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Marketplace Scratch Pad

Guest post

Scott Jagow Jun 26, 2009

I was hanging around the water cooler today (the actual water cooler), and Senior Editor Paddy Hirsch told me he was reading David Faber’s new book, And Then the Roof Caved In. Already? It just came out this week. Paddy doesn’t miss much. Anyway, the book’s subtitle is: How Wall Street’s Greed and Stupidity Brought Capitalism to Its Knees. So that might pique your interest. If not, here’s Paddy with a few thoughts on the book:

So, I’ve been reading David Faber’s new book And Then The Roof Caved In. It’s a bit Wall Street-y, but if you know enough about financial markets to make you dangerous, it’s a pretty good read.

A couple of things jumped out at me that I thought I’d draw to your attention.

Here’s the first thing:

“Myths have a way of being perpetuated long enough that they become unquestioned facts. One such myth that has been bruited about in 2008 and 2009 is that the lax lending standards of Fannie and Freddie promulgated the current crisis. It is not true.”

I have to say, I’d bought into this myth myself. Maybe because the people on the Hill have been so relentless in pointing the finger at Fan and Fred. But Faber says that it was Fannie and Freddie that kept lending standards high, right up until 2003/2004. That was when they were both slapped for understating earnings. They all but withdrew from the market, and Wall Street lenders stepped in.

In 2003, roughly $4 trillion worth of mortgages were originated in the United States … In that same record year, 70 percent of those mortgages were sold to Fannie Mae and Freddie Mac. Seventy percent of that $4 trillion conformed to Fannie and Freddie’s guidelines.

In 2006, roughly $3 trillion of mortgages were originated in the United States. In that year, Fannie Mae and Freddie Mac accounted for only 30 percent … In three years the share of mortgages they bought had gone from 70 percent to 30 percent. The guidelines for lending that Fannie and Freddie had so diligently applied to the mortgage market were no longer operative.

In other words, the guidelines to keep borrowers from taking out mortgages that they couldn’t afford did exist – they were Fan and Fred’s guidelines, but Wall Street lenders simply ignored them.

And here’s the kicker. After a short timeout, Fan and Fred decided to get back into the market.

“In June 2005, Fannie Mae found itself at a strategic crossroads, according to a then-confidential presentation prepared for Fannie’s then-CEO Daniel Mudd. The document, unearthed by Representative Henry Waxman’s Committee on Oversight and Government Reform, lays out two clear choices. Fannie Mae could either “stay the course” [stick with the prime, well-documented mortgages they had always issued] or “meet the market where the market is” [i.e, do what Wall Street lenders were doing].

Of course, they followed the money, and tossed out their own rulebook. And that was that.

The second thing that struck me was that we’ve been hearing a lot about consumer protection and the need for an agency to stop us from being ripped off by unscrupulous lenders.

Faber spoke to Sheila Bair and Dr Edward Gramlich, who was on the board of the Fed until 2005. The essence of his interviews with them, as well as interviews with people who lent to subprime borrowers, is that none of these loans would have been possible, if lenders had insisted on just one thing: that borrowers fully document their income. That’s right, all they had to do was ask people to tell the truth. And here’s the thing – they had the power to make people tell the truth, courtesy of the IRS:

IRS form 4506 allows a mortgage lender to have access to a couple of key lines of a person’s tax return in order to verify his or her income.

Here’s Bair:

I mean we’re not talking about rocket science here. We’re talking about underwriting at the fully indexed rate. Meaning when you make a loan, make sure they can afford it when it resets, not just at the initial teaser rate. We’re talking about verifying income. I mean, if there were two evils that drove this it was what we called teaser rate underwriting and not documenting income.

Faber then spoke to Alan Greenspan, who said the laws needed to crack down on abusive practices were already on the books. But there was no enforcement.

If there is egregious fraud, if there is egregious practice, one doesn’t need new supervision and regulation. What one needs is law enforcement.

A lot of this rings true to me. If lenders were required to implement form IRS 4506, then people simply would not have been able to get these loans. So do we really need a whole new consumer protection agency? I can’t help thinking that all we need to do is tell people not to lie, and prosecute them when they do.

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