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.