A while back, the elite got all riled up (for example) because some people suggested that Fannie and Freddie (the GSEs) were to blame for the financial crisis.
As a former employee of one of the GSEs, I think that if you had to pick one particular entity to blame for the crisis, your best bet would be the GSEs. This book explains why.
I’ll try to summarize in a paragraph and then dig into details:
The financial crisis is ultimately a crisis of crappy assets. It’s crappy assets that brought down (and continue to trouble) banks, and it’s bailouts of banks that are getting sovereigns in trouble now. The crappy assets are mortgages and the GSEs dominated the mortgage market – even if you were in the mortgage business and didn’t trade with the GSEs, you were still affected by all of their decisions. The GSEs were, for all intents and purposes, synonymous with the US housing market. Everyone else was a bit player. The GSEs used their taxpayer subsidy to buy mortgages of progressively lower quality and it eventually blew up. They also used very aggressive political tactics – often outright threats and bribery – to make sure that mortgage underwriting standards continued to decrease. It may be unfair to place the blame solely on the GSEs (they didn’t set mortgage rates below 4%, for example) but it’s not extremely unfair.
To quote Steve Sailer’s review of the book:
Morgenson, who is for both honest, effective business and for honest, effective regulation, cleverly gets around these contemporary prejudices by making her history’s arch-villain the Crony Capitalist-in-Chief, James A. Johnson. Johnson, chairman during the crucial years 1991-1998 of that disastrous private / public hybrid Fannie Mae, was the man who, more than anybody else, set the mortgage meltdown in motion.
Indeed, it’s hard to find a better villain than Johnson (hilariously described as a businessman by Wikipedia).
Before I discuss the book, I can’t resist providing some summary of the GSEs from my own experience.
The first thing that you need to know about the pre-crisis GSEs is that they were huge. It’s nearly impossible to overstate how big they were.
The second thing that you need to know about the GSEs is how they work. The GSEs don’t actually issue mortgages, they buy mortgages that have already been issued. Once they buy a mortgage, they either: 1) hold it in their own portfolio or 2) sell it as part of a package of mortgages on which they guarantee the principle amounts. In the first case they made money because they could borrow very cheaply (due to an implicit government guarantee) so they were making the difference between the mortgage rate and the rate at which they borrowed. In the second case, they made money by taking a guarantee fee.
Obviously, you’ll see two things right away: 1) the more mortgages they buy, the more money they make and 2) there are no practical limits to 1) since the risk of buying/guaranteeing bad loans ultimately resided with someone else. In other words, the more mortgages they buy, the more money they make. It’s really that simple and everyone that worked there knew it.
Finally, the third thing you need to know is that there are two GSEs, both guaranteed by the government, both offering the identical service and both insatiably hungry for more mortgages. In this environment, they each became willing to bend over backwards for companies that initiated lots of mortgages (Countrywide for Fannie and Wells Fargo for Freddie – Morgenson notes that by 2007, 28 percent of the mortgages Fannie purchased were supplied by Countrywide).
For these special companies, the GSEs were willing to fund mortgages (i.e. buy them from the company) before the ink was dry on the contracts, subject only to these companies promises that the loans were legit. If you remember the first thing about the GSEs (i.e. that they’re huge) you’ll see that no one could possibly verify that the GSEs were being sold legit loans. They were buying way, way too many loans. When I worked there, they didn’t even pretend to try to verify.
In other words, your humble blogger is 0% surprised by this story. The story says that Countrywide made fraudulent loans. It doesn’t say that many of the fraudulent loans were sold to the GSEs (particularly, Fannie in this case) but that’s what happened to most of Countrywide’s loans. Everyone at the GSEs knew that this was happening and everyone was happy about it – remember the more loans they buy, the more money they make. If a little fraud would let them buy more loans, then a little fraud was good and a lot fraud was better.
Now the former leaders of the GSEs are being sued by the government for this fraud, but everyone was happy about it at the time. (Incidentally, it’s fun to see part of USG suing another part of USG, isn’t it?). Here’s an anecdote from Morgenson on how this sort of fraud often worked:
"Say the guy [applying for a mortgage] is a worker at Baja Fresh fast food and also works for 7-11 at night," explained a former Countrywide broker. "We couldn’t state his income on the loan because it wasn’t high enough, so we would change his title to manager at each job. With that, the computer system will assume his salary is $100,000, and the loan goes through."
Many of these doctored loans were welcomed with open arms by Countrywide’s friends at Fannie Mae. Indeed, documents produced to Congress in 2010 show a concerted effort by executives at Fannie Mae in 2004 to cultivate Countrywide’s top executives. Their goal: to assure that the lender would help Fannie maintain profitability.
Finally, before I get back to the book, I want to stress that the GSEs were huge. It looks like their losses may eventually total $1 trillion. That’s all you need to remember next time someone tells you they didn’t cause the crisis, especially considering that the GSEs drove down lending standards throughout the mortgage industry, making them responsible for much more than their direct losses alone.
Morgenson’s book is mostly devoted to the Fannie Mae. It occasionally leaves Fannie to discuss other causes of the crisis. It does an able job of discussing other parts of the crisis, but other books do better. If you read this book, and you should, you can skip the parts that don’t deal with Fannie.
The story of Fannie is the story of it’s interaction with government. Government wanted more homeowners and Fannie wanted more mortgages. Everybody could win if Fannie could buy more loans. The main thing holding Fannie back was underwriting standards – Fannie couldn’t buy mortgages that were too risky. This brings us to the fourth thing that you need to know about the GSEs: much of the money they made was funneled into politics. Their strategy to lower lending standards was beautiful politics:
"The idea . . . was to finance so much low-income housing that Fannie Mae’s government perquisites could never be taken away."
And indeed, the perquisites would have to increase.
The politicking paid off with this bill. It created a subservient regulator and required the GSEs to meet housing goals related to poor people. This required the GSEs to loosen down-payment requirements, "the 1992 act encouraged Fannie and Freddie to buy mortgages where borrowers put down . . . 5 percent or less."
The next card the GSEs played was the race card. The GSEs got accused of racism, as any lender not actively engaged in "positive" discriminate will. At first, this scared them, but they seized the opportunity to further reduce lending standards (i.e. buy more mortgages). "As Johnson would later proudly point out, Fannie Mae spent $7 billion between 1994 and 1997 on ‘underwriting experiments.’"
Next came "alternative qualifying" standards. These eliminated historic underwriting requirements around the size of a borrower’s housing payments relative to his income and the size of his debt relative to his income.
There’s lots more, like the Trillion Dollar Commitment, which invested a trillion in subprime and Alt-A loans. Don’t worry though, these amounts couldn’t have caused a mortgage crisis!
HUD was one of Fannie’s regulators. Under Clinton, HUD was run by Andrew Cuomo. "One of Cuomo’s first moves was to proclaim that Fannie and Freddie should buy more subprime mortgages." This was typical of the GSEs "regulation." By 1999, regulations required that "30 percent of the housing units financed by the [GSEs] mortgage purchases benefit low- and moderate-income families." At the time their actual numbers were "42 percent," but Cuomo raised it to "50 percent." "By 2008, some $1.6 trillion of toxic mortgages, or almost half of those that were written, were purchased or guaranteed by Fannie and Freddie."
Perhaps the most entertaining part of the story – and the part that ultimately explains why the GSEs are to blame for the crisis – is Morgenson’s discussion of the brutal tactics that Fannie employed against it’s enemies. Its tactics ranged from lobbying and donating to friends to attacking enemies and buying academics to ensure studies were conducted appropriately. Their tactics make the big tobacco companies look like amateurs by comparison. The result was a political environment in which no one could question the benefits of ever more home loans made to borrowers of ever lower quality.