Intense competition between mortgage lenders for revenue and market share, and the limited supply of creditworthy borrowers, caused mortgage lenders to relax underwriting standards and originate riskier mortgages to less creditworthy borrowers. Prior to 2003, when the mortgage securitization market was dominated by regulated and relatively conservative Government Sponsored Enterprises, GSEs policed mortgage originators and maintained relatively high underwriting standards. However, as market power shifted from securitizers to originators and as intense competition from private securitizers undermined GSE power, mortgage standards declined and risky loans proliferated. The worst loans were originated in 2004–2007, the years of the most intense competition between securitizers and the lowest market share for the GSEs.
U.S. subprime lending expanded dramatically 2004–2006
As well as easy credit conditions, there is evidence that competitive pressures contributed to an increase in the amount of subprime lending during the years preceding the crisis. Major U.S. investment banks and government sponsored enterprises like Fannie Mae played an important role in the expansion of lending, with GSEs eventually relaxing their standards to try to catch up with the private banks.
Subprime mortgages remained below 10% of all mortgage originations until 2004, when they spiked to nearly 20% and remained there through the 2005–2006 peak of the United States housing bubble.
Some long-time critics of government and the GSEs, like American Enterprise Institute fellow Peter J. Wallison, claim that the roots of the crisis can be traced directly to risky lending by government sponsored entities Fannie Mae and Freddie Mac. Although Wallison's claims have received widespread attention in the media and by policy makers, the majority report of the Financial Crisis Inquiry Commission, several studies by Federal Reserve economists, and the work of independent scholars suggest that Wallison's claims are not supported by data. In fact, the GSEs loans performed far better than loans securitized by private investment banks, and GSE loans performed better than some loans originated by institutions that held loans in their own portfolios.
Wallison has been widely criticized for attempting to politicize the investigation of the Financial Crisis Inquiry Commission, and his critics include fellow Republican Commissioners. Morgenson and Rosner also highlight the role of the GSEs in non-prime lending. Others agree and disagree.
On September 30, 1999, The New York Times reported that the Clinton Administration pushed for more lending to low and moderate income borrowers, while the mortgage industry sought guarantees for sub-prime loans:
Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits. In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers... In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.
In the early and mid-2000s (decade), the Bush administration called numerous times for investigation into the safety and soundness of the GSEs and their swelling portfolio of subprime mortgages. On September 10, 2003 the House Financial Services Committee held a hearing at the urging of the administration to assess safety and soundness issues and to review a recent report by the Office of Federal Housing Enterprise Oversight (OFHEO) that had uncovered accounting discrepancies within the two entities. The hearings never resulted in new legislation or formal investigation of Fannie Mae and Freddie Mac, as many of the committee members refused to accept the report and instead rebuked OFHEO for their attempt at regulation. Some believe this was an early warning to the systemic risk that the growing market in subprime mortgages posed to the U.S. financial system that went unheeded.
A 2000 United States Department of the Treasury study of lending trends for 305 cities from 1993 to 1998 showed that $467 billion of mortgage lending was made by Community Reinvestment Act (CRA)-covered lenders into low and mid level income (LMI) borrowers and neighborhoods, representing 10% of all U.S. mortgage lending during the period. The majority of these were prime loans. Sub-prime loans made by CRA-covered institutions constituted a 3% market share of LMI loans in 1998, but in the run-up to the crisis, fully 25% of all sub-prime lending occurred at CRA-covered institutions and another 25% of sub-prime loans had some connection with CRA.
An analysis by the Federal Reserve Bank of Dallas in 2009, however, concluded unequivocally that the CRA was not responsible for the mortgage loan crisis, pointing out that CRA rules have been in place since 1995 whereas the poor lending emerged only a decade later. Furthermore, most sub-prime loans were not made to the LMI borrowers targeted by the CRA, especially in the years 2005–2006 leading up to the crisis. Nor did it find any evidence that lending under the CRA rules increased delinquency rates or that the CRA indirectly influenced independent mortgage lenders to ramp up sub-prime lending.
Economist Paul Krugman argued in January 2010 that the simultaneous growth of the residential and commercial real estate pricing bubbles undermines the case made by those who argue that Fannie Mae, Freddie Mac, CRA or predatory lending were primary causes of the crisis. In other words, bubbles in both markets developed even though only the residential market was affected by these potential causes. Others have pointed out that there were not enough of these loans made to cause a crisis of this magnitude. In an article in Portfolio Magazine, Michael Lewis spoke with one trader who noted that "There weren’t enough Americans with [bad] credit taking out [bad loans] to satisfy investors’ appetite for the end product." Essentially, investment banks and hedge funds used financial innovation to enable large wagers to be made, far beyond the actual value of the underlying mortgage loans, using derivatives called credit default swaps, collateralized debt obligations and synthetic CDOs.
As of March 2011 the FDIC has had to pay out $9 billion to cover losses on bad loans at 165 failed financial institutions.