The Great Deformation (77 page)

The HUD ownership strategy identified housing “down payment” as some kind of arbitrary and unjust social barrier, like racial discrimination, that purportedly could be mitigated by government intervention. But that was profoundly wrong: down payments were actually a fundamental impulse of the free market arising from the fact that, under American law and custom, the traditional fixed-rate nonrecourse mortgage loan amounts to a one-way call option.

If interest rates go up, borrowers are protected and enjoy the savings; if they go down, borrowers can refinance without penalty; and if the borrower's income fails he can mail the keys back to the lender without fear of a stint in debtor's prison or its equivalent civil punishment. Owing to these features, meaningful borrower skin in the game in the form of large cash down payments is fundamentally necessary to deter abuse and generate a market return to mortgage investors.

AT THE CENTER OF THE HOME OWNERSHIP CRUSADE:

CRONY CAPITALIST FOLLY

The preponderant reality of contemporary governance is money-based interest group politics. Accordingly, if a class of citizens merits income transfers from the state under some imaginable public policy standard, the
worst possible answer is to shower a random subset of that class with in-kind subsidies through the private market.

These in-kind subsidies almost always get captured by vendors and providers; they become the sustenance for yet another syndicate of crony capitalist rent-seekers. The better answer is to impose a means test and mail cash to eligible citizens. In the case at hand, such cash transfers would allow beneficiaries to choose between applying the cash to rent, a mortgage, or something else.

When viewed in this framework, it is evident that pursuit of social uplift through home finance subsidies was a huge policy error. Indeed, the crude quantitative goal of the Clinton administration's crony capitalist coalition—raising the home ownership rate to 67.5 percent by the year 2000—was especially pernicious. The graph of long-term home ownership trends proves why and with startling clarity.

From the first quarter of 1987 through early 1995, the graph line was flat at 64 percent, oscillating tightly around that level, and for good reason: the real incomes of the lower half of US households declined by about 15 percent during this period. Owing to this weakened capacity to service a home mortgage, including the contribution of an economically meaningful down payment, an increase in the home ownership rate was simply not warranted.

Furthermore, 1994 was the fulcrum year when China radically devalued its currency and triggered the rise of a mercantilist export machine that was bound to further erode American working-class incomes. In a word, if the free market had its way, the curve on the home ownership graph after early 1995 would have headed down, perhaps eventually into the 50–60 percent range as nationwide capacity for home ownership fell steadily.

Instead, public policy drove the curve sharply upward. When shortly after the turn of the century the home ownership rate broke above 69 percent, the implied variance between that policy-induced outcome and a plausible free market “contrafactual” case was huge. Perhaps 10–20 million households were artificially induced to take on a home mortgage, or to refinance one they already had in order to extract MEW.

THE $6 TRILLION GSE BALANCE SHEET EXPLOSION

Not surprisingly, Washington's crusade to artificially raise the home ownership rate via relaxation of mortgage standards soon gathered formidable momentum. Consequently, the balance sheet footings of the GSEs exploded in a manner never before seen in the accounts of an American state agency. When the national home ownership strategy was launched in 1994, the GSE's total balance sheet exposure was $1.7 trillion. During the remaining
six years of the Clinton term these obligations grew by 70 percent, to $2.9 trillion.

By then, the crony capitalist coalition was so deeply entrenched in both parties that the feeble efforts of the George W. Bush White House staff to slow down the freight train were utterly unavailing. By 2004, the GSE balance sheets had ballooned to $4 trillion and, when Hank Paulson finally nationalized this rogue lending machine, footings had reached nearly $6 trillion.

Needless to say, a $5 trillion gain in government-backed housing finance in 14 years was a profound deformation of finance. Owing to the money-printing policies of the Greenspan Fed and the currency-pegging mercantilism of the Asian central banks, there were virtually unlimited buyers for US government debt paper, including the GSE variant. There was nothing to stop the parabolic rise of GSE housing guarantees and investment except the self-discipline and underwriting standards of Freddie and Fannie themselves.

But, alas, all of the economic and political forces were moving in the opposite direction at dizzying speed: the Greenspan stock market bubble was transforming Freddie and Fannie executives into stock option speculators; the crony capitalist coalition endlessly hammered GSE underwriting standards lower; and Washington officials heralded every increment of its success in raising the home ownership rate from 64 to 69 percent.

At the same time, it failed to see that the GSE balance sheets had gotten freakishly large as they leapt upward by the trillions; that loan-to-value ratios were increasing rapidly; that credit scores of new borrowers were steadily falling; and that housing prices were rising so fast that fundamental credit risk was being thoroughly papered over.

By the turn of the century, it could be well and truly said that the GSE-based mortgage finance system had become a doomsday machine with no braking mechanism and no sentient pilot. In fact, however, this was just the warm-up phase. The more virulent subprime stage of the housing mania was yet to come, but the launching pad for it was a direct by-product of the GSE explosion fueled by Washington's wholly misguided home ownership strategy.

MORTGAGE BROKERS GONE WILD

This massive expansion of what amounted to a socialized credit pool for housing changed everything about the home finance market, but the most crucial aspect was the vast expansion of “takeout” financing available to mortgage brokers and other nonbank originators. Since, unlike depository banks, the latter were largely unregulated, the rise of mortgage broker finance
was heralded as another triumph of the free market. It wasn't, not by a long shot.

As has been seen, most of this purported “capital markets funding” for home mortgages was actually coming from the Freddie and Fannie branch of the US Treasury, so there was nothing “free market” about it. The reason this cardinal reality got continuously overlooked, even by honest free market advocates, was the illusion that the GSEs ran a “secondary market” for home mortgages.

As demonstrated above, however, it actually amounted to a fee-scalping operation, a digital version of the same New Deal filing cabinets where it had started. While its PR flacks claimed it was a “deep” and reliable source of mortgage finance “liquidity” that lowered mortgage financing costs, the GSE market was liquid only because it was a sub-branch of the Treasury bond market. GSE mortgage costs were low because they were written against Uncle Sam's credit.

The rest of the GSE story was just a marketing smoke screen that took the focus off what was really happening to the structure of home finance; namely, that bricks-and-mortar banks and thrifts were being driven out of the mortgage-lending business by the very “secondary market” that was allegedly the savior of housing.

Banks and thrifts were being replaced by pure mortgage brokers; that is, by what were effectively fee-for-service mortgage origination contractors to the US government (i.e., Fannie and Freddie). And, as at the Pentagon, it was essentially a “cost-plus” business: the greater the volume of services, the larger the harvest of fees.

So here was another profound deformation of the free market. The K Street lobbies for the mortgage bankers and brokers portrayed their clients as capitalist entrepreneurs who plied their trade in the unregulated markets. But mortgage brokers really had no reason for existence, because the separation of underwriting from long-term investment in the resulting mortgages did not create any value added. As shown in
chapter 20
, what this artificial divorce did create, as history would soon prove, was ample opportunity to destroy value, owing to underwriting error, information disconnects, and fraud and abuse along the daisy chain of securitization.

HOW WASHINGTON DESTROYED THE REAL HOME MORTGAGE BANKERS

Prior to August 1971, home mortgage finance had remained largely in the province of local savings and loan banks because their “originate and hold” model was a source of deep competitive advantage. The economics of home mortgage lending, after all, turn entirely on the default loss rate over
the long contract period of fixed-rate mortgages, not on trimming nickels and dimes from application processing costs. Profitability in home finance was always and everywhere a function of borrower selection.

Accordingly, traditional thrifts and banks accumulated a huge intangible asset in the form of their knowledge of neighborhood economic and social trends, along with their files on borrower histories and character, and the information obtained from rigorous loan applicant assessment procedures. These intangible assets, along with direct and immediate accountability for soured loans and strong incentives to cure delinquencies, were the source of their underwriting proficiency.

The long-forgotten truth is that the traditional mortgage industry was based on the skill of seasoned “bankers.” Now, owing to the triumph of the GSE securitization model, bankers were obsolete: what counted was the sales patter and typing speeds of the glorified document clerks who populated the mortgage broker offices.

As indicated above, this inferior mortgage banker and broker model triumphed because the traditional thrift-based mortgage industry was among the foremost casualties of the raging inflation and double-digit interest rates which resulted from Arthur Burns' monetary mayhem. By 1980, for example, the federally regulated S&Ls held about $425 billion of home mortgages bearing an average interest rate of 4 percent in an environment in which open market interest rates had soared to 15 percent. On a mark-to-market basis, therefore, the industry was deeply insolvent.

As indicated above, a recurrent pattern now set in where one deformation from the breakdown of sound money only begat another. In this case it was a witches' brew of accounting make-believe and deregulation served up by the Reagan White House. The heart of the problem was that the S&L industry was heavily concentrated in Republican congressional districts, thereby militating in favor of some kind of reprieve from the harsh medicine of the free market.

VOODOO ECONOMICS: THE ORIGINAL PLAN TO EXTEND AND PRETEND

Yet the thrift industry was so deeply insolvent that it would have required a $25 billion bailout, a figure nearly as big as Reagan's entire spending cut package. As budget director, I feverishly opposed giving back one dime of those hard-won spending cuts in order to transfer cash to the insolvent thrifts. At the same time, the White House politicos led by Ed Meese waved their Adam Smith banners furiously, insisting that the thrift industry deserved Uncle Sam's help because the S&Ls had not caused the crisis, which was more or less true.

Not a problem
, came the answer from the Treasury Department. The S&Ls would be enabled to raise billions in “regulatory” equity by selling net-worth certificates to the government insurance fund which, in turn, would pay for this new stock, not with cash, but with IOUs. Self-evidently, an arrangement in which bankrupt S&Ls loaned money to the federal government so that it could buy their own worthless equity would have made Charles Ponzi proud.

Treasury officials rationalized this scam as a bridge to buy time so that, as it turned out, an even more misguided cure could take hold; namely, deregulation of the S&Ls' asset powers. Their seat-of-the-pants theory was that home mortgage lending was a “bad business” and that S&Ls could survive only if they were permitted to escape from their alleged balance sheet prison, where traditionally 80 percent or more of assets consisted of home mortgages. Diversification into commercial real estate, business loans, and capital securities including junk bonds, on the other hand, was heralded as an especially good idea because these were purportedly “higher return” investments.

It is hard to find a more discombobulated confluence of confused ideas and bad policies. Home mortgage lending was actually a good business in which the S&Ls had built long-term core competence, but it had been turned into a nightmare by the inflationary monetary policies of the Fed. Now, in an effort to mitigate the damage, the S&Ls were being turned loose to enter the commercial real estate lending business—about which they knew nothing, and at the worst possible time.

As described in
chapter 6
, the “coalition of the bought,” which had pushed through the giant 1981 tax cuts, had included full representation from the commercial real estate development industry, and they had come away from the trough with a stupendous prize; namely, the privilege of ultra-rapid (ten-year) tax depreciation on office, hotel, and other buildings which ordinarily had useful lives of thirty to fifty years. Accordingly, as soon as the economy emerged from the Volcker recession, commercial building was off to the tax-incentivized races, and the newly liberated thrifts were in the thick of the lending.

ROGUE'S ARMY OF BORN-AGAIN THRIFTS