Like Captain Renault in the 1942 movie Casablanca, I am “shocked… shocked” to find that gambling has been going on in the mortgage-backed securities business.
And so, apparently, is the United States government, which announced on Tuesday, February 5, that it has sued ratings agency Standard & Poor’s for knowingly inflating ratings on risky mortgage investments, thereby allegedly helping to trigger the 2008 financial crisis.
As reported on the Huffington Post, the U. S. Justice Department alleges in a suit filed in Los Angeles that S&P committed fraud by giving high marks to mortgage-backed securities “because it wanted to earn more business from the banks that issued the investments.” According to the lawsuit, Huff Post says, “S&P knew that home prices were falling and that borrowers were having trouble repaying loans. Yet these realities weren’t reflected in the safe ratings S&P gave to complex real-estate investments known as mortgage-backed securities and collateralized debt obligations.”
Excuse me for pointing out that the Emperor has no clothes, but it was the U. S. government that created the incentives for banks to make these bad loans to begin with, starting with the Carter-era Community Reinvestment Act of 1977. According to the Federal Reserve itself, The Community Reinvestment Act was “intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound operations.”
That last clause is, of course, simply an ex post facto rationalization of a policy that was ill-conceived to begin with. In reality, in the opinion of the Congress that enacted the statute, 12 U.S.C. 2901, banks were not lending enough money to poor people to buy homes in poor neighborhoods, in favor of higher-income people with better credit ratings and greater assets in better neighborhoods. This did not satisfy the growing 1970’s ideal of “social justice.” The underlying subtext was that the home loan industry was racially or otherwise demographically discriminatory, because such “traditional” lending criteria as income, assets, and credit history favored members of certain historically-advantaged demographic groups over others.
As the Wall Street Journal editorial page argued fruitlessly for years, the notion that banks by and large discriminated on the basis of anything other than financial risk was both logically and empirically unjustified. Subject to federal government bailouts, banks and other lenders survive only if they follow sound business practices, including making more loans that perform than loans that don’t. If lenders had been systematically discriminating against certain loan applicants on the basis of anything other than financial qualifications, then demographic minority group members who did get loans should have exhibited lower default rates than borrowers overall because the minority group applicants would necessarily have been subject to higher standards and therefore have been better credit risks than others.
But that was manifestly not the case: overall default rates were about the same, showing that lenders were doing an equally good (or bad) job in evaluating the creditworthiness of all borrowers, regardless of their non-financial demographics. Banks and savings and loans may have made mistakes in individual cases, but they were not systematically discriminating on the basis of anything invidious.
Still, the government was not satisfied. In the words of the Fed, the CRA required that “each depository institution’s record in helping meet the credit needs of its entire community be evaluated periodically.” More sinisterly, the Fed warned, “[t]hat record is taken into account in considering an institution’s application for deposit facilities.” In other words, start making loans that you otherwise wouldn’t – or else.
The CRA was implemented by Regulation BB (12 CFR 228), which was substantially revised in May 1995, under President Bill Clinton, and updated again in August 2005, under President George W. Bush. Starting in 1995, government regulators evaluated banks based on their use of “innovative and flexible” lending standards, including reduced down payments and credit requirements. Banks that didn’t meet those targets, including for example Citibank and Washington Mutual, were denied merger plans until they pledged more loans to credit-poor minority applicants.
The effect of such pressure was profound. Between 1995 and 2008, as reported by Investors Business Daily, the total value of CRA loan commitments pledged by banks to ACORN and other “not-for-profit” organizations grew from approximately $100 billion or so to $4.1 trillion – an increase of four thousand percent. According to a new study by the National Bureau of Economic Research, such “flexible” lending by large banks rose by an average 5%, yet such loans defaulted about 15% more often, not exactly a winning business proposition.
The biggest culprits besides Congress were not the banks or the credit-rating agencies but Freddie Mac and Fannie Mae, the government-backed agencies that dominate the home-loan mortgage market. “We want your CRA loans because they help us meet our housing goals,” Fannie Vice Chair Jamie Gore lick told lenders at a now-infamous 2000 banking conference, right after the Department of Housing and Urban Development increased Fannie Mae’s “affordable housing” quotas to 50%. “We will buy them from your portfolios or package them into securities,” Gore lick promised.
And that’s exactly what happened, especially between 2004 and 2006, when banks sold CRA mortgages as fast as they could for securitizing by Fannie Mae and Freddie Mac and then by Wall Street. Pretty soon giddy Wall Street traders were buying and selling not only the securities themselves but also derivatives of those securities and were engineering exotic devices like “default credit swaps” with no regard for, or financial stake in, the underlying loans. The result was predictable and inevitable – an artificial boom in housing prices stimulated by subsidized buying, otherwise known as a bubble. And bubbles always burst.
Such economically irrational but politically-induced behavior was not limited to lenders actually subject to the CRA. Perhaps the name “Countrywide Financial,” the now-defunct subprime giant, rings a bell. HUD regulators pressured Countrywide, among others, to agree to support such lending under threat of being brought under the CRA. Small wonder that Countrywide was soon advertising to banks that “Countrywide can potentially help you meet your CRA goals by offering both whole loan and mortgage-backed securities that are eligible for CRA credit.”
Now that the whole house of cards has collapsed – destroying trillions of dollars in personal wealth, stagnating the world economy and demoralizing credit-worthy homeowners who have seen their accumulated life savings dissipate – the government that engineered the crisis has apparently decided that it’s really S&P’s fault. “Put simply, this alleged conduct is egregious – and it goes to the very heart of the recent financial crisis,” Attorney General Eric Holder announced at his Tuesday news conference.
In one respect, of course, the Attorney General is right. The conduct is indeed egregious, but it’s the conduct of policymakers in Congress and the regulatory agencies, not the ones who follow their orders. To blame S&P for not stopping the housing market madness of the past decade or so is akin to blaming the police department for not pulling you over when you’re driving too fast after having had too much to drink. In fact, it’s even worse than that: it’s more like forcing bars to serve alcohol to minors, then putting them behinds the wheel of cars they can’t afford and setting them loose on the highway in the rain – and then blaming the cops.
Like Captain Renault, the federal government is shocked – shocked – to find that gambling is going on in the casino. Just before it asks for its share of its winnings.
David Applegate is a Chicago-based trial lawyer and partner at the law firm of Williams Montgomery & John Ltd.
