Thread by @ParkSlopeFlngsm

The unspoken cause of the 2008 financial crisis: lowered lending standards to poor urban neighborhoods in exchange for regulatory approval of mergers and then passing those loans off to the GSEs

I’m taking this from a really, really good 2014 book about the politics of banking crises, “Fragile by Design,” by Charles Calomiris and Stephen Haber 🧵

They’re both academic economists who appear to be right-leaning. Calomiris has done a stint with the Manhattan Institute and Haber a long tenure with the Hoover Institute. If they’re liberal, they’re of the neoliberal deregulatory type

So what do they argue happened? There’s no one single cause for such an immense blowup; a few different pieces had to come together; two important ones came in the early 90s with the Riegle-Neal Act of 1994 and the GSE Act of 1992

I’ll get into the GSEs in a bit

The Riegle-Neal Act deregulated banking and allowed for a merger bonanza

Banks prior to this were often heavily regulated at the state level. Historically, many states didn’t even allow branch banking within a state, let alone interstate banking. Banks were “unit banks,” independent shops that served only their local community

Today it seems as if everything is Chase, Wells, Citi, or BofA with a smattering of credit unions. The 1994 act allowed for banks to scale up and become nationwide for the first time. Chase and Bank of America couldn’t have existed in their present form

The political change came about in large part due to the Savings and Loan crisis of the 1980s

High inflation and interest rates hurt many small S&Ls (old loans they made at low rates became unprofitable when they had to pay depositors the newer high rates). States relaxed their regulations to allow large out-of-state banks to acquire the small lenders, and at the federal level Congress amended a 1956 law in order to allow failed banks to be acquired by bank holding companies regardless of state law. Politicians judged that acquisitions by larger banks were better than bankruptcies and bailouts by the FDIC or state governments

The 1994 Riegle-Neal Act enshrined this reorientation at the federal level, superseding state laws and allowing bank holding companies that met certain operating standards to do interstate branching and acquisitions across state lines

Importantly, however, Riegle-Neal included compliance with the 1977 Community Reinvestment Act (CRA) as part of merger oversight

The purpose of the CRA was to get banks to lend more to credit-starved neighborhoods—mostly urban minorities. Back then banks were still small and they didn’t yet have good electronic records, so banks mostly only lent money to local customers whom they could assess were trustworthy borrowers. The CRA tried to pressure banks to expand their customer base into nearby minority neighborhoods whom banks viewed as risky borrowers (often with good reason)

The new bank mergers finally provided politicians and local activists with a lever to get banks to pony up for CRA commitments. The mergers had to be approved by regulators: the Federal Reserve and the Dept of Justice. CRA ratings were considered as a factor

Banks had a chance for huge profits as they scaled up into national enterprises, so they were willing to play ball and buy off the activists with loan commitments

See this chart. CRA loan commitments remained piddling after 1977, only in the mid-90s did they exploded

ACORN, Association of Community Organizations for Reform Now, was a notorious and perhaps the largest network of local activists conducting this grift

The head of ACORN testified before the Fed in *favor* of the merger of NationsBank and Bank of America in 1998, which would create the largest bank in US history:

“The ACORN Housing Corporation/NationsBank partnership alone has produced over $236 million in mortgages. Virtually all these loans were to lower income households, with small downpayments, with nontraditional credit, with cash on hand, and with older, urban housing stock. And these loans perform well with low delinquencies. Nations-Bank has been flexible. They were the first multistate lender to negotiate their mortgage underwriting standards with us. And their step forward did a lot to bring our kind of underwriting standards for low income people into the mainstream of the mortgage market. At the time these things were pretty radical, but today no one thinks twice about the appropriate use of low downpayments, nontraditional credit, food stamps as income, voluntary child support, cash on hand, or steady income rather than the same job for two years.”

Another umbrella group for activists, National Community Reinvestment Coalition, had an explicit guide on how to exploit the merger process:

“Merger and acquisition activity presents significant opportunities for community groups to intervene in the approval process and raise CRA concerns and issues. Some banks are very desirous of Outstanding ratings so that they can present a clean reinvestment record to regulators”

Billions upon billions of loan commitments to dubious creditors

It started under Clinton, but George W Bush seemed happy to continue the policy. Why? I’m not sure; you could have a separate analysis about that. I know @Steve_Sailer has written about Dubya’s push for minority lending

It makes sense for Clinton: it redirects money to a key Democratic voting constituency, the nonwhite urban poor. For Bush, it doesn’t help his voting base. In fact it’s an implicit subsidy paid for by his voting base. Maybe they thought home ownership makes people more conservative? That’s a thread for someone else to pull on

We need to talk about the GSEs, Government Sponsored Entities. You know them as Fannie Mae, Freddie Mac, and Ginnie Mae. These are nicknames/acronyms for, respectively, FNMA, Federal National Mortgage Association, FHLMC, Federal Home Loan Mortgage Corporation, and GNMA, Government National Mortgage Association

These are entities created by the federal government to boost home ownership. Fannie Mae was a New Deal creation to help add liquidity to the mortgage market. Freddie Mac was later created to provide a competitor to Fannie Mae because of a quirk in their legal status: Fannie was spun off from the govt and turned into a private corporation. Ginnie Mae is the portion of Fannie that handled FHA and VA loans (govt backed loans). It was also spun off

A real alphabet soup of agencies. This is all pretty boring and confusing, right? Well, yes, and that works to the government’s favor because they can pull bullshit more easily without people noticing

The GSEs were granted a few big advantages by the government.

First, they have the implicit backing of Uncle Sam; it’s always been presumed that their mortgage portfolio would be backstopped by the taxpayers if they ever went bankrupt

They were exempted from state and local income taxes, as well as the federal bankruptcy code

Additionally, and importantly, they were allowed to have lower capital ratios than banks

Because of their lower capital ratios, they were able to have higher leverage on their assets and a higher return on equity, thus it was only natural that they would gain market share over time

If you don’t understand the financial jargon, take this simple example: you want to buy a rental property for $ 100k. The bank makes you put down 20%, $20k, as collateral. The $20k investment is the denominator for calculating your return. If you net $5k in rent after costs, you’ve made $5k/$20k = 25% return

If another bank only requires you to put $10k down, your return on investment gets better. If you net $5k in rent, that’s a 50% return on $10k but only a 25% return on $20k

The risk here is to the bank: if the value of the property falls by $20k and they have to repossess it, they lose money to the guy who only put up $10k but they break even if there’s $20k of collateral. The bank uses the down payment to lessen its own risk

Banks are required to hold a certain amount of capital to ensure their soundness. The government essentially said that the GSEs don’t need to hold as much collateral on mortgages. This advantage made it easy for them to grow over time, and they were also incentivized to do so because they were quasi-private companies with shareholders who expected a good return

It made sense for banks to create mortgages, collect an origination fee, and then slough them off to the GSEs to hold on their balance sheet

In an extra twist, the mortgages could be repackaged into Mortgage Backed Securities (MBS)—basically a bunde of mortgages where you buy a small slice of lots of mortgages instead of holding one—and those MBS had lower capital requirements than the underlying mortgages. So theoretically, and I’m sure this actually happened on occasion, a bank could sell its mortgages to the GSEs, the GSEs package them into an MBS with the help of an investment bank’s securitization department, and then the banks turn around and buy back those same mortgages in the form of MBS, and they’d have lower capital requirements than if they’d simply held the loans as their own portfolio of assets

Another piece of the puzzle: part of the 1992 GSE act (signed by HW Bush) called for the Federal Department of Housing and Urban Development (HUD) to set affordable housing goals and exert political pressure on the GSEs to expand low income lending. The GSEs enjoyed priveleges granted to them by Congress, therefore they needed to keep politicians happy

Chart below of HUD’s subprime lending targets for the GSEs

Look at this chart of the percentage of mortgages that required 3 percent or less for down payment. Almost zero in 1990 to almost half in 2007

Another chart: GSEs were responsible for the majority of high risk lending in the mid-2000s

One more: the growth of subprime lending in the 2000s

(Ironically, Alt-A is short for alternative to agency, loans that were originally considered too shoddy to sell to the GSEs. The GSEs were now the primary buyers of the crap)

You know the Christian Bale meme playing Michael Burry in the Big Short? This is the crap he was looking at irl

The whole thing was a way for the government to do “off the books” redistribution to urban districts. They didn’t come before the American people and say, “hey, we’re going to take tax money and give it to poor black neighborhoods for down payments on mortgages.” That’s a tough sell at the polls

Instead they used political leverage on banks in conjunction with activist groups to get banks to lend to these areas with implicit govt subsidy, disguised behind boring processes like lending standards and merger oversight, with euphemisms like “expanding credit to historically underserved communities”

To sum up the whole process, it went like this

-1977 Community Reinvestment Act demands banks lend more to poor neighborhoods

-Banks were still small at this time, so it only made a small difference at the margins

-Megabanks created after 1994 started being subject to a lot more political pressure. They agree to make dodgy CRA-inspired loans as a bribe for merger approvals

-The GSEs are used by the government to increase home ownership overall and HUD gives them explicit targets for low income lending

-The banks start using the GSEs as the place to dump their bad loans

-The looser lending standards apply to the entire market. The banks can’t discriminate and say, “oh, only poor blacks get zero-down loans, middle class suburbs still need to put 20% down.” Everyone, including market segments that should have been safe, gets access to the new reckless standards

-GSEs and dogshit loans eventually dominate the mortgage market. Hasta lasagna, don’t any on ya

All of this had only been going on for 10-15 years—two presidential admins: Clinton and Dubya. It was basically inevitable given the incentives that had been created. 2008 was just the point at which the bubble popped

You’ll often hear people, particularly left populists, vaguely handwave about under-regulation of banks

If they get specific, they’ll probably cite the repeal of Glass-Steagall in 1999. This is just post hoc ergo propter hoc reasoning. Glass-Steagall was New Deal-era legislation that forced commercial banks (which take deposits and loan money to individuals) to divest of investment banking divisions (which do things like raise capital for large institutions and actively trade in the markets for their own profits)

This didn’t cause the financial crisis. Many of the largest banks that went under were either standalone commercial banks (Washington Mutual; Wachovia) or investment banks (Lehman; Bear Stearns; Merrill Lynch). If anything, the repeal of Glass-Steagall helped stop the bleeding, because it allowed for megabanks JP Morgan and Bank of America to step in and purchase Bear Stearns and Merrill, respectively, injecting some much needed capital to keep those operations up and running

It was not deregulation or lack of regulation that caused the situation. The regulatory regime itself created the crisis. Private sector banks were responding to political pressure to provide more credit to low income urban minorities, hence a need to reduce credit standards, and to the financial logic of passing mortgages on to the GSEs, who enjoyed the competitive advantage of lower capital requirements and implicit govt backstop

Private sector banks likely never would have lowered their standards, and never would have shifted so much of their loan portfolio to the GSEs, in the absence of these external pressures. It’s more accurate to say that the financial crisis was *caused* by bad regulation

Consider this remarkable chart of mortgage defaults in the US vs Canada. Canada did not have a financial crisis because they did not have a mortgage bubble

The crisis was caused by the US political system creating a backdoor for artificially cheap lending. The bill came due