How US Politicians Brought Down
the Global Financial System
Patric H. Hendershott and Kevin Villani
PBFEAM, July 9, 2011
Taipei, Taiwan
What Brought Down Global System?
• Large global holdings of Fannie and Freddie
MBSs and private label securities (PLBs) held by
governments, banks and retirement systems
• Both the MBSs and PLSs were highly-rated
securities backed by sub-prime mortgages (and
sub-prime was REALLY sub-prime)
• The avalanche of sub-prime loans came on top
of a normal boom, funding an abnormal rise in
US house prices from mid2004 through 2006
The Crash
• Some of the mortgage loans were so bad that
they would fail (default) even if house prices
didn’t fall – a fifth were delinquent in six months
• House prices were due to fall because they has
been artificially run up
• Defaulting loans and falling house prices
reinforced each other, leading to a total collapse
of the US housing market and many financial
institutions
• And thus the expression sub-prime debacle
Brief Overview on US Mortgage System
US has developed a housing finance system that
differs from most developed economies
- Most mortgages are securitized and most
securities are tranched
- The leading securitizers are federally-sponsored
agencies, Fannie Mae and Freddie Mac (F&F)
System was developed in part to get around
branching restrictions – regional capital
shortages would develop providing an impetus
for securitization
So What Caused the
Sub-Prime Debacle?
Two competing narratives:
• The politically correct narrative pushed by the
Financial Crisis Inquiry Commission
established by the US Congress (2009) and
embodied in the Dodd-Frank Act of 2011
• An alternative factually correct narrative
pushed by conservative US think tanks
Politically Correct Narrative
Causes that made sub-prime debacle systemic
• Deregulation and inadequate regulation
• Wall Street greed led to massive PLSs that,
when defaulted, dragged down Fannie Mae
and Freddie Mac (F&F)
• Home buyers, lenders, etc behaved irrationally
Solution is more comprehensive regulation
(Dodd-Frank Act)
Some Truth (Regulation Was Awful)
But Three Myths
First myth: deregulation was a cause of debacle
• Removal of deposit rate ceilings (1980)
• Elimination of branching restrictions (1994)
• repeal of Glass-Steagall (1999), which had
required separation of commercial and
investment banking
All of these steps strengthened the financial
system; they were not a cause of debacle
Myth 2: Private Sector Dragged Down
Fannie Mae and Freddie Mac
• F&F were mandated to make percentage of
loans to those with below median income (30,
42, 56) – also below 60% of median – were
mandated to make bad loans
• F&F required to fund half of sub-prime loans
in 2005
• F&F bought 40% of subprime private label
securities (PLS) during the boom
Myth 3: Behavior Was Irrational
• Borrowers didn’t need to expect house price
appreciation to make owning a wise economic
decision (nothing to lose – no money down, live
rent free)
• F&F executives made hundreds of millions
• Loan originators – securitizers of PLSs - made
billions making/selling crap loans
• NRSROs (Nationally Registered Statistical Rating
Organizations) made billions ratings MBSs
How Did Everyone Make Money?
Leverage
• Homeowners borrowed up to 100%
• F&F borrowed 99% at just above the
government rate – federally sponsored
• PLS leverage was only 95% (sometimes 98%)
Even if things eventually went bad, what was
made before that more than compensated
Factually Correct Narrative
• Regulation was near complete by 2001 (and
enforcement was almost totally inept)
• F&F had largely replaced the private market in
the conforming loan segment
• Prudential regulation controlled PLSs
Moral hazard created by politicians/regulators
was the sole cause of the debacle
Error 1: Fannie Mae and Freddie Mac
• Privatization created public risk for private
profit model: incredible moral hazard problem
• Regulator put in HUD where attempts to
regulate were overruled: conflict of prudential
and mission regulation
• Extreme leverage
• 30/42/56 and 50% of sub-prime market in 2005
Error 2: Recognized Security Raters
• Establishment of NRSRO by the SEC: removed
potential competition of other raters
• Raters determined how much of the issue
could be put into investment grade tranch and
thus pay a low coupon
• Risk assessors then relied on ratings rather
than evaluating the risk of the investment
• With little competition, ratings (especially of
second mortgages) were far too generous
Error 3: Basil I Capital Requirements
(response to previous S&L debacle)
• Risk weightings: commercial loans and mortgages
100%, MBSs 50%, AAA/AA rated securities 20%,
governments 0%
• Huge impetus to securitize – to originate
mortgages to sell, producing major moral hazard
in loan originations
• Relied on NRSRO ratings; gave them (undeserved)
credibility
• Generally eroded market discipline
Error 4: Commercial Banks
• TBTF banks were allowed to develop as
banking system consolidated
• Off-balance sheet funding was allowed (SIVs)
• Banks were permitted to issue preferred stock
(AAA rated, of course) and count it as equity
capital
• Erroneous Basil I requirements; in 2001 20%
weighting given to PLS AAA/AA segments
Error 5: SEC and Investment Banks
• Bail out of LTCM (1998) illustrated that
investment banks, too, could be TBTF (Geitner)
• Still, capital requirements were far less than
those of commercial banks
• SEC declared five largest to be “consolidated
supervised entities” and lowered capital
requirements in 2004, but provided little
supervision
Why Was Regulation So Bad? Politicians
• They believed that their judgment (or that of
their appointees) could substitute for market
discipline
• They believed that off budget subsidies through
finance could be given (Housing Lending Goals)
• They received millions in political contributions
and payoffs
• They created crony capitalism and called it a
new hybrid public/private partnership
Some Errors of Politicians
• Put F&F regulator in HUD and prevented him
from stopping bad loan purchases
• Voted against raising far too low F&F capital
requirements
• They didn’t oversee behavior of SEC, FDIC, etc.
Repeal Dodd-Frank
• Doesn’t fix money market regulation – invest in
government securities (not Greek debt)
• Retains F&F, contending that government
sponsorship can be limited with moral hazard
• Extends investment market regulation to
derivatives/hedge funds
Creates a committee of politicians, bureaucrats
and professors to prevent the next crisis – and
housed in the Treasury Department!
Restoring Investment Market Discipline
• Eliminate F&F – no government sponsorship
• Repeal NRSRO designations
• Alter risk-based rules for mortgages to reduce
the incentive to originate to sell
• Encourage a market determined allocation of
risks (covered bonds, ABSs)