Us And Credit: A Little History

Easy credit has large, positive, immediate, and widely distributed benefits, whereas the costs all lie in the future. It has a payoff structure that is precisely the one desired by politicians, which is why so many countries have succumbed to its lure. Rich countries have, over time, built institutions such as financial sector regulators and supervisors, which can stand up to politicians and deflect such short term myopia. The problem in the United States this time was that the politicians found a way around these regulatory structures, and eventually public support for housing credit was so widespread that few regulators, if any, dared oppose it.

Prior to the Great Depression (also a time of great credit expansion and by golly also a period of great income inequality) mortgages were different. At that time mortgages where offered only by banks and credit unions and were short term, 5 years with a single capital repayment when the loan came due. These loans were variable rate, so the borrower bore the credit risk. In the 30s at the height of the Depression, loans were drying up and foreclosures a looming threat (10% of loans were threatened by foreclosure). So the government stepped in, creating HOLC and the FHA. HOLC was to buy defaulting loans and restructure them to 20 year amortizing mortgages with a fixed rate. The government held these loans for a short time but moved these into the private sector when it could … but the private sector at the time did not trust long term loans. So … the FHA guaranteed them, financing this by requiring insurance. HOLC disbanded in 1936 and was restructured as FNMA (Fannie Mae). FNMA bought FHA insured mortgages and financed them by issuing long term bonds sold to insurance and pension funds. 

In the 1960s short term interest rates went up and the system broke. To fix it, FNMA was split in two, FNMA and GNMA (Ginnie Mae). GNMA continued as FNMA had before, but now FNMA sold its repackaged loans directly to the public. When Lyndon Johnson had budget fights at hand, FNMA balance sheets were removed as a government liability. FHLM (Freddie Mae) was also created at this time to repackage loans made by the thrifts (credit unions) … and for the same reason it too was privatized. In the 1970s and early 80s. Fed chairman Paul Volcker increased short term interest rates to “hitherto unimagined levels” to tame inflation. This was lethal for the savings and loan industry and it would have gone bankrupt. But … housing was too important politically and the industry too well connected. So it was deregulated. The sizeable loss for the thrifts was converted neatly into an enormous loss for the taxpayers. This meant that Fannie and Freddie came to play in increasingly important role in mortgage financing. 

Fan and Fred are curious beasts, known to the industry (apparently) as GSEs or government sponsered enterprises. They have private shareholders to whom their profits are due. They are however not public. They have political perks and duties. They are exempt from federal and state taxes, government appointees on their boards, and a line of credit from the US Treasury. The “full faith and credit” of the US backs these organizations. These perks come with a mandate to — support housing finance. To do this they do two things, they buy mortgages which conform to certain size limits and credit standards. They also package these loans together and issue mortgage backed securties after insuring them against default. They also started borrowing directly from the market and investing mortgages backed securities. 

Here is where the politicians stepped in. In 1992 Congress passed the “Federal Housing Enterprise, Safety, and Soundness Act.” The act instructed HUD to develop affordable housing goals for the agencies and monitor progress towards these goals. Rajan notes that when Congress writes an act with “Safety and Soundness” in the title, you must realize that Congress means that ironically. Even though Fan/Fred couldn’t head off this bill, they did manage to restructure it to their advantage. They insured that the legislation required that they hold less capital than other regulated financial institutions and that this new regulator (within HUD) was subject to Congressional appropriations. This meant that if it really started, you know, regulating Fan/Fred the friends of Fan/Fred in Congress could cut their purse strings. 

The combination of an activist Congress, government supported private firms hungry for profit, and a weak and pliant regulator proved disastrous.

Under the Clinton admin, HUD steadily increased the amount of funding it required the agencies to allocate to low income housing. The administration set ever higher mandates for the percentage of these loans, from 42% in 1995 to 50% in 2000. In 1977 the CRA (community reinvestment act) had required banks to lend in their local markets, but set no explicit goals, which was left to the regulators. The Clinton admin put pressure on the regulators to apply threats and fines on banks to increase loans … and so they did. In 2000, the Clinton admin ramatically cut the minimum down payment required to qualify for an FHA (federally insured loan) to 3%,  increased the maximum size of the mortgage, and halved the premiums it charged for the insurance. Mr Bush’s administration doubled down on these practices. The pushed the mandate to 56%. 

How much lending went this way? Well, in Rajan’s words