I think it is safe to say that our economy is in a mess. The mortgage crisis and the panic in the stock market are now front page news. The credit crunch that has been festering over the last year has now come to a head and it looks likely that we are in for a deeper recession than many had hoped. When things go bad it is human nature to point fingers and try to access blame. Over the last few weeks I have gotten several emails and seen one video that claim the housing mess came about from too much government mandated lending to low income and minority home buyers. There is plenty of blame to go around, but Wall Street didn’t gorge itself on CRA (Community Reinvestment Act) and low income housing loans. These loans are low profit and banks do as little as they can to keep in compliance with the laws. The loans that got us into the situation were the high risk, high profit sub prime and no income verification loans.

The emails I’ve been seeing point specifically to the CRA, which was passed in 1977 and expanded in 1995. The idea behind this act was to increase lending in areas that had been blighted, and to make loans available to low and moderate income borrowers and small businesses who were otherwise unable to get financing. Red lining, banks not willing to lend in areas with high minority concentrations, was a big problem in the real estate industry. The idea behind this and similar laws was to make it so larger banks couldn’t discriminate against borrowers based on the area of the home, and make it possible for these areas to improve. These loans were all fully underwritten and the borrowers had to show an ability to repay the loan. Often times these loans spark a renovation in the otherwise blighted neighborhood. We’ve seen this in action in Chicago. All across the city, neighborhoods that had been down for the count, have now been revitalized. Over the last years there were other initiatives to increase the home ownership rate in both the Clinton and Bush administrations. These programs have had higher default rates than standard conventional loans. But not to an excessive degree, and compared to the overall mortgage market they were just a small drop in a big bucket.

The root of our current crisis comes down to the flow of money and the desire to make a higher return. India and China have exploded in growth over the last 10 years and this pumped a lot more money into the global economy. Because of this there was a huge demand worldwide for investments to put this money into. Mortgage backed securities (bonds based on pools of residential mortgages) were looked at as nearly as safe and secure as treasury notes. Wall Street took these pools of mortgages and sliced and diced the loans into derivatives (swaps, options, collateralized debt obligations, and the like), a new class of investment where an investor could take aspects of the loans to fit their risk/reward profile. The mortgages were cut into tranches (more slicing and dicing), which meant one mortgage might have parts of its loan held by 15 different investors. The system was so complicated that most investors had no idea what they were buying, but the yield was better than treasuries, and they were told it was safe, so that was all they needed to know.

Real estate was booming at the time, and defaults were low. Because there was a huge demand for these investments, and because home prices kept going up the risk seemed low. The Wall Street firms pushed the mortgage industry for more product that they could turn into securities and send out to their pipeline of eager buyers. Because there wasn’t enough high quality loans available, underwriting guidelines loosened. The sub prime market exploded. Sub prime loans have been around for at least the 16 years I’ve been in the mortgage industry, but it was always a small niche for those borrowers with bad credit but a larger down payment. With the demand for more loans sub prime took up the slack. Wall Street took these loans which had lower credit scores, lower or no down payments, and often no verification of income or assets, and packaged them up for sale. The return to the investors on these loans were higher, but they were packaged as if the risk was similar to the higher quality conventional mortgages. The bond rating agencies rated the junk loans as nearly as safe as the good stuff.

Here is where the real greed comes in and everything gets out of control. The sub prime companies were the first ones to lower the underwriting standards, but as the major banks and the GSEs (Fannie and Freddie) in the conventional market saw the profits that were being made, they followed suit and loosened their guidelines, too. Credit and down payment requirements were lowered and for those with good credit income verification became more of an option than a requirement. Those of us who had been in the mortgage industry for a while, shook our heads and wondered how they could take on some of the loans that they did.

Everything worked great until home prices started to fall. As home prices fell, loan defaults rose, which caused a chain reaction of fear. Investors who thought they had safe investments, realized they’d been playing at the casino. Confidence disappeared and no one wanted to buy mortgage backed securities at any price. Greed gave way to fear which is how we got where we are now.

The Equal Housing and CRA loans, as well as FHA loans geared toward lower and moderate income buyers, were a tiny sliver of the loans originated in this period. But some inner city neighborhoods were hit with over 80% of the loans being sub prime, even for borrowers who could qualify for conventional financing. This predatory lending has destroyed neighborhoods and people’s lives.

There is plenty of blame to go around. Not only Wall Street but the mortgage and real estate industry, mortgage brokers, and the home buyers themselves have a share of the blame. It is part of human nature to go too far, to look only at the sunny side when things are good, and dwell only on the gloom when things go bad. Real estate has always been a good investment, and I think that is still the case. The economy is shaky now, but if you buy a home at the right price and hold for the long term you will do well. But we need to look realistically at how we got into this problem, and pointing fingers and blaming the easy target isn’t going to help in the long run.

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