Regulation – Not Lack Thereof – Led U.S. into Financial Crisis

Pundits and politicians, including President Obama, used the recent anniversary of the Lehman Brothers collapse to once again blame a lack of government regulations for causing the financial crisis.

The great tragedy of the financial crisis, however, was not that Washington regulations failed to prevent it, but instead that Washington regulations helped lead us into it.

Federal policies designed to expand homeownership in an "off-budget" fashion encouraged lending to people who bought homes they could not afford to keep. Perhaps not surprisingly, a federal government which lives beyond its means tragically encouraged American families to do the same.

One of the most damaging of those initiatives has been the Community Reinvestment Act, which was undertaken with good intentions but is today in need of repeal. Proponents of CRA-like mandates have maintained that only a small portion of subprime mortgage originations are related to the CRA. However, though they may be small in volume, CRA loan mandates remain large in precedent. They inherently required lending institutions to abandon their traditional underwriting standards to comply with this government mandate. CRA implicitly put the government's "Good Housekeeping Seal of Approval" on such loans.

Along with CRA, no one should forget the central role Fannie Mae and Freddie Mac played in sparking the crisis. These private companies were awarded monopoly powers by Congress in exchange for meeting certain affordable housing goals. Fannie and Freddie exploited their congressionally granted charters to borrow at discounted rates and ultimately dominated the secondary mortgage market. They wildly inflated their balance sheets and personally enriched their executives via implicit (now explicit) government backing not to mention via the cooked books that allowed politically connected executives to make off like bandits with what their regulator described as "ill-gotten bonuses in the hundreds of millions of dollars."

Given their prominence in the market, investors and underwriters came to believe that if Fannie or Freddie touched a loan, it was safe, sound, secure and most important, "sanctioned" by the government.

More than 70% of subprime and alternative-A mortgages that led to the crisis were backed by Fannie and Freddie, the Federal Housing Administration and other taxpayer-backed programs. If anyone is looking for a root cause of the financial crisis, this is it.

Yet, despite the inherent dangers in such transactions, Fannie and Freddie's congressional supporters encouraged them to roll the dice a little bit more. Well, they did, and the result was the mother of all bailouts nearly $200 billion and the worst financial crisis since the Great Depression.

But when it came time for Congress to address the crisis, the Democrats produced a bill that failed to tackle its root causes. Nowhere in the Dodd-Frank Act's 2,300 pages will you find one single reform to Fannie or Freddie. Instead, Dodd-Frank leaves them in a state of perpetual federal conservatorship. As a result, hardworking taxpayers today back nine of every 10 new residential mortgage securitizations and taxpayers are on the hook for more than $5 trillion in mortgage guarantees.

What you will find in Dodd-Frank, however, are provisions that make bailouts permanent, enshrine "too big to fail" into law and give Washington bureaucrats more power, more authority and more control over personal financial decisions that Americans should be making for themselves. Dodd-Frank will prove to be every bit as far-reaching in its harmful consequences as the Democrats' radical plan for "fixing" the nation's healthcare system Obamacare.

While Democrats were voting for Dodd-Frank and its 400 new regulations, they were voting against the alternative put forth by House Republicans: the Consumer Protection and Regulatory Enhancement Act. Our proposal would have ended taxpayer bailouts and restored market discipline. It would have put the government-sponsored enterprises on the path away from taxpayer reliance and transitioned our secondary mortgage market toward free market competition and it would have streamlined the complex regulatory structure for enhanced enforcement of consumer protection laws and safety and soundness.

So five years after the crisis and three years after the passage of Dodd-Frank, where do we go from here?

For starters, both parties and the president should work together to create a sustainable housing finance system, end the bailout of Fannie and Freddie and phase out their failed business model. That's exactly what House Republicans have proposed to do with the PATH Act, which stands for Protecting American Taxpayers and Homeowners.

The PATH Act passed the Financial Services Committee in July. It creates a sustainable housing finance system by limiting government control of the mortgage market, putting private capital at the center of the mortgage system and giving homebuyers more informed choices about their mortgage options. The PATH Act includes reforms to save the FHA from insolvency and preserves the 30-year fixed-rate mortgage. In fact, for the first time the FHA would be specifically required to offer a 30-year fixed-rate insurance product under the PATH Act.

The PATH Act is our best chance to create a housing finance system that is sustainable for homeowners, taxpayers and our economy.

Rep. Jeb Hensarling, R-Texas, is chairman of the House Financial Services Committee.

Comments (22)
Editor's Note: BankThink received the following Feedback regarding this article.

Recently, Representative Jeb Hensarling took to the pages of American Banker to brazenly and incorrectly blame the Community Reinvestment Act (CRA) for the housing crisis. It's unfortunate that a federal legislator would publicly release an op-ed about a law that he obviously has not read or simply does not understand. By opposing CRA he is explicitly saying that banks should be able to lend only to the rich and have no requirement to lend to creditworthy moderate- or middle-income borrowers.

Hensarling's assertion that CRA was "one of the most damaging initiatives..." that resulted in "...lending to people who bought homes they could not afford to keep..." displays not only his lack of understanding of the CRA law but also of what happened during the mortgage crisis. CRA requires banks to make loans that are safe and sound - that language is actually in the law, not just the CRA regulations. The evidence The Financial Crisis Inquiry Commission found in 2011 that "CRA was not a significant factor in subprime lending or the crisis," and that "... only 6% of ... high cost loans had any connection to the law." A recent analysis of 2012 Home Mortgage Disclosure Act data by Neil Bhutta and Glenn Canner at the Federal Reserve presents yet more evidence that CRA was not responsible for the crisis. In fact, it was the unregulated independent mortgage companies, institutions not covered by CRA, that took a safe and sound mortgage industry and converted it into a wild west, no-holds-barred, subprime, predatory lending industry.

It was Wall Street and non-CRA lending institutions that screwed up the American system of mortgage finance. Unfortunately, Fannie and Freddie, after losing an enormous amount of market share, followed these unregulated and greedy institutions into the subprime abyss. Fannie and Freddie are guilty of stupidity for following Wall Street onto that path, but they are not guilty of causing the housing crisis.

Mr. Hensarling can blame CRA or Fannie and Freddie until the cows come home, but the facts don't support his position. Senator Phil Gramm, for whom Mr. Hensarling worked from 1985-1989, opposed anti-predatory legislation that would have prohibited these unsustainable loans and saved the US taxpayers, and millions of homeowners, a lot of pain and loss. Mr. Gramm, Mr. Hensarling, Wall Street, the Credit Rating Agencies, and their independent mortgage company friends have never been called to task for the key role they played in creating and elongating this dark period of mortgage abuses.

John Taylor is President and CEO of the National Community Reinvestment Coalition.
Posted by Jeanine Skowronski, Deputy Editor, BankThink | Friday, September 27 2013 at 5:27PM ET
Here you go, Mr Newton:
Posted by FrankBird | Thursday, September 26 2013 at 12:59PM ET
25+ years in banking and securities industries.
Posted by andkel | Thursday, September 26 2013 at 12:40PM ET
Andkel: What are your banking credentials that would support your blanket statements without including supporting evidence in your post?
Posted by Bob Newton | Thursday, September 26 2013 at 12:10PM ET
C'mon. Perpetuating the Big Lie.
Facts don't lie, pols do.
Subprime loans weren't originated for CRA purposes and most no-doc, pick-a-payment loans went to investors and well heeled borrowers. The basic problem is that - unlike years ago - Wall Street enabled the originators to have no skin in the game, so they didn't care if they made risky mortgages since someone else would be owning them.
I am sorry if the truth doesn't align with political posturing.
Posted by andkel | Thursday, September 26 2013 at 10:53AM ET
At some point we might hopefully discover that regulations do not and can not work. If they did, we would not have this, or any previous mess that we have had to endure.

To callously promote the idea that more regulations are needed is nothing more than self-serving, as opposed to serving the public. The people on the street (those supposedly being regulated) will always have a leg up on those trying to figure out what they are doing in order to prevent them from doing it. Regulations only serve to sanction activities which have already occurred.

I suggest that "accountability" is the only benchmark all endeavors should be striving for. You know, doing business in the sunshine! Then, and only then, will information be properly revealed so a customer can make an informed and intelligent choice. If they do, good for them; if they don't, so be it. There's nothing like a good learning curve...
Posted by Theo Rising | Wednesday, September 25 2013 at 12:51PM ET
Leeman BrothaZ sums up housing crash in music video -
Posted by LeemanBrothaZ | Wednesday, September 25 2013 at 11:12AM ET
Mr Newton. The "right wing" label comes the fact that Jeb Hensarling's explanation is exactly what the American Enterprise Institute and the Heritage Foundation started spewing once the extent of the meltdown became obvious. Their argument = don't blame the system, blame "liberals" and "the poor." They were adopted as stock GOP talking points. Hensarling is merely parroting them.

Sure those regs played a part, but to put the full blame on them is absurd. Both because it is incorrect (all of those condo flippers in Miami were poor people?) and because it ignores the fact that the defaults were also, as you note, partly due to cyclical factors. Cycles happen, it's part of economic life.

On another note, anyone else notice how Mr Hensarling fought against a SEC probe of high-frequency trading following the "flash crash"? There must be a bunch of HFTs in his district, right?

Posted by FrankBird | Wednesday, September 25 2013 at 11:11AM ET
Perhaps a detailed analysis of the failed loans could be performed using some of those funds taken from the major players in the industry. On an anecdotal level, I can testify that many of the foreclosures in my home town at the time were for newly built, $250K homes (i.e., not many of the other houses forced back on the market could have been financed by "sub-prime" loans int he first place). People were trying to live beyond their means, and many of them would happily tell you that six figure incomes are somehow "middle class." Somehow, I think Animal Farm may contain the base lesson we must build from. We'll see what the PATH details are ... and if they define a better mousetrap.
Posted by teknoscribe | Tuesday, September 24 2013 at 11:21PM ET
Typical of perfect storms, there were several forces that came together in 2008 to trigger the crisis. Mr. Hensarling correctly identifies CRA as one major cause. There were others. Mr. Bird, in his comment above, correctly identifies the natural cycle of financial markets as a major one. The great mistake that originators, investors, and the rating agencies made was assuming that people would take every effort to make their mortgage payments no matter how tough their circumstances became; when this turned out to be untrue, the default rate skyrocketed. (Why he introduces this correct conclusion with a gratuitous sneer at the "right wing" is a mystery.)

Mr. Hensarling's main point, that Dodd-Frank is a disaster for our financial system, is absolutely correct in every way. I can't think of a single clause in Dodd-Frank that improves anything for anyone - except government bureaucrats. It is a fascist takeover of the financial industry, just as Obamacare is a fascist takeover of the medical industry. Both laws should be repealed in their entirety as soon as possible, if the economy is to have any hope of turning back toward recovery.
Posted by Bob Newton | Tuesday, September 24 2013 at 8:12PM ET
There is truth here in every comment. In my view it started with government programs, if not more than, let us say for arguments sake 10%, it still set the tone for a wider span and scope. When FNMA & Freddie started licking their chops watching private investors buying B & C Loans and securities, many enhanced credit wise and tranched into many levels of risk, they wanted a piece of the action and they did it big time. Then the greed and fraud became a major factor and many companies 100% B & C or just companies that wanted to participate in what looked like a never ending home equity increasing market where risk seemed nominal because of the tremendous equity increases in homes across the nation ad also because they felt as soon as hey sold heir securities they were free of any substantial risk. Holding an ownership interest of a certain % just keeps the originators honest. God knows we need that. Truth be told, where were our leaders and our senior managers. Many Senior Servicing Managers including myself knew this was a bomb waiting to explode. I was fortunate enough to have enough input at the Operating Committee level and Board Level to limit much of this, but it was difficult with everyone around making so much money. Greed is part of human nature. I am not blessing it at all, it just exists and many CEO's never truly understood the risk of B & C or the hedging or non hedging of the asset which just made things worse. Fannie & Freddie worked well for many years until the greed set in. I don't understand this need in healthcare or in our own industry to want to start everything from scratch. Why not take the multitude of good things the GSE's have done over the years, fix the problems and get the right people to create the proper culture of honesty, integrity, upward and downward communication, sharing how one's job relates to others that they touch, walk and talk to all the people all the time and not just your direct reports, create career paths for all and train managers how to do that. Share in the profits with all the people that positively participated in any years success. Even if we split senior bonuses, increases, stock, with all, the ultimate success of the new enhanced entity would bolster everyone's ultimate combined income in time. Look ahead, not for 3 months or 1 year but much longer. Realize certain businesses have seasons and explain this to investors. Do not play the game of attempting to increase earnings each quarter especially with having to mark to mark your mortgage assets at the same time. Run the company as if it was yours. As if your each and every decision impacted your family. Because your responsibility is not just to the Investors but also to your employes and their children, wives, etc. I am a conservative that believes in capitalism, but not the kind that steals, abuses, and allows power to corrupt as it is now in our own government. Our Empire is starting to collapse. If we do not get back to the basics that made us great in business and as a Nation we will be doomed. I know we can do this. I have seen it down over and over again in my years. Yes, everything commented before me has truth in it. Let us look at our recent and passed history. Learn from our mistakes and move on. The forest may burn, but this is not an unhealthy thing. As far as bailouts, I am against them, but something was needed in the situation we were in at the time and I believe, putting corrupt politics aside, the Republicans would have done a similar thing. Maybe not to the extent that occurred, but similar. Let us move on together. Divided we will fail. Let us be honest with each other. Everyone as to blame in a sense. Admit our mistakes, work together and build for the future. AMEN!
Posted by robrose | Tuesday, September 24 2013 at 6:56PM ET
Jimmy Carter signed CRA into law in 1977. That same year he also signed a mine safety act. The mine safety act had as much to do with the subprime mortgage crisis as CRA did. Think of the firms that were most instrumental in subprime: non-bank mortgage brokers, lenders (New Century, Option One) and securitizers (Bear Sterns, Lehman, Merrill Lynch). Which of these were subject to CRA? As many as were subject to the mine safety act.
Posted by | Tuesday, September 24 2013 at 5:23PM ET
The failure of LEADERSHIP and MANAGEMENT we have all witnessed is a natural result of greed and political corruption (relativism - under the guise of compromise).

Unfortunatly this is the nature of our political system. PACs supply money to their candidates which in turn write favorable legislation for the major donors while promising their constituents more and more, which in turn allow the PACs to fund larger and larger campaigns keeping their candidates in for decades.

When banks were allowed to securitize mortgages (Countrywide), which created (who ever heard of) no-dock loans, along with the entitlement generation that everyone should be able to buy a home (GSE's) and the repeal of Glass-Steagell - the resulting financial crisis and its magnitude shouldn't have been a surprise.

FDR said it best: "We have always known that heedless self interest was bad morals, we now know that it is bad economics."
Posted by veribanc | Tuesday, September 24 2013 at 3:45PM ET
My understanding is that root-cause was the creation of a new Financial Instrument, that worked analogously to a mortgage-note-mutual-fund. The base idea, backed up by economic theory and maths, is that if you group a set of class-B notes together, the group will behave as a class-A note as the overall risk is lessened.

This grouping of higher risk notes to produce a lower risk note drastically increased the demand for the higher risk notes, as they could then be sold for a profit.

Mathematically, it may even be true...with class-B notes. It certainly falls apart below a certain theshold, and did. But in the meantime, there was a huge demand for...risky mortgages. The bundled risk fell apart at the level, and the whole scheme self-destructed.

The obvious argument for the "inherent" safety was that the reward was balanced by the risk of default. So, the folks rolling the dice took out literal insurance policies on the risk...and the ball kept rolling. When the value of the bundled notes collapsed, the insurance claims snowballed, and it all went down the proverbial toilet.

Greed, backed by a feeling of invincibility.
Posted by murdochj | Tuesday, September 24 2013 at 3:40PM ET
There's always a way to deflect responsibility and liability. If the big banks that are to big to jail were concerned about their basic function in our financial system instead of the big bonuses at the end of the year, we shouldn't have the crises we have had to endure. That goes for JPM, BofA (bunch of assh**es) and the rest.
Posted by exregulator | Tuesday, September 24 2013 at 3:37PM ET
Interesting conversation.... Here is my take:
As I read the article and the comments, a questions kept popping into my mind. Where is the old traditional American enterprise culture that created the most powerful nation which has been the envy of the world for decades?

Entrepreneurs that take risk to get into business (yes there is good and bad risk), work hard, play by the rules (not seeking opportunities to game the system for quick profit), exercise "personal integrity", fair play, sound management, and SERVE their clients well, tend to make reasonable to big profits without causing harm to their clients or to society at large.

I have been observing the financial sector for decades and I feel that the common thread of the hardships it has endured tend to be caused by a failure of LEADERSHIP and MANAGEMENT.

And, when bank management fails, and cause hardships at systemic levels, Governments in a modern society feel obliged and they should step in and level the playing field. How they do it is another question that is out of my area of expertise.

Let us keep in mind my favorite quote by a famous author, John C. Maxwell, "everything rises and falls with leadership". This is true for all of us: bank leaders, regulators and ordinary citizens!
Posted by Jean-Baptiste Sawadogo | Tuesday, September 24 2013 at 3:05PM ET
I've been trying to find exactly where in the Community Reinvestment Act, or its regs, lending companies like Countrywide were required to make stated-income pick-a-payment loans on homes with wildly-inflated appraisals.

Guess I'll have to keep on looking . . .
Posted by Rob Randhava | Tuesday, September 24 2013 at 2:41PM ET
I am so tired of reading this right-wing fable. If the mortgage crisis was caused by forced lending to poor peole (read minorities), how do you explain that the worst hit areas were Las Vegas, Phoenix and Miami? Sure there are plenty of poor people there, but the majority of defaults were by amateur and profesional "flippers" not poor families who owned homes they "shouldn't have." I'll grant you there were a lot of those, but for every Detroit there was an Atlanta where commercial real estate speculators failed in droves. Or homes out ion the Califonia desert.

You might also look on the default rates among mortgage pools. If the GSEs were to blame, why were the highest default rates in mortgages generated and packages by Wall Street firms?

Look, failure is an inherent part of capitalism. It's not a bad thing. Accept it.
Posted by FrankBird | Tuesday, September 24 2013 at 2:02PM ET
Fannie and Freddie have been a disaster for MANY years. Their leadership and management have been very weak and overpaid,and their lack of sound lending standards has devastated the mortgage marketplace. Unfortunately, much of their terrible underwriting was encouraged by the politicians who thought everyone should own a home-whether they could afford it or not.
It will take years-and a strong political will- to re-balance the mess they created.
Posted by Big Bob | Tuesday, September 24 2013 at 1:57PM ET
Hensarling has the story right. It's too bad the Reagan Administration didn't end the GSEs as the President's Commission on Housing recommended when it was still feasible.
Posted by kvillani | Tuesday, September 24 2013 at 1:54PM ET
I agree with getting rid of CRA since it's inception it has caused many financial institutions a great amount of concern/harm (remember ACORN). The government pressing everyone to make loans to the underserved/underbanked population, that in most cases did not deserve/qualify for a mortgage in the first place, created justification for lose standards and 100% financing. (this was the beginning of the sub-prime mess)I disagree however, with phasing out FNMA FHLMC and creating the so called PATH Act by putting "private capital" at risk. The Big Banks would simply step in and control the marketplace increase price, dictate terms,make the rules and no one would be safe from the greed factor.
Posted by mtgbk | Tuesday, September 24 2013 at 1:33PM ET
greed-gentleman is a much overlooked factor. no risk--not one person has been found guilty of any violation during the mortgage crisis.

with Corker style bill in place very little of this would have happened.

look at the most recent Title One stats and this will prove me right.

allen hardester
Posted by hardester | Tuesday, September 24 2013 at 12:54PM ET
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