Nathan Sass

The Great Recession – The road to Hell, paved with good intentions

In Economics, The Great Recession on September 30, 2010 at 5:12 PM

“The Great Recession” as it has come to be called, has some real reasons for its existence. Contrary to popular opinion, I don’t believe that it was initiated by the collapse of the housing market. That event was just the final domino is a long chain that stretches back decades. The foundation of this economic failure goes back to 1977, not 2007.

The Housing market collapse was a the ultimate result of “Community Lending” regulations that were intended to make regulatory “adjustments” to the previously less regulated home lending market. The Community Reinvestment Act (CRA) was passed in 1977 (Carter/Dem Congress) in order to require lending to low and moderate income borrowers and to eliminate disparities in the amount of lending in certain urban areas. The original act still, however, required that the lending be in accordance with “safe and sound lending practices”, meaning no excessive risk taking by lenders.

In 1992 (Clinton/Dem Congress), the CRA was amended to require HUD, Fannie Mae, Freddie Mac and affiliated private lenders to make a specific percentage of lending to support “affordable housing” and required Fannie Mae and Freddy Mac to securitize these loans. The goals of the Clinton administration were altruistic, to be sure. This was the genesis of the Fannie/Freddie securitized sub-prime loans. (Meaning loans to underqulaified applicants, not at rates below the Prime rate.)

The Clinton administration believed that the lending practices in place prior to its amendment did not allow too many of the poor to access the American dream of home ownership.  So they enacted a legislative change to the credit market that required lending institutions to make sub-prime loans, with the promise that Fannie Mae and Freddy Mac would back those riskier loans with the full faith and credit of the US Government.

Lenders were told that they would face penalties if they did not participate in this new program, which was done at the behest of groups like ACORN. (You can Google the “Community Reinvestment Act” and see who supported it, what it required and when it was passed. This is not my opinion.)

When these loans began to be made, the lending institutions took full advantage of what was thought to be an opportunity to make large profits with almost no risk to themselves. The growth in ARM loans for those with sub-prime credit were seen as very lucrative, and the lender assumed almost no risk of default due to the default protections of Fannie/Freddy/US Taxpayers.

Further amendments in 1999 (Clinton/Rep Congress) repealed parts of Glass-Steagall that prevented banks from offering some products, and prevented non-banks from conducting banking activities. This broadened the reach of Community lending exponentially as literally thousands of new financial companies (GMAC, E-Trade, QuikenLoans, etc.) were permitted into the Mortgage market, and became subject to the minimum lending requirements of the Community Reinvestment Act as amended in 1992.

This means that more and more lenders were required by law to increase their activities in sub-prime lending market.  Due to the false sense of security provided by Fannie/Freddie backing, soon they all but dropped the simple checks on income level etc. to approve loans and because not lending subjected them to stiff consequences.

When the Federal Reserve reduced rates to near 0%, there was an obvious impact in the housing market.
The result was a huge increase in housing sales, and therefore construction of new homes to meet demand. These loans, many of them Adjustable Rate Mortgages (ARMs) were used for increasingly larger and larger dollar loans, even including new construction, many backed by Fannie/Freddie.

The situation began to reach its peak shortly after the first round of ARMS adjusted, and rates rose dramatically after the Fed had begun to raise short term rates following the recovery from the 2001 recession. As more and more loans were adjusted up from the previously exceedingly low rates, people became unable to make their payments.

The sub-prime loans that were made in part to qualify under Community Reinvestment Act had encouraged lenders, via Fannie/Freddie guarantees, not to use sound lending practices to make lending decisions were the first to see massive default rates.

As these loans defaulted, Fannie/Freddie began to have to make the loans whole, and the value of the Mortgage Backed Securities they had been marketing fell through the floor.

When this occurred, the second element of the perfect storm kicked in. As part of the fallout of the Enron scandal, Mark to Market (MTM) rules were put into effect by the SEC as part of GAAP (Generally Accepted Accounting Principles). Mark to Market requires the holder of assets to reset the value of assets held to be adjusted daily to the fair market value of that asset.

MTM forced lending institutions to devalue literally millions of Mortgage Backed Securities that in many cases did not even contain many, or any, sub-prime loans. Mortgage that were current and stable in actuality and held as assets lost value on paper because a small subset of the market had realized a loss.

This had the impact of making some lending institutions poorly capitalized literally overnight. When a lender is poorly capitalized, they must raise capital, reduce lending, and recover ASAP or risk insolvency and FDIC action. The rapid pace of this led to an almost instantaneous shutdown of the lending market for areas not even related to the Mortgage market. Small business lines of credit were revoked, for example, in large numbers.

When the TARP bailouts were initiated, the most poorly capitalized lenders took the TARP funds and held them as cash reserves. While the intent of TARP was to increase lending, it did no such thing because MTM made anything other than cash equivalents so volatile that banks preferred cash holdings to loans outstanding. Banks were willing to make the small amount of interest on deposits or treasuries rather than risk more MTM driven insolvency.

No amount of pressure by the US Government could make them move from this position, and many institutions repaid the TARP loans with newer cash reserves, but did not increase lending after the fact.

Further, TARP required that institutions that were not risking insolvency “accept” TARP funds over their objections so as to prevent there being a market stigma on those that did need those funds to survive. This caused even more negative repercussions on those lenders and a further unwillingness to lend.
This, of course, led to many businesses losing the ability to use lines of credit to expand, make capital improvements, and in some cases survive small temporary losses. It is the last of these examples cause layoffs, and in some cases closures of otherwise long term viable businesses.
Now begins the death spiral.

Layoffs lead to more foreclosures, which leads to devaluation of homes and leads to further reductions in MTM values of mortgage assets, which leads to less lending and reduced equity and fewer purchases of homes, which leads to more layoffs in increasing sectors of the economy which leads to even more devaluation and MTM impacts ad infinitum.

This was a totally foreseeable result of 2 independent pieces of legislation that, on their own, had arguably moral justification. One was meant to increase the opportunity of home ownership to levels beyond what an unregulated market allowed, and the second was in response to criminal activity that resulted in losses by some investors and employees of the firms engaged in fraudulent behavior.

The sad part is that the MTM changes were totally unnecessary, as the actions of Enron management was already illegal and there needed to be no further regulation to sanction this behavior.

So, in the end, the housing bubble itself was a result not in normal market forces at work, but the direct result of the modification of the market by government to obtain a “more equitable” condition.

The housing sector will not recover until a bottom is allowed to be reached through normal market forces, but again we have an administration actively attempting to prevent this from occurring as it is considered “inequitable” and is using government actions to try to alter the market. Loan principle reductions, debt forgiveness, purchase incentives and the like do not alter the actual conditions of the market; they only serve to create another housing price bubble that must be allowed to burst to get to a bottom, prolonging the pain for all of us.

The solution is to allow the housing market to reach a bottom point at which those with capital are willing to risk it on investments in housing assets. Artificial props on the price of those assets discourage these actions from taking place.

Foreclosures are not a good thing for those going through them, but must be allowed to run their course to reset the market for housing assets to the prices that are consistent with what the market would have dictated before Community Lending produced and artificial surge in buyers, an artificial increase in the asset value, and an eventual crash as those loans predictably defaulted.

The long story short here is that progressive policies are by their very nature policies that seek to “rectify” conditions in the free market that are considered “undesirable”. The market does not stand powerless to these efforts, however, and will always seek to compensate for those corrective actions.

The fastest way out of this situation is not more government intrusion into the market itself, but to allow the markets to adjust themselves. If the US government announced that the MTM rules were going to be revisited, and possibly rescinded, and that the Community Reinvestment Act changes of 1995 were to be repealed, you would see lenders be able to correctly value their assets and avoid insolvency. These lenders would also be free to make loans to credit worthy applicants free from any punitive actions based on low income lending requirements.

Just as water seeks its own level, no matter how hard you try to push the water in a puddle to be deeper in one end than another, it will always thwart your efforts and evade your actions in ways that can be foreseen. All you accomplish is a lot of splashing around and a lot of pain for anyone who lives in the puddle.


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