On 24 November 2008, Treasury Secretary Henry Paulson announced that the federal government would absorb billions of dollars in losses suffered by Citigroup in return for shares of stock in the troubled bank. With rapidly falling stock and more than $300 billion in "troubled assets," Citigroup was on the verge of total collapse. If the federal government allowed one of the nation's largest banks to collapse, Paulson explained, the impact on the rest of the world's already precarious financial institutions would be catastrophic. This unprecedented government intervention in America's banking industry, supported by Republican President George W. Bush, was necessary to save our free market economy.
For many, the announcement was shocking; just a month earlier, Citigroup had been identified as one of the country's healthier banks. When banking giant Wachovia failed, the government approved a takeover offer from Citigroup—testimony to its supposedly healthy status. But now, Citigroup joined the ranks of troubled financial institutions like Washington Mutual and Lehman Brothers. But for others, with a different, somewhat longer perspective, the announcement was shocking because it came from a Republican administration—and Republicans are traditionally the party of reduced governmental involvement in the economy and reduced governmental regulation of America's businesses.
How did a Republican administration get to this place?
The financial crisis that gathered momentum over the course of 2008 had several causes. But most agree that America's foreclosure crisis was chief among them. And for many, this crisis in the housing industry was largely due to a series of regulatory failures—a relaxation of government regulations dating back to the 1970s and the failure of government regulators to adapt their practices to several new features of the mortgage industry.
Failure to regulate the subprime market. Subprime mortgages are lousy loans given to "subprime" borrowers. If you have a bad credit history, are already deep in debt, or your income does not seem high enough to pay off a loan, lenders will not trust you with the "prime" interest rate. Instead, you might be offered a subprime mortgage—one with a higher interest rate, expensive start-up fees, and/or penalties for early repayment.
In addition, most subprime mortgages carry variable interest rates; that is, the interest rate changes over the course of the loan. In fact, most of these loans carry an introductory or "teaser" rate, one very affordable to a borrower on a tight budget. In other words, you might start off with an affordable rate, but it will increase after a couple of years, often by as much as 50%. This means that, all of a sudden, you can't afford your monthly payment, you fall behind, and you are hit with late penalties and perhaps a punitive increase in your interest rate. The next step is foreclosure; the holder of your mortgage assumes ownership of your home and tries to recover some of its money by selling or auctioning the home.
Okay, so why was all this a regulatory failure? Well for starters, in 1995 the federal government raised the limit on the size of the loans offered through the Community Reinvestment Act of 1977. This act aimed to provide funding to disadvantaged borrowers anxious to purchase a home. By raising the limits, the federal government enabled high-risk borrowers to borrow more money than many could afford. The result was an increase in home foreclosures, and therefore an increase in "bad debt" held by the banks—money they could not recover and therefore could not lend out to other borrowers.
But the number of risky loans issued through this program represented just a small part of the subprime market. A much higher percentage of subprime loans were sold by mortgage brokers working with conventional lenders, and these mortgage brokers were a growing constituency within the mortgage industry that many believe were seriously underregulated.
Failure to adequately regulate mortgage brokers. Mortgage brokers don't work for a particular bank—they work for themselves or a brokerage that sells mortgages offered by dozens of lenders, not just one particular bank. When you are shopping for a loan, a mortgage broker can offer you loans from multiple lenders with different details; you can choose the one that best fits your wallet.
The number of mortgage brokers skyrocketed in recent decades—and understandably so; it was a pretty lucrative line of work. Unlike the lending institution that makes its money over time, brokers make most of their money up front by collecting a portion of the loan start-up costs. In addition, since they make their money by selling other people's money, they don't carry any personal risk. Even if borrowers fail to repay their loans, the broker is not out any money.
What a business. But like all good things, the industry was soon crowded—so crowded that brokers had to find new customers for their services: customers that had not been targeted in the past. Where did they find these new customers? That's right—in the subprime market. Folks who had bad credit and/or low incomes were now enthusiastically pursued. And brokers now had the tools they needed to capture these new customers: a variety of gimmicky loans that seemed both affordable and risk-free, ones with introductory low rates, or loans that required payments only on the interest for five years.
Of course, even an inexperienced homebuyer realized that his or her mortgage payments would eventually increase, but by then, the broker reassured him, he would have built equity in the house. (Equity is the amount of the home that you, not the bank, own. You can build equity by paying down your loan or, more commonly, you build equity as the house increases in value. When the house you bought for $200,000 increases in value to $300,000, you have an additional $100,000 in equity.) Once you build equity, you can re-finance your home—that is, take out a new loan—and since you now have considerable equity in your home, you are a more attractive borrower and can get a much better (or "prime") mortgage.
This is a reasonable strategy—provided the housing market remains healthy. However, it is a very high risk in a bad market. But again, why is this a regulatory failure as opposed to a failure in judgment? The government cannot require that people properly predict the future of the housing market. True, but the government can require that brokers take greater pains in qualifying a person for a loan. Brokers operated under pretty relaxed rules. Most dramatically, they were often not required to document a borrower's income when he applied for a loan; a $35,000-a-year clerk could pass himself off as a $100,000-a-year superclerk without any sort of documentation or verification.
But why were brokers so willing to submit misleading applications? As we said above, it wasn't their money or even their employers' money. They were shielded from the ultimate consequences of a risky loan. The real question is this: why were the lenders willing to make loans without stricter documentation requirements? The answer is that they were just as shielded from the consequences of these bad loans. During the 1990s, unregulated changes within the mortgage industry had the effect of separating lenders from the consequences of their decisions. Just like the brokers, lenders financed mortgages knowing that they would not ultimately be stuck with a bad debt.
The failure to properly assess and regulate "Mortgage Backed Securities." In the old days, when you borrowed money from a bank for a home, the bank held your mortgage, or debt. You paid the bank back over the course of 25 or 30 years. But over the last decade or so, this practice has changed. Now banks take your mortgage, bundle it with a bunch of others, and sell them to investors. The bank gets some cash and the investors look forward to a steady income fed by borrowers making their monthly mortgage payments.
These bundled mortgages, called Mortgage Backed Securities (MBSs), were hot investments during the 1990s. America's housing market was booming and prices were rising, which meant that mortgages were a pretty safe bet. In the worst case scenario, if a person fell behind in his or her payments, or if the holder of the mortgage had to foreclose, the house generally could be sold at a profit and no one would lose money.
When the housing market started to slip a bit around 2000, these MBSs lost some of their appeal. A few investors began to question their value, but most maintained faith that housing prices would rise and mortgages would retain their value—especially since neither the public regulatory agencies nor the private rating agencies suggested there was any cause for alarm. Both President Bush and Alan Greenspan, the former chairman of the Federal Reserve Board, said that the housing market was essentially sound, and neither even hinted that these MBSs represented a problematic new element in America's financial structure. Consequently, the regulatory agencies on which we depend to monitor the investment instruments and financial practices of all these institutions failed to look closely at the sort of risks these investments represented. Similarly, private agencies like Standard and Poor's and Moody's, which evaluate and rate different types of investments, failed to recognize that these new investment instruments were loaded with risk.
But the reality was that a growing percentage of these mortgages being bundled and sold were at risk of failure and the individual and institutional investors (banks, insurance companies, union pension funds, etc.) were pouring billions into "troubled" or "toxic" assets. Amazingly, as late as spring 2007, no one seemed to be aware that these MBSs were poison—that is, until the number of foreclosures began to rise.
Subprime + mortgage brokers + MBSs = financial meltdown. Okay, so the federal government relaxed its lending regulations. Some argue that it actually encouraged loans to high-risk borrowers. Mortgage brokers enthusiastically went after the subprime market and sold high-risk loans to under-qualified borrowers. They were able to convince lenders to pony up the cash because neither the lenders nor government regulators demanded full documentation of borrowers' income. The entire chain of brokers and lenders were just a little too relaxed about everything because they knew that these shaky mortgages would be bundled and sold to other parties. Neither the private rating agencies nor the government regulators recognized that the MBSs in which financial institutions were investing were badly flawed assets.
In retrospect, it's pretty clear that there is plenty of blame to pass around. Borrowers, brokers, and banks all failed to respect the risks being taken at every level. But there was also an ideological failure. Alan Greenspan, the respected former head of the Federal Reserve Board, admitted that he failed to exercise enough vigilance over the changing market because he believed that the markets would regulate themselves. He assumed that banks and other mortgage lenders would anticipate the risks inherent in these new lending practices and take care to protect their assets and investments. But they did not. For those who believe in the need for government regulation, this is the bottom line: markets will not regulate themselves, so the government must.