How Washington created sub-prime

Allister Heath
AMERICANS love lawsuits. It’s the way they do business. But the news that the authorities supervising the US housing agencies are suing 17 banks over the sub-prime crisis was unintentionally hilarious.

To see why, recall that the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp (Freddie Mac) – government sponsored enterprises created by the state – have underpinned US housing for decades. Because of government guarantees, they could borrow cheaply. Their role was to buy vast amounts of mortgages from the private sector; these paid a higher rate of interest than the rate they had to pay on their bonds, allowing them to pocket the difference. There was just one caveat: Fannie and Freddie could only buy safe mortgages. Banks were willing sellers of mortgages – even though they might have made more over time keeping them – as it passed on the risk of default and prepayment.

As Russell Roberts of George Mason University has shown, these restraints started to be torn up from 1993. The politicians convinced Fannie and Freddie to boost purchases of mortgages going to low income folk previously deemed too risky – and subprime was born. Given that Fannie and Freddie were the dominant buyers of mortgages, it was obvious that private banks would provide the kinds of loans their top customer wanted, so this trashed industry standards.

Governments have long tried to help the poor own their own homes, for noble reasons. Subprime started off as an “affordable home” programme by which traditional, market-based constraints were eroded; the authorities realised they could use lenders to deliver their goals on the cheap.

The Community Reinvestment Act was strengthened, the Federal Housing Administration cut deposits, and the Department of Housing and Urban Development put pressure on banks to lend to the unqualified. Bill Clinton, a key driver here, introduced affirmative action quotas for Fannie and Freddie; banks that didn’t lend to the poor were sued. In 2003, George Bush signed “the American Dream Downpayment Act” to allow those who couldn’t afford deposits to buy homes.

In 1993, 30 per cent of Freddie’s and 34 per cent of Fannie’s purchased loans were made to folk with incomes below their local median. The new rules required this to hit 40 per cent in 1996, 42 per cent in 1999, rising all the way to 55 per cent in 2007. The target for special affordable loans – core subprime – was 20 per cent in 2000, 22 per cent in 2005 and 28 per cent in 2008. In the mid-1990s, Fannie and Freddie unveiled automated loan software; this introduced a “scientific” approach using credit scores. But while that made sense, they also claimed that loans once considered too risky were actually safe. The agencies bypassed “stodgy” lenders and helped create a new generation of brokers who originated riskier loans for them.

Wall Street was very far from blameless; but it would never have dared enter subprime in such an extreme, destructive way without government support. Sure, once subprime became the government’s priority, banks encouraged and rationalised it, selling new-fangled mortgage bundles which grossly underestimated default risk and making billions for themselves, as ever. Stupid investors lapped it up. But while toxic debt was repackaged and glamourised on Wall Street, it was originally invented in Washington.
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