The difference between the housing bubble's bursting in the U.S. and in the rest of the world is that the U.S. bubble was topped off with a subprime lending debacle.
The U.S. had more liberal down payment requirements and underwriting standards for decades and simply ran out of qualified buyers. So from mid-2004 through mid-2007, more than a million borrowers sat across the table from lending officers signing loan documents and accepting more than $1 trillion in loans that neither borrower nor lender expected to be repaid. The Financial Crisis Inquiry Commission's report concluded that borrowers were victimized by irresponsible lenders. It never explains why!
This commission was established to blame Wall Street greed and did, indeed, do so. But this narrative would not suffice as a basis for mortgage capital markets policy, so the commission also promoted the narrative that multiple, independent and complex causes created the financial crisis and that all these factors are amenable to mitigation by more government regulation. This narrative plays down the role of the government-sponsored enterprises, Fannie Mae and Freddie Mac, as but one of many independent market and regulatory failures — while extolling the GSEs' underlying virtues.
There wasn't much new in this discussion, and three of the four Republican commissioners dissented, putting less emphasis on the greed narrative and narrowing down somewhat the list of complex causes.
The GSE options paper just released by the administration does not recommend their reincarnation and cautiously presents alternatives. But the alternative guarantee programs go well beyond the initial intent of the GSEs; their agency status was inadvertent and their growth entirely political. Why did we even have GSEs when no other market economy has them? The implicit "third way" economic theory supporting them is that markets do not function well without extensive, pervasive prudential regulation. Social lending goals are needed to meet the shortage of "affordable" housing loans and to mitigate racial discrimination by lenders. The availability of cheap, fixed-rate mortgages is a consequence of GSE "positive externalities." The FCIC report implicitly supports this narrative, attributing systemic regulatory failure to ideological bias and implying that lenders and investors are systemically racially biased, incompetent, ignorant, irrational and panicky.
The report used 10 of its 662 pages to address social lending mandates, and it concluded: "These [housing] goals only contributed marginally to Fannie's and Freddie's participation in those [risky] mortgages" Peter Wallison wrote a second Republican dissent arguing that these goals alone explain why the GSEs would reduce and virtually end down payment requirements — bypassing private mortgage insurance — and weaken underwriting guidelines. And he is right.
But that does not explain why private-label, mortgage-backed securitization financed so many of the subprime loans. Most of these were securitized by large investment — now all universal — banks that most believe are too-big-to-fail.
Two causes of the subprime bubble emerge, each necessary and together sufficient to virtually assure the debacle and financial system collapse. The first was Fed policy that would let a bubble develop somewhere, and the second was the massive government-induced distortions — mostly due to the moral hazard created by excessive bank depositor and GSE investor protections and social lending quotas — that virtually assured a subprime lending bubble of systemic proportions.
The conclusion is unassailable that prudential regulators failed pervasively, chronically — as all of their failures had precedents — and systemically to mitigate moral hazard at publicly regulated private financial institutions — banks and GSEs. Moral hazard is the only explanation for homebuyers' taking out mortgages they almost certainly knew they could not repay; loan originators' willingness to make such loans; a lack of borrower underwriting, down payments and primary mortgage insurance; GSE creditors' and equity investors' willingness to fund them on a systemic scale before collapsing and bringing down the global financial system and why taxpayers got the bill.
Public regulation of excessively protected private financial companies proved a poor substitute for market discipline. Defenders of GSEs make two related arguments to shift the blame from politicians to regulators and from the GSEs to private-label securitization.
The first argument is that pursuit of profit rather than social goals explains GSE subprime lending. That is unlikely. Lending to progressively weaker borrowers, with actuarial losses increasingly likely, was obvious to private mortgage insurers and to GSE experts as well. Further, the GSE profit motivation cannot explain either the complete regulatory failure among all agencies responsible to maintain prudential lending guidelines or the complete lack of political oversight or accountability for that lapse. But this debate over GSE motivation is a diversion: If goals were the cause, this implies they shouldn't be imposed on private housing banks; if profits were the cause, housing banks should not be private.
The second argument is that the GSEs followed, rather than led, the subprime market. The evidence for this is mixed, but competition in regulatory arbitrage between GSEs and private-label securitization undeniably fueled the bubble. GSEs initially led, were then restrained by a 30% capital penalty imposed in response to their earlier accounting scandals and later led again during the bubble.
But this argument, too, is a diversion. Government-induced distortions caused a subprime lending debacle in the 1990s for nonqualifying loans funded by private-label securities, but the collapse did not cause a systemic crisis. In spite of all the other financial system flaws since revealed, only GSE political distortions and their market dominance can explain the bubble's magnitude and duration and the ensuing global systemic collapse.
GSE defenders also argue that they supply numerous externalities, for example, market leadership, innovation, countercyclical stability, "liquidity" and (the most emphasized) fixed-rate-mortgage availability.
This is mostly GSE propaganda. That the incentive conflicts associated with securitization are inherently irresolvable without a government guarantee, be it implicit or provided by the FDIC, is also false. Both domestic and international experience suggest that these conflicts can be mitigated with better borrower underwriting and bigger cash down payments, with mortgage insurance required for loan-to-value ratios of more than 80% and with higher risk retention and capital requirements for issuers. This concern does not warrant a special housing bank charter or some similar hybrid, with their inherent political conflict between mission and prudential regulation.
That political oversight of banks could undermine rather than reenforce prudential regulation was always problematic, especially for institutions that are too-big-to-fail. But deposit insurance is here to stay, and thus bank regulation must be depoliticized and fixed no matter what, which includes eliminating subsidy mandates and regulatory and tax arbitrage in capital market funding vehicles. The report concluded that the GSE model was "fundamentally flawed." It should also have concluded that they plan an unneeded role, as a consequence of political expediency, and were instrumental in the systemic collapse. Based on this historical experience, it is guaranteed that the guarantees proposed in options 2 and 3 would repeat the GSE experience.
Patric Hendershott is a visiting chairman in the real estate program at San Diego State University College of Business Administration and a half-time chairman in property economics and finance at the University of Aberdeen in Scotland. Kevin Villani is a former chief economist at Freddie Mac.
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