When asked about income taxes, he talked about corporate taxes. When asked about the Federal Reserve, he brought the conversation around to Glass-Steagall. When asked about the Community Reinvestment Act (CRA), his focus turned to the “government-sponsored enterprises” (GSEs): Fannie Mae and Freddie Mac.

Here’s how he did it:  

In 1992, the Federal Housing Enterprises Financial Safety and Soundness Act…required Fannie Mae and Freddie Mac to purchase a percentage of mortgages going to low and moderate income borrowers — CRA eligible loans. In 1996, the Department of Housing and Urban Development set a target for Fannie and Freddie that 42 percent of their investment must go to CRA-eligible borrowers. The same target was increased to 50 percent in 2000 and then to 52 percent in 2005.

Fannie securitized close to $400 billion of CRA mortgages between 2000 and 2002. Fannie and Freddie were the primary drivers fueling the demand for secondary market subprime securities.

But prior to 1992…Fannie Mae and Freddie Mac would not purchase these loans because the loans didn’t meet their guidelines. However, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 changed this by requiring Fannie and Freddie to purchase CRA loans.

This policy, according to Prof. Mishra, “caused the failure of…Fannie Mae and Freddie Mac, and their failure is at the heart of the housing market meltdown.”

Yet again, he offers zero evidence to support his conclusions.

The 1992 law had nothing to do with the “subprime securities” that Fannie and Freddie purchased. Fannie and Freddie did not purchase any subprime mortgage-backed securities (MBS) until 2001.

As a result, their market share shrank from 57% of the mortgage market in 2003 to 37% in 2006:

In other words, the influence of Fannie and Freddie was drastically falling during the peak years of the housing bubble. During those years, Wall Street securitized over 30 percent more loans than Fannie and Freddie:

As a result, Wall Street’s asset growth accelerated, while Fannie and Freddie’s decelerated:

Even when Fannie and Freddie did get involved in the subprime business, they barely dipped their toes in the water. To this day, only 2 percent of their credit exposure consists of subprime securities. At Freddie, only 4 percent of their single-family mortgages belong to borrowers with FICO scores below 620. As a result, only 5 percent of their losses have come from subprime loans:

Wall Street, in contrast, put the majority of their MBS business — 71 percent, as of 2006 — into subprime and alt-A loans:

As, a result, subprime mortgage originations exploded at exactly the same time as Wall Street’s market share:

It’s rare in economics to find such a clear arrow pointing to who and what caused something. But there it is: Wall Street’s securitization of risky mortgages caused the housing bubble. Not Fannie and Freddie, whose participation was minimal, declining, and late in the game.

Even when Fannie and Freddie did participate in the subprime market, it was not to satisfy HUD targets, but rather to profit and regain market share.

The U.S. government’s Financial Crisis Inquiry Commission (FCIC) investigated these affordable housing targets, both by analyzing the securities purchased and by interviewing the employees and regulators involved. They didn’t find a shred of evidence to blame the targets for the subprime boom:

In 2003 and 2004, Fannie Mae’s single- and multifamily purchases alone met each of the goals; in other words, the enterprise would have met its obligations without buying subprime or Alt-A mortgage-backed securities. In fact, none of Fannie Mae’s 2004 purchases of subprime or Alt-A securities were ever submitted to HUD to be counted toward the goals.

Estimates by the FCIC show that from 2003 through 2006, Freddie would have met the affordable housing goals without any purchases of Alt-A or subprime securities, but used the securities to help meet subgoals.

…all but two of the dozens of current and former Fannie Mae employees and regulators interviewed on the subject told the FCIC that reaching the goals was not the primary driver of the GSEs’ purchases of riskier mortgages and of subprime and Alt-A non-GSE mortgage–backed securities. Executives from Fannie…pointed to a “mix” of reasons for the purchases, such as reversing the declines in market share, responding to originators’ demands, and responding to shareholder demands to increase market share and profits…

…only about 4% of all loans purchased by Freddie between 2005 and 2008 were bought “specifically because they contribute to the goals” – loans it labeled as “targeted affordable.”

In fact, as of late 2008, [these targeted affordable loans] had performed better than expected in relation to the whole portfolio. The company’s major losses came from loans acquired in the normal course of business.

In other words, Fannie and Freddie didn’t purchase subprime securities because the government told them to. Rather, they did it for the same reason as everyone else: Because it was profitable, and the regulators didn’t stop them.

And yet, Fannie and Freddie still performed better than Wall Street:

In 2004, the GSE default rate was 4.3 percent of their mortgages compared to a default rate in private industry of 15.1 percent of mortgages. In 2005, the GSE default rate was 7.8 percent—high and disturbing; but in private industry it was 28.7 percent, the source of the severe crisis. In 2006 and 2007, default rates reached 13.2 and 14.9 percent in the GSEs and 45.1 and 42.3 percent in the private market.

Another way to measure their riskiness is VaR, a statistic that estimates how much money a company would lose if the economic environment changes (as it did in 2007 and 2008). Since VaR was a mediocre predictor of the recent crisis, economists Tobias Adrian and Markus K. Brunnermeier created CoVaR, a measure of the company’s effect on the entire financial industry when it’s in distress. Compared to Wall Street, Fannie and Freddie have average VaR‘s and lower CoVaR‘s than any of the other major players:

No matter how you measure it, every one of Prof. Mishra’s conclusions is wrong. Neither the Community Reinvestment Act nor Fannie Mae nor Freddie Mac nor HUD’s affordable housing targets caused the real estate bubble and subsequent recession. I’ve said it before, and I’ll say it again:

This debate is called a “red herring,” and it’s how bad politicians get elected. They distract you with the wrong culprit for a very real crime. And you know what? It works.

But there’s a way to stop them: Don’t let them change the subject.

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Specifically, many banks were ignoring creditworthy, qualified borrowers in low-income, mostly-minority neighborhoods — a practice known as “redlining.” If banks were going to accept federal deposit insurance and access to the Federal Reserve’s discount window, the least they could do was make credit available to everyone who deserved it, regardless of where they lived or what color their skin was.

The CRA empowered regulators to “encourage” banks to lend to these borrowers — if they were just as likely to repay as borrowers receiving loans in other communities. The law didn’t specify how to encourage this behavior, so it took awhile for regulators to figure out how to enforce it.  

The 1990s were the peak of the CRA’s influence. Thanks to deregulations in 1994 and 1999, a merger wave swept through the banking industry. Regulators adopted stricter CRA rules in 1995 and blocked mergers between banks that had not lived up to those rules.

The merger wave died out by 2001, leaving regulators with fewer opportunities to enforce the CRA. New rules in 2005 and 2007 significantly reduced the number of banks that regulators had to fully evaluate under the CRA.

Meanwhile, the mortgage industry changed. Nonbank lenders took market share away from banks. These new independent mortgage companies didn’t need federal deposit insurance and therefore weren’t regulated by the CRA.

Thus, the rise of the housing bubble coincided with a decline in the influence of the CRA. That alone should be evidence enough to dismiss the CRA as a cause of the bubble (and the subsequent recession).

Blaming the CRA is even more ridiculous when you consider that every insider account from every major mortgage lender has indicated that they did what they did because it was enormously profitable, not because they were forced to.

In fact, of all the subprime loans made at the height of the housing bubble, only 6 percent were made by banks in the communities evaluated by the CRA.

That’s hardly surprising, given the increasing market share of lenders not regulated by the CRA. About half of all subprime loans were issued by these independent nonbank lenders.

Most of the risky lending didn’t even take place in low-income communities. About 60 percent of all subprime loans were issued to middle- and high-income borrowers and neighborhoods.

The vast majority of loan originations simply had nothing to do with the CRA.

Criticism of the CRA also hinges on the assumption that loans issued to satisfy the CRA were riskier than other loans. The numbers tell a different story.

Subprime loans issued in CRA communities “have performed virtually the same” as loans in similar communities outside the CRA’s jurisdiction, according to the Federal Reserve Bank of Minneapolis. Economists at the University of North Carolina tracked the performance of 50,000 CRA loans and found that they were 3.5 times less likely to default than subprime borrowers with non-CRA loans.

In fact, most foreclosures during the recession occurred in middle- or high-income communities, not low-income CRA communities.

While these facts let the CRA off the hook for the housing bubble and subsequent recession, they are damning evidence of the law’s insufficient response to the changing face of discrimination.

The growing power of unregulated lenders has undermined the CRA’s effectiveness. Within the same communities, they issued far more subprime loans than CRA lenders, and their loans were significantly more likely to result in foreclosure.

And discrimination still exists. A black household in Detroit with the same creditworthiness, employment, income, and demographics as a white household is twice as likely to face prepayment penalties, less likely to be approved for a mortgage, and pays an annual interest rate 1.1% higher, on average, than the white household.

Clearly, many communities still need — and deserve — safe, affordable lending. If we want to avoid another real estate crash, we cannot leave this task in the hands of unregulated nonbank lenders.

It’s time to extend the CRA’s reach beyond banks and thrifts, not to repeal it.

==========

This op-ed was published in today’s South Florida Sun-Sentinel, alongside an opposing view from Prof. Chandra Mishra of Florida Atlantic University. We were answering the question: “Were Community Reinvestment Act regulations really to blame for the mortgage crisis?”

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Samuelson, a Washington Post columnist, calls Fannie Mae and Freddie Mac “economic mongrels” whose “losses stemmed from unrealistic ‘housing affordability goals’ [and] lax lending in pursuit of higher profits.” Not only is this statement factually incorrect, but nowhere in the entire op-ed does he explain why Fannie and Freddie exist in the first place. If you’re trying to criticize their policies and resolve the “question of what to do about” them, that’s kind of important.

In June 2009, I wrote one final op-ed for my most loyal readers. This one didn’t make it into the Hazleton Standard-Speaker, for which I had stopped writing a couple weeks earlier. Since there seems to be a lot of ignorance about the issues I discussed, let’s make it public:  

The United States is exceptional.

Whether our country is exceptional in the way it is typically depicted is a debate for another day, but we are indeed one of the few nations who can claim one specific mantle: the long-term, fixed-rate mortgage.

Not quite as sexy as you’d hoped?

The United States has gone through a mid-life crisis. It wanted the sleek sports car and the sexy mistress, and it forgot how good its stable job and family had been to it since its wedding day. It jumped on adjustable-rate mortgages, when the old-fashioned fixed-rate mortgage was sitting at home, just as beautiful as the day they met.

It got caught. Now, before estrangement leads to divorce, it’s time to come back home.

Unless you’re a banker, it probably comes as a surprise that 30-year, fixed-rate, prepayable mortgages don’t exist in many countries. Imagine the challenge a bank faces. First, the bank borrows your money in the form of deposits; then it loans that money out in the form of mortgages. It only keeps a fraction of your money in its vault as a reserve to pay daily withdrawals. Economists call this “borrowing short” and “lending long” because the deposits are short-term instruments (since you withdraw from them on a pretty regular basis) and the mortgages are long-term instruments (since they don’t have to be completely paid off for thirty years).

Now picture what happens when inflation rises. Suddenly, everything costs more, so you need to withdraw more money — which, of course, means the bank needs to give back more of that borrowed money. In order to do so, the bank needs to get back some of the money it leant so it can pay you. If they had used adjustable-rate mortgages, interest rates would automatically rise with inflation, so you would owe more money on your interest payment — and the bank would therefore have more money with which to pay depositors.

But they didn’t use adjustable-rate mortgages. Not in the twentieth-century United States. They used fixed-rate mortgages, so you don’t owe any more money than your usual interest payment. Since it is a long-term instrument, you won’t pay it back for many years, so the bank has no way to get the money it needs to pay the depositors.

The bank goes bankrupt, which is a shame because it means banks would shy away from long-term, fixed-rate mortgages.

Fixed-rate mortgages are good for consumers. As real estate economist Susan Wachter explained to Congress earlier this week, “Individual households are the least-well-equipped to weather instability in the financial system.” The solution, in economist-speak, is “duration matching.” You plan to live in your house for the long-term, so it makes sense for your mortgage to be long-term and not subject you to “unpredictable short-term cost fluctuations.”

A fixed-rate mortgage, Wachter explained, is also fairer: “Consumers do not want to have to worry about whether fine print or predatory lending will result in them losing their home and their investment. Consumers want the process of financing homeownership to be fair and transparent.” With adjustable-rate mortgages, in contrast, rates can rise when consumers least expect it, they can’t pay their monthly due, and the bank forecloses. And that is exactly what has triggered much of the bursting housing bubble of the last few years.

How can we encourage banks to lend long-term, fixed-rate mortgages without endangering their solvency?

That was the question the government sought to answer in 1968 when it created the Government National Mortgage Association, known colloquially as “Ginnie Mae.” (…) “Fannie Mae,” the Federal National Mortgage Association, had been around since the Great Depression as a government agency, but by 1968 the Johnson administration had decided to sell the company to the public to fund the Vietnam War. Ginnie Mae was spun off as the remaining government-owned portion during the sale.

Ginnie Mae was tasked with purchasing government-issued mortgages and securitizing them. They would buy up loans made by agencies like the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA); then they would bundle them together and sell shares in them in the manner described in my last column about securitization—except without the tranching.

In 1970, Congress established the Federal Home Loan Mortgage Corporation, which you know as “Freddie Mac,” to buy and securitize mortgages that the government did not insure. Their purview was the “conventional market,” which included all private-bank-issued mortgages less risky than the “jumbo” class. Fannie and Freddie would end up competing for this market.

Fannie, Freddie, and Ginnie were only allowed to securitize fixed-rate mortgages, which resolved the dilemma banks faced in trying to give consumers what they wanted. By securitizing fixed-rate mortgages, they gave the banks a market in which to sell their mortgages, increasing the profit potential of fixed-rate mortgages and giving the banks a bigger incentive to issue them to consumers. They also standardized the MBSs, which made them easier to sell — which in turn made more investors want to buy them. Economists call this “increasing liquidity.” The upshot for consumers was that the increased demand for MBSs put more pressure on banks to sell mortgages, so they lowered interest rates to attract more borrowers.

The other advantage of the “government-sponsored enterprises” (GSEs) was that they assumed all default risk. If a mortgage underlying one of their MBSs went south, the GSE would pay the investor out of their own pocket. The GSE did not, however, bear interest rate risk or prepayment risk. (If interest rates rise, the value of a fixed-rate mortgage decreases because the investor can make more money by lending to someone else who would pay them the higher interest payments.) Because investors didn’t have to worry about whether the mortgages would default, they were willing to pay a higher price, which made banks even more willing to issue fixed-rate mortgages — which meant even lower interest rates for consumers.

All this sounds like a win-win. Where did the GSEs go wrong?

[...]

Private banks began securitizing mortgages in the 1980s…because it was a good way to make money. But throw in poor capital requirement formulas and the loophole of off-balance-sheet vehicles, and it becomes a great way to make money. Try to fix the regulation by putting inept rating agencies and obviously biased internal risk managers in charge, add a bad probability model, and you have a recipe for too much debt and too risky securitization.

But why was the securitization so risky? After all, the GSEs had been doing it since 1968, and they didn’t seem to have any trouble.

The GSEs have strict standards. They are not allowed to securitize subprime mortgages, which underlie most of this crisis—another reason why it is ludicrous to pin the blame on them. Private banks, on the other hand, can securitize whatever they want. In the run-up to the peak of the housing bubble, private banks securitized increasingly risky mortgages—subprime mortgages belonging to people with high likelihood of default, adjustable-rate mortgages whose eventual rate increases would make it difficult for consumers to make their interest payments, and so forth—because more mortgages meant more profits and more market share. Since private-label securitizers do not guarantee default risk as the GSEs do, they had no incentive to keep risky mortgages at a reasonable level. If the mortgages defaulted, they figured, it would be the investor’s problem. (Of course, they were all buying each other’s MBSs, so one bank’s apathy is another bank’s problem.)

The rest [is well known by now]. Lending standards declined, low interest rates fuelled the boom, etcetera. The GSEs did not securitize these risky mortgages, though near the height of the bubble Congress pressured the FHA to insure mortgages with no down payment, which was clearly a bone-headed move. Where the GSEs got in trouble was with their portfolio. As private companies, they try to make a profit and increase market share just like the banks. They created a portfolio to buy riskier MBSs from the private banks because they were losing market share as the private-label securitizers were getting all the subprime business. Unlike their traditional business, the portfolio subjected them to all risks: default, interest rate, and prepayment. This portfolio [and the general decline in housing prices, caused by private securitization] is what caused the GSEs’ losses, triggering their eventual nationalization.

One can make the argument that privatizing the GSEs removes the “privatized profits and socialized losses” incentive, but recent experience suggests that you do not have to be “government-sponsored” to have your losses socialized by the government. The GSEs are too big to fail, just like Citigroup and Bank of America, and privatizing them won’t do a darn thing to change that.

What privatization will do is kill the long-term, fixed-rate mortgage, the foundation of American housing for half a century. Unlike the mortgage interest tax deduction or local land use regulations, the GSEs did not increase prices without increasing homeownership. Unlike low interest rates and lax lending standards, the GSEs did not encourage people to buy houses they could not afford or banks to buy risky assets with too much debt.

For forty-one years, the GSEs have done nothing but make the American dream a reality for people who might never have had the chance in their absence. After the crisis is over, they should be returned to their original status, perhaps as a regulated public utility so we are clear on the public/private allocation, but without their portfolio. They should have a strong regulator, whereas previously their regulator was powerless in the face of the massive GSE lobby. The result would be American exceptionalism at its finest.

That’s a very short version of the story I tell in my forthcoming book. Remind me to ship a copy to Robert Samuelson when it’s published.

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