The Quiet Change in Commercial Banks
Some men rob you with a six-gun—others rob you with a fountain pen.
—Woody Guthrie
The Change
Commercial banks no longer only do what most people think: make loans and collect interest on them. Bankers decry that activity as plain vanilla banking. Commercial banking has entered the age of financialization. This is how it started:
• They no longer keep home mortgages on their books.
• They group the mortgages together in a package with, say, a total principal amount of $1 billion.
• Then sell it to investors as a residential mortgage-backed security (RMBS).
The grouping of these mortgages into a package that is more easily saleable is creating a security that can be sold on the financial markets and so is called securitization.
This package is then transferred to a corporation created for the single purpose of owning and managing the mortgage portfolio. Often, the commercial bank that originated the mortgages becomes the manager of this corporation and is called a mortgage servicer. The borrowers continue to pay to that bank, so they usually have no idea that their mortgage has been sold by the bank to investors.
This new commercial bank business model is called “originate and sell”.
Fannie Mae: Perverse Incentives Enter
In the stories of Fannie Mae (Federal National Mortgage Association (FNMA) and Freddie Mac (Federal Home Loan Mortgage Corporation (FHLMC), we will see examples of good intentions-bad outcomes because they were implemented by bankers with no controls over their greed.
● Fannie Mae was created in 1938 to help average Americans buy a home.
● Freddie Mac was founded in 1970 to be a competitor of Fannie.
Banks are limited in the amount they can lend by the requirement to keep a level of equity against loss from uncollectible loans called regulatory capital. But if the banks could get the loans off their books, they could lend more and make more.
Fannie was a brilliant innovation to increase bank lending power.
● It would buy the mortgages from the banks in large pools;
● Securitize them as explained above (RBMS); and
● Sell them to investors.
Bankers loved the arrangement because the risk of default was shifted entirely to the investors. Another plus, bankers got most of the profit upfront in a lump sum payment. They didn’t have to wait 30 years. A whopping amount of upfront cash for bigger banker bonuses.
Investors loved the product, considered equal in safety to treasury bonds but paying a higher yield. Actually better because, there was an implied guarantee that because Fannie and Freddie were government agencies, if there was any loss, the government would make it up to the investors.
The risk of default on most of the mortgages of the nation was now transferred entirely to the taxpayers.
The banks no longer had the loans on their books so they could make new loans, the only limitation being the number of quality customers.
● What might the bankers do to protect their new level of bonuses when the pool of qualified applicants dried up?
New York State bank manager Michael T. Connelly told me that because the risk was transferred off the bank’s books, whenever a mortgage was to be securitized, the mortgage officers applied the standards, “loosey goosey” (his words).
Connelly added that because the private mortgage lenders were paying their loan officers a substantial commission for successful applications, the commercial banks we’re losing their loan officers to the private lenders. Thus, the commercial banks had to start paying their loan officers a commission. It was a recipe for disaster.[1]
As well, Mary Garvin, who ran a business that involved advising car dealerships in New York state, told me that starting in 1999, car salesmen were jumping into the mortgage business. She knew if they were doing to mortgage sales what they had done with car sales, "this won't be some backdoor sale gone wrong, this will be a huge problem and show up on the national stage".
In their book about the financial crisis, All The Devils Are Here, Bethany McLean, and Joseph Nocera devote a whole chapter to the luxurious lifestyle these loan officers were leading and the perks they were given:
“During subprime two kids, just out of school—sometimes high school—became loan officers, some of them pulling down $30,000 or $40,000 a month. (Slickdaddy G told Bob that in one especially good month he took home $125,000).”
● What might the loan officers do to protect their huge commissions when the pool of qualified applicants dried up?
Uncovering What Actually Caused 2008
Fannie and Freddie have the usual lending standards that are common sense: proof of a job with income sufficient to make the mortgage payments, a good job history, a good credit score, and such. The one innovation was to only require a 5% down payment rather than a 20% to allow lower income families to buy a home. But otherwise, the usual standards were in place. Only mortgages that conformed to the standards, and hence were called ‘conforming mortgages’, were eligible for the Fannie and Freddie residential mortgage backed securities (RMBS).
At one point Fannie and Freddie slightly lowered their lending standards, but they were still reasonable standards in place.
Recall how the media and the Internet were flooded with stories about ninja borrowers – no income, no jobs and no assets. In the movie version of The Big Short, one of the hedge fund antiheroes, Mark Baum, went on site to investigate who these borrowers were and was shown in a strip joint, talking to a dancer who owned six properties.
A goal of the movie was to make a dull subject interesting but examples like this supported the deception that Fannie and Freddie had no lending standards whatsoever. Not true, but an essential foundation of the Big Lie explanation of the 2008 crash.
So, the critical question is: if Fannie and Freddie had conforming mortgage standards, and there were a huge number of these completely unqualified borrowers that didn’t meet any standards, how did so many get loans that their defaults could bring down the housing market?
Notice this is not a question asked by the hundreds of commentators who rushed to publish and be the first ones to explain to us what happened in 2008. We will look at the evidence.
Well written and interesting! The move from "plain vanilla banking" to the "originate and sell" model, alongside securitization and the perverse incentives embedded in this system, is a hallmark of the broader transformation rooted in the USA's transition from the Old Republic to the Neoliberal Era.
During the times old the Old Republic (~1830s to ~1970s), banking was primarily localized and community-oriented, restrained by regulatory frameworks like the Glass-Steagall Act and interstate banking restrictions. These structures encouraged prudence in lending and maintained a closer match up between banks' interests and those of their customers. However, the Neoliberal Era dismantled these decentralizing structures and safeguards. Deregulation and financial centralization paved the way for speculative practices. Things like Fannie Mae and Freddie Mac, initially designed to expand access to homeownership, became vehicles for risk transfer and profiteering
This didnt happen in a vacuum. The dismantling of the various capital flow inhibitors (which had been around, in varying forms, since the 1830s) and the concentration of financial power undermined the regional economic diversity and resilience that had been one of the main calling cards of the Old Republic. The rise of securitization and subprime lending grew and grew in this centralized system, where local oversight and accountability were replaced by impersonal, profit-driven mechanisms.
Your anecdote about "loosey-goosey" is right on. The Neoliberal obsession with short term profits over long-term economic health transformed financial institutions from pillars of local economic growth into engines of systemic risk.
The crisis of 2008 revealed the fundamental flaws of this shift, exposing how the financial sector's alignment with Neoliberal principles led to widespread economic harm. A return to principles that emphasize decentralization, accountability, and match up between financial institutions and public welfare needs to be restored. The Old Republic's emphasis on localized economic control and financial prudence offers the lessons we need for building a more stable and equitable system, and in fact, it would even be much more economically vibrant
Fannie and Freddie were relative latecomers to the mortgage bubble. https://www.thebalancemoney.com/did-fannie-and-freddie-cause-the-mortgage-crisis-3305659
" In 2005, the Senate sponsored a bill that prohibited them from holding mortgage-backed securities in their portfolios. Congress wanted to reduce the risk to the government. By 2009, the two GSEs owned or guaranteed 44%, or $4.8 trillion (in 2009 dollars), of residential mortgage debt, up from 36% in 2006.3 Congressional Budget Office. "Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market," Pages 10-11.
But the Senate bill failed..."
Most of the bundled had already been made by private banks in the aftermath of the repeal of Glass-Stegall (encouraged and signed by President Clinton, but a bill proposed by Republicans--the Gramm-Leach-Bliley Act--and passed by bipartisan majorities.)