Revisiting The Original "Big Lie"

I was reminded the other day of the power of narrative in this country, and how disinformation promoted on a mass scale can lead a huge portion, or even a majority of the population to believe a falsehood, if the lie is simply repeated enough. It becomes embedded in the national conscience.

What brought this to mind was the recent appearance of a guest on Bloomberg Surveillance, who mentioned what really caused the financial crisis of 2008. And the reason, being obscure, doesn’t lend itself to the prevailing belief. Nor has it gotten much exposure, and after all these years, I found it surprising it had, at long last, been mentioned on a national news outlet, albeit one with a narrow audience.

It has been an article of faith that “loosening lending standards” by the Clinton Administration, particularly for the Community Reinvestment Act in 1994 set the stage for the coming debacle.

There are a few obvious flaws in this theory. For one, the default trail disproves it.

You’ll note that by the end of George Bush’s first term in 2004, the delinquency rate has bottomed out to an ultra-low 1.4%. To entertain the idea that looser underwriting triggered defaults 14 years after the rule change beggars belief. If things were so reckless, where were the delinquencies before this?

The focus of the ire of the proponents of blaming the CRA is simply political. The law was put in effect to blunt redlining and promote access to credit to neighborhoods that were usually starved for it. All the law says that if you’re a bank doing business in a community, you have to offer services back to that community: The Community R-E-I-N-V-E-S-T-M-E-N-T Act.

If you don’t serve those communities, you have no requirement to participate.

Since this is a regulation, people of a certain political stripe started scapegoating it after the crisis. There are some other problems with this theory besides the 14 year incubation period from passage to crisis. One, it’s a very small slice of the mortgage origination space. Even if CRA loans had a default rate of 20%, it would barely cause a ripple in the market. The dollar volume just isn’t there. Delinquency rates are higher for this kind of loan, but not by much. But since the sector was so constrained as to who and where these loans could be offered, the finger pointing just doesn’t make sense.

The other problem is CRA loans are only offered in defined census tracts that qualify for such loans. These are called “Assessment Areas” and they’re restricted to certain criteria. And the foreclosure stats after the 2008 crisis don’t align geographically with CRA census tracts. In fact, most of the damage done was in what came to be known as the “Sand States” by the mortgage industry in the aftermath of the debacle: Nevada, Florida, California and Arizona. Foreclosure rates in those states were double that of the rest of the nation, a lot of this spurred by a retirement boom in these areas. Many of these properties were also bought for investment, which leaves CRA out of the category altogether. It was a classic “boom and bust” recipe but carried out on an outsized scale.

So what caused the crisis? When these things happen, it’s generally a confluence of factors, but the lynchpin was a change in what is known as the Net Capital Rule. In 2004, in a short quiet meeting in an office located in the SEC’s offices, Chairman Christopher Cox and representatives of companies like Bear Stearns, Merrill Lynch and Lehman Brothers, the rule that limited the debt-to-equity ratio of 12 to 1 for these broker-dealers was scrapped, leaving them with no limits on leverage. Ironically, Commissioner Cox was reassured by the fact that these institutions were so large, and therefore “strong,” the removal of a leverage ceiling wouldn’t affect them. That was a naïve view. In short order, the debt-to-equity ratios of these firms exceeded 35 to 1, and all of that leverage got plowed into the subprime mortgage channel. That lit the fuse. And once the major broker-dealers failed, it was only a matter of time before the dominos fell.

“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

Bear Stearns would collapse and was sold to JP Morgan Chase for $10 a share just five days later.

Small wonder when the financial maelstrom was at its zenith, then candidate John McCain blurted out that President Bush should fire Christopher Cox. But all of this was lost in the din of the crisis. Over 85% of the mortgages that defaulted were Sub Prime loans, mostly underwritten and securitized by non-traditional mortgage banks. They have all vanished after having left a trail of financial ruin behind them.

But the scapegoating of the CRA became something of a cottage industry for conservative pundits, who wouldn’t leave it alone. This particular specimen produced a keeper of a tweet, in 2023, no less.

Call it "Schrodinger's mortgage."

The obvious answer is if you don’t do lending in a CRA census tract, you’re under no obligation to make loans there. Other commentators like Jeff Jacoby of the Boston Globe wrote embarrassing articles reflecting their complete ignorance of mortgage underwriting.  Someone with a sense of shame would apologize, but that kind of contrition is rarely seen these days.

The other flaw in blaming CRA is that people don’t live in a home for years on end and then decide to foreclose, unless something cataclysmic happens to the owner, say a job loss or illness. Statistically, in normal markets, most foreclosures occur in the first couple of years of ownership, as people find that it's more of a handful than they bargained for, and the lack of strong price appreciation in so short a time can’t bail them out.

What the delinquency chart does show is that after the leverage limits are removed, the delinquency rate almost immediately takes a “hockey stick” turn, and no one in the Administration is doing a thing to step on the brakes. The practices continued right up the crisis’ doorstep without restraint.

Secretary Cox was no amateur. He had an accomplished academic record, (Harvard Law and Business) an impressive and wide-ranging political career, (Counsel to President Reagan) served nine terms as a Congressman and advised the Federal courts. By every measure, a remarkable record and a success at everything he tried in life. But this was an example of blind fealty to a philosophy that believed regulations and guard rails were bad things that hampered business growth and prosperity. That belief would lead to a double-digit unemployment rate and negative GDP. Later, with no sense of irony, President Bush appointed him to help administer TARP, the Troubled Asset Relief Program.

We learned a lot of lessons from the Great Financial Crisis. The Dodd-Frank laws were passed, guardrails have been put back and, and in more detail. They’ve served us well. Subsequent downturns and the pandemic haven’t spiked mass delinquencies. Not only that, the financial crisis gave us important lessons about how to blunt the effect of a sharp downturn on the economy.

The Sub Prime lending segment that was once flourished is gone. I should mention that there was a segment of the mortgage industry called “Non-Conforming” loans that actually served a legitimate purpose and served many people who could not obtain a conventional loan based on Fannie Mae and Freddie Mac’s underwriting templates. Called “Low Doc” or “No Doc” loans in the industry, and “Liar Loans” by those outside it, a good credit history could get you a mortgage, albeit at a higher rate and a stiffer down payment than a conventional one. Those loans served a real purpose, but that industry, which comprised many legitimate and sober lenders, was swept away.

In any case, the lesson to be learned here is that narratives matter, even if there isn’t a shred of truth to them. It was more convenient to blame the crisis on a program designed to assist the poor than the regulators, Wall Street brokers, hedge funds, and ratings agencies who did the damage, served no jail time and escaped punishment.

And sometimes, the fate of economies and nations turn on such things.

11/6/2024