Clinton, Bush policies fueled foreclosure crisis

Our society owes Peter Wallison some thanks, even if we ignored him. A senior fellow at the American Enterprise Institute, Wallison issued one of the most prescient warnings about our current problems nearly a decade ago.

A September 1999, New York Times article detailing how Fannie Mae was lowering its credit standards for home mortgage loans quoted Wallison warning, “This is another thrift industry growing up around us. If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.”

It is hard to hit the nail more squarely on the head than that. Wallison was exactly right. Fannie Mae, which acted at the direction of the Clinton Administration in repeatedly lowering its standards to encourage mortgage lending to otherwise uncreditworthy buyers, was a major contributor to the subprime debacle that we face today. The only error Wallison made was in comparing the eventual problem to the savings-and-loan failures of the late 1980s. The current debacle’s impact on the United States economy is several times the size of the SL crisis.

Those who argue that the current financial crisis is due to government action focus on two policies: first, the Community Reinvestment Act, which required banks to “serve the credit needs of their communities,” and, second, government pressure on mortgage companies Fannie Mae and Freddie Mac to handle riskier mortgages. The first argument is highly overstated. But the second one is right on target. These government-sponsored entities have been mismanaged for 40 years. The mismanagement was greatest during the Clinton Administration.

Moreover, while these GSEs distributed campaign contributions liberally to both Republicans and Democrats, it was a Democratic party-line stand in 2005 that kept a reform bill authored by Nebraska Republican Sen. Chuck Hagel from reaching the floor of the Senate.

One can make a good argument that at the time Fannie was set up in 1938, private capital markets had failed. Markets had not developed institutions to efficiently funnel capital into home mortgage lending and the short-term, frequently refinanced mortgages then available made families terribly vulnerable to losing their homes in an economic downturn.

Fannie packaged government-guaranteed home loans and sold them to private investors, often life insurance companies and pension funds. Fannie then used the money to buy more mortgages. The government guarantee and the securitization process demonstrated that it was possible to mobilize private capital to fund longer-term home mortgages.

That lesson was evident when the Johnson Administration spun Fannie off as a separate private corporation in 1968, largely to make the federal budget look better during the Vietnam War. If Fannie had been treated as just another financial corporation, the story might have turned out well.

But it wasn’t. It always had special tax treatment that other financial institutions did not enjoy. It was allowed special accounting rules. It was allowed higher leverage. And, despite statutory declarations to the contrary, it enjoyed the implicit guarantee of the federal government.

With such special treatment, Fannie and its younger counterpart, Freddie, maintained a quasi-monopoly position in the home mortgage market. Yes, private firms, notably Salomon Brothers, got into mortgage securitization by the 1980s. But Fannie and Freddie always had special status, spent enormous amounts on lobbying and complied with political pressures.

The Clinton Administration came in with explicit goals about increasing home ownership. Fannie and Freddie were the chosen vehicles to accomplish this. In 1996, the Department of Housing and Urban Development ordered the GSEs to ensure that 42 percent of the loans they handled were to below-median-income borrowers and 12 percent had to be “special affordable” mortgages to people with less than 60 percent of median income. These required percentages were increased over time.

Fannie and Freddie complied, funding hundreds of billions of dollars of mortgages with subprime terms, adjustable interest rates and low down payments. In 1999, it started a program to encourage cooperating lenders to increase subprime lending.

These initiatives came from the Clinton Administration, but they continued under President Bush with the subprime goals extended even further in 2005 and planned for further extension in 2008. This was part and parcel of the “ownership society” championed by Bush.

The subprime debacle is bigger than this. Purely private firms took the shaky practices of GSEs and turbocharged them. But when blame is meted out, Fannie, Freddie and the elected officials that manipulated them deserve a big portion.

© 2008 Edward Lotterman
Chanarambie Consulting, Inc.