Private risk, public risk: public policy, market development, and the mortgage crisis.

• Author: Immergluck, Daniel

Introduction I. The Development of Risk-Limiting Mortgage Markets in the United States A. The Local Building and Loan B. The 1930s: Federal Leadership in Home Finance C. The Growth of Unstructured, Plain-Vanilla Securitization D. The Rise of Structured, Risk-Inducing Securitization II. Federal Policy in the Late Twentieth Century: Nurturing Securitization, the Decline of Originate-to-Hold Lending, and Back-Door Deregulation III. Policy Debates over Regulating High-Risk Mortgage Lending, 1995-2008 A. North Carolina Makes the First Big Move Toward More Comprehensive Regulation of Subprime Loans B. Lenders, the GSEs, and the Credit Rating Agencies Fight Attempts to Regulate High-Risk Mortgage Lending at the State Level C. Federal Agencies Study Abusive Lending and Regulators Warn of Subprime Risks to Banks 1. The OTS and OCC Act to Preempt State Regulation of High-Risk Lending Conclusion INTRODUCTION

Following the boom in subprime and high-risk lending from 2002 to 2006--after an earlier escalation in the late 1990s--loan defaults and foreclosures surged in many parts of the country in 2006 and 2007. (1) As the subprime debacle evolved into a broader mortgage crisis, which later catalyzed national and global economic decline, the costs of failing to regulate a new, high-risk mortgage market--revolutionized by private-label securitization--became painfully obvious. By early 2008, the mortgage crisis had led to direct losses to investors in mortgage-backed securities in the $350 to $420 billion range, but because these losses occured at leveraged financial institutions, their full impact was estimated to be $2 trillion or more. (2) By August of 2008, write-downs and losses of mortgage-backed securities by commercial and investment banks had climbed to over $500 billion, and were projected to end up at somewhere on the order of $1 trillion or more, even before accounting for leveraged impacts, and some were predicting that total write-downs and losses would reach well beyond these levels. (3) The impacts on financial institutions were further magnified by the use of credit default swaps and other derivative instruments.

By the fall of 2008, the problems of credit and financial markets had grown so large that they had brought down a number of major financial firms, including Lehman Brothers, Washington Mutual, and AIG, and compelled the government takeover of the government sponsored enterprises, Fannie Mac and Freddie Mac. Even more broadly, the financial crisis had spread to commercial paper markets and inter-bank lending, slowing credit flows in these markets and affecting a much broader segment of the real economy. These developments led the Treasury Department, together with the Federal Reserve Board, to push for a major federal program to purchase distressed mortgage-backed and related securities from financial institutions. (4) After some substantial fits and starts, the Emergency Economic Stabilization Act was passed which provided for a $700 billion Troubled Assets Relief Program ("TARP"), which provided the ability to buy mortgage-backed securities and to invest in equity shares of financial institutions. (5)

As the country's attention moved from a severe, but narrower, subprime mortgage crisis to a much broader national and global economic crisis, less notice was given to the costs of the heavy and concentrated foreclosures caused by subprime lending. Borrowers lost their homes and saw their credit records decimated. Many renters--who clearly had no role in the mortgage process--found themselves with little notice to vacate their homes. Neighborhoods around the country were littered with vacant and abandoned properties, which can depress the values of nearby homes and create havens for blight and crime. (6) The problems were not just confined to the inner-city. In some places, entire suburban or exurban subdivisions that had been planned or started at the peak of the high-risk lending boom in the mid-2000s were left half-empty or worse. Cities and suburbs were forced to become custodians of abandoned properties in order to slow the contagion effects of derelict properties. (7)

This Article describes the development of mortgage markets in the United States during the twentieth century, with particular emphasis on the growth of high-risk market segments beginning in the 1990s. Part I provides a brief look at the history of institutional mortgage markets in the United States, with particular focus on the federal role in the development of stable, risk-limiting products and markets. Part II turns to the growth of securitization. It then discusses structured finance and its impacts on mortgage markets, again with specific attention to the role of federal policy in nurturing these systems. Finally, Part III discusses the policy debates and developments surrounding subprime and other high-risk mortgage lending from the 1990s through the 2007-2008 mortgage crisis.

1. THE DEVELOPMENT OF RISK-LIMITING MORTGAGE MARKETS IN THE UNITED STATES

   The structure of homeownership finance played a key role in the relatively limited extent of homeownership in the United States through the early decades of the twentieth century. Prior to the late nineteenth century, institutional lending for homeownership was relatively rare, although early forms generally date back to the first terminating building society in 1831. (8) For the nonaffluent, owner occupancy was usually achieved during this pre-institutional period through some combination of doing one's own construction, extensive household savings, borrowing from individuals, and land contract financing. (9)

   It is no coincidence that institutional lending in the United States and in England grew substantially with the Second Industrial Revolution and large scale urbanization in the late nineteenth century and early twentieth century. Rural homesteaders faced fewer obstacles to homebuilding and ownership than urban households. Land was relatively inexpensive and materials could generally be harvested off the land. As cities grew and land values rose, however, working class and modest-income families could rarely afford to buy land and build a house without some sort of financing over time. (10)

   The rise of stable, risk-limiting mortgage finance markets in the broad middle part of the twentieth century--epitomized by the long-term dominance of the plain-vanilla thirty-year fixed-rate mortgage--was dependent on a persistent and substantive role for the federal government. The timeline of U.S. mortgage market development and change is not one of bright lines and clear boundaries, although there were certainly periods during which change occurred quite rapidly. Rather, different outside forces--including those based in technology, policy, and demography--interacted with each other to produce new financial products and practices, changes in the structure of the financial services industry, and various opportunities and vulnerabilities among homeowners and would-be homeowners in different parts of the country.

   1. The Local Building and Loan

      From the early decades of the twentieth century through at least the 1970s, it is arguable that no single type of lender was more important to the development of government-supervised, risk-limiting mortgage markets than the building and loan ("B&L"), later called the savings and loan ("S&L"). The B&L became a major provider of mortgage credit, and because of its direct and indirect impacts on the structure of home finance and the mortgage market itself. Traditional, permanent B&Ls developed into a significant industry in the later decades of the nineteenth century. (11) Early B&Ls were primarily local institutions, with many members knowing each other or having some common association. Social and geographic cohesiveness gave them an informational advantage that kept underwriting costs and defaults low. B&L members/borrowers depended on the solvency and profitability of the B&L, and the fate of the B&L rested closely with the success of borrowers. (12)

      Besides B&Ls, life insurance and mortgage companies were important providers of mortgages in the late nineteenth century and early twentieth centuries. (13) Mortgage companies made loans and then sold either individual loans (what would now be called "whole loan" sales) or bonds backed by the loans to investors. The bonds sold by mortgage companies, however, were not like the mortgage-backed securities that became so common in the late twentieth century. These bonds more closely resembled corporate bonds because they remained general obligations of the originating mortgage company, and the underlying mortgages remained on the books of the mortgage company. (14)

      Local B&Ls grew significantly in the early twentieth century--supported to some degree by state-level regulation that had begun in the late nineteenth century--and maintained their emphasis on homeownership finance. (15) After the Panic of 1907 and through the boom period of the early 1920s, the number of local B&Ls grew, buttressed by the social and cultural mores that favored homeownership and by the general growth in real estate and the economy. (16) With the real estate collapse of the late 1920s and the onset of the Great Depression, the number of B&Ls declined, but at the beginning of the Great Depression, B&Ls made about one-fifth of home mortgages in the United States. (17) Moreover, commercial banks tended to fare even worse than B&Ls in the early 1930s, in part because bank depositors could withdraw their funds more quickly than those who held B&L shares, which exacerbated bank runs and failures.

      There were significant differences in the structure and nature of credit provided by various types of lenders. B&Ls provided longer-term loans with higher loan-to-value ratios (but still rarely ever exceeding 80%) than banks or insurance companies. (18) In the 1920s, the average term of mortgages was eleven years for those...