The beginning of another bank crisis?

One definition of insanity is doing the same thing over and over and expecting a different result. Late  last month, the Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, announced that the two institutions would start purchasing mortgages with down payments as low as 3 percent instead of the already absurdly low 5 percent minimum both institutions currently require. These FHFA-insured loans are for borrowers with weak credit.

Also, the federal regulator announced loosened mortgage lending rules. It removed the 20 percent down payment requirement for high-quality mortgages that banks determine to have low risk of default and made it less likely that Fannie and Freddie will force lenders to buy back mortgages that go bad.

By expanding the types of mortgages Freddie and Fannie will buy, the FHFA hopes to spur banks to make more loans to first-time buyers and increase homeownership among those with low and moderate incomes. These watered-down underwriting standards are a big win for affordable housing advocates and the banking and real estate industries.

But the feds are sowing the seeds for another meltdown by loosening recently enacted safeguards. Bookshelves sag with encyclopedic volumes arguing that a major factor in the financial apocalypse of 2008 was relaxed lending practices that led to the housing bust. How quickly we forget.

Back then the weakening of underwriting standards, and especially low down payments, increased home ownership and housing prices, which led to a housing price bubble. The banks had packaged and sold to investors bundles of risky mortgages with teaser rates that ballooned after a few years. Many borrowers ended up defaulting on the loans when the interest rates spiked. As a result, the value of the mortgage securities plummeted, and banks and investors holding them lost billions.

The debacle helped ignite the financial meltdown that plunged the economy into the deepest recession since the 1930s and necessitated taxpayer bailouts of banks and Fannie and Freddie. Following this debacle, there was a push to tighten mortgage lending standards and have banks retain a small portion of the loans they sold as stipulated in the Dodd-Frank Act of2010.

Those of you who’ve seen the classic movie “It’s a Wonderful Life” will remember George Bailey describing to his nervous depositors how the home mortgage business worked. You would visit your local bank and, among other things, the institution would require you to pay a significant portion (like 20 percent) of the purchase price upfront. Along with this down payment, purchasers would be required to demonstrate proof of income.

By granting a home mortgage, George’s thrift institution was exposing itself to risk. A buyer could fail to make the monthly mortgage payments. And since the institution kept the mortgage on its books as an asset, it remained exposed to this risk until the mortgage was paid off.

This process meant the initial lending decision was based on careful consideration of the customer’s creditworthiness. To the extent feasible, the institution would seek to grant mortgages only to its own customers so it could be confident that the homebuyers were safe credit risks. The pluses and minuses of this simple model are obvious.
By selling the packaged loans to others, banks could remove the loans from their balance sheets, which allowed the banks to increase their loans without technically violating the rules in regard to minimum capital ratios.

Providing low down-payment loans to borrowers with weak credit, then bundling and selling those loans drove the American financial system to the brink of collapse. Less than a decade later it appears that no one remembers.

originally published: November 8, 2014

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