The Financial Crisis Inquiry Commission formed by the US Congress studied the issue.
Its pretty silly to blame the CRA for a market failure. Markets fail, sometimes spectacularly.
The CRA simply wasn’t a significant factor in this market failure. The biggest contribution the CRA made to this market failure (which wasn’t entirely mortgage based. See, credit default swaps) was that it provided enough actuarial data so that banks could build models. Banks realized the higher interest rates being charged for subprime mortgages were more than enough to cover the higher default rates. As the demand for these subprime mortgages increased, we moved beyond the parameters on which the historical data was based, the loan to value ratios were approaching 100%, the income ratios were doing the same, and none of these things were required by the CRA, the subprime mortgages were being underwritten on standards looser than what the CRA encouraged. That was not regulation being shoved down their throats, that was banks chasing returns.
We also saw an explosion in mortgages that relied on declared income rather than documented income. This used to work in the past when the local banker would take a mortgage from the local car dealer who kept all his money in his business but when you expand the pool to cab drivers who had no visible means of making the mortgage payments but who declared he was making $100K/year and investors were buying them, then the fault lies with the lender. The borrower has never been the gatekeeper to credit, it is the lenders duty (in a system that includes bankruptcy) to be diligent about who he lends money to. But the lenders didn’t care because they were going to turn around and sell that cab driver’s mortgage to some pension fund.
Blaming the CRA in a world where the demand for subprime mortgages far exceeded anything the CRA might have required is like blaming the minimum wage (or perhaps even league minimum wages) for the outsized salaries of professional sports athletes.
So the whole mechanism worked out to legal scamification. The loan author would sell off the debt, make a little profit and walk away from any responsibility. This seems like a flaw in the overall system, legal hucksterism.
The CRA was altered, by Congress, several times. But each time they chose to lowered, or loosened, the requirements. In the end, loans were made with virtually nonexistent underwriting standards. No actual verification of income or assets, little, or no, consideration for the applicant’s ability to repay the loan, and no down payment. Congress OK’d the sales of unsound investments.
The heavily-regulated banking, mortgage, and investment industries couldn’t have taken advantage of the situation without Congress first lowering the standards, and secondly, by Congress repeatedly refusing to address the issue when warning signs began to appear.
It sounds like you are saying that there was insufficient regulation. I agree.
According to your won cite, there are Smart People on both sides of this issue. The fact that you like one side better does not equal “refuted”.
It was disputed.
Not just Congress. As my cite notes, some states attorney generals tried to put a lid on some of this lending and Greenspan told them to get lost.
There were several unrelated problems that combined to create the crisis. Here are some.
1. Misapplication of the principles of insurance. Major insurance began with shipping, where a key precept is that founderings are uncorrelated. The ocean isn’t going to spring a big leak and cause many ships to sink at once! Insurance revenue and payouts are proportional to the number of ships, but, because founderings are independent, the effective risk suffered by insurers is roughly proportional to the square root of the number of ships.
Obviously this doesn’t apply to insuring debts in an integrated economy. Junk bonds and home mortgages are NOT uncorrelated; it is possible for “the entire ocean to spring a leak” in this case – the leak is called “recession.”
AIG failed to grasp this point(*). The unit ensuring debt instruments was racking up big profits before the ocean sprung a leak; billlions of this profit were paid out as bonuses to employees of that unit. When trouble hit, problems were not proportional to the square root of N, the number of homes, but proportional to N. Yes, AIG’s managers apparently failed to grasp the most elementary concepts of insurance, concepts that were intuitively clear centuries ago long before mathematical decision-making was taught in schools.
(* - AIG, contrary to recent SCOTUS dogma, is not a “person” and the persons of its stockholders were not directly involved in its decision making. Since AIG managers are still driving Ferraris and vacationing on the Riviera it may be misleading to say “AIG made mistakes.” AIG’s decisions may have served the interests of those making the decisions quite well.)
2. Failure to grasp the instability of bubbles. Not only was the system vulnerable to “the ocean springing a leak”, but the leak was predictable, indeed inevitable. The housing boom was out of proportion to past experience, and it should have been appreciated that a reversion to the mean was due.
While many otherwise intelligent people may have been hypnotized into believing this was a New Order of Bubble that would reverse centuries of human experience, many important leaders knew differently. Certainly banks like JPMorgan Chase made huge sums betting that the Bubble would burst. Of course such leaders used their knowledge for personal greed rather than public welfare. An incompetent U.S. Administration and dysfunctional Congress sealed our fate.
3. Casino-like activities on Wall Street. I wonder how aware Americans are of the sort of deals that were made on Wall St. during the GWB-era credit boom. Insuring debt from default sounds benign but deals went far beyond any obvious purpose. In some cases, banks bet big that a corporation would default on a bond, and then made a deal with that corporation to induce such a default! A popular attitude seemed to be that “boys like to have fun” and that bankers playing billion-dollar poker with each other was fine, if no obvious laws were broken.
But, as has been preached in recent threads, banks are given their huge power and wealth as part of a social contract to further human economy. It’s a shame that regulations to prevent abusive behavior had been torn down. It’s a shame that a modest reform like Dodd-Frank is treated as a solution, rather than one tiny step toward a solution that’s still very far away.
Unfortunately, I am sure it’s not that simple. After all, these people are in the insurance business. I agree (and clearly history agrees) that they failed to adequately assess the risk, but it’s not like they were a bunch of idiots who couldn’t count.
Can you provide an example of this?
Also, as far as people failing to recognize a bubble, I am pretty sure it was more a matter trying not to be the last man holding the bag, rather that wishful thinking that it would never end.
Rob
The CDOs were quite opaque. As third or fourth order derivatives, it was just not possible to assess their viability, because the backing assets/collateral were so obscured by the redistribution of content that it would take ages to figure out what they were really worth. Insurance companies like AIG were not so keen to go to that much effort.
Do you have a cite that insurance managers even considered the concept of correlated risks? I’ll stipulate that the managers weren’t “a bunch of idiots”, indeed already implied that some of them personally profited from their companies’ woes.
Example of banker encouraging client to default? I don’t keep bookmarks and wondered what clever Googling it would take to satisfy you. In fact the very first paragraph of my very first Google hit should suffice:
[QUOTE=septimus]
I wonder how aware Americans are of the sort of deals that were made on Wall St. during the GWB-era credit boom.
[/QUOTE]
I guess sweeteviljesus’s query helps answer my question.
How did/do CDOs mature? I ask because somehow the mortgage payment has to flow from the mortgage holder to the CDO holder. They get some percentage of a particular mortgage and that mortgage has a risk associated with it. Now, that mortgage might be a stated income loan for 100% of the note and should be assessed as having a higher risk. Does the risk spread around proportionally to the percentage of exposure in the CDO? I never understood why this was hard for the quants.
Thanks,
Rob
Your cite doesn’t say whether or not that was illegal. If not, how would one craft a law against such a thing?
It might be enough to push softly in the right direction. Even a small tax on financial transactions – a so-called Tobin tax – would be beneficial. Those complaining that a small Tobin tax would stifle financial productivity are … ill-advised.
You could read what the CDO concept looks like.