Yesterday, at NHC’s offices, a working group of many of the leading experts on reform of Fannie Mae and Freddie Mac met for five hours to discuss, debate and ultimately to reach consensus on how to move forward on comprehensive housing finance reform. As policymakers undertake comprehensive housing finance reform, it is useful to understand the root causes of the financial crisis and identify those causes that have not been addressed in regulation or statute, particularly as they relate to the GSEs.
It is both convenient and tempting to reduce root causes of the financial crisis into easily understandable, often simplistic explanations. Sometimes these explanations are intended to further a specific form of policy response. These include but are not limited to irresponsible borrowers, consumer mortgage product innovations that spun out of control, serial equity stripping, market share pressure that forced companies to ignore prudent risk management in a race to the bottom, complex financial products designed by greedy Wall Street investment bankers, easy foreign investment money, predatory lenders, government policies meant to create affordable housing opportunities, and government sponsored enterprises pursuing private profits at taxpayer expense. Individually, none of them could have caused the financial crisis, but together, they formed a perfect storm, often leveraging each other in the process.
Some have suggested that more competition is the answer. More GSEs, under this view, would create more stability. Yet, this ignores the race to the bottom that occurred between Fannie Mae and Freddie Mac, which I wrote about in Housing Wire last July. Our mortgage finance system was designed for 50-80 lenders providing 80 percent of the GSEs’ volume. As lenders consolidated, their own competitive pressures led to demanding lower guarantee fees, and ultimately, lower credit standards. By the time Countrywide Home Loans held nearly 30 percent of Fannie Mae’s business, they could dictate any terms, and they did, as did many of Freddie Mac’s largest customers.
Fannie and Freddie could have said no, but they did not because they had a well-founded fear of losing so much market share they would become irrelevant, possibly even insolvent. It was a choice between jumping off the cliff or drinking the poison and hoping for an antidote. Drinking the poison seemed like the better choice. Today, Countrywide is gone and the top five lenders in today’s mortgage market have learned their lesson, but for how long? In time, as the current generation of mortgage leaders retire, the same pressures for market share may emerge and lenders will press for lower fees and more permissive underwriting. Any new system must recognize this basic dynamic of unhealthy competition.
Mortgage lending, like all forms of investment, is ultimately an exercise in pricing and managing the risk of giving one’s money to someone else and pricing that extension of credit or capital in a way that ensures the highest risk-weighted return that the market will pay. A healthy competitive system creates natural pressures to reduce price and manage risk of default. It’s not a new idea. “Like water flowing downward, goods will naturally flow forth ceaselessly day and night without having been asked.” Si Ma Qian said that before the Romans had conquered Jerusalem in his book “Tai Shi Gong Shu.” Yet this 2100 year old concept, popularized by Adam Smith in the 18th century, is complicated by human nature. This is precisely what happened during the run up to the financial crisis and its aftermath.
Ultimately, we will have to find the right mix of speed limits and guard rails to ensure all participants are able to function both efficiently, effectively and safely. That work must rely on a thorough understanding of what went wrong and why. We will have plenty of opportunities to make new mistakes. We don’t need to ignore and repeat the old ones.