Fragile By Design: A Review

For over 20 years, Fiderer has been a banker covering the energy industry. Before that he was a tax lawyer. He wrote extensively about the crisis in Huffington Post until early 2011, when there was blowback in response his characterization of claims made by Peter Wallison, about Fannie and Freddie’s role in the mortgage crisis, as “lies.” He is currently trying to finish a book on the rating agencies in his spare time.


Pundit-Level Arguments Dominating Elite Business Schools Financial Crisis Discussions

by David Fiderer


Fragile By Design: The Political Origins of Banking Crises and Scarce Credit is a tour de force, and not in a good way. The book’s history of U.S. banking is troubling. The narrative covering the period from the Civil War until the 1990s is highly selective and misleading. Worse, the section that covers U.S. banking over the past 25 years is a set of distortions and falsehoods that should be obvious to anyone with a basic knowledge of the recent financial crisis.

Yet the book has been greeted enthusiastically. It was recently considered by the Financial Times and McKinsey for the Business Book of the Year Award, and its thesis about the recent financial crisis has been presented by the authors at events hosted by the World Bank, the Bank of England, the San Francisco Fed, the Atlanta Fed and the SEC. “[I]f you are looking for a rich history of banking over the last couple of centuries and the role played by politics in that evolution there is no better study,” wrote The New York Times reviewer. “It deserves to become a classic.” The book’s false portrayal of the recent crisis, left unchallenged, is likely to be used as a standard reference work for conservatives intent on rewriting history.

The two authors, Prof. Charles Calomiris of Columbia and Prof. Stephen Haber of Stanford, are well known. Calomiris’s 67-page CV cites, among many accomplishments, his stints as a Visiting Research Fellow at the International Monetary Fund and as a Senior Fellow at the Bank of England, as well as his 21-year affiliation with the American Enterprise Institute. Haber, who teaches Political Science at Stanford, is a Senior Fellow at Stanford’s Hoover Institution.

The book’s central argument is that the proximate cause of the financial collapse was the risky lending mandated by Community Reinvestment Act (CRA) and by affordable housing goals set for government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. This familiar narrative, identified as “The Big Lie” by Joe Nocera, Barry Ritholtz, and others, is still deemed valid by a lot of people who should know better. Simply put, loan performance at Fannie and Freddie has always been exponentially superior to that of any other sector in residential mortgages, whereas the loan performance of private label residential mortgage securities has been radically worse than that of other sectors in the mortgage market. Most of the credit losses were tied to private mortgage securities. To state otherwise is a lie.

Calomiris and Haber embrace The Big Lie, and double down by tracing everything to Bill Clinton’s grand strategy of income redistribution as a response to economic inequality or as a sop to community activists at ACORN. Their story is as follows: in the 1990s banks sought government approval for proposed mergers and soon recognized that such approval was subject to certain conditions set by Clinton and his urban activist allies. The banks were compelled to book vast numbers of recklessly imprudent loans extended to the urban poor, by way of the CRA and GSE affordable housing goals.

Once banks started making ultra-risky loans under the CRA, they quickly started making ultra-risky loans to everyone else, because all these crappy loans could be sold to the GSEs, which then foisted them off onto unsuspecting investors who bought GSE mortgage securities. And once the GSEs started financing ultra-risky loans to poor people, they were forced to apply the same ultra-risky credit standards to everyone else. Eventually, the CRA and housing goals created a kind of Animal Farm dystopia, where everyone was equal because everyone’s mortgage was underwritten with the same recklessly imprudent terms.

In short, the GSEs, working in tandem with the banks and the investment banks, created and sold private mortgage securities, CDOs, and credit default swaps to unsuspecting investors. And when home prices stopped rising and the music stopped, the GSEs, the banks, and the investment banks were stuck holding those same private mortgage securities, CDOs, and credit default swaps, which is why many of them became insolvent.

No, I am not distorting Calomiris and Haber’s work.

The Financial Times, reviewing this book, says that “[t]hose on the left…tend to close their ears to this story, filing it under Republican disingenuity.” Sadly for the FT, this crackpot narrative has been debunked many times over. The Federal Reserve Board “found no connection between CRA and the subprime mortgage problems.” A subsequent Fed study found “lender tests indicate that areas disproportionately served by lenders covered by the CRA experienced lower delinquency rates and less risky lending.” Per the Minneapolis Fed: “The available evidence seems to run counter to the contention that the CRA contributed in any substantive way to the current mortgage crisis.” These findings were echoed by the Richmond Fed.

The St. Louis Fed posed a question: “Did Affordable Housing Legislation Contribute to the Subprime Securities Boom?” And the data offered a clear-cut answer: “No… We find no evidence that lenders increased subprime originations or altered pricing around the discrete eligibility cutoffs for the Government Sponsored Enterprises’ (GSEs) affordable housing goals or the Community Reinvestment Act.” An earlier Fed study arrived at a substantially similar conclusion, as did nine out of ten members of the FCIC.

How do Calomiris or Haber address and respond to these studies? They don’t, and they aren’t alone. The lack of response to the critics of The Big Lie defines the entire genre. And these aren’t random writers; these are business professors at elite universities and think tanks who reject an empirical analysis framework for engaging their critics. Read Fault Lines by Raghuram Rajan at the University of Chicago. Read Guaranteed To Fail by Profs.Viral Acharya, Stijn Van Nieuwerburgh, Matthew Richardson, and Lawrence J. White, all at NYU. Or, on related topics, read “Rethinking FHA” by Prof. Joseph Gyourko at Wharton, or “Do We Need the 30-Year Fixed-Rate Mortgage?” by Prof. Anthony Sanders of George Mason University and Prof. Michael Lea at San Diego State. None of them compare loan performance of the GSEs, or FHA, or 30-year fixed rate loans, with that of other sectors in the same market.

It’s worth taking a minute to dissect the historical fantasy Calomiris and Haber construct. Their central narrative goes as follows:

Once the basic rules of this game were laid down in the early 1990s, the game unfolded in a predictable manner. Fannie and Freddie were forced to reduce their underwriting standards to accommodate increasing lending mandates to targeted groups. Importantly, those weaker standards were applied to all borrowers: to have done otherwise would have been a tacit admission that a portion of their portfolio was, in fact, high risk, which would have alarmed their shareholders. Many commercial banks, knowing that they could either sell high-risk loans to Fannie and Freddie or convert them into mortgage-backed securities guaranteed by Fannie and Freddie, jumped into the subprime securitization market. [Emphasis in the original.] […]

We cannot emphasize this point strongly enough: when Fannie and Freddie agreed to purchase loans the required only a 3% down payment, no documentation of income or employment, and a far from perfect credit score, they change the risk calculus of millions of American families, not just the urban poor. […]

As a matter of logic, it is conceivable that Fannie and Freddie could have selectively relaxed underwriting standards for targeted groups. As a practical matter, however, doing so would have been very difficult.

This is core to their story: affordability goals weren’t a small portion of GSEs’ loans. They effectively rewrote the entire mortgage market for everyone in the country.

Yet anyone who did a five-minute web search would demolish this notion. This link and this link are but two examples of many public filings that show how the GSEs used different credit standards for different types of borrowers, forgoing the entire logic of the Fragile by Design narrative. The entire premise of affordable housing goals was that the GSEs had the capacity to take on incremental exposures of higher-risk loans as a small counterweight to their huge portfolios of low-risk mortgages. Every business student knows basic portfolio theory.

And as a practical matter, just about every public utility, common carrier, pharmaceutical company, and hospital “effectively discriminates against most Americans by explicitly granting special arrangements to targeted groups.” Consider, for example, the rampant and institutionalized age discrimination seen at movie theater box offices. And yet, everyone who followed the companies knew that the GSEs used more relaxed standards for certain targeted groups.

Some of the authors’ zingers are harder to unpack. Consider the GSE loans they describe above, ones that “required only a 3% down payment, no documentation of income or employment, and a far from perfect credit score,” ones that changed “the risk calculus of millions of American families.”

There is zero evidence that the loans described by Calomiris and Haber ever existed. From 2001 through 2006, GSE originations that had loan-to-value (LTV) ratios of 95 percent or higher and FICO scores of 639 or lower represented between 1 and 2 percent of total originations. According to GSE credit guidelines, those borrowers had characteristics that disallowed any kind of reduced documentation, much less no documentation or employment.

Fannie and Freddie could not, by law, assume the primary credit risk on any mortgage with an LTV in excess of 80 percent. If a loan had an LTV higher than 80 percent, then the first loss was covered by private mortgage insurance. In addition, the GSEs’ policies prevented them from assuming 80 percent credit exposure on high-LTV loans. So, for example, if Fannie booked a loan had an LTV of 97 percent, the minimum insurance coverage would be 35 percent, so that Fannie’s net risk exposure would be no more than 62 percent of the LTV. The data is very clear that homes financed by the GSEs never experienced the steep rise, or drop, in prices that was measured by the Case-Shiller composite (see page 90).

In other words, the amount of low-down-payment loans available in the marketplace was never decided by the GSEs. It was decided by private mortgage insurers, which were not regulated by the federal government.

Business Models: The Difference Between Originate-to-Distribute and Buy-and-Hold

Calomiris and Haber blur commercial banks with non-banks and the GSEs, and they conflate GSE mortgage securities with private label mortgage securities and their progeny, throughout their text. Private label mortgage securities transfer credit risk and interest rate risk from the underwriting bank to the bondholders, whereas GSE mortgage securities do not transfer credit risk, only interest rate risk. All GSE mortgage bonds benefited from unconditional corporate guarantees.

Moreover, the financial meltdown of September 2008 was not triggered by bank failures; it was triggered by the failures of non-banks and by the unforeseen consequences of derivatives. The government had a clear legal path and precedent for dealing with bank failures like Wachovia, Washington Mutual, and IndyMac. But it had no clear path and no precedent for dealing with the imminent collapse of Lehman Brothers and AIG. This uncertainty about the fate of non-banks, which included the non-bank subsidiaries of bank holding companies, rocked the financial markets after Lehman filed for bankruptcy on September 15, 2008.

Remember that time everyone had to suddenly memorize all the financial acronyms? If you read about the financial crisis, you should know about CDOs (collateralized debt obligations); and about CDS (credit default swaps); and the initials MBS, which generally refer to the private label mortgage-backed securitizations, where most credit losses resided. Just one more serving of alphabet soup: CDS collapsed AIG, and CDO collapsed Citigroup, Merrill Lynch, UBS, MBIA and AMAC. Fannie and Freddie had nothing to do with CDOs and CDS.

Fannie and Freddie did hold large amounts of their own securities, but again, it made no difference whether they sold or held them, because their credit risk exposure never changed, and those holdings had nothing to do with regulatory capital. And the GSEs did hold about $225 billion of the most senior tranches of private mortgage securities. Court filings and settlements indicate that most of the losses were caused by fraud.

When the GSEs were taken over by the government in September 2008, Fannie’s serious delinquency rate was 1.36 percent, well below levels seen in the mid-1980s. And Freddie’s serious delinquency rate, 0.93 percent, was lower than the lowest national average ever recorded by the Mortgage Bankers Association. According to the MBA, the nationwide serious delinquency rate as of June 30, 2008 was 4.5 percent. For subprime mortgages it was almost 18 percent. Again, in terms of loan performance, the GSEs were in a class by themselves.

The Premise of The Big Lie

There’s only one reason why The Big Lie seemed so plausible to so many people. The polite word for it is social stereotyping. Affordable housing goals are set for “Central Cities, Rural Areas and Other Underserved Areas.” These goals target “low and moderate income borrowers.” A Financial Times columnist translates this into “the government’s euphemism for ethnic minority neighbourhoods.”

Calomiris and Haber do the same. They scrub away references to anything rural or to moderate-income borrowers. “At the core of this bargain was a coalition of two very unlikely partners: rapidly growing megabanks and activist groups that promoted expansion of risky mortgage lending to poor and intercity borrowers, such as the Association of Community Organizations for Reform Now (ACORN),” they write. They reference ACORN 11 times.

The book’s broader narrative about U.S. banking is framed around an urban/rural divide. Prior to the 1990s, the farmers in rural states were suspicious of nationwide banking that would concentrate economic power in the money centers of the Northeast. (The authors sidestep the impact of the National Banking system and the absence of a central bank until 1913.) Calomiris and Haber contrive another urban/rural divide to explain the CRA and affordable housing goals. This was the core of a “grand bargain” that favored a key constituency of the Democratic Party, the urban poor and urban activists like ACORN, at the expense of Republican constituencies in rural areas.

If you go in for that kind of stuff, then it makes perfect sense that any government program intended to benefit low-income people must corrupt the free marketplace and eventually create a financial disaster. Who needs empirical data to prove that? This kind of fact-free analysis, a staple of cable TV and certain media outlets, has become pervasive. But it has no place in a legitimate business setting or university setting. Determining whether or not a loan’s terms match “the market,” a much more useful debate, involves a very detailed analysis of the borrower and the loan product, which is way beyond the ken of Calomiris and Haber.

There is no evidence that CRA goals ever represented a material hurdle towards attaining regulatory approval of the large bank mergers in the 1990s. Of the 13,500 applications submitted to Fed, only 25 were denied, with eight being denied because of “unsatisfactory consumer protection or community reinvestment issues.” The GSEs, however, were subject to ability-to-repay regulations and other anti-predatory constraints put in place in 2000.

The irony is rich. This private label securitization system was built over decades, and at every step of the expansion of this predatory and abusive lending system conservative economists were there lending support. Calomiris in particular was an active participant, fighting against any prohibition against single premium credit insurance, opposing prohibitions on loans based on housing collateral that disregarded a borrower’s ability to repay, and writing in 1999 that 125 percent LTV lending was no big deal.

After skyrocketing in size and scope before the crisis, the securitization of the housing market is now dead. There’s debate on whether it can ever come back to life. As we discuss what the future of housing finance and the financial sector looks like, there needs to be a real accounting for what has happened in the past. Sadly, a group of elite academics are more dedicated to confusion and playing up innuendo than actual analysis and the truth.

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