Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram G. Rajan Read Free Book Online

against the package after guaranteeing the mortgages against default. They also started borrowing directly from the market and investing in mortgage-backed securities underwritten by other banks. Because the mortgages were sound, these were fairly safe and extremely profitable activities. But much of the profit stemmed from their low cost of financing, deriving from the implicit government guarantee, and this was a critical political vulnerability.

The Affordable-Housing Mandate
     
    As evidence mounted in the early 1990s that more and more Americans faced stagnant or declining incomes, the political establishment started looking for ways to help them with fast-acting measures—certainly faster than education reform, which would take decades to produce results. Affordable housing for low-income groups was the obvious answer, and Fannie and Freddie were the obvious channels. Congress knew it could use Fannie and Freddie as vehicles for its designs because they benefited so much from government largesse, and their managers’ arms could be twisted without any of the agencies’ activities inconveniently showing up as an expenditure in government budgets.
    In 1992, the U.S. Congress passed the Federal Housing Enterprise Safety and Soundness Act, partly to reform the regulation of the agencies and partly to promote homeownership for low-income and minority groups explicitly. The act instructed the Department of Housing and Urban Development (HUD) to develop affordable-housing goals for the agencies and to monitor progress toward these goals. Whenever Congress includes the words
safety and soundness
in any bill, there is a distinct possibility that it will achieve exactly the opposite, and that is precisely what this piece of legislation did.
    Even though the agencies could not head off legislation, they could shape it to their advantage. They ensured that the legislation allowed them to hold less capital than other regulated financial institutions and that their new regulator, an office within HUD—which itself had no experience in financial-services regulation—was subject to congressional appropriation. 29 This meant that if the regulator actually started constraining the behavior of the agencies, the agencies’ friends in Congress could cut the regulator’s budget. The combination of an activist Congress, government-supported private firms hungry for profits, and a weak and pliant regulator proved disastrous.
    At first Fannie and Freddie were not eager to put their profitable franchise at risk. But seeing the political writing on the wall, they complied. Steven Holmes, a reporter for the
New York Times,
offered a prescient warning in the 1990s: “In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulty in flush economic times…. But the government sponsored entity may run into trouble in an economic downturn, prompting a government rescue similar to that of the Savings and Loan industry in the 1980s.” 30 As housing boomed, the agencies found the high rates available on low-income lending particularly attractive, and the benign environment and the lack of historical experience with low-income lending allowed them to ignore the additional risk.
    Under the Clinton administration, HUD steadily increased the amount of funding it required the agencies to allocate to low-income housing. The agencies complied, almost too eagerly: sometimes it appeared as if they were egging the administration on to increase their mandate so that they would be able to justify their higher risk taking (and not coincidentally, management’s higher bonuses) to their shareholders. After being set initially at 42 percent of assets in 1995, the mandate for low-income lending was increased to 50 percent of assets in 2000 (in the last year of the Clinton administration).
    Some critics worried that the agencies were turning a blind eye to predatory lending to those