Time after time after time while attending seminars on the current problems I see “the Market” copping the blame for causing all this. It is also all over blogs everywhere. Supposedly, if only the regulators had been doing their jobs well, or current “fads” in deregulation had not existed then there would have been no problems.
As regular readers of this blog would know, I would class myself as very much of a sceptic on this type of analysis. There are several suppositions in there that I find at best unconvincing and at worst straight out wrong.
Firstly – apart from a few loans given out by fraudsters most of the loans were made in the expectation of returns. Banks are not charities and so they were expecting to get prinicipal and interest back. Where the loans were made to people with NINJA conditions (no income, no job or assets) it would have been through capital increase – i.e. appreciation in the value of the home.
A second problem here was those banks using brokers to sell the loans and then giving them incentives for getting the loans in through the door, rather than (as happens here – and not by regulation) for continuing performance through trail commissions. This mean that some brokers were just handing them out and using high-pressure techniques and breaking both the law and their contracts with the banks.
At a regulatory level, however, the problem gets more interesting. Firstly, Fannie and Freddie, as GSEs (government sponsored enterprises) were using their implicit government support to lower the lending rates to the prime loans they were (largely) restricted to. This also heavily skewed the markets – home lending through Fannie and Freddie became the same as lending to governments, so there was no risk sensitivity. They were also able to (and increasingly did) use these borrowing rates to issue many complex derivatives based on home loans. They were also, as GSEs, not subject to the same regulations as everyone else. Nobody really cared about this because there was an understanding that Uncle Sam would ride to the rescue if needed – as they did.
Worse, since 2004 Fannie and Freddie were not restricted to prime loans – they had about USD 500 billion in the sub prime market. The entry of Fannie and Freddie into this market acted to further squeeze the private money into the riskier end.
A further, major, regulatory problem is the way that housing loans were (and in the US still are) treated under Basel II. For capital purposes all home loans were treated exactly the same – whether a ninja loan to someone in the projects or a 10% LVR loan on a $10,000,000 stately home on Long Island.
Everyone knew this was silly, so there grew up a large market in
derivatives based on home loans that was designed to arbitrage the
difference between the loans the GSEs could touch and those they could
The net result of this interplay between the GSEs, the capital regulations and lax lending standards due to high monetary growth was that the banks were stuffed with cash they had to get out the door. They were unable to use the cash to make loans to the good risks that Fannie and Freddie had cornered and the capital regulations said that all home loans were as safe as each other. The brokers were often being paid to make loans (not necessarily good ones) and the banks did not care as much as they should have as, for the last 10 or more years, home prices had risen as much as, if not more, than their prime lending rates. Many of the banks were also, by their charters, prohibited from lending outside the US or for other than homes.
If Fannie and Freddie had not been there and the capital regulations (if they existed) had actually been risk sensitive then lending would have been (IMHO) better – but, as always, not perfect. This would have reduced (but perhaps not eliminated) the ninja loans, meaning the house prices would not have gone up as much, meaning returns from other than capital would have been examined.
I am not trying to assign sole blame for this to the regulators. All I am saying is that they did not help – so expecting more regulation to fix the problem would be the triumph of hope over experience. In the US at least, the problem was in large part caused by the multiple overlapping systems of regulation, the effects of the GSEs and the frankly stupid incentives it gave many of the market participants. My strong suggestion would be to look at sorting these out first before running off and trying to put in place more straitjackets for an industry that is already tightly bound.