Dismantling the economy’s legal infrastructure V-4: the transformation of mortgage finance in the 1980s

The 1980s saw dramatic reform of the structure of the banking system as the 1970 Hunt Commission’s recommendations for increasing the flow of funds into the mortgage market began to be adopted: first, bank and thrift funding was put on an equal footing; then, existing restrictions on mortgage lending by both commercial banks and thrifts were largely eliminated; at the same time, a policy of regulatory forbearance towards the troubled thrifts was enacted – in the vain hope that they would earn their way to solvency.

Legislation during these years also promoted the growth of mortgage securitization which played an increasingly important role in the mortgage market. The originate-to-distribute model of mortgage finance was born, where non-bank affiliates of commercial banks originated mortgages, and Fannie Mae and Freddie Mac set the standards that “conforming” mortgages had to meet in order to be salable. In short, over the course of the 1980s the mortgage finance system was completely transformed from one in which banks played a peripheral role to one where banks played the most important role. This took place because the predominant theory at the time, portfolio theory, saw no reason to maintain the distinction between banks and thrifts that had been drawn when banking theory was dominant.

It was in this period that the US banking system was effectively divided into two classes. An elite segment of very large banks thrived in the new environment and were able to leverage the new system of “market-based” finance into special treatment: these were the too-big-to-fail banks. The rest of the banking system, however, struggled in this environment where non-banks and the elite banks had special privileges that the typical bank did not. This section addresses the reforms that directly affected the majority of banks, while the next section will focus on the nascent too-big-to-fail banks.

Charts 1 through 4 below, drawn from FDIC data, demonstrate how very different the business model of the 7 largest US commercial banks was from that of the bulk of the banking system. Over the course of the 26 years covered by these charts the 7 largest US banks grew from accounting for only 20% of US bank assets to accounting for about 50% of US commercial bank assets just prior to the 2007-09 crisis. They continue to account for about 50% of assets today.

Chart 1: US commercial bank assets excluding the seven largest banks

Assets CB less 7

Chart 2: Seven largest US commercial bank assets

Assets Big 7

Chart 3: US commercial bank liabilities excluding seven largest banks

Liab CB less 7

Chart 4: Seven largest US commercial banks liabilitiesLiab big 7

The problem of monetary control

By the end of the 1970s many commercial banks were struggling. Their key source of funding was being eroded by competition with financial intermediaries that had been granted preferential regulatory status: the thrifts in the Northeast could pay interest on transaction accounts, MMFs could pay interest while offering limited checkwriting privileges, and for their biggest clients the banks had to compete with the totally unregulated Eurodollar market. In this difficult environment regulators had suddenly authorized the writing of “off balance sheet” guarantees. Unsurprisingly this set off destabilizing competitive dynamics, where the largest banks began to shift their business to fee-earning off-balance-sheet activities, promoting disintermediation at the expense of the banking system as a whole. Thus, in Chart 5 we see significant growth in MMFs and deposit substitutes at the end of the 1970s even as the growth in demand deposits stagnates.

Chart 5: Cash assets

Cash assets

Through the 1970s the Federal Reserve actively managed reserve requirements and their application to different instruments – including Eurodollar funding – in order to control the supply of credit. The Fed found, however, that banks were giving up their Federal Reserve membership in order to escape the regulatory burden of maintaining non-interest-bearing required reserves. Over the course of the 1970s the percent of transaction deposits held by member banks fell from 75% to 65% (and this measure did not include MMFs). The Fed’s ability to implement monetary policy was being eroded. A unilateral Fed proposal to start paying interest on reserves was blocked by Congressional opposition (Feinman 1993: 575-78). The Fed believed that monetary control required extending its authority to impose reserve requirements to cover all depository institutions (Volcker 1979). (Note that Volcker in his testimony on this issue is clearly aware that MMFs also have implications for monetary control, but does not appear to have solutions to offer.)

The Depository Institutions Deregulation and Monetary Control Act of 1980 (“DIDMCA,” Pub. L. 96-221) largely eliminated the distinction between thrifts and commercial banks on the liability side of the balance sheet (as the 1970 Commission had recommended):[1] it authorized thrifts to offer checkable deposits, phased out Regulation Q’s interest rate caps on all depository institution accounts, made thrifts subject to the Federal Reserve’s reserve requirements (with an eight year phase in), opened the Fed’s discount window to the thrifts, and raised the deposit insurance limit for both banks and thrifts to $100,000. On the asset side of the balance sheet, it repealed all usury restrictions on mortgages, including those at the state level (CEA 1981: 111).

Observe that the standard view at the time attributed the stabilization of the banking system in the 1930s to deposit insurance[2] (since the structural reforms of the 1930s were viewed as misguided) and thus there was an expectation that the expansion of deposit insurance mandated by the 1980 Act – together with the elimination of Regulation Q – would give the banks and thrifts a decisive competitive advantage over MMFs and Eurodollar accounts (FDIC 1997: 93). While DIDMCA was effective at stemming the outflow of deposits (see Chart 5), it slowed the growth of MMFs only temporarily.

In fact, there is strong evidence that any government sanction of a financial instrument that, like a bank deposit, is convertible at par into currency will be perceived as official support by the general public: the second wave growth of MMFs (see Chart 5) dates to the 1983 decision by the SEC (48 FR 32555) to formally authorize accounting for money market funds like bank deposits (that is, with a $1 net asset value) instead of using investment fund accounting. It is doubtful that MMFs are consistent with the intent of the Investment Company Act of 1940, which has two sections on “face amount certificate” companies that specify the capital and reserves that these companies are required to hold. As a result, in order for MMFs to operate as they had at the end of the 1970s, the SEC had to grant them exemptions from the Act and Rule 2a-4 (see 47 FR 5428). The 1983 Final Rule formalized this process of granting exemptions to the law in a regulation. In short, the post-Depression regulatory structure was explicitly designed to prevent investment funds from competing with deposits – unless they, like banks had capital and reserves. We have apparently learned the hard way that this structural separation was as important as deposit insurance in stabilizing the banking system post-Depression.

The Garn St Germain Act and its consequences

By 1980 the thrifts had been struggling for years with their legacy portfolios of long-term mortgages that had low fixed interest rates. The dramatic interest rate increases that accompanied Volcker’s policy of taming inflation had a devastating effect on these institutions, leaving many of them insolvent. Instead of recognizing the need to follow Roosevelt’s 1933 model of dealing assertively with a banking crisis by closing some thrifts and recapitalizing others, policymakers chose to eliminate restrictions on the thrifts’ asset portfolios in the hope that the thrifts would be able to earn their way to solvency.

The 1980 DIDMCA had already eliminated all interest rate ceilings on mortgages. In 1982 legislation dramatically broadened not just the types of residential mortgages the thrifts could make, permitting adjustable rate mortgages, balloon payments and negative amortization, but also dramatically increased what had been strict caps on commercial real estate lending (Pub. L. 97-320; McCoy et al. 2009: 499). It also eliminated entirely statutory limits on mortgage lending by commercial banks (§403(a)) such as the requirement that aggregate real estate loans not guaranteed or insured by a government agency could not exceed the greater of bank capital plus surplus or savings plus time deposits.[3]

For the first time in US history the regulation of bank mortgage lending was being left entirely in the hands of regulators. That is, the statutory restrictions on banking that legislators of the 1930s had put in place to protect financial stability and prevent real estate bubbles were first reframed by portfolio theory as “anti-competitive” and “inefficient,” and then eliminated by legislators unfamiliar with the actual history of the legislation. The OCC responded promptly with a regulation that placed no restrictions on national bank real estate lending (FDIC 1997: 95). In addition, within 5 years of this dramatic shift away from statutory restrictions, every single member of the Federal Reserve Board of Governors had been appointed by Reagan and the Fed was throwing its weight behind a deregulatory agenda.

Another part of the same legislation, known as the Garn St. Germain Act, made it easier for the depository institution insurers to provide assistance to troubled banks. Since 1935 the FDIC and FSLIC had been authorized to provide assistance to the merger of a failing bank with a sound one (Isaac 1984: 202). In some cases, the insurers provided “open bank assistance” to these mergers in the form of loans, deposits or purchases of assets, so that deposit-holders and other bank counterparties of the failed institution would experience no inconvenience. Prior to the Garn St. Germain Act the statutory requirements for such assistance were the determinations (i) that the institution was in danger of closing and (ii) that its services were “essential to the community.” Subsequent to the act these criteria were broadened significantly: the insurers could provide open bank assistance for the purpose of preventing the closing of an institution, restoring a closed institution to normal operation, or due to the danger of financial instability (§§ 111, 122; Gorinson & Manishin 1983: 1325).[4] They also could provide this assistance in additional ways including purchasing securities, assuming liabilities, and making contributions. The issue of “net worth certificates” to undercapitalized institutions whose loan portfolios were at least 20% mortgages were authorized (Title II).[5]

Observe that it was not just the thrifts that would be transformed by the Garn St. Germain Act. The law made it possible for the FDIC in 1984 to take Continental Illinois National Bank over on the basis of financial stability concerns. The development of the “too big to fail” doctrine protecting large banks will be explored in the next section. The same legislation also raised the statutory limit on national bank loans to a single borrower from 10% of bank capital to 15% of capital or, if the loan was secured by marketable assets, to 25% of bank capital (FDIC 1997: 94). While small rural banks were the public poster child for this reform, it had obvious benefits for the too-big-to-banks that often dealt with large corporate and government accounts.

As for the thrifts, as might have been expected, the reforms proved disastrous. Insolvent institutions are, after all, not well positioned to go through the learning process of mastering a new business. By 1989 the thrifts’ worsening condition could no longer be ignored and was addressed in the Financial Institutions Reform, Recovery and Enforcement Act (“FIRREA,” Pub. L. No. 101-73) by a complete overhaul of the regulatory structure governing them. The FHLB Board was abolished and replaced by two new agencies, the Office of Thrift Supervision governing the thrifts and the Federal Housing Finance Board governing the Federal Home Loan Banks. Freddie Mac was placed under the supervision of the Department of Housing and Urban Development, just like Fannie Mae (Colton 2002: 14). At long last, a new Resolution Trust Corporation was created to administer the assets of the failed thrifts, and the FSLIC was replaced by a fund administered by the FDIC. FIRREA required those thrifts that were solvent to lower their risks by selling loans and increasing their holdings of liquid assets. The resolution of the insolvent thrifts would end up costing more than $130 billion. As an additional step in the elimination of the structural distinction between the thrifts and the commercial banks, FIRREA opened membership in the FHLB system to commercial banks.

We should also note that in 1987 the Competitive Equality Banking Act was passed (“CEBA”, Pub. L. 100-86).[6] It had the important effect of closing the “non-bank bank” loophole, that had been created in 1970 when the Bank Holding Company Act had been amended to define a bank as an entity that accepted demand deposits and made commercial loans. By either restricting funding to exclude demand deposits or avoiding making commercial loans, a financial institution could preclude Federal Reserve regulation of its holding company. In the early 1980s the OCC did a brisk business in such “non-bank” charters. CEBA redefined a bank to include any entity insured by the FDIC in addition to any entity that accepted transaction accounts and made commercial loans (FDIC 1997: 98).[7]

Mortgage Securitization

One consequence of the efforts to deal with the troubled thrifts was the stimulation of securitization. When a thrift sold a below-market-rate mortgage, instead of taking the loss immediately – which would have reflected the reality of the transaction – thrifts were permitted by an FHLB Board policy adopted in 1981 to spread the loss over the remaining years of the mortgage (Lea 1996: 166). The result of this policy was a boom in mortgage securitization that facilitated a transition in the finance of conventional mortgages from the thrifts to the GSEs. As a result, the GSEs were financing more than half of all mortgages originated in the US from the late 1980s on and most of these mortgages were then securitized (Lea 1996: 166). In short, the collapse of the thrifts was eased dramatically by the rise of agency securitization.

While Freddie Mac’s business model from its founding in 1970 was based on the securitization of conventional mortgages (Howard 2014: 117), through the 1970s Fannie Mae focused on purchasing loans for its own portfolio and addressed the challenges of mortgage finance in the 1970s by shortening the length of its funding. Thus, the high interest rates of 1979 affected Fannie Mae in the same way that it had affected the thrifts: Fannie Mae was losing money on a daily basis and risked exhausting its capital. Fannie Mae, however, unlike the thrifts was not offered capital relief or allowed to change its mission. Indeed, the recommendation of the 1982 President’s Commission on Housing was that the GSEs should be fully privatized. Left to earn its way into solvency, Fannie Mae was successful in doing so by (i) dramatically widening the types of mortgages it purchased to include for example ARMs (On these mortgages Fannie required originator guarantees instead of underwriting the loans itself.) (ii) funding new purchases with debt issues that were maturity matched; (iii) generating fee income by securitizing mortgages (starting in 1981); and (iv) as interest rates fell extending debt maturities (Howard 2014: 27-28).

In 1983 Freddie Mac developed the first mortgage backed securitization that used tranching to address the uncertainty inherent in the timing of mortgage prepayments: some tranches were designed to pay off first. (This product was called a Collateralized Mortgage Obligation or CMO, but to limit the use of jargon I will call it a multi-tranche MBS.) While the multi-tranche MBS had more desirable properties for investors than the single tranche MBS, it was not clear under contemporary tax laws whether pass-through taxation would always apply or whether the structure itself could be subject to taxation (creating an undesirable situation of taxation both at the level of the structure and at the level of the investor) (Howard 2014: 118). This problem was addressed in the 1986 Tax Reform Act (Pub. L. 99-514) which created Real Estate Mortgage Investment Conduits (REMICs). By qualifying as a REMIC an MBS could have pass-through taxation (Howard 2014: 120).

This tax reform had been recommended by the 1982 President’s Commission on Housing, which also advocated that “all mortgage lenders and borrowers should have unrestricted access to the money and capital markets” (Colton 2002: 11). Thus, the Commission recommended the 1984 Secondary Mortgage Market Enhancement Act (SMMEA) which sought to put private label mortgage backed securities (PLMBS) on an even playing field with Agency MBS. Prior to this legislation PLMBS had been subject as securities to significant registration requirements and did not qualify as legal investments for many regulated entities. SMMEA exempted PLMBS from state antifraud and registration laws and made them legal investments for banks, thrifts, insurance companies, and pension funds (Howard 2014: 119-20).

Note that the latter created a significant distinction between Agency MBS and PLMBS. Agency MBS was deemed an appropriate investment for banks because the agencies were closely regulated government-sponsored entities with the goal of benefiting homeowners and the mortgage market. While PLMBS was also issued by regulated entities, that is banks, the goals of bank regulation place emphasis on the safety and soundness of the banking system and allow for bank failure. And there was no expectation that bank regulators should emphasize the interests of the mortgage market – or of MBS investors. Thus, SMMEA introduced the additional criterion that PLMBS had to receive an investment grade rating from a rating agency in order to be deemed an appropriate investment for a bank or other regulated institution. The end result was, however, that SMMEA was one of the early laws granting the credit rating agencies “de facto” supervisory authority over a segment of the financial industry.

As a result of this legislation, the market evolved so that the GSEs set standards for the mortgages they would purchase and securitize, and those loans that fell outside this category were held by banks or thrifts or placed in PLMBS. The loans eligible for purchase by the GSEs were known as “conforming” loans, while the ineligible loans were “non-conforming” and comprised of “jumbo” loans – or loans for an amount in excess of the GSEs’ statutory maximum – and “subprime” loans – which didn’t meet the GSEs’ lending criteria. (Later, and especially when the GSEs broadened their lending criteria, the number of categories increased and the terminology shifted.)

Because the GSEs made their money on volume, they competed to reduce costs to borrowers and to reduce origination costs by, for example, developing automated underwriting programs and encouraging competition between a large population of loan originators (Howard 2014: 90-91). To better match liabilities with assets, the GSEs started issuing callable debt, which by 1990 had become common (Howard 2014: 43). At the same time, because they bore the credit risk of every loan purchased for the life of the loan, they studied the market in order to set sustainable credit standards (Howard 2014: 91). By 1993 Fannie Mae, which had been at risk of failure in the early 1980s had brought its credit losses down to 4 basis points – despite lending on newer products like adjustable rate mortgages (Howard 2014: 46).

As securitization grew to be a more and more important source of mortgage finance, mortgage lending itself transitioned from the originate-to-hold to the originate-to-distribute model. This was accompanied by a shift to the origination of most mortgages by unregulated mortgage companies and brokers instead of by regulated thrifts as had been the case in the past (Immergluck 2009: 465). These unregulated mortgage companies were often subsidiaries of the bank holding companies. On the one hand, the new system was fiercely competitive which tended to keep costs down. On the other hand, many of the originators were thinly capitalized (Lea 1996: 168-69). On balance, however, mortgage securitization functioned well through the 1980s and 1990s.

Through most of the 1990s the GSEs made possible the standardization of mortgage underwriting and kept the cost of the 30 year mortgage consistently low at a spread of less than 1.5% to the 10 year US Treasury Bond (see Chart 6).[8] This was made possible by the entry of mutual funds, pension funds, and foreign entities into US housing investment (Lea 1996: 167).

Chart 6: Mortgage and Baa bond spreads

30Yr mtg 10 yr T spread

[1] On the asset side, it also allowed savings and loans to hold 20 % of their assets as consumer loans.

[2] See Isaac (1984: 198) citing Friedman and Galbraith.

[3] Additional restrictions that were lifted had required 30-year amortization for certain loans, had limited the maximum loan-to-value of mortgages, and had limited the aggregate unpaid balance on second lien real estate loans to 20% of bank capital plus surplus.

[4] It is highly likely that the Federal Reserve pushed for the addition of this latter clause, but I have not yet been able to document this claim.

[5] Mergers were also permitted across regulatory boundaries (e.g. of banks and thrifts or despite geographic restrictions), but only after determining that mergers within regulatory boundaries were not equally advantageous (Gorinson & Manishin 1983: 1326).

[6] The Fed had just lost a lawsuit challenging its effort to close the loophole by adopting regulations that relied on very broad rather than narrow interpretations of the relevant terms. Board of Governors of the Federal Reserve v. Dimension Financial Corporation, 474 U.S. 361 (1986).

[7] CEBA also imposed a six-month moratorium on regulatory agency decisions that expanded the role of banks in securities, insurance, or real estate (FDIC 1997: 97). In theory Congress was to reach a decision on these issues and enact a new statutory framework to replace Glass-Steagall. No such law was passed, however, and as soon as the moratorium was over the regulatory repeal of the statutory framework (that will be discussed in detail in a section on the Greenspan era) continued.

[8] As Lea notes standardization might have worked against the interests of non-traditional borrowers who could no longer successfully appeal their case to the local lender (1996: 167).

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