Government Promoted the Risky Non-Traditional Mortgages that Triggered the Financial Crisis

Ed Pinto, who was an executive at Fannie Mae long before it went into the toilet and nearly took the financial system down with it, notes that “the financial crisis resulted from an unprecedented accumulation of weak and risky Non-Traditional Mortgages (NTMs)” promoted by both the government and the government-sponsored mortgage giant Fannie Mae. “Each type of NTM featured increased borrower leverage and risk.”

In Government Housing Policy: The Sine Qua Non of the Financial Crisis, he describes in detail how government housing policy explicitly promoted massive increases in leverage and moral hazard by both borrowers and investors and chronicles the central role played by Fannie Mae and Freddie Mac as the clearly-acknowledged kings of moral hazard and leverage. As he points out, government involvement included the facts that (1) Congress, at the behest of community advocacy groups, forced Fannie and Freddie to replace conservative underwriting with flexible underwriting knowing that banks would follow suit; (2) Fannie vowed to transform the housing finance system using flexible underwriting, in an effort to protect its charter privileges bestowed by Congress; and (3) HUD, after a decade of effort, proudly took credit for a revolution in affordable lending. This revolution then led directly to the 2008 financial crisis, which precipitated a $160 billion bailout of Fannie Mae and Freddie Mac, the nation’s two government-sponsored mortgage giants.

(Unlike the private banks, which repaid their bailouts with interest, Fannie Mae and Freddie Mac are not expected to repay taxpayers, and their bailout tab may rise to $1 trillion, according to Bloomberg News. The Obama administration earlier lifted the $400 billion limit on bailouts for Fannie Mae and Freddie Mac, so that they could continue to buy up junky mortgages at taxpayer expense, and showered their executives with $42 million in compensation. In May 2010, the administration and its congressional allies blocked efforts to reform Fannie Mae and Freddie Mac.)

Banks have long been under pressure from lawmakers and regulators to give loans to people with bad credit, in order to provide “affordable housing” and promote “diversity.” That played a key role in triggering the mortgage crisis, as a New York Times story illustrates. As it noted, “a high-ranking Democrat telephoned executives and screamed at them to purchase more loans from low-income borrowers, according to a Congressional source.” Freddie Mac’s executive “eventually yielded to those pressures, effectively wagering that if things got too bad, the government would bail them out.”

Analysts who once downplayed the government’s role in causing the financial crisis now have changed their tune, concluding that government regulations that promoted risky loans played a major role in spawning the crisis. An earlier study by Edward Pinto about the role of government housing policies in spawning the financial crisis can be found here.