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I've been reading a couple of books on economics out of curiosity and it got me thinking about the 2007 financial crisis. Hindsight is always 20/20, but if you've ever worked with lower income people it's impossible not to notice financial literacy/decision making typically are not skills they possess. I run into people very often who possess no concept of debt or the consequences of it - particularly as it relates to interest.

That all said, if I were running a bank and my goal were to generate wealth, it's a no-brainer that I wouldn't be taking bets on subprime mortgages. Likelihood of default is high, likelihood of delinquency is high, and the worst part is that it's not in my experience due to an inherently untenable financial situation - it's a lot of irresponsible and/or uneducated financial decisions. That last part being important because a lack of money isn't really the inherent problem - it's how the money gets spent.

Subsequently I find it very interesting that all these big banks effectively made bets on high risk families paying large debts. It seems extremely obvious to me what the outcome would be.

Are there other factors which affected the bank's decisions? Why did they think this would pay off?

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    $\begingroup$ Is it really such a no-brainer? Other banks were making money hand-over-fist with these mortgages - do you really want to be left out? And the banks that issued the mortgages weren't the same banks that lost money by holding them. $\endgroup$ Commented Jun 12, 2023 at 7:51
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    $\begingroup$ if you've ever worked with lower income people it's impossible not to notice financial literacy/decision making typically are not skills they possess — I find this overgeneralisation somewhat offensive. There are many low-income people who manage their budget very well, and also a fair number of people born rich who don't manage it at all (in the worst case, squander their entire fortune). It's people who neither have money nor financial literacy who get into trouble the quickest. $\endgroup$
    – gerrit
    Commented Jun 12, 2023 at 8:35
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    $\begingroup$ The math summary is: If a single loan has a 50% chance of making $100k profit, and 50% of $10k loss, then the expected profit is $45k. If you have a 10 of these whose odds are independent, then there's 99.9% chance of making at least some profit on average. (Hindsight: The odds of failures weren't independent.) $\endgroup$ Commented Jun 12, 2023 at 17:06
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    $\begingroup$ @gerrit "There are many low-income people who manage their budget very well" - yes, there are. But many don't, so this was also an overgeneralisation. And the fact that the crisis happened is strong evidence that the ratio of the population you described was not high enough. $\endgroup$
    – vsz
    Commented Jun 13, 2023 at 4:25
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    $\begingroup$ @GrantCurell It's not directly salient to answering the question, but the generalisation is neither necessary for the question nor fair to those poor people who are financially responsible. It's not a data-driven statement either, because the majority of poor people never buy homes to begin with and "approved for a risky mortgage" is not the same as lacking financial literacy, in particular not without considering a control group who were not approved and independently assessing the financial literacy of both groups. $\endgroup$
    – gerrit
    Commented Jun 13, 2023 at 13:37

3 Answers 3

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If you want all details read this excellent Brookings report on the Origins of the Financial Crisis by Baily et al. Its an excellent source on this topic and it is not too technical for laymen to understand.

Here is a summary of the report:

First, there was quite large market of people in the US who traditionally were not able to get mortgages due to poor lending scores and other issues. This in itself is not reason to extent mortgages to such people because banks of course don't want to get bankrupt, however it meant that there was always large market that businesses would want to tap into if they could.

This became possible in late 70s thanks to several factors. First was financial innovation, namely adjustable rate mortgages with no down payment and teaser rates. Second, was securitization which was pioneered by government-sponsored enterprises devoted to mortgage lend­ing, Fannie Mae and Freddie Mac. These organizations were originally set up by government to buy mortgages from banks that met certain criteria to promote borrowing to poorer households at low interest rate and securitization was seen as an innovation that can help with this. This is because mortgages to low income households were always riskier and hence paradoxically the poorer you are the more interest you would have to pay or you might left without ability to tap into credit market at all. Securitization was supposed to solve this issue by combining such mortgages with higher quality mortgages where the whole bundle would be considered safe. This securitization got more complex over years as financial firms developed collat­eralized debt obligations, and later these were even insured by insurance companies in cause of default.

All this securitization made people believe that these financial assets are extremely safe (hindsight is 20/20). This emboldened banks to start lending to households they would not lend before. This was further fueled by very easy monetary policy that kept interest rates low (which in turn means that the adjustable rate mortgage were actually very affordable), and in addition by lack of financial regulation that would impose more conservative lending standards. Moreover, moral hazard likely make this even worse as some banks considered themselves too big to fail.

This system worked while the adjustable mortgages were affordable for people in low interest environment and with house prices rising (which increased value of collateral for the household). Fed was pursuing loose monetary policy for long time already, and house prices had long-run upward trend for decades. As a result very few people considered these lending practices highly risky at the time. People simply believed that securitization solved the issue. In addition some of the financial instruments were given better rating from rating agencies than they should.

When both interest rates increased and house prices dropped it resulted in meltdown. The problem with adjustable rate mortgages is that although they can be much cheaper they make household exposed to interest rate risk. The fall in house prices also meant that people were not able to refinance so default was only option for many.

So to summarize it, banks did not perceived these loans as risky. Mortgage backed securities had good ratings. Moreover, the whole idea of securitization is actually a sensible idea, it was developed by government sponsored enterprises with good intentions in mind. Moreover, when central banks pursue loose monetary policy for some reason many financiers expect it to last forever (even recent hikes in interest rate resulted in bank failures despite of all the new regulations that force banks to be more conservative in lending). In addition at the time lack of financial regulation combined with implicit government guarantees (because of too big to fail issue) created incentives for people to worry less about risk then they would do if there are no guarantees.

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  • $\begingroup$ Comments have been moved to chat; please do not continue the discussion here. Before posting a comment below this one, please review the purposes of comments. Comments that do not request clarification or suggest improvements usually belong as an answer, on Economics Meta, or in Economics Chat. Comments continuing discussion may be removed. $\endgroup$
    – 1muflon1
    Commented Jun 16, 2023 at 13:51
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@1muflon1's answer is correct, but only tells half of the story. The other half of the story, that Brookings studiously avoids mentioning, because it conflicts with their values, is that lenders were forced to make sub-prime loans by government policy:

during the 1980s and 1990s, powerful activist groups demanded that banks reduce their lending standards, such as reliance on creditworthiness and higher down payments, and organized protests against those that would not, claiming that higher standards disproportionately hurt low-income earners and minorities. For example, in congressional testimony, one community activist, Gale Cincotta, made clear that “lenders will respond to the most conservative standards unless the GSEs are aggressive and convincing in their efforts to expand historically narrow underwriting.”

Under enormous pressure from these groups, the Clinton administration decided to expand federal government servicing of low-income and minority borrowers through various “affordable-housing goals.” Imposed in 1992, the different goals created a quota system requiring a certain percentage of the loans that the GSEs acquired each year to have been made to borrowers in financially isolated communities or those who were at or below the median income in the communities in which they lived.

The enforcement mechanisms had teeth:

Bank regulators began to pressure banks to make subprime loans. Guidelines became mandates as each bank was assigned a letter grade on CRA loans. Banks could not even open ATMs or branches, much less acquire another bank, without a passing grade—and getting a passing grade was no longer about meeting local credit needs. As then-Federal Reserve Chairman Alan Greenspan testified to Congress in 2008, “the early stages of the subprime [mortgage] market... essentially emerged out of the CRA.”

and were continuously expanded until 2008 (Bush continued Clinton's policies in this area, as part of his effort to try to appeal to minorities):

The initial low-to-moderate income quota for Fannie and Freddie was around 30 percent per year, a goal that was not too hard for them to meet. But the LMI goal was continually raised, to 40 percent in 1996, then 50 percent in 2001, and up to 56 percent in 2008. Impressively for a government agency, the GSEs hit their targets—by June 30, 2008, 57 percent of the 55 million mortgages in the financial system were non-traditional, meaning either subprime or otherwise of low quality.

Here are the links to the FREDDIE MAC and FANNIE MAE reports if anyone wants to verify the figures above. They are correct. E.g. for 2007(page 5), Fannie Mae had a goal of 55% of all mortgages being to "Low to moderate Income" and achieved 55.3% and a goal of 25% being "Special Affordable" (defined as "low-income families in low-income areas and very low-income families") and achieved 26.5%.

It's easy to see that if you are forced, by government policy, to write 1/4 of your mortgages to very low income people, usually with very low credit scores and a high likelihood of not being able to pay, the only mortgages you can give them are sub-prime ones. Things like Ninja Loans are not comprehensible without the context that they counted towards a high, mandatory quota.

Note that I'm not implying this was specific to Fannie and Freddie. All lenders were pressured into this sort of lending as described in my second quote, but these 2 accounted for more lending than everyone else combined leading into the crisis and were extremely open about their quotas, so they are the best illustrative example.

The banks tried to make lemons into lemonade and engaged in all the financial skull-duggery described by Brookings, because:

Whatever went on inside the various agencies, financial regulators—whose job it was to enforce safety and soundness regulations—in the end deferred to government affordable-housing goals. Conflicted laws created conflicted regulations and conflicted regulators. Safety and soundness considerations required that regulators step on the brake. Affordable-housing goals required them to step on the gas.

So there were 2 ends of the horseshoe, government mandates and the willingness of the financial system to exploit the resulting tsunami of sub-prime loans that created the crisis.

Sources:

https://fee.org/articles/how-the-federal-government-created-the-subprime-mortgage-crisis/ https://uspolicymetrics.com/the-clinton-era-roots-of-the-financial-crisis/ https://www.aei.org/articles/fannie-freddie-caused-the-financial-crisis/ https://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_wallison_dissent.pdf

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    – 1muflon1
    Commented Jun 13, 2023 at 20:58
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Quick answer: the banks who created the mortgages got paid for creating them (origination fees) then offloaded the risky loans to someone else within 30-60 days. Why there was a downstream market for these loans...that's up for debate / speculation / books.

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    $\begingroup$ The government backed these sub-prime loans. $\endgroup$
    – Nayuki
    Commented Jun 13, 2023 at 19:45

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