The Real Scandal: How Feds Invited the Mortgage Mess

Perhaps the greatest scandal of the mortgage crisis is that it is a direct result of an intentional loosening of underwriting standards—done in the name of ending discrimination, despite warnings that it could lead to wide-scale defaults.

At the crisis’ core are loans that were made with virtually nonexistent underwriting standards—no verification of income or assets; little consideration of the applicant’s ability to make payments; no down payment.

Most people instinctively understand that such loans are likely to be unsound. But how did the heavily-regulated banking industry end up able to engage in such foolishness?

From the current hand-wringing, you’d think that the banks came up with the idea of looser underwriting standards on their own, with regulators just asleep on the job. In fact, it was the regulators who relaxed these standards—at the behest of community groups and “progressive” political forces.

In the 1980s, groups such as the activists at ACORN began pushing charges of “redlining”—claims that banks discriminated against minorities in mortgage lending. In 1989, sympathetic members of Congress got the Home Mortgage Disclosure Act amended to force banks to collect racial data on mortgage applicants; this allowed various studies to be ginned up that seemed to validate the original accusation.

In fact, minority mortgage applications were rejected more frequently than other applications—but the overwhelming reason wasn’t racial discrimination, but simply that minorities tend to have weaker finances.

Yet a “landmark” 1992 study from the Boston Fed concluded that mortgage-lending discrimination was systemic.

That study was tremendously flawed—a colleague and I later showed that the data it had used contained thousands of egregious typos, such as loans with negative interest rates. Our study found no evidence of discrimination.

Yet the political agenda triumphed—with the president of the Boston Fed saying no new studies were needed, and the US comptroller of the currency seconding the motion.

No sooner had the ink dried on its discrimination study than the Boston Fed, clearly speaking for the entire Fed, produced a manual for mortgage lenders stating that: “discrimination may be observed when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower-income minority applicants.”

Some of these “outdated” criteria included the size of the mortgage payment relative to income, credit history, savings history and income verification. Instead, the Boston Fed ruled that participation in a credit-counseling program should be taken as evidence of an applicant’s ability to manage debt.

Sound crazy? You bet. Those “outdated” standards existed to limit defaults. But bank regulators required the loosened underwriting standards, with approval by politicians and the chattering class. A 1995 strengthening of the Community Reinvestment Act required banks to find ways to provide mortgages to their poorer communities. It also let community activists intervene at yearly bank reviews, shaking the banks down for large pots of money.

Banks that got poor reviews were punished; some saw their merger plans frustrated; others faced direct legal challenges by the Justice Department.

Flexible lending programs expanded even though they had higher default rates than loans with traditional standards. On the Web, you can still find CRA loans available via ACORN with “100 percent financing . . . no credit scores . . . undocumented income . . . even if you don’t report it on your tax returns.” Credit counseling is required, of course.

Ironically, an enthusiastic Fannie Mae Foundation report singled out one paragon of nondiscriminatory lending, which worked with community activists and followed “the most flexible underwriting criteria permitted.” That lender’s $1 billion commitment to low-income loans in 1992 had grown to $80 billion by 1999 and $600 billion by early 2003.

Who was that virtuous lender? Why—Countrywide, the nation’s largest mortgage lender, recently in the headlines as it hurtled toward bankruptcy.

In an earlier newspaper story extolling the virtues of relaxed underwriting standards, Countrywide’s chief executive bragged that, to approve minority applications that would otherwise be rejected “lenders have had to stretch the rules a bit.” He’s not bragging now.

For years, rising house prices hid the default problems since quick refinances were possible. But now that house prices have stopped rising, we can clearly see the damage caused by relaxed lending standards.

This damage was quite predictable: “After the warm and fuzzy glow of ‘flexible underwriting standards’ has worn off, we may discover that they are nothing more than standards that lead to bad loans . . . these policies will have done a disservice to their putative beneficiaries if . . . they are dispossessed from their homes.” I wrote that, with Ted Day, in a 1998 academic article.

Sadly, we were spitting into the wind.

These days, everyone claims to favor strong lending standards. What about all those self-righteous newspapers, politicians and regulators who were intent on loosening lending standards?

As you might expect, they are now self-righteously blaming those, such as Countrywide, who did what they were told.