Deregulation and the Financial Panic - Term Paper Example

How Government Requirements for the Banking System to Provide Affordable Housing Led to a Global Economic Crisis Introduction In 2008 and 2009, the United States of America experienced an economic crisis and recession. This crisis resulted from unscrupulous lending practices, relaxed underwriting criteria, portfolios containing exotic mortgage products and under-supported homebuyer education, which yielded risky mortgages. The greatest contributor to this economic crisis and recession was the spreading out of these risky mortgages to unqualified borrowers. This paper discusses how the US government’s requirements for the banking system to provide affordable housing led to a global economic crisis. According to Liebowitz, the greatest mortgage crisis scandal is possibly that it directly resulted from intentional loosening of underwriting standards. This was with the objective of ending discrimination, despite warnings that it could culminate into extensive defaults. He explains that at the core of the financial crisis are loans, which were made with practically non-existing underwriting standards. In fact, there was no asset or income verification, no down payment and there was little consideration of the applicants’ ability to repay (1). Relaxed underwriting standards implied that there would be a considerable reduction or removal of assets, income, savings and credit history as well as the overall repayment capability from the equation. This is in addition to permitting products that avoided the criteria for basic good lending practices. Banks did not come up with the idea of loosening underwriting standards. The regulators, at ‘progressive’ political forces and community groups’ behest, loosened them. This encouraged lenders to offer products and underwrite loans impartially, irrespective of the borrower’s repayment capability and financial soundness (Liput, para4). Quite naturally, borrowers responded to the incentives that the new policies permitted them. This was irrespective of their socioeconomic status thus leading to the spread of risky lending to the wider mortgage market (Lucas, Para19). Apparently, borrowers spent money on houses whose value ended up being far below the loan. Consequently, they could not pay it back. Buyers used too much leverage as they used debt to increase gains, only to find that regrettably, it amplified losses instead. As a result, most banks either were near bankruptcy or became bankrupt. Due to globalization and currency integration such as dollarization, goods and services, stock and financial markets, trade and housing have close inter-connection globally, resulting into greater global interdependence. As one of the world’s largest economies, any slowdown in the economy of the United States will inexorably spread to other countries. This is exactly what happened leading to the rapid spread of a severe financial crisis around the world. The spreading out of risky mortgages to borrowers who were less qualified was imprudence that the federal government fostered (Horwitz, para2). It did this through two kinds of the misguided policies including credit expansion that presented the unsustainable mortgage financing means, and the mandates and subsidies to write riskier mortgages. The explanation for the atypical mortgage lending growth – nonprime lending in particular that nourished the housing bubble, which later burst sequentially leading to the abnormal mortgage defaults number, attendant credit-market inhibitions and collapsing of financial institutions is attributed to the distortions brought about by these policies (White, para17). White argues that these misguided monetary as well as housing policies twisted the normally strong financial institutions into unsustainable positions, disrupted prices of assets and interest rates in addition to diverting loanable funds into wrong investments. These were serious setbacks to the economy of the US (Gramm, para9). On purpose, congressional leaders declined to regulate the distortions created by the government’s inherent assurance that it would not allow the firms to fail, and the way this brought about their speedy expansion. Congress and the executive branch fostered the expansion of risky mortgages in numerous ways, the first one being relaxing down-payment standards on mortgages that the Federal Housing Administration assured. This Administration was founded in 1934 to insure mortgage loans that private firms made to eligible borrowers. Originally, for a borrower to qualify to obtain a mortgage loan, the Federal Housing Administration, among other things, required that he or she provide a non-borrowed 20% down payment on the house he or she wanted to purchase. At the time, private mortgage lenders such as savings banks deemed that down payment low. Nonetheless, the Federal Housing Administration brought its requirements to lower than 20%. Private down payment requirements consequently started falling headed for the level of Federal Housing Administration (White, para27). Private mortgage insurance arose simultaneously for non-Federal Housing Administration borrowers who had down payments below 20%. In that case, the Federal Housing Administration started lessening its standards to remain below private lenders’ standards, ostensibly anxious for bureaucratic reasons with checking its market share from attenuating too far. The required down payment on the most popular program of Federal Housing Administration by 2004 had decreased to only 3% and there were proposals in Congress to reduce it to zero. Traditionally, mortgages with very low down payments are associated with and have had exceedingly high default rates (Zahn, Para3). White explains that the second way in which Congress and the executive branch propagated the expansion was through strengthening the Community Reinvestment Act. This Act was first passed in 1977 and for its first 12 years or so, it remained relatively harmless – it simply imposed reporting necessities on commercial banks concerning the extent to which the banks lent funds back into where they gathered deposits (Pressman, para2). In 1989, Congress amended the Act and made banks’ Community Reinvestment Act ratings public information. In the year 1995, further amendments gave the Act serious teeth as regulators now could deter the merging of a bank with a low Community Reinvestment Act rating approval with another bank. Regulators could also prevent such a bank from opening new branches. Groups like the Association of Community Organizations for Reform Now (ACORN) actively started pressurizing banks to make loans threatening them that if not, they would register complaints with the objective of rebutting the bank valuable approvals (DiLorenzo, para9& 10). To carry out business, financial institutions had to have good Community Reinvestment Act compliance. Worse still, institutions would receive Community Reinvestment Act compliance on condition that they actually found someone to whom they would grant a loan. The activists received a powerful seat at the table thus handing over decisions pertaining to lending from financial institutions to them. Now, ACORN in part exercised control over who got Community Reinvestment Act mandated loans, but not banks only. This yielded risk to banks while ACORN and others mounted up riches. Quick profits motivated Banks and they set out on high-risk and unsound risk-management practices. Some banks entered into alliances with community groups to hand out millions in mortgage money to borrowers with low income, previously deemed non-creditworthy. This was in response to ACORN’s demands and to the new rules of Community Reinvestment Act. Other banks made the most use of the newly approved option to boost their Community Reinvestment Act rating through procuring special ‘Community Reinvestment Act mortgage-backed securities’. These were packages of inexplicably subprime loans securitized by Freddie Mac and certified as meeting Community Reinvestment Act standards. A small share of the total current bad mortgages crop definitely originated from Community Reinvestment Act loans (Vadum, Para9). The third way in which Congress and the executive branch fostered the expansion of risky mortgages was through the Housing and Urban Development Department’s demands on banks and other lending institutions. From the year 1993, its officials began bringing legal actions against mortgage bankers who rejected a higher percentage of minority applicants compared to white applicants. To evade legal trouble, lenders relaxed their income qualifications and down payment (White, Para30). The fourth and the most important way in which Congress and the executive branch fostered the expansion in risky mortgages to borrowers who were under-qualified was through subsidizing the dramatic expansion of the two government-sponsored mortgage buyers, Fannie Mae and Freddie Mac, by means of implicit taxpayer guarantees. This was by purposely declining to rein in the two mortgage buyers’ hyper-expansion or otherwise manage the moral hazard problem of implicit guarantees and pushing them progressively more to support, through expanded nonprime loans procurements, affordable housing to low-income applicants (Mangun, para4). The government mandated Fannie Mae and Freddie Mac to buy a certain percentage of bank-originated mortgages with the Fed- created credit, giving mortgage lenders every encouragement to continue making loans, even though borrowers had failed to meet traditional lending criteria (Horwitz, para3). Together with Congress, the department of Housing and Urban Development pressured Fannie Mae and Freddie Mac from the year 1992 to amplify their mortgage purchases going to low and moderate income borrowers. White explains that the Department of Housing and Urban Development gave the two government-sponsored mortgage buyers an explicit target for 1996: they had to direct 42% of their mortgages financing to borrowers in their area, whose income was below the median. In 2000 and 2005, the Department increased targets to 50% and 52% respectively. For 1996, they required that 12% of all Fannie and Freddie’s mortgage purchases be ‘special affordable’ loans, typically to borrowers with income below 60% of the median income in their area. To cap it all, in 2000 and in 2005, the Department increased that number to 20% and 22% respectively, while the goal was to be 28% percent in 2008. Fannie and Freddie met those goals every year (2000-2005), funding zillions of dollars worth of loans, several of them being nonprime and adjustable-rate loans made to borrowers who purchased houses with below 10% down (Lucas, Para10). As White affirms, Fannie Mae and Freddie Mac found in the end that their new flexible lending lines were profitable and therefore kept on enlarging their nonprime mortgages purchases under the rising targets from the subsequent Secretaries in the department of Housing and Urban Development. The implicit backing of Fannie and Freddie from the Treasury of the US made their hyper-expansion possible. They had to borrow lump sums in wholesale financial markets to fund their massive growth. Institutional investors were willing to lend to them cheaply or at rates only slightly over those on the risk-free securities of the Treasury and to a good extent below those that other financial intermediaries paid. This was despite the risk of default that in normal cases would go with private firms holding such defectively diversified and greatly leveraged portfolios. The investors thought that in case Fannie or Freddie would be unable to repay them, then the Treasury would. Therefore, the investors were very willing and following the collapse of the two and their subsequent conservatorship, this turned out to be the case (Hensarling, Para5). White explains that since the Great Depression, the United States’ mortgage foreclosure rates mounted to the highest levels in 2008. Numerous major financial institutions including insurance companies, commercial and investment banks that had great ties to real estate lending either were sold for pennies on the dollar or went bankrupt. There was a dramatic attenuation in mortgage-backed securities’ trading volumes and prices. Moreover, lending disinclination stretched to other markets and the US economy went into a long downturn (6). Conclusion The United States’ housing bubble-burst negatively affected the country’s economic development, which led to a severe financial crisis that rapidly spread around the world. Apparently, the housing bubble and its after effects emanated from the Housing and Urban Development Department along with its Federal Housing Administration, Federal Reserve-created market distortions and the government backing of Fannie Mae and Freddie Mac. Americans went through a severe housing crisis and resultant recession in the years 2008 and 2009, a slump that regrettably perverse government policies on lending practices precipitated. References DiLorenzo, T.J. (2008). The CRA Scam and its Defenders. Retrieved from http://mises.org/story/2963 Gramm, P. (2009). Deregulation and the Financial Panic: Loose money and politicized mortgages are the real villains. Retrieved from http://www.heartland.org/article/24759/Deregulation_and_the_Financial_Panic_Loose_Money_and_Politicized_Mortgages_Are_the_Real_Villains.html Hensarling, J. (2009). The True Causes of the Housing Crisis. Retrieved from http://www.heartland.org/policybot/results/25245/The_True_Causes_of_the_Housing_Crisis.html Horwitz, S. (2009). The Real Six Causes of the Recession. Retrieved from http://www.iedm.org/uploaded/pdf/Horwitz0909_en.pdf Liebowitz, S. (2008). The Real Scandal: How Feds Invited the Mortgage Mess. Retrieved from http://www.independent.org/newsroom/article.asp?id=2114 Liput, A. (2008). What Goes Around Comes Around: How Government-Induced Relaxed Lending Criteria Helped to Create the Mortgage Market Collapse. Retrieved from http://www.mortgageindustrytrends.net/What_Goes_Around_Comes_Around Lucas, F. (2009). Federal Government Was Culprit in Housing and Economic Crisis, Says Congressional Report. Retrieved from http://www.cnsnews.com/news/article/50680 Mangun, (2008). The Crisis: The Explanation. Retrieved from http://www.nowpublic.com/world/crisis-explanation Pressman, A. (2009). Community Reinvestment Act had nothing to do with subprime crisis. Retrieved from http://www.businessweek.com/investing/insights/blog/archives/2008/09/community_reinv.html Vadum, M. (2008). ACORN’s Food Stamp Mortgages. Retrieved from http://spectator.org/archives/2008/10/29/acorns-food-stamp-mortgages. White, LH. (2009). Housing Finance and the 2008 Financial Crisis. Retrieved from http://www.downsizinggovernment.org/hud/housing-finance-2008-financial-crisis Zahn, D. (2008). Guess again, whos to Blame for U.S. Mortgage Meltdown. Retrieved from http://www.wnd.com/index.php?fa=PAGE.view&pageId=75717 Read More