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THE SUB-PRIME MORTGAGE CRISIS: THE PROBLEM OF

INSTITUTIONAL RESPONSE S TO A COMMUNITY LEVEL

PROBLEM

Americas Leaders Program

Arunan Sivalingam

Fall 2008

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SUB -PRIME CRISISHow Did We Get Here?

Fall 2008

AbstractThis paper will examine the historical factors that have led to the current financial meltdown, led in large

part because of the subprime mortgage market. Although blame has been aimed at excessive regulation

and de-regulation alike, a major factor has been in the micro mechanisms that exist in the mortgage mar-

ket itself. These mechanisms are closely linked to macro level factors in the full chain of securitization

that has taken place with the increase in new and innovative financial instruments. This paper concludes

with analyzing the ineffective and misguided policy responses aimed at larger institutional actors, and

ways in which responses can be undertaken at the community level.

This system was designed for plain vanilla loans, and we were trying to push chocolate sundaes through

the gears.

MARC GOTT, former director in Fannie Mae's loan-

servicing department, explaining the company's collapse

The collapse of four major financial entities in the United States, and a government backed rescue

package of $700 Billion dollars (roughly the government calculated cost of the Iraq War so far) has

helped nerve up expectations of the economic storm of the century. The causes of the crisis have been

tossed around verbatim, with excess deregulation and regulation spawned as culprits. A historic election

year has not made matters any less contentious; waking up a blissful world economy from its splendour.

Frugality is the term being used over excess. In these times Capitalism is losing its candour, as the

American electorate has become infuriated over the use of tax dollars to bail-out the financial sector. It

has become known as the socializing of risk and the death of the free market. Embedded within this

sudden restructuring and shifting of the global credit markets is the fundamental assumption it was built

on for the last thirty years: deregulation and the free functioning of the market. The old mantras utter-

ances do not seem to sound the same chime. The emerging market (BRICs) and the least developing

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countries have taken the tone of chastising the United States for not being able to keep its own cards in

check, while lecturing others. The chief International Financial Institutions (IFIs), the World Bank and

the International Monetary Fund (IMF) are also quickly working to recast the way in which market fun-

damentals need to be examined; a sudden change in decades old policy. Although the crisis has been a

result of interactions taking place in the real estate and housing market in the United States, the effectshave gone global. It is here where the roots of the problem need to be examined, and if the responses can

adequately help negate the unprecedented decline being felt in the global economy.

Black cat, white cat as long as it catches mice.

Deng Xiopeng

It is often quoted that history repeats itself; the current financial situation does not show itself to

be an exception to that rule. To understand the current crisis, going back to a similar time, namely the

1930s is important. After all, it is after the great depression that the values and institutional mechanisms

leading to the current crisis were created.

The great depression revealed just how much chaos could be created by mere psychological panic. Like

we see today, the failure of many large institutions (mainly banks) created widespread fear. It was be-

cause of this, President Roosevelt instituted specific institutional reforms such as the Federal Deposit In-

surance Corporation (FDIC) to guarantee bank savings to a sufficient level. More important was Roose-

velts creation of Fannie Mae, properly known as the Federal National Mortgage Association (FNMA) in

1938 (Congleton, 2008). This fundamentally altered a basic value system in America: namely the ideal

for home ownership. Before this point, mortgages were held and dealt with by banks, thus all the risk fell

on them. After the creation of Fannie Mae, mortgages were spread out more within the financial system.

Fannie Maes mandate was to create credit so banks could make more mortgage loans, and thus have

more people move toward home ownership and be a part of the ownership society (Congleton, 2008).

The inclusion of other exogenous factors helped create what is known as the post World War II boom.

Much of this has to do with individual psychology then sound public policy. Peacetime brought forth a

new invigoration of freedom and the building up of familial relationships, causing an increase in housing

and Sub-urbanism. By the 1960s, homeownership had reached over 60%, although at such a high rate,

an additional housing institution was created in 1968. Freddie Mac, or properly know as the Federal

Home Loan Mortgage Corporation (FHLMC) was created to further increase the liquidity and ultimate

demand for mortgages (Congleton, 2008, 3). These two events are crucial when examining the current

crisis, which will be explored later in this paper. The U.S government worked diligently to increase

home ownership, with Fannie Mae becoming a private company with quasi government regulation. This

meant that indirectly its loans would be backed by the government, which was not the case, but later pro-

vided the underlying impetus for increased buying of its securities.

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Another important piece of policy to examine is the Community Reinvestment Act (CRA) of 1977. When

looking at the current crisis there is blame being pointed at both the supply and demand side of the mort-

gage market. Although many are pointing to the predatory supply side lending of loans, many are also

firing back at those who took at loans they could not afford. Yet convenience glosses over the fact that

the repayment rate with the CRA was much higher than seen currently with the sub-prime mortgage mar-ket. Unlike predatory lending, which created distorted incentives for brokers to make a profit from in-

creasing loans to customers, the CRA was focused on providing credit to low-income individuals who had

the means and desire to own a home. New York is a good case city that reveals the outcomes of CRA

programming in helping residents buy their own homes. Local Initiatives Support Corporation, a key

partner organization with the City of New York helped over 17,000 low income families receive loans.

Company president Michael Rubinger states, Guess how many of those 17,000 loans have ended in

foreclosure...thats right five. (U.S Newswire, 2008, 3). Luci Ellis in her paper, The Housing Meltdown

reveals how banks covered by the CRA made less sub-prime loans then the independent banks in crisis

now. Rubinger believes it is the easy scapegoat to blame government programs, and not the lax manage-

ment guidelines in place by financial institutions to look at profit over following sound business proto-

cols. Government policy will require some blame, yet going back to 1977 to the Community Reinvest-

ment Act has not provided the evidence for such charges. The push for Affordable mortgages came later

in 1992 by Freddie and Fannie (with government encouragement) and will be examined later in this pa-

per.

The crack cocaine of our generation appears to be debt. We just cant seem to get enough of it. And,

every time it looks like the U.S consumer may be approaching [their] maximum tolerance level, somebody

figures out how to lever even more debt using some new and more complex financing...

Jeff Saut, Chief Investment Strategist, Raymond

James & Associates, September 2007

The last and most important area to examine in the lead up to the crisis is the private supply-side, i.e. the

role of predatory lending. As shown in the preceding paragraph the Community Reinvestment Act helped

those who would otherwise not be eligible for mortgage loans. Yet the approach was much different than

that taken by parallel institutions, which saw these loans as a way to make easy profit. In his bookBad

Money, Kevin Phillips documents the evolution of derivatives and financial instruments starting from the

early 1970s. It is no coincidence that a proliferation of such securitization instruments increased in themid- eighties at a time where the economy was in a down turn and interest rates were high. Investors

were looking for options to help hedge uncertainties in the market. Although this phenomenon is not par-

ticularly relevant for that time, it gives a starting point for how such investment instruments eventually

brought about the current financial crisis. The derivatives market acted as the pull for lenders and brokers

in the housing market. The shear monetary value of the derivatives market is telling: some estimates have

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tions taken by those in the prime and sub-prime mortgage market, the findings were very revealing.

Many sub-prime borrowers did not seek out assistance from family or others who were familiar with

loans, as compared to those in the prime market. In addition, many sub-prime borrowers stated they felt

confident with their credit ratings and personal finances, when this was in direct contradiction to their ac-

tual financial situation (Lax, H., Manti, M., Raca, P., & Zorn.,P, 2004). Thus a fundamental gap existedbetween what borrowers thought they knew and were getting. Many of the brokers actually worked in

clauses which put penalties for repaying a loan too quickly, and extra processing and home inspection

fees which were not necessary (Renuart, 2004). Yet the extra spread on interest rates between prime and

subprime borrowers is understandable along with other miscellaneous fees when looked in the broad

context of securitization in the previous paragraph (Renuart, 2004). The extra fees and increased interest

rates were what would be paid out to investors who bought these mortgages on the secondary market, thus

there was a push from mortgage lenders to brokers to get such extra spreads. In the end one can see the

impact of perverse incentives to sound business practice as shown by the figure to the right. The evidence

can be seen by this one statistic alone: the value of mortgage-backed securities issued by the subprime

market grew from $11 billion in 1994 to $133 billion in 2002, a period of less than ten years (Renuart,

2004, 472).

Although the crisis was spurred by the mechanics of what was taking place in domestic housing markets

all over the United States, the micro-level phenomenon was being fed by macro level factors (namely the

need for greater investor returns).

This extended internationally to investors looking for sufficient returns, and the United States who could

only finance its need for more consumption through its debt. A well known fact for some time now has

been that low-income countries have been financing increased consumption growth in the United States

and other countries. This has been done mainly through their purchasing of low-interest bearing treasury

notes and bonds, as pointed out by Stiglitz and others. Yet the Bond Market Association reports that the

secondary mortgage and mortgage derivative market has been larger than the US Treasury note and bond

market since 2000 (Congleton, 2008, 6). This again shows the large amount of leverage these types of

debt instruments held even internationally.

The low-income countries were financing the growth of the OECD (Organization for Economic Coopera-

tion and Development) through their high savings rates, interestingly the two countries with the highest

increased rate of savings were China and East Asia (see figure). Yet ironically the U.S strategy was not to

save, but try to make up its short-fall by the returns on its exported investment instruments. As pointed

out by Carman Reinhart and Kenneth Rogoff, instead of the U.S recycling surplus dollars as in the early

70s it borrowed them, and lent them out to a developing market within its own borders. Over a trillion

dollars was put into the subprime market with the same end result of default, only this time it was not

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countries, but individuals spanning various spatial locations all over the United States (Reinhart, Rogoff

2008).

Nobody foresaw the Great Depression of the 1930s, or the crises which affected Japan and Southeast

Asia in the early and late 1990s. In fact, each downturn was preceded by a period of non-inflationary

growth exuberant enough to lead many commentators to suggest that a new era had arrived.

Bank for International Settlements, June 2007

September 15, 2008, Black Monday as it has come to be called signalled the beginning of the end

for the recent financial crisis. It was here that everyone learned the two biggest entities backing the mar-

ket for mortgages (Fannie and Freddie Mae) needed to go under government conservatorship. Further-

more, the Fed had to step in and provide AIG with an $85 billion dollar bailout, its first of many, and saw

five of the nations financial institutions ceasing to no longer exist in less than a few weeks. Along with

the fall of banks and the mergers of others, came the domino effect in the stock markets. Two trillion dol-

lars in retirement savings wiped out in mere weeks, as Washington Post staff writer Bridget Schulte asked

pointedly in her column, is it good-bye to the golden years? The domino effect of seeing such major in-

stitutional players fall at once, created a psychological panic not seen in at least over half a century. The

fact that this all happened in the middle of a all-important election, and right after a time when Americans

were still furious about high oil prices (due to high speculation in commodities) could not make matters

any worse. To exhaust through the timeline of events would be tedious, but what is important to point

out is the all encompassing measure of the contentious $700 billion dollar bailout. As soon as it became

evident the monstrous beast that stood before the world financial system, Treasury Secretary Henry Paul-

son moved quickly for congress to approve his bailout plan. Criticism abounded as the initial plan, a

mere two and a half pages asked for sweeping authorities. Section 8 was a case in point, which stated

decisions by the Secretary would be non reviewable by any court of law or administrative agency, even

more pointed, no mention of how taxpayer money would be repaid ( Emergency Economic Stabilization

Act 2008). The proposal was criticized by both the right and the left, by economists to laypersons, as the

bill proposed no specific mechanism to address the impending crisis. As Jim Jubak, stated in his MSN

money column, the gift of taxpayer dollars would only give further incentive to Wall Street to continue its

entrenched ways, and provide an incentive under Paulsons plan to overvalue asset prices (Jubak, 2008).

An election year did not make things easier, as it was politically convenient to call out the bailout of Wall

Street firms, over those hurting on Main Street (Obama Press speech, Oct 2008).

The inability of Paulson to stick to a concrete plan, helped to weaken confidence on Wall Street. As the

bailout was being voted on a second time, and even with its passage, the mood on Wall Street remained.

The Week of October 6-10, showed the largest drop in the DJIA (Dow Jones Industrial Average) since

1933, a decline of over 18 percent. Although the crisis was due to defaults by individual borrowers across

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the country it was financial institutions that have been received federal assistance. The figure to the right

shows the large amount of non bank losses in this crisis. But the fed under the auspices of the Treasury

still pursued its strategy to inject capital into banks. By the end of October, the Fed was forcing the nine

largest banks to accept credit, even at their refusal. Pearlstein criticizes this dyslexia of the Treasury as

the reason the crisis was not being dealt with appropriately. Only after two months into the meltdown, didthe fed offer an additional $800 billion targeted toward consumer spending. Working backwards toward

the causes of the financial crisis, the focus on banks and macro level institutions has revealed the height

of moral hazard, as those who created the crises are the ones being offered the first ride out. No suffi-

cient reform has taken place against the institutions which helped perpetrate this crisis, only the lack of

transparency abounds. As can be seen with the reluctance of the Treasury to detail how two trillion in

TARP (Troubled Asset Relief Program) money was dealt out.

New reports have now surfaced that many lenders using the cover of the FHA (Federal Housing Admin-

istration) have come back as new companies; cashing in on the insurance backing of the FHA, to againmake profit from predatory lending (Terhune & Berner, 2008). A spokesperson of the FHA, even admit-

ted, [the FHA] is not ready to deal with the onslaught of new lenders who are trying to cash in. (Ter-

hune & Berner 2008, 38). Although cries of socialism abound, it is really the long-standing corporate

nanny state that is being shown for what it has truly been. The lack of regulation, and the way in which

the current bailout is being handled is only helping financial institutions who were to big to fail merge

and become too big to fail. In recounting a childhood question Ralph Nader asked his father, he describes

the situation perfectly. Why will capitalism always survive.? Naders father replied, Because Social-

ism will always be used to save it.

One of the biggest problems that have surfaced due to the current crisis has been the reluctance for those

operating within the financial system to acknowledge what has happened. Just as William Paley rebuked

Smiths notion of the Invisible Hand with his argument of the providence given by natural forces (Sher-

mer, 2008). The same was being done by a key player in the current financial crisis, Mr. Greenspan, as he

remarked, who am I a mere moral to second guess the collective wisdom of markets (Henwood, 2008).

It seems all people wanted was recognition by Wall Street and the major players who were closely linked

to this crisis to acknowledge they had not taken the proper precautionary measures to avoid this inevitable

crisis. In his October 10 column of the Washington Post, Stephen Pearlstein chastised the Wall Street elite

for not even speaking a word to the public after the crisis. The only appearances they made were in pri-

vate vehicles to the awaiting closed door rooms to be briefed by Treasury Secretary Paulson, and Fed

Chairman Bernanke (Pearlstein, 2008). In contrast, their Japanese counterparts during the Asian crisis of

1997 saw executives publically apologize for what had been an outcome of their business operations (not

to underestimate the obvious cultural differences to expect such a response from the Wall Street commu-

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nity). This has become a metaphor for the sense of entitlement many firms are expecting now in terms of

federal funds to take them through the crisis. The attitude has been to not blame those who were in posi-

tions to be linked to what was happening, but to blame their crisis of faith in the long held ideal of the

unregulated market. In his October 24th testimony before congress, former Fed Chairman Greenspan re-

marked how he was in a state of shock that what he fundamentally believed his whole life (minimallyregulated free markets) had unravelled in a matter of weeks. Yet many warnings had been sent his way by

advisors and Senators alike, as seen with Senator Feinstein of Californias letter to Mr. Greenspan in

2003, calling for more regulation in the Energy Derivatives market.

Although again, this crisis was created and generated at the local level in the offices of mortgages brokers

and lenders across the country, the solutions have been implemented and pushed toward macro level play-

ers such as the banks and financial institutions who played a leading role in growing their risk to unjusti-

fiable levels. It is therefore important to look at solutions for homeowners, and structural changes to not

allow for another housing based bubble to occur, as has been the root cause for many other crisis as well(Asian Crisis of 1997, etc).

Yale economist, Robert Shiller, details various key findings about the current crisis that have not been

well researched in the area of residential housing. Beyond his obvious findings of the increase in home-

ownership rate beginning in 1997, and its positive correlation with investment in housing as a share of

GDP, his most interesting find is the lack of historical data; no long-term data exists in any country re-

garding house prices (Shiller 2008). Shillers research found the belief in increased home values was a

mere psychological phenomenon rather than economical. If Baumols law is correct; stating those goods

and services that are akin to technological processes decrease in value over time, then it is easy to under-

stand the fall in housing. This is applicable to housing, as inputs (interior, finish) are always changing to

fit stylistic and cost considerations. (Shiller, 2008). Therefore housing prices can fall, as it has been

shown in various places, not just with the current U.S financial crisis. The problem has been the underly-

ing belief that fixed capital (land) and increase in population would inevitably create scarcity and there-

fore higher prices (Shiller, 2008). Since the housing market has shown to be about psychological specula-

tion and mis-information, it is important to create mechanisms to prevent such misalignment of informa-

tion. Many have called for looking at housing like insurance, a standard plan applies and opt-out is only

considered if the individual choose such a plan (Shiller, Barr, Mullainathan, and Shafir). Due to the fact

mortgages and as can be argued for health insurance, the problem of asymmetric information is large in

comparison to the benefit of full consumer autonomy. Many individuals do not understand the underlying

economic and legal issues that go into such processes. It is therefore better in the long-run, and society in

general (seeing the positive as avoidance of large scale crisis) to provide standardized sets of mortgages,

than allowing for supplier (lenders) to create terms that are beneficial for their own purposes. It has been

shown the biggest aspect in helping to create the current crisis was the way in which lenders, and con-

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sumer misinformation has helped spawn the financial meltdown. It is thus imperative that these mecha-

nisms be re-examined, and ensures false and misaligned reward structures are not in place to help those

who use predatory schemes to profit. Ironically, this has not been the case, with the government still try-

ing to pursue the ideal of every American owning their own home. The fed has done what it can to prop

up the housing market, not trying to address the underlying issue that many of the individuals should nothave gotten loans in the first place. In addition, on Dec 3 the Treasury Department announced its plan to

intervene in the mortgage market directly, decreasing the borrowing rate to 4.5% (Washington Post, Dec 3

2008). The problem this has caused is individuals now waiting for better rates, and the government trying

to create a false mechanism to promote perusals for home loans, and more lenders to give them ironi-

cally the initial cause of the problem. As various individuals have pointed out, institutional mechanism to

stimulate a false mechanism to increase home loans is the wrong response; rather the rethinking of mort-

gage lending itself is needed.

In late September I was surprised to see advertisement for a Save the block party over the traditionaluse of the term. Instead of celebrating it has become a time of trying to hold people together. The head-

lines have been numerous, presenting the enormous fall in home values and foreclosures. Although the

responses have been necessary, the question has been around the appropriateness and targeting of the aid.

It has been increasingly understood the mechanisms which helped create the current crisis: misinforma-

tion created at the community level in giving loans to unqualified and uninformed individuals. Although

the response has been at targeting major financial institutions, and trying to keep home sales and home

values high and sustained. Yet the irony is both measures, the major institutions helped incentivise the

practices which led up to the current mess, with the current crisis a outcome of false expectations in an

overinflated housing market. It is thus important to realize that the lesson learned from this crisis is at the

grassroots level. Looking at the way business is conducted, and the role of those who conduct financial

transactions and their responsibility toward the public good must be closely evaluated (Khurana, Nohria,

2008). The responses have been the major concerns in the aftermath of the crisis, not the actions that

have led up to the crisis which will help dictate future solutions and preventative measures.

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References

Abromowitz, D.M., and Jakabovics, A. Shared Equity in Action: Recovery and Affordability Are Possible Amid theCrash in Housing Prices. Center for American Progress, Washington, D.C (April 9).

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from ABI/INFORM Global database.

Caplin, Andrew., Cunningham, N., Engler, M., and Pollock, F. 2008. Facilitating Shared Appreciation Mortgages toPrevent Housing Crashes and Affordability Crises. The Brookings Institution, Washington, D.C (Sept 2008).

Congleton, R.D. (Oct 2, 2008). Notes on the Financial Crisis and Bail Out, Moderate Scepticism. George MasonUniversity.

CRA Not to Blame for Economic Crisis. (Oct 6, 2008). US Newswire. Retrieved October 13, 2008, from Academic

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Nations Publications.

Dolinar, R. Why Did This Have to Happen? (Aug 25, 2008).Endocrine Today. 6(15), 26.

Economist. (Sept 20, 2008). The Last Resort. 388 (8598), 86.

Feinstein, D. (November 5, 2003). Letter Addressed to Alan Greespan. http://feinstein.senate.gov/public/

Ferguson, N. (Oct 2, 2008). The End of Prosperity. TIME. 172 (14), 41.

Henwood, D. (Oct 13, 2008). Crisis of a Gilded Age. The Nation.

Jones, O., and Grebler, L. (1961). The Secondary Mortgage Market: Its Purpose, Performance, and Potential. LosAngeles: UCLA Business School.

Khurana, R and Nitin N. (Oct 2008). Its Time to Make Management a True Profession.Harvard Business Review.

70-80.

Lax, H., Manti, M., Raca, P., & Zorn.,P.(2004). Subprime Lending: An investigation of Economic Efficiency. In K.

Rengert (Eds),Housing Policy Debate. 15, 3, p. 533-573. Fannie Mae Foundation.

Paley, W.Natural Theology: Or, Evidences of the Existence and Attributes of the Deity, Collected from the Appear-

ances of Nature. Hallowell, ME: Glazier & Co., 1826.

Reinhart, C., Rogoff, K. (2008). Is the 2007 U.S. Sub-Prime Financial Crisis So Different? An InternationalHistorical Comparison . School of Public Policy and Department of Economics. University of Maryland.

Jubak, J. (2008). Lets Not Rush to Blow $700 Billion. MSN Money.

Renuart, E. (2004). An Overview of the Predatory Mortgage Lending Process. In K. Rengert (Eds),Housing PolicyDebate. 15, 3, p. 467-503. Fannie Mae Foundation.

Shermer, M. (2008). The Mind of the Market. Altadena: Times Books.

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Terhune, C., Berner, R. (Dec 1, 2008). The Subprime Wolves Are Back.Businessweek.

Appendices:

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