ARM’d and Dangerous
Review of Other People’s Houses: How Decades of Bailouts, Captive Regulators, and Toxic Bankers Made Home Mortgages a Thrilling Business by Jennifer Taub. Yale University Press, 2014.
This article is from Dollars & Sense: Real World Economics, available at http://www.dollarsandsense.org
This article is from the
May/June 2015 issue.
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Other People’s Houses is a must-read for those wanting to understand what happened to the American Dream of homeownership and building wealth by paying off one’s mortgage. It is a scholarly, insightful, and deeply depressing account of how the U.S. government let financial institutions impose excessive risks on middle-class households. The consequences of this are still being felt.
Jennifer Taub, a professor at the Vermont Law School, focuses on what she knows best—the regulatory and legal issues that impact financial institutions and lending. She also weaves a good deal of history and economics into her story about how the American Dream of homeownership was killed. Her book demonstrates that the recent housing collapse was not some new crisis, but a continuation of the 1980s Savings and Loan crisis.
Taub develops this link through the story of one family and one mortgage. In 1984, Harriet and Leonard Nobelman bought a condo in Dallas; eventually this mortgage was owned by American Savings & Loan. By 1989, illness and job loss led to financial problems for the Nobelmans and they stopped making mortgage payments. Their mortgage company refused to modify their loan and began foreclosure proceedings. The Nobelmans sought relief through bankruptcy, which postponed the foreclosure.
Their case eventually reached the Supreme Court. A 1993 decision kept the Nobelmans, and all homeowners, from reducing their mortgage debt via bankruptcy. At this point, financial institutions developed a false sense of security. They thought borrowers would be forced to repay mortgages no matter what, so they could lend without worrying about write-downs. Washington Mutual (WaMu) bought American Savings & Loan, inheriting the latter’s corporate culture of risky lending. CEO Kerry Killinger grew WaMu into a huge and reckless lender.
Option adjustable-rate mortgages (ARMs) became WaMu’s flagship product, comprising more than half of its mortgage originations. Option ARMs offer low teaser rates. They also give homeowners the option to pay only part of their mortgages each month, with the rest added to the principal. After five years the mortgage becomes a regular loan at a higher interest rate. Borrowers were told not to worry about this because they could always refinance; at worst they could sell the house and downsize.
When option ARMs “reset” to higher rates, many homeowners found themselves underwater (their house was worth less than what they owed). With negative equity, they could neither refinance their mortgage nor sell their home for enough to pay off the remaining debt. American Savings had only $30 billion in assets when WaMu bought it. WaMu had $300 billion when it had to be shut down. Part of the reason it grew so large is that the Office of Thrift Supervision (OTS) was reluctant to close WaMu because the OTS was funded by assessments on the institutions it regulated. WaMu supplied more than 12% of its 2008 budget. Taub tells a riveting story about problem mortgages, but she is at her best when identifying the institutional changes that led to these problems.
First, there was deregulation. The 1982 Garn-St. Germain Act allowed ARMs with low teaser rates and option ARMs. The 1994 Riegle-Neal Interstate Banking Act enabled state thrifts (as S&Ls are known) like WaMu to set up branches around the country rather than being confined to a single state. This raised the issue of which state would regulate thrifts, something that came under the jurisdiction of the Federal Reserve. Fed Chairman Alan Greenspan let financial institutions shop around, believing investors could police markets better than government regulators.
A second problem was securitization. The Secondary Mortgage Market Enhancement Act of 1984 allowed private mortgage-backed securities (MBS) with different tiers or classes. Risky loans could be put into lower tiers, giving investors higher returns for greater risk. The 1999 repeal of the Glass-Steagall Act of 1933, which had separated commercial from investment banking, enabled banks to use their deposits to buy such securities.
Third, collateralized debt obligations (CDOs), which are insurance contracts against a borrower’s default, convinced regulators that there was no risk letting banks buy MBSs. Fourth, rule changes turned banks into over-leveraged gamblers. Leverage means that banks use little of their own money or capital to make investments or loans; the rest is borrowed from depositors or others. In November 2001, the Fed and the FDIC lowered capital requirements on MBSs. Capital requirements force shareholders to bear some of the costs of bad loans made by banks. They also reduce the cost to taxpayers of bailing out banks and paying insured depositors.
Fifth, the system was rife with conflicts of interest. Regulators of financial institutions were owned by the financial institutions in their region or, as with the OTS, they were funded by those they regulated. Politicians, dependent on financial institutions for campaign contributions, pressured regulatory agencies not to regulate and threatened to reduce their funding (and force layoffs) if they were too strict.
Credit rating agencies also faced considerable conflicts of interest. Before any security can be sold, it must be analyzed and rated by an independent agency. Ratings (AAA, AA, A, etc.) are supposed to reflect the quality of the security or the likelihood that the buyer will get repaid. The problem is that rating agencies make money from rating securities and banks send their business to agencies giving their securities high ratings. Wanting business, agencies gave high ratings to MBSs. According to Taub, rating-agency employees who tried to actually assess the risk of MBSs were verbally attacked by their supervisors.
Finally, there was a political problem. In 2008, Senator Richard Durbin (D-Ill.) proposed allowing mortgage modifications by changing the bankruptcy code. The Congressional Budget Office estimated that this would have helped more than one million homeowners at no cost to taxpayers. Finanical-industry opponents screamed “moral hazard.” (This is the economic term for a situation in which insurance makes someone less careful. For example, people with car insurance may be a little more likely to leave their car unlocked because they know that they are protected against losses from theft.)
Taub correctly notes that there is no moral-hazard problem with mortgage write-downs because lenders do not have to make risky loans in the first place. In fact, the Durbin Amendment would have prevented the moral hazard of irresponsible lending using government-insured deposits. Candidate Obama opposed mortgage write-downs during the 2008 election; President Obama has honored this pledge.
Things remain precarious today. Homeowners cannot discharge or reduce mortgage debt through bankruptcy. Banks are over-leveraged, insufficiently regulated, and remain too big to fail. The government still sides with banks rather than consumers.
And things may soon get worse. Homeowner-relief measures developed shortly after the fall of Lehman Brothers and the start of the Great Recession were inadequate, according to Taub. However, Taub does not mention that much of this support is about to end.
Home Affordable Modification Program (HAMP) modifications reduced mortgage rates to as low as 2% for struggling homeowners, with the government paying the difference to financial institutions. One million HAMP loans will reset at higher rates over the next four years. After a decade of stagnant incomes, the homeowners will not likely be able to make higher mortgage payments. And with close to 40% of homeowners underwater or nearly underwater on their mortgages, and the Federal Reserve ready to raise interest rates, housing looks ARM’d and dangerous. The U.S. economy sits in its crosshairs.