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

 
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.

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