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Who's The Villain In Subprime Bust? Data Point To Gov't

Mortgage-backed securities loaded with "toxic" subprime loans fueled the housing bubble and crash. Many blame Wall Street bankers for the MBS debacle. But actual data show that government policy was the main culprit.

Packages of mortgages sold to investors were a safe investment for decades. It wasn't the creation of mortgage securities that triggered the subprime boom. Rather, government policy unleashed subprime into the MBS market.

"The Department of Housing and Urban Development was pushing the National Homeownership Strategy since 1995 that basically said, 'Do away with down payments,'" said Ed Pinto, a resident fellow at the conservative American Enterprise Institute. "Doing away with down payments drove an increase in leverage throughout the market and the result was that everyone got on the bandwagon, including the market for MBSs. As a result, credit loosened tremendously.

Affordable Mandate

HUD not only encouraged no down payments but also adopted affordable housing mandates for the government-sponsored en terprises that issue mortgage securities, Fannie Mae and Freddie Mac. Beginning in 1996, the GSEs had to make 40% of new loans they financed to borrowers with incomes below the national median.

With lower underwriting standards and a mandate to fulfill, Fannie and Freddie's MBS issuance began to take off. It surged more than 116%, from $342 billion in 1997 to $741 billion in 1998.

It was a recipe for disaster as Fannie and Freddie had an implicit guarantee (since made explicit) that the government would cover any losses that they suffered. With that backing, investors were all too willing to gobble up the GSEs' MBS offerings, even if they included subprime loans.

But this also pushed up housing prices, making it harder for new borrowers to afford a home.

"That became known as the 'affordability gap,'" said Pinto. "Housing prices are going up 15% a year and we have to loosen underwriting standards even more so that borrowers can afford the higher prices.

Just Lower Your Standards

By 2000, Fannie and Freddie were financing loans with zero down payments. The private market soon followed. By 2006, 30% of all homebuyers made no down payment.

Also in 2000 HUD required Fannie and Freddie to increase to 50% of new loans they financed to borrowers with incomes below the national median. It also encouraged increasing the allowable debt ratio of borrowers and lowering credit score standards. This made far more potential borrowers eligible to buy a home.

But these were riskier borrowers, and these changes also added more fuel to home prices.

After those changes, Fannie and Freddie's business skyrocketed. Their MBS issues jumped from about $469 billion in 2000 to $1.1 trillion in 2001. The increase continued, rising to $1.5 trillion in 2002 and $2.2 trillion in 2003.

As GSEs' issuance of mortgage securities began to fall in 2004, the private MBS market took up some of the slack. Private issuance rose from $684 billion in 2003 to $980 billion in 2004 to a high of $1.3 trillion in 2005.

Yet private mortgage securities never matched that of the GSEs. From 1995-2009, the private market issued about $6.8 trillion in MBSs vs. $14 trillion for Fannie and Freddie.

Since the crisis, the private MBS market has been very slow to recover. Fannie, Freddie and a much-expanded Federal Housing Administration dominate home loan finance even more than during the boom.