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Government deregulation and failed regulation of the commercial and investment banking industries were important contributors to the subprime mortgage crisis. These included allowing the self-regulation of Wall Street's investment banks and the failed regulation of Wall Street rating agencies, which were responsible for incorrectly rating some $3.2 trillion dollars of subprime mortgage-backed securities. The introduction of new mortgage products by the Alternative Mortgage Transactions Parity Act (AMTPA), passed by Congress in 1982, ended the long standing practice of limiting banks to making conventional fixed-rate mortgages. Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages. Fannie Mae and Freddie Mac also carry blame. The two GSEs purchased over $500 billion dollars in high risk Alt-A mortgage products, which they had previously classified as too risky for purchase in the 1990s. Both Alan Greenspan and the SEC testified before Congress that the shadow banking system was not effectively regulated, even though it had become nearly as important as the regulated depository banking system in providing credit.

Role of the SEC

Leverage Ratios of Investment Banks Increased Significantly 2003-2007

The Securities and Exchange Commission (SEC) has conceded that self-regulation of investment banks contributed to the crisis. The SEC relaxed rules in 2004 that enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages.

The top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch) during 2008, creating instability in the global financial system. The remaining two converted to commercial bank models in order to qualify for Troubled Asset Relief Program funds (Goldman Sachs and Morgan Stanley).

The SEC is also responsible for establishing financial disclosure rules. Critics have argued that disclosure throughout the crisis was ineffective, particularly regarding the health of financial institutions and the valuation of mortgage-backed securities.

Repeal of the Glass Steagall Act

The Glass-Steagall Act was enacted after the Great Depression. It separated commercial banks and investment banks, in part to avoid potential conflicts of interest between the lending activities of the former and rating activities of the latter. Economist Joseph Stiglitz criticized the repeal of the Act. He called its repeal the "culmination of a $300 million lobbying effort by the banking and financial services industries...spearheaded in Congress by Senator Phil Gramm." He believes it contributed to this crisis because the risk-taking culture of investment banking dominated the more conservative commercial banking culture, leading to increased levels of risk-taking and leverage during the boom period.

Economist Robert Kuttner and Paul Krugman have criticized the repeal of the Glass-Steagall Act by the Gramm-Leach-Bliley Act of 1999 aspossibly contributing to the subprime meltdown, although other economists disagree.

Community Reinvestment Act

The CRA was originally enacted under President Carter in 1977. The Act was set in place to encourage banks to halt the practice of lending discrimination. There is debate among economists regarding the effect of the Community Reinvestment Act, with detractors claiming it encourages lending to uncreditworthy consumers and defenders claiming a thirty year history of lending without increased risk. Detractors also claim that amendments to the CRA in the mid-1990s, raised the amount of home loans to otherwise unqualified low-income borrowers and also allowed for the first time the securitization of CRA-regulated loans containing subprime mortgages. A study, by a legal firm which counsels financial services entities on Community Reinvestment Act compliance, found that CRA-covered institutions were less likely to make subprime loans (only 20-25% of all subprime loans), and when they did the interest rates were lower. The banks were half as likely to resell the loans to other parties.

Federal Reserve Governor Randall Kroszner, says the CRA isn’t to blame for the subprime mess, "First, only a small portion of subprime mortgage originations are related to the CRA. Second, CRA-related loans appear to perform comparably to other types of subprime loans. Taken together… we believe that the available evidence runs counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis," Kroszner said: "Only 6% of all the higher-priced loans were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their CRA assessment areas, the local geographies that are the primary focus for CRA evaluation purposes."

FDIC Chairman Sheila Bair disputes that the CRA was a problem "Let me ask you: where in the CRA does it say: make loans to people who can't afford to repay? No-where! And the fact is, the lending practices that are causing problems today were driven by a desire for market share and revenue growth ... pure and simple."

Financial Derivative Regulation / Commodity Futures Modernization Act of 2000

The Commodity Futures Modernization Act of 2000 exempted derivatives from regulation, supervision, trading on established exchanges, and capital reserve requirements for major participants. Concerns that counterparties to derivative deals would be unable to pay their obligations caused pervasive uncertainty during the crisis. Particularly relevant to the crisis are credit default swaps (CDS), a derivative in which Party A pays Party B what is essentially an insurance premium, in exchange for payment should Party C default on its obligations. Warren Buffett famously referred to derivatives as "financial weapons of mass destruction" in early 2003.

Like all swaps and other financial derivatives, CDS may either be used to hedge risks (specifically, to insure creditors against default) or to profit from speculation. Derivatives usage grew dramatically in the years preceding the crisis. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total over-the-counter (OTC) derivative notional value rose to $683 trillion by June 2008, of which about 8% were CDS.

CDS are lightly regulated. As of 2008, there was no central clearing house to honor CDS in the event a party to a CDS proved unable to perform his obligations under the CDS contract. Required disclosure of CDS-related obligations has been criticized as inadequate. Insurance companies such as American International Group (AIG), MBIA, and Ambac faced ratings downgrades because widespread mortgage defaults increased their potential exposure to CDS losses. These firms had to obtain additional funds (capital) to offset this exposure. AIG's having CDSs insuring $440 billion of MBS resulted in its seeking and obtaining a Federal government bailout.

Like all swaps and other pure wagers, what one party loses under a CDS, the other party gains; CDSs merely reallocate existing wealth [that is, provided that the paying party can perform]. Hence the question is which side of the CDS will have to pay and will it be able to do so. When investment bank Lehman Brothers went bankrupt in September 2008, there was much uncertainty as to which financial firms would be required to honor the CDS contracts on its $600 billion of bonds outstanding.

Economist Joseph Stiglitz summarized how credit default swaps contributed to the systemic meltdown: "With this complicated intertwining of bets of great magnitude, no one could be sure of the financial position of anyone else-or even of one's own position. Not surprisingly, the credit markets froze."

Former President Bill Clinton and former Federal Reserve Chairman Alan Greenspan indicated they did not properly regulatederivatives, including credit default swaps (CDS). A bill (the Derivatives Markets Transparency and Accountability Act of 2009 (H.R. 977) has been proposed to further regulate the CDS market and establish a clearinghouse. This bill would provide the authority to suspend CDS trading under certain conditions.

NY Insurance Superintendent Eric Dinallo argued in April 2009 for the regulation of CDS and capital requirements sufficient to support financial commitments made by institutions. "Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems...In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver." He also wrote that banks bought CDS to enable them to reduce the amount of capital they were required to hold against investments, thereby avoiding capital regulations. U.S. Treasury Secretary Timothy Geithner has proposed a framework for legislation to regulate derivatives.

The role of Fannie Mae, Freddie Mac and the FHLB in the crisis

Fannie Mae and Freddie Mac are government-sponsored enterprises (GSE) that purchase mortgages, buy and sell mortgage-backed securities (MBS), and guarantee nearly half of the mortgages in the U.S. A variety of political and competitive pressures resulted in the GSE taking on additional risk, beginning in the mid-1990s and continuing throughout the crisis and their government takeover in September, 2008.

HUD loosened mortgage restrictions in the mid-1990s so first-time buyers could qualify for loans that they could never get before. In 1995, the GSE began receiving affordable housing credit for purchasing mortgage backed securities which included loans to low income borrowers. This resulted in the agencies purchasing subprime securities. In 1996, HUD directed Freddie and Fannie to provide at least 42% of their mortgage financing to borrowers with income below the median in their area. This target was increased to 50% in 2000 and 52% in 2005. In addition, HUD required Freddie and Fannie to provide 12% of their portfolio to “special affordable” loans. Those are loans to borrowers with less than 60% of their area’s median income. These targets increased over the years, with a 2008 target of 28%.

In 2004, HUD ignored warnings from HUD researchers about foreclosures, and increased the affordable housing goal from 50% to 56%.

In addition to political pressure to expand purchases of higher-risk mortgage types, the GSE were also under significant competitive pressure from large investment banks and mortgage lenders. For example, Fannie's market share of subprime mortgage-backed securities issued dropped from a peak of 44% in 2003 to 22% in 2005, before rising to 33% in 2007.

In the early 2000s, Fannie Mae aggressively bought Alt-A securities, where these loans may require little or no documentation of a borrower’s finances. In the early 1990s Fannie Mae had abandoned Alt-A products because of their high risk of default. As of November 2007 Fannie Mae held a total of $55.9 billion of subprime securities and $324.7 billion of Alt-A securities in their portfolio. As of the 2008Q2 Freddie Mac had $190 billion in Alt-A mortgages. Together they have over $500 billion in Alt-A mortgages.

However, economist Paul Krugman argued during July 2008 that although the GSE are "problematic institutions," they played a small role in the crisis because they were legally barred from engaging in subprime lending. Economist Russell Roberts has taken issue with Krugman's contention that the GSEs did not engage in subprime lending, citing a June 2008 Washington Post article which stated that "[f]rom 2004 to 2006, the two [GSEs] purchased $434 billion in securities backed by subprime loans, creating a market for more such lending." Furthermore, a 2004 HUD report admitted that while trading securities that were backed by subprime mortgages was something that the GSEs officially disavowed, they nevertheless participated in the market.

By 2008, the GSE owned, either directly or through mortgage pools they sponsored, $5.1 trillion in residential mortgages, about half the amount outstanding. The GSE have always been highly leveraged, their net worth as of 30 June 2008 being a mere US$114 billion. When concerns arose regarding the ability of the GSE to make good on their nearly $5 trillion in guarantee and other obligations in September 2008, the U.S. government was forced to place the companies into a conservatorship, effectively nationalizing them at the taxpayers expense. Paul Krugman noted that an implicit guarantee of government support meant that "profits are privatized but losses are socialized," meaning that investors and management profited during the boom-period while taxpayers would take on the losses during a bailout.

Announcing the conservatorship on 7 September 2008, GSE regulator Jim Lockhart stated: "To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off, eventually stabilizing at a lower, less risky size."

The Federal Home Loan Banks are less understood and discussed in the media. The FHLB provides loans to banks that are in turn backed by mortgages. Although they are one step removed from direct mortgage lending, some of the broader policy issues are similar between the FHLB and the other GSEs. According to Bloomberg, the FLHB is the largest U.S. borrower after the federal government.[720362] On January 8, 2009, Moody's said that only 4 of the 12 FHLBs may be able to maintain minimum required capital levels and the U.S. government may need to put some of them into conservatorship.[720363]

Federal regulatory influence of states

Some have argued that, despite attempts by various U.S. states to prevent the growth of a secondary market in repackaged predatory loans, the Treasury Departmentmarker's Office of the Comptroller of the Currency, at the insistence of national banks, struck down such attempts as violations of Federal banking laws.

Inconsistent capital requirements and risk classification

In the United States, capital requirements played an important role in stimulating mortgage securitization. A paper by Paul S. Calem and Michael LaCour-Little points out that mortgages originated and held by banks are put into an arbitrary risk classification that requires more capital than similar mortgages originated by third parties but held as securities. Freddie Mac and Fannie Mae are regulated differently, and for all but the riskiest loans Freddie and Fannie face lower capital requirements and hence lower costs.

Even more surprising is the way that capital requirements favor private mortgage securities (securities not issued by Freddie Mac or Fannie Mae). Those securities, even when backed by high-risk mortgages, can obtain attractive risk ratings from credit rating agencies through use of tranches that only are subject to losses if a substantial proportion of loans goes into default. FDIC capital regulations give a lower risk weight to highly-rated mortgage securities, which may be backed by loans with little or no down payment, than to loans originated within the bank with down payments of up to 40 percent. These relative risk ratings embedded in capital requirements are the opposite of actual experience.

FDIC Chair Shelia Bair cautioned during 2007 against the more flexible risk management standards of the Basel II accord and lowering bank capital requirements generally: "There are strong reasons for believing that banks left to their own devices would maintain less capital—not more—than would be prudent. The fact is, banks do benefit from implicit and explicit government safety nets. Investing in a bank is perceived as a safe bet. Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did."

Conservative criticism before Congress

During March 1995 congressional hearings William A. Niskanen, chair of the Cato Institute, criticized the proposals for political favoritism in allocating credit and micromanagement by regulators, and that there was no assurance that banks would not be expected to operate at a loss. He predicted they would be very costly to the economy and banking system, and that the primary long term effect would be to contract the banking system. He recommended Congress repeal CRA.

Gerald P. O'Driscoll, former vice president at the Federal Reserve Bank of Dallas, stated that Fannie Mae and Freddie Mac had become classic examples of crony capitalism. Government backing let Fannie and Freddie dominate the mortgage-underwriting. "The politicians created the mortgage giants, which then returned some of the profits to the pols - sometimes directly, as campaign funds; sometimes as "contributions" to favored constituents."

Some lawmakers received favorable treatment from financial institutions involved in the subprime industry. (See Countrywide financial political loan scandal). In June 2008 Conde Nast Portfolio reported that numerous Washington, DC politicians over recent years had received mortgage financing at noncompetitive rates at Countrywide Financial because the corporation considered the officeholders under a program called "FOA's"—"Friends of Angelo". Angelo being Countrywide's Chief Executive Angelo Mozilo.On 18 June 2008, a Congressional ethics panel started examining allegations that chairman of the Senate Banking Committee, Christopher Dodd (D-CT), and the chairman of the Senate Budget Committee, Kent Conrad (D-ND) received preferential loans by troubled mortgage lender Countrywide Financial Corp. Two former CEOs of Fannie Mae Franklin Raines and James A. Johnson also received preferential loans from the troubled mortgage lender. Fannie Mae was the biggest buyer of Countrywide's mortgages.

On September 10, 2003, U.S. Congressman Ron Paul gave a speech to Congress where he said that the then current government policies encouraged lending to people who couldn't afford to pay the money back, and he predicted that this would lead to a bailout, and he introduced a bill to abolish these policies.

Policies of the Bush Administration

President Bush advocated the "Ownership society." According to the New York Times, "he pushed hard to expand home ownership, especially among minorities, an initiative that dovetailed with his ambition to expand the Republican tent — and with the business interests of some of his biggest donors. But his housing policies and hands-off approach to regulation encouraged lax lending standards." He insisted that Fannie Mae and Freddie Mac (the GSE) meet low-income housing goals and advocated government loans to help low-income homeowners make down-payments. The Bush administration also replaced Fannie and Freddie's chief regulator in 2003 immediately after the regulator published a report warning of the risks posed by the GSE.

Efforts to control GSE were thwarted by intense lobbying by Fannie Mae and Freddie Mac. In April 2005, Secretary of the Treasury John Snow repeated call for GSE reform, saying "Events that have transpired since I testified before this Committee in 2003 reinforce concerns over the systemic risks posed by the GSEs and further highlight the need for real GSE reform to ensure that our housing finance system remains a strong and vibrant source of funding for expanding homeownership opportunities in America … Half-measures will only exacerbate the risks to our financial system." Then house Minority Leader Harry Reid rejected legislation saying " we cannot pass legislation that could limit Americans from owning homes and potentially harm our economy in the process." A 2005 Republican effort for comprehensive GSE reform was threatened with filibuster by Senator Chris Dodd (D-CT).

Importance of home equity extraction to economic growth

A significant driver of economic growth during the Bush administration was home equity extraction, in essence borrowing against the value of the home to finance personal consumption. Free cash used by consumers from equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period. Using the home as a source of funds also reduced the net savings rate significantly. By comparison, GDP grew by approximately $2.3 trillion during the same 2001-2005 period in current dollars, from $10.1 to $12.4 trillion.

Economist Paul Krugman wrote in 2009: "The prosperity of a few years ago, such as it was — profits were terrific, wages not so much — depended on a huge bubble in housing, which replaced an earlier huge bubble in stocks. And since the housing bubble isn’t coming back, the spending that sustained the economy in the pre-crisis years isn’t coming back either." Niall Ferguson stated that excluding the effect of home equity extraction, the U.S. economy grew at a 1% rate during the Bush years. Since GDP growth is a significant indicator of the success of economic policy, the government had a vested interest in not fully explaining the role of home equity extraction (borrowing) in driving the GDP measure pre-crisis.

Moral hazard from other bailouts

A taxpayer-funded government bailout of financial institutions during the savings and loan crisis may have created a moral hazard and acted as encouragement to lenders to make similar higher risk loans.


  1. Geithner-Speech Reducing Systemic Risk in a Dynamic Financial System
  2. Shwarcz Paper - Disclosure's Failure in the Subprime Mortgage Crisis
  3. SEC Investigation
  4. Stiglitz - Vanity Fair - Capitalist Fools
  5. Thomas J. DiLorenzo, The Government-Created Subprime Mortgage Meltdown,, September 6, 2007 accessdate=2007-12-07
  6. The Economist-Derivatives-A Nuclear Winter?
  7. BBC-Buffet Warns on Investment Time Bomb
  8. Forbes-Geithner's Plan for Derivatives
  9. Clinton-Derivatives
  10. Greenspan - CDS Regulation
  11. CDS Regulation
  12. Dinallo-We Modernized Ourselves Into This Ice Age
  13. Geithner-Regulatory Reform-OTC Derivatives May 2009
  14. AEI - The Last Trillion Dollar Commitment
  15. NYT-Pressured to Take More Risk, Fannie Reached Tipping Point
  16. The Reckoning - Building Flawed American Dreams, The New York Times, October 18, 2008
  17. NYT - Pressured to Take More Risk, Fannie Reached Tipping Point
  19. NYT-Fanny, Freddie and You
  20. [1]
  21. [2]
  22. [3] p. 46, 108-110
  23. Release Z.1, Table L.124, line 16; L.125, line 2.
  24. Release Z.1, Table L.124, line 1 - line 21.
  25. Peter J. Wallison, Charles W. Calomiris, AEI-The Last Trillion Dollar Commitment, American Enterprise Institute, September 30, 2008.
  26. Bloomberg-U.S. Considers Bringing Fannie & Freddie Onto Budget
  27. NYT-Fanny, Freddie and You
  28. U.S. Treasury Department - Statements by Secy. Paulson and Director Lockhart
  29. Calem & LaCour paper
  30. FDIC Regulations
  31. Shelia Bair Remarks-June 2007
  32. William A. Niskanen, Repeal the Community Reinvestment Act, Testimony of William A. Niskanen, Chairman Cato Institute before the Subcommittee on Financial Institutions and Consumer Credit, Committee on Banking and Financial Services United States Senate, March 8, 1995.
  33. Gerald P. O'Driscoll, Jr., Fannie/Freddie Bailout Baloney, New York Post, September 9, 2008.
  34. Ron Paul in the House Financial Services Committee, September 10, 2003
  35. NYT-Reckoning - White House Philosophy Stoked Mortgage Bonfire
  36. [4]
  37. [5].
  38. [6].
  39. Greenspan Kennedy Report - Table 2
  40. Equity extraction - Charts
  41. Reuters-Spending Boosted by Home Equity Loans
  42. BEA GDP Data-Excel
  43. Krugman-Life Without Bubbles
  44. Ferguson - Interview
  45. {{cite web |url={9F4C2252-8BA7-459C-B34E-407DB32921C1}&siteid=rss |last=Brown |first=Bill |title=Uncle Sam as sugar daddy; MarketWatch Commentary: The moral hazard problem must not be ignored |publisher=MarketWatch |date=2008-11-19 |accessdate=2008-11-30}}

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