The Sub-Prime Lending Debacle in a Word: Capital Politicians and Regulators Depleted It, Causing a Systemic Financial Crisis

Abstract

Fannie Mae and Freddie Mac (F&F) funded conforming mortgages with cheap debt no matter how little capital they had or how risky the loans due to their public “agency” status. Private label securitizers (PLSers) were able to compete during the last decade due to public deposit insurance and regulation that allowed them to do the same thing. Implicit F&F and PLS capital subsidies totaling about $10 billion per trillion dollars - cumulatively about $800 billion for the decade - pulled both F&F and PLS into sub-prime lending, while government housing policy pushed unqualified borrowers into the market to share the subsidy. F&F competed with PLSers by increasing both leverage and loan risk, but also cooperated by meeting F&F housing goals with AAA PLS backed by pools of sub-prime loans. This high risk strategy was reportedly profitable during the first half of the decade so long as house prices continued rising rapidly, the rise fueled by this competition. PLSers and F&F competed first to go for broke funding unprofitable pools of sub-prime loans likely to default, and eventually to go broke while looting their firms and taxpayers, causing the lending bubble of 2005-2007 to inflate to systemic proportions.