11 January 2009

The US government's role in the global financial crisis

Even the most determined lending institution will have difficulty cultivating business from minority customers if its underwriting standards contain arbitrary or unreasonable measures of creditworthiness. Consistency in evaluating loan applications is also critical to ensuring fair treatment. Since many mortgage applicants who are approved do not meet every underwriting guideline, lending policies should have mechanisms that define and monitor the use of compensating factors to ensure that they are applied consistently, without regard to race or ethnicity.

—{Closing The Gap:} A Guide To Equal Opportunity Lending, The Federal Reserve Bank of Boston

People immediately point the finger of blame at bankers and corporate executives in the search for answers to the unfolding global economic disaster. This is not surprising, given the attention the media has given to lenders offering loans to people who were clearly in no position to afford the repayments. Many would have heard of so-called NINJA loans, where NINJA stands for No Income, No Job and no Assets. There were option ARMs that allowed the borrower to select monthly repayments that would increase their debt. Finally, lenders made it easy for borrowers to avoid making a down payment by giving out a second piggyback mortgage to pay off the down payment required by the first mortgage. Clearly there had been a decline in lending standards that fuelled the housing bubble, which eventually bursted and created financial misery for millions. The question that remains unanswered is why were lending standards loosened to such an extent that lenders became virtual mortgage vending machines. Stan J. Liebowitz at The Independent Institute has released a report explaining how the government intervened in the mortgage market with good intentions, but created greater problems than those it was attempting to solve.

In Anatomy of a Train Wreck: Causes of the Mortgage Meltdown, Liebowitz explains how a push by the US government to increase home ownership, especially among the poor and ethnic minorities, led to a weakening of lending standards. There was a perception that minorities were being discriminated against in mortgage applications. As a result, the Community Reinvestment Act (CRA) was passed, forcing banks to provide loans to applicants from all neighbourhoods within the areas they operate. It was aimed at preventing redlining, where banks refused to offer services to residents in certain designated areas. The US government also passed the Home Mortgage Disclosure Act (HMDA), which required lenders to provide detailed data about their mortgage applications. Data obtained via the HMDA allowed lenders to be named and shamed in the media for apparent discrimination by comparing the rejection rates of applicants by race.

Liebowitz concludes that the mortgage meltdown was caused by adjustable-rate mortgages—both prime and subprime—given out under lax lending standards. He disputes the widely held view that the housing bubble and subsequent burst was driven by subprime loans given by unscrupulous lenders to vulnerable clients. Foreclosures for both prime and subprime loans began to soar in the third quarter of 2006, but the main contributors to the rise in each were the adjustable-rate mortgages.

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