grade. Nobody forced AIG to offer CDS coverage for mortgage-backed CDOs. And nobody forced people to invest in CDOs.
For the most part, then, Fannie and Freddie were bystanders in the new mortgage derivatives market, which had been predominantly created by financial institutions such as AIG and Bear Stearns in an effort to profit from a new method of financing risk. The GSEs did not cause the mortgage bubble.
Congress did not pass any laws regulating these loans or the institutions that made them, or the CDOs into which they were bundled. The problem with subprime mortgages was not that the CRA encouraged investment in neighborhoods rather than bleeding them dry, nor was it that Freddie and Fannie were encouraged to buy subprime loans in CRA-covered neighborhoods. The problem was that these mortgages and investment vehicles had the illusion of transparency and loss protection, and had no oversight to either eliminate the illusion or enforce true transparency and loss protection.
Some other day, we’ll discuss other facets of the collapse. For now, it’s enough to recognize that the Community Reinvestment Act, the Federal National Mortgage Association, and the Federal Home Loan Mortgage Corporation were not the ones responsible. The collapse would have happened even if there had never been a CRA, or a Fannie Mae, or a Freddie Mac.
It’s time to put this particular story to rest.
- A Brief History of Fannie Mae and Freddie Mac (time.com)
- Why Millions Won’t Get Help From Big Mortgage Settlement (gloucestercitynews.net)
- Human Depravity, Fannie, and Freddie (asahartz.wordpress.com)
- Again, The CRA Did NOT Cause the Crash! (wcward57.wordpress.com)
- What the Settlement Means (logarchism.com)
- David Coates: Republican Truth and Real Truth: GSEs and the Housing Bubble (huffingtonpost.com)
- Dish Check: Who Caused The Financial Collapse? I (andrewsullivan.thedailybeast.com)
- Hey Bloomberg! Data Shows GSEs Did Not Cause Meltdown (ritholtz.com)
About dcpetterson (198 posts)
D. C. Petterson is a novelist and a software consultant in Minnesota who has been writing science fiction since the age of six. He is the author of A Melancholy Humour, Rune Song and Still Life. He lives with his wife, two dogs, two cats, and a lizard, and insists that grandchildren are the reward for having survived teenagers. When not writing stories or software, he plays guitar and piano, engages in political debate, and reads a lot of history and physics texts—for fun. Follow on Twitter @dcpetterson