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The US housing crisis and the economic headaches that ensued have captivated the world. Everyone

is being affected by the shockwaves sent through the global economy. The event that precipitated this was the

collapse of the US housing market and then the subsequent collapse of the secondary derivatives market that

had been built on top of it. As with all busts, there is a boom that preceded it and by understanding the boom,

we can understand how not to repeat the same mistakes.

Many reasons have been offered up as causes for the housing boom. The 1995 and 1999 modifications to the

Community Reinvestment Act have been mentioned because they pressured certain banking institutions to

reduce their lending standards in order to meet the new requirements of the Act. The Government Sponsored

Enterprises of Fannie Mae and Freddie Mac provided a safety net for those banks by purchasing trillions of

dollars worth of risky mortgages and guaranteeing anything that was slid across their desk, further fueling the

sub-prime boom. Artificially low interest rates provided by the Federal Reserve made borrowing money much

less expensive than it ought to have been. We’ve also seen accusations of unregulated credit default swap

markets and corporate greed.

All the reasons offered up so far have merit, while some deserve more attention than others. Fannie Mae and

Freddie Mac in particular deserve a closer look. In December 2004 Donald T. Nicolaisen, Chief Accountant for

the Securities and Exchange Commission, issued a statement regarding the compliance of Fannie Mae’s

accounting practices for deferred purchase price adjustments and for derivatives and hedging activities with

FAS 91 and FAS 133.i Fannie Mae CEO Franklin D. Raines and CFO J. Timothy Howard left their positions in

the firm amidst this scandal.ii In his statement, Nicolaisen indicated that Fannie Mae had not been properly

applying these standards. During a hearing prompted by these revelations and a troublesome report by the

Office of Federal Housing Enterprise Oversight, representatives of Fannie Mae were able to rebuke efforts by

regulators to increase their oversight of these institutions despite what was obviously a growing problem.

In May 2006, after further investigation into Fannie Mae's accounting activities, the SEC published a press

release indicating that Fannie Mae had agreed to pay a $400 million penalty.iii The penalty was assessed due

to violations of the same standards that they were caught breaking in 2004. These misstatements reached

back to 1998 and included senior management's manipulation of earnings by understating depreciation to the

tune of $200 million. One incentive for this was a bonus program requiring them to attain certain targets

enabling the executives to receive the annual maximum. By misstating earnings, the executives were also

hiding the problems inherent in Fannie Mae that were pointing to a potential collapse. In a concluding

statement made in June 2006, Christopher Cox, Chairman of the SEC stated "The significance of the corporate

failings at Fannie Mae cannot be overstated. The company has said that it estimates the restatement of its

financial statements for the years ended December 31, 2003, and 2002, and for the quarters ended June 30,

2004, and March 31, 2004 will result in at least an $11 billion reduction of previously reported net income. In all

likelihood this will be one of the largest restatements in American corporate history." iv Despite these

accounting frauds, no criminal charges have been filed against a single Fannie Mae officer or executive.

The true cause of the housing boom can be difficult to pinpoint since there are so many contributing factors.

Because of Fannie Mae's improper treatment of revenue stretching back to 1998, we could assume that it

began even earlier than that. An analysis of CPI adjusted housing prices reveals that the boom began

sometime in late 1997.

 

Changes to the Community Reinvestment Act began in 1989 but the more drastic changes were made

throughout the 1990's. The CRA evaluated banks according to the amount of loans they were making to areas

that the CRA officials deemed needy. Changes in 1995 made the bank's ratings available to the public.vii This

was probably a crucial change that allowed for the many lawsuits against banks claiming that they were

prejudiced against certain minorities. Furthermore, banks could also be prevented from performing normal

operations if they were not fully complying with CRA mandates. Banks were stuck having to comply with this

legislation and from 1993 to 1998 the total loans made to poorer Americans rose by 39%.viii In order to further

exercise these mandates, in October 1997, First Union Capital Markets and Bear, Stearns & Co launched the

first publicly available securitization of CRA loans, issuing nearly $400 million of such securities.ix These

securities were guaranteed by none other than Freddie Mac and had an implied "AAA" rating since Freddie

Mac was a Government Sponsored Enterprise.

Even with all this being considered, in a February 2008 House hearing, law professor Michael S. Barr, a

Treasury Department official under President Clinton revealed that his studies indicated that 50% of the

subprime loans came from independent mortgage companies that were not regulated by the CRA. Another

25% to 30% came from only partially CRA regulated banks and their subsidiaries.x The exact results of this

study may be disputable; however it indicates that the CRA is probably not responsible for any more than 50%

of the subprime loans. There must be other contributing factors.

If we go back and examine the landscape in 1997 in more detail for anything that might fuel a rapid increase in

the demand for homes, we come face to face with the Taxpayer Relief Act of 1997.xi This was a piece of

legislation that passed the house and senate on July 30, 1997, just in time for our boom. The Act passed

overwhelmingly in both houses and made significant changes to certain tax provisions. It contained several

items in it that would make owning a home significantly more attractive to potential buyers. For instance, it

reduced the top capital gains rate from 28% to 20% and the 15% bracket was slashed to 10%. The

Government also increased the home sale exemption to $500,000 for couples and $250,000 for individuals. In

the past, exclusions of only $125,000 were available and only to those aged 55 and over. Real estate

commentators hailed this Act as one of the prime reasons as to why so many people were now seeking to buy

homes.xii

With the incredibly low interest rates being offered through the Federal Reserve, the housing market became

increasingly lucrative for investors to make tax-free gains of up to half a million dollars. No-money down loans,

no income verification and increasingly higher amounts of principal being lent out fuelled a speculative boom

and created a nation of house flippers and wrappers, eager to make a quick buck out of real estate. With

double-digit annual returns on real estate, everyone was excited to make money. We've seen this very same

situation before during the roaring 20's where artificially low interest rates offered by the Fed allowed investors

to purchase stock on margins as high as 90%. Like all booms though, the excitement must eventually come to

an end.

Many lessons can be learned from the events that brought about this crisis. For starters, we need to be aware

of interest rates and the amount of influence they can have on the market. When the price of money is set too

low by the central banks it creates a surplus demand for credit that is begging to find a way into the market.

This money finds its way through whatever areas in the banking system are giving out the easiest access.

Once this outlet is found, whatever industry it emerges into experiences a massive boom in value, only to have

the bubble pop and prices come crashing back to earth. In the future, these complex interactions and the Law

of Unintended Consequences need to be kept in mind in order to avert another future disaster.

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Chris Horlacher is a Senior Accountant at an international public accounting firm in Toronto, Ontario. He has a Honours

Bachelor of Accounting degree from Brock University and is currently pursuing a CA designation. Chris can be

contacted at chorlacher@mountaincable.net