Mortgage Crisis: Fed Was Asleep At the Wheel

During his term, the former Fed chairman Alan Greenspan was much like Sergeant Schultz on the 1960s hit comedy series Hogan's Heroes. Fans will recall that the good-hearted German POW camp guard would invariably look the other way after spotting all sorts of untoward behavior. Once in a while a real crisis would develop, but somehow things always worked out.

"I hear nothing, I see nothing, I know nothing!"- That's the way it seems to have been in the last twenty years, since Alan Greenspan first sat in the big chair at the Federal Reserve way back in 1987.

Even more so in the last five years.

In a story originating from Irvine, California (aka subprime central), my new favorite economist Jim Svinth of Lending Tree wondered why regulators didn't catch on to all the hushed voices and sneaking around over the last few years and acted sooner to avoid the current subprime mortgage mess.

"That horse has left the barn," he commented, adding "the Federal Reserve should have acted three years ago."

It's hard to argue with that assessment or the timeframe.

Early in 2004 would have been an excellent time to have a look at what was going on in mortgage lending. The year before, significant problems were uncovered at both Freddie Mac and Fannie Mae related to derivatives and credit scoring.

The result? At the urging of the Fed chairman, a bigger share of mortgage debt was offloaded to Wall Street. As shown in the chart below and as noted here previously, "three years ago the GSEs were reined in and then the Fed hit the snooze button".

Wall Street firms and mortgage originators began digging tunnels, forging papers, and all sorts of shenanigans followed.

"I hear nothing, I see nothing, I know nothing!"

The Credit Suisse Mortgage Report

The chart above is from the new Credit Suisse paper on mortgage lending, available over at Bill Cara's blog Mortgage Liquidity du Jour: Underestimated No More (.pdf). It is a comprehensive, 67-page accounting of what has happened in the world of real estate finance over the last few years, likely to answer just about any question you might have on the subject.

See pages 52 through 55 for a review of what hasn't happened in the area of mortgage lending regulation - Recent Events May Force Regulators' Hand.

Apparently, back in 2004, it wasn't enough to have short- term interest rates at one percent with U.S. Treasury purchases by the Bank of Japan pushing the 10-year note to about 3.5 percent.

At this same time, mortgage lenders began making "liar loans" in huge numbers. That is, no-documentation and low-documentation loans that make up more than 80 percent of the next mortgage lending trouble spot - Alt-A loans.

What a good time everyone had while home prices rose. Like Sergeant Schultz, many looked the other way including those responsible for regulating the industry.

Now for the bad news - the current subprime mortgage mess is probably just the beginning and all that will be accomplished by new regulation will be to quicken the shakeout currently underway.

Home prices are probably going to go down. Maybe a lot. Here's why.

As noted in the recent report on delinquencies from the Mortgage Bankers Association, the highest rates of foreclosures are occurring in non-bubble states. As noted earlier this week here, the fastest rate of change in delinquencies is now occurring in some of the bubbliest areas.

One possible explanation is that prices have risen so high in bubble areas in recent years that distressed homeowners have still been able to sell and pocket some gains rather than go into foreclosure, though that may be changing.

The foreclosure report was for the fourth quarter of 2006 and if the more recent rate of change in subprime delinquencies is any indication, things are changing very quickly now.

As Mr. Svinth commented, everyone would have been much better off if lenders had been better regulated three years ago.

It looks like Congress is getting ready to do that now.

Comments

[huangjin:]

Or conversely, the Fed and the government can let Wall Street take a bath and learn a lesson the hard way.

2007 Mar 15 04:44 PM

[Malkiel:]

It's pretty tough for a Republican administration to put the brakes on an industry that screams "free market" and looks like a bunch of geniuses creating a money machine while things are going well. We've got to have some kind of shakeout with credit cards too, because their usurious practices have been going on even longer. It may be that when home equity dries up the credit card companies will be the next to have their underside exposed.

When government gets proactive about problems everyone on Wall Street complains, calls it "government interference", blames the Democrats, and bullies Washington into leaving them alone; but when the pinch comes, suddenly they demand to know where government was. Sheesh, talk about hypocrites...

2007 Mar 15 05:24 PM

[Winston Kotzan:]

While its true that if some regulation had been placed on irresponsible mortgage lenders several years ago, why criticize Mr. Greenspan for it? All his job was to keep interest rates in check to make sure the economy runs smoothly without rampant inflation. It is not the Federal Reserve's job to police careless lenders.

Had the government interfered before this incident occurred, then Wall Street would have complained about the laizzez-faire interference. Businesses would groan that they would be unable to serve their customers, homeowners would complain that the government denied them a loan! Instead, the government chose to give us a little freedom and as a result the subprime sector will have a few hiccups.

The subprime problem is a setback for some of the more reckless lenders, but this small segment of the economy shouldn't be able to shut down the system as a whole. Banks will suffer some losses, but will adjust and the situation will correct itself in the long run. For now, this presents an interesting opportunity to find the companies that will survive and hold onto them.

2007 Mar 16 02:11 AM

[Johnny Bitc...:]

Did you notice Greenspan's latest comment about "insanity" in the derivatives market ? He also noted that settlement procedures were anachronistic and "dangerous".

Is it not rather remarkable that private citizen Greenspan has just made these discoveries recently, strongly suggesting that as Federal Reserve Chairman he was not aware of these "dangerous" problems. I can remember Greenspan in front of Congress confidently assuring the nation that the use of derivatives are a stabilizing force which helps distribute risk to those that want the exposure, etc., etc.......

It's funny, though, I don't remember him pointing out these "dangerous" problems with settlement back then !

I wonder what the hell Greenspan is talking about ? Are we about to discover large counterparty defaults ? All the counterparties are in the Caymans ?

Pretty scary that Greenspan is now admitting implicitly that he didn't understand the dervivatives market very well when he was the most powerful central banker on the planet !

A little scary ?

Yep.

John Ewing.

2007 Mar 16 02:53 AM

[Fred W:]

All you had to do to know something was seriously wrong was to spend a couple of days in a subprime office during the boom...you only need to listen to a couple of conversations to figure out that fraud was the reason many applicants could qualify. Many of agents of these companies have left the country since.

2007 Mar 16 06:30 PM