The FCIC Misled The American Public

By Peter J. Wallison.

Everyone agrees that the 2008 financial crisis was the result of a “mortgage meltdown,” the default of an unprecedented number of subprime and Alt-A mortgages (often called nontraditional mortgages, or NTMs) in the U.S. financial system. The central question, then, is why so many of these NTMs were outstanding in 2008. The majority report of the Financial Crisis Inquiry Commission blamed insufficient regulation, which it said allowed the private sector — led by Wall Street — to originate and sell these deficient mortgages to unsuspecting buyers.

As a member of the FCIC, I argued that U.S. government policies — particularly the affordable housing goals (AH goals) imposed in 1992 on the government-backed mortgage giants Fannie Mae and Freddie Mac — were the real cause of the financial crisis. The goals required Fannie and Freddie, when they acquired mortgages from originators, to meet a quota of mortgages that had been made to homebuyers at or below the median income.

The U.S. Department of Housing and Urban Development was given authority to increase the goals and it did so, aggressively, over time. This forced Fannie and Freddie — which previously had limited their purchases to prime loans — to lower their underwriting standards; they could not find a sufficient number of prime mortgages to meet the goal quotas. Figure 1 shows the increases in the AH goals between 1996 and 2007.

RISING FEDERAL AFFORDABLE HOUSING GOALS, 1996 TO 2007

Because Fannie and Freddie dominated the housing-finance system, the deterioration in their underwriting standards caused the standards in the mortgage market as a whole to decline. This built the enormous 1997 to 2007 housing-price bubble. When the bubble collapsed, the result was a nationwide decline in housing and mortgage values, the mortgage meltdown and, eventually, the financial crisis. I made this point in my dissent from the FCIC’s report and, with more data, in my 2015 book, “Hidden in Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Could Happen Again.”[2]

The FCIC majority refused to consider this idea seriously, and focused its report entirely on the private sector:

[I]t was the collapse of the housing bubble — fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages — that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008.[3]

About Fannie Mae, the report said:

We find that the risky practices of Fannie Mae…particularly from 2005 on, led to its fall: practices undertaken to meet Wall Street’s expectations for growth, to regain market share, and to ensure generous compensation for its employees. Affordable housing goals imposed by the Department of Housing and Urban Development (HUD) did contribute marginally to these practices.[emphasis added]

Thus, the FCIC’s claim was that Fannie bought the subprime and risky mortgages that ultimately caused their insolvency because these loans were profitable or enhanced their mar­ket share — what Wall Street wanted; the AH goals contrib­uted only marginally. However, even I was surprised to find, when I finally got access to some of the FCIC’s records after the commission closed down, that the FCIC had received and ignored a great deal of documentation from Fannie and Freddie that contradicted its claims.

The examples are numerous, but a few are included below. They are all from Fannie, which is where the FCIC focused its attention, but Freddie’s documents are fully consistent with Fannie’s.

The report says that Fannie and Freddie had no difficulty meeting the goals. As evidence, the report states: “In fact, none of Fannie Mae’s 2004 purchases of subprime or Alt-A securities were ever submitted to HUD to be counted toward the goals.”[5] But here is a Fannie report to HUD from 2002 about its difficulty meeting the goals:

In 2002, Fannie Mae exceeded all our goals for the ninth straight year. But it was probably the most chal­lenging environment we’ve ever faced. Meeting the goals required heroic fourth quarter efforts on the part of many across the company. Vacations were canceled. The midnight oil burned. Moreover, the challenge freaked out the business side of the house. Especially because the tenseness around meeting the goals meant that we considered not doing deals — not fulfilling our liquidity function — and did deals at risks and prices we would not have otherwise done.[6] [emphasis added]

In an Oct. 31, 2005 presentation to HUD, Fannie further cited several undesirable tradeoffs needed to meet the agency’s goals, including that “[d]eal economics are well below tar­get returns; some deals are producing negative returns” and that “G-fees may not cover expected losses.”[7] Similarly, in a July 2007 staff meeting, the cost of meeting that year’s goals was placed at $1.156 billion.[8] It doesn’t sound as though Fan­nie expected these loans to be profitable, or that they would please Wall Street.

What about the FCIC’s statement that Fannie and Freddie bought these loans for market share? If Fannie and Freddie actually wanted to increase their market share, the way to do it was to reduce the fees they charged to guarantee mortgage-backed securities. That way, they would become a lower-cost provider than other channels that originators might use to sell their loans. But as shown in the following 2008 summary by their regulator, Fannie increased its average guarantee fees between 2004 and 2007.

TABLE 1: FANNIE MAE GUARANTEE FEES, 2004 TO 2007

SOURCE: OFHEO

Perhaps the most telling exclusion from the report were data published with Fannie’s 10-Q report for the second quarter of 2009 – after the firm was taken over by the government but almost two years before the FCIC issued its report. Table 2 includes an excerpt from the 10-Q that shows all the NTMs they held at that time. These amounted to $838 billion, less than a third of Fannie’s $2.8 trillion book of business, but they were responsible for 81 percent of its 2008 credit losses.

TABLE 2: FANNIE MAE CREDIT PROFILE BY KEY PRODUCT FEATURES  (AS OF JUNE 30, 2009)

SOURCE: Fannie Mae

The FCIC majority thus seemed to have made up its analysis for why Fannie and Freddie bought all these risky NTMs in order to fit the conclusion it wanted to reach: that insufficient regulation and Wall Street greed — and not government housing policy — caused the financial crisis.

This was a gross disservice to the American public, whose view of the financial crisis was deliberately distorted. The consequences include the 2010 Dodd-Frank Act, which has slowed the economy’s growth, and the absurd fight in the current Democratic presidential race about who will punish Wall Street the most.