Good intentions sparked credit crisis

Kevin Paterson takes a weekly look at the latest developments in the market and brings you what\'s hot and what\'s not in the world of mortgages

Good intentions sometimes have disastrous consequences, as can be seen when researching the roots of the liquidity crisis that is gripping our economy like an octopus enveloping its prey.

On investigation, a tangled web of greed, ignorance and well meaning meddling becomes apparent, starting with US legislation brought in during the late 1970s and revised in the mid-1990s to help the poorest in society and minimise discrimination by big financial institutions. Sadly, such altruism is often exploited.

The Community Reinvestment Act passed by the US Congress in 1977 required banks to offer credit across their catchment areas and prohibited them from targeting only wealthier neighbourhoods – a practice known as redlining. The most common use of this term concerned mortgage discrimination by banks and other financial institutions.

The purpose of the CRA was to provide credit, including home ownership opportunities, to underserved populations and commercial loans to small businesses. At the time, the legislation met with a considerable amount of opposition from the banking community.

The CRA mandates that each banking institution be evaluated to determine if it has met the credit needs of the whole community. This performance has to be taken into account when the government considers institutions’ applications for deposit facilities.

The Clinton administration strengthened the CRA by focussing regulators’ attention on institutions’ performance in helping to meet community credit needs. In 1995 the act was revised with a view to substantially increasing the amount of loans to small businesses as well as to low and moderate income borrowers. Crucially, these revisions also allowed the securitisation of loans containing sub-prime mortgages.

The secondary mortgage market in the US was created in the late 1930s via two government agencies intended to bring stability to the mortgage market. Known as Freddie Mac and Fannie Mae, these government-sponsored enterprises were not allowed to securitise anything other than prime loans.

These loans were then packaged and sold as mortgage-backed securities to investors, with an implicit guarantee from Freddie Mac and Fannie Mae that all interest, including the principal debt, would be repaid regardless of whether borrowers repaid their loans.

In February 2007 Freddie Mac announced that it would buy sub-prime loans too, but only those on full charge rates and not teaser rates. Even so, this small level of exposure has amounted to more than $12bn in declared losses so far.

The pressure on banks from the US government have been enormous. As Freddie Mac and Fannie Mae only securitised prime loans this effectively gave them a monopoly, with the rest being left to the banks. So anything sub-prime had to be packaged and securitised separately if the banks were to meet their obligations under the revised CRA.

But this does not let the banks off the hook. A spiral of greed started, buoyed by rising property values – US house prices increased by 124% between 1997 and 2006 – and a plummeting base rate. Banks sought innovative, quick and complicated ways of underwriting and packaging sub-prime loans.

The automation of the underwriting process accelerated the problem. In 2007 40% of all sub-prime business was generated by automated underwriting, accompanied by little or no supporting documentation.

This reduced the underwriting time on a typical sub-prime case from more than a week to 30 seconds, with arguably fewer controls in place.

The banks also aggressively targeted brokers who were responsible for more than 68% of all mortgage origination in 2004, of which almost half was sub-prime.

The trend was exacerbated by the erosion of the risk premium charged between prime and sub-prime borrowing. Between 2001 and 2007, this fell from 2.8% to 1.3%, with teaser rates below 4% often being referred to as interest-only ad-justable rate mortgages. The UK outlawed these low-start mortgages in the late 1980s after a scandal.

My point is that finance-related social engineering does not work. This is a message our government should heed, given its continual drum-beating and disregard of concerns about the mandating of long-term fixed rates.