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The road to financial ruin finds its roots in government policy
Posted by: McQ on Friday, October 03, 2008

I've been beating the drum about examining one the root causes of this financial mess and laying it at the proper doorstep. Russell Roberts does a very good job of that in today's WSJ. First he lays out the conventional wisdom:
Many believe that wild greed and market failure led us into this sorry mess. According to that narrative, investors in search of higher yields bought novel securities that bundled loans made to high-risk borrowers. Banks issued these loans because they could sell them to hungry investors. It was a giant Ponzi scheme that only worked as long as housing prices were on the rise. But housing prices were the result of a speculative mania. Once the bubble burst, too many borrowers had negative equity, and the system collapsed.
He then notes that while in many cases this is what is being sold as the whole truth, it is, in fact, only part of the story. If this sort of a mess is to be avoided, it is critical the rest of the story be told as well:
The fall in housing prices did lead to a sudden increase in defaults that reduced the value of mortgage-backed securities. What's missing is the role politicians and policy makers played in creating artificially high housing prices, and artificially reducing the danger of extremely risky assets.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target — 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area's median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

Fannie and Freddie also purchased hundreds of billions of subprime securities for their own portfolios to make money and to help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities.
So there you have hard numbers driven by government policy and a promise to back the loans they pushed on the industry - by percentage of total loans - with the full faith and credit of the US government. It was financial failure by the numbers, for heaven sake.

The root of it all?
Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor people allowed Congress and the White House to subsidize low-income housing outside of the budget, at least in the short run. It was a political free lunch.
But it wasn't so free was it?

And on the banking side, another political culprit is found:
The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters — their bottom line and the so-called common good. First passed in 1977, the CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story, too. In 1997, Bear Stearns did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages.

By pressuring banks to serve poor borrowers and poor regions of the country, politicians could push for increases in home ownership and urban development without having to commit budgetary dollars. Another political free lunch.
And the final piece of the meltdown can be found at the Fed:
The Fed did its part, too. In 2003, the federal-funds rate hit 40-year lows of 1.25%. That pushed the rates on adjustable loans to historic lows as well, helping to fuel the housing boom.

The Taxpayer Relief Act of 1997 and low interest rates — along with the regulatory push for more low-income homeowners — dramatically increased the demand for housing. Between 1997 and 2005, the average price of a house in the U.S. more than doubled. It wasn't simply a speculative bubble. Much of the rise in housing prices was the result of public policies that increased the demand for housing. Without the surge in housing prices, the subprime market would have never taken off.
Roberts pinpoints the locus of the problem:
Fannie and Freddie played a significant role in the explosion of subprime mortgages and subprime mortgage-backed securities. Without Fannie and Freddie's implicit guarantee of government support (which turned out to be all too real), would the mortgage-backed securities market and the subprime part of it have expanded the way they did?
Roberts says "perhaps". I say probably not, or at least not to the extent we see it today. Banks and financial institutions that would give subprime loans wouldn't have been as prevalent and would have known full well the risk those sorts of instruments carried since there would have been no backing from the government in case a housing bubble burst. But you can also argue it was these subprime instruments which helped fuel the housing bubble and speculation. Without the government quota loans out there it is quite possible that there would have been no housing bubble and housing prices would have grown at a much slower and more stable rate.

Key line in the article:
But before we conclude that markets failed, we need a careful analysis of public policy's role in creating this mess.
Very careful - and that's the one thing I am not seeing happen in this fiasco. Right now the politicians are like cats covering you know what and essentially ignoring the role government played in this. The spin is all about the myth of "deregulation" and the exclusive fault of "Wall Street greed".

Well it isn't just about those things. Deregulation isn't the problem, poor government policy is. And while there were certainly many on Wall Street who took advantage of the situation, it was a situation created by government policy and government demands within the industry. Until and unless those policies are exposed, investigated and changed, there is nothing at all to say that we won't be in a similar situation somewhere down the road - assuming we survive this one.

As Roberts concludes:
Beware of trying to do good with other people's money. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis.
And beware of expecting any meaningful change when the same institution that got you into this mess is charged with getting you out of it.
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Previous Comments to this Post 

Okay, but there are more government policies that are at fault here as well.

One of the least talked about, but in my mind near the top of the list, is land use regulations. I have posted on that over at Risk and Return in the past, but it is no accident that the lions share of the damage has been in places that have progressively made housing more expensive through restricting supply and led to a belief that the market was set on a constant upward path of appreciation.
Written By: Lance
I share the disdain for all the poor government policies and actions, but where’s the disdain for all the fools buying 1,500 square foot ranches for $750,000 (or more) - homes that only a few years prior cost 1/3rd of that (or less)? Where’s the disdain for all the fools who bought homes well above their means with ARMs or interest only loans? Where’s the disdain for the fools buying houses to flip because they assumed they’d keep appreciating 25% a year or more?

None of these people had to do any of this. And if more people had enough sense, it really wouldn’t matter what government policies or lender policies are, no matter how perverse and idiotic.

It’s all too easy to fall back on the cliche’ that ’people respond to incentives’. Well yes they do, but that doesn’t mean they have to be stupid about it. And if they are, they should be prepared to fully pay for their mistakes. We aren’t lab rats.

Written By: Grimshaw
URL: http://
There’s certainly plenty of "disdain" to go around, Grim, but according to a recent study, homeowners are a very small part of the problem.

And I include the speculators and flippers in the same category as "Wall Street greed", but also understand that they were essentially exploiting a distorted market. Take care of what was distorting the market and much of that takes care of itself.
Written By: McQ
It takes two to complete a transaction. One can have the power to distort a market with unreasonable incentives, but it still takes a willing participant to agree to the transaction. And that willing participant, if he’s paying attention, should be aware of his risk and act accordingly. I’m not against taking the risk, but lets not pretend that eventually it was going to bite everyone caught without a chair when the music stopped.

Furthermore, your cite refers to owner-occupied homes. It claims that more of the problem has to do with commercial real estate and investment/speculative properties. That’s still people taking on risk that they ultimately were not prepared to manage when the risk came home to roost. Whether people were buying commercial real estate in Denver, flip homes in San Diego, or personal homes in San Fran, buyers and sellers were clearly exhibiting tulip-bulb behavior. No sane person could possibly believe that a property that sold for 200k in year 1 would suddenly be worth 600k in year 3 and 1.2 million in year 5. There were no underlying fundamentals to support any of it. People convinced themselves that the good times would last, at least until they closed out their positions.
Written By: Grimshaw
URL: http://
"I share the disdain for all the poor government policies and actions, but where’s the disdain for all the fools buying 1,500 square foot ranches for $750,000 (or more) - homes that only a few years prior cost 1/3rd of that (or less)?"
That disdain is frozen in markets just like some people are saying about credit, and it’s because Paulson is offering seven hundred billion dollars for its disposal. That’s where it is.

Don’t let anyone roll you around, Grim. Your point is essential.
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