Home > Markets > The causes of the mortgage crisis

The causes of the mortgage crisis

I have written elsewhere (here and in chapter 30 of my upcoming book) on this subject but here is a post committed solely to dispelling the myth “the free market” caused the crash of financial markets in 2008. I hear the lies repeated every day, even by my political economy professor: the reason the banks made such risky bets was there was no regulation and no oversight of the sector. The truth is, regulation was rampant.

Let us start with the Federal Reserve. The Fed is hardly ever mentioned as a cause of the crisis. Artificially-low interest rates (1%) encouraged artificially-high risk taking for certain sectors, including construction and lending to people who could not afford to buy homes. Fed policy increased the supply of money (look out for inflation) with the result that more dollars were created between 2000 and 2007 than had been created in the rest of the history of the United States. (It has done so again in the years since.) House prices rose.

They rose the most in California, where various laws made it impossible to develop the land, creating artificial scarcity and driving up home prices. But they rose in other localities too, in most cases because of similar restrictive building laws. 90% of the land in Nevada is owned by the federal government, so instead of a free market, the availability of land for building depends on the government’s approval of each use of it. Less than 10% of the land in the US is actually developed, but under the guise of preserving nature (a handout to environmentalists), the government protected land near residential areas and thus raised the price of it. As a result, many places saw a housing boom artificially brought on by government, whereas other places saw no boom at all. Thomas Sowell explains.

A fundamental misconception of the housing market existed both during the boom and after the bust. That misconception was that the free market failed to produce affordable housing, and that government intervention was therefore necessary in order to enable ordinary people to find a place to live that was within their means. Yet, the hard evidence points in the opposite direction. It has been precisely where there was massive government intervention, in the form of severe building restrictions, that housing prices skyrocketed. Where the market was more or less left alone, places like Houston and Dallas, for example, housing prices took a smaller share of family income than in the past. (The Housing Boom and Bust, 24)

The booms that did result, however, were, like many local problems, misperceived by an officious federal government as a national problem, requiring national-level intervention.

Easy access to housing began under the Clinton administration. Fannie Mae and Freddie Mac, government-backed but publicly-traded corporations that would be bailed out if necessary (a formula for moral hazard if ever there was one) also pushed to expand mortgage loans to people with bad credit under Bill Clinton. Bill Clinton’s Secretary of Housing and Urban Development, Andrew Cuomo

made a series of decisions between 1997 and 2001 that gave birth to the country’s current crisis…. He turned the Federal Housing Administration mortgage program into a sweetheart lender with sky-high loan ceilings and no money down, and he legalized what a federal judge has branded ‘kickbacks’ to brokers that have fueled the sale of overpriced and unsupportable loans. Three to four million families are now facing foreclosure, and Cuomo is one of the reasons why.

(Here are three more people to blame, in case you are interested.)

Democratic Congresspeople were reluctant to demand any oversight of Fannie, a campaign contributor. Fannie and Freddie guaranteed loans to people who were bad credit risks. These government-sponsored enterprises held about $5 trillion in mortgages. The Fed lent money to the banks at near 0% interest because, well, it could create money without hurting the people making the decision to do so.

At least as important regarding the subprime mortgage meltdown is the fact that owning homes had become the political cause du jour. Not everyone has to own a house to live; but if people are given houses, whether or not they can afford the mortgages, they might vote for the people who made it possible. The desire to introduce coercion into a market is always for the benefit of the coercer. Sometimes it benefits the constituent, and sometimes it leads to one of the most costly financial crashes in history. The Community Reinvestment Act (CRA) was meant to eliminate racial inequality in availability of credit. If banks did not lend to minorities in high enough numbers to satisfy the authorities, they could be crushed by lawsuits. (Remember, poor people were already being stung by local land use restrictions that raised housing prices. The CRA would enable them to get credit for something they might have been able to afford in a free market.) Instead of leaving interest rates to the market, politicians found it politically expedient to help minorities buy homes. It makes sense: if one can finally buy a home, one’s standard of living appears to have risen, and rising living standards get politicians reelected. Lending standards loosened.

Bear Stearns said the mortgages were sound. The three rating agencies (a state-protected oligopoly), you remember, the ones that said the mortgage-backed securities were great when they were garbage, served to reinforce the popular lending-to-everyone policies. Tax codes encouraged overinvestment in housing. To blame lack of government oversight for the crash is to get things backwards. The banks did what the government wanted them to do: hand out more and riskier loans. Those who talk of deregulation as a cause of the crisis fail to point to a single episode of deregulation, aside from the repeal of one clause of the Glass-Steagal act, which did nothing to enable banks to make bad loans. To say the banking sector was deregulated is to ignore or misunderstand the many regulations in place that helped cause the crisis.

One study finds that federal outlays for banking regulation—the laws big banks supposedly fear so much—increased from $190m in 1960 to $1.9b in 2000 and $2.3b in 2008. The US has 115 regulatory agencies. Funding to the Securities and Exchange Commission under George W. increased sizeably, with the result that its staff increased by one quarter. The number of rules businesses needed to follow rose. There may be an ideal regulatory agency or system, but it has nothing to do with what what the agencies actually do. These ones did what the politicians wanted: encouraged banks to make home loans to people who could not afford them, and solved a problem that did not exist, namely a nationwide lack of affordable housing. The result was disaster. Either government cannot be trusted to oversee corporations because it has been corrupted by them, or else it cannot be trusted because it is so incompetent. Either the fox is guarding the henhouse or the headless rooster is. More layers of regulations added to the existing system are not likely to help the public.

Moreover, it may be a mistake to call the crash a failure of regulation. Again, the corporations did what the government told them to, and people responded to incentives that monetary and lending policies created. Whenever we consider a policy a failure, we need to question whether it is indeed a failure or whether the goals and eventual outcomes went just as planned. After all, the crisis has ended up further enriching the rich, through bailouts and stimulus.

The securities and investment industry contributed $53m to congressional and presidential campaigns in 2008. (They have not slowed down since then.) Then, they stood back with their hands out and received more than a trillion dollars for their generosity. The bailout bill was defeated at first, but legislators, in their inimitable way, searched for a new way to pass the bill. They got more Congresspeople on board by sprinkling horsetraded favours in with the bailout money. (Something similar happened when Ronald Reagan bailed out big banks in 1983.) Special interests got what they wanted, legislators got what they wanted—win-win!

The argument the government made at the time was that these firms were “too big to fail”. In other words, their failure would mean the collapse of many more firms and the economy itself; therefore, they might need to be rescued. But the fate of Lehman Brothers, with more than $600b in assets, is instructive. It seemed too big to fail; yet, when it did fail, its assets that were worth preserving were bought by other firms. Keeping firms on life support discourages investment, encourages wild risk taking and drains money from those firms who are, in fact, productive and allocates it to those who have proven they are not. Promising to bail out failed firms created the moral hazard that enabled this crash.

Along came a large (more than 400-page) bailout bill, which anyone who opposed or even wanted to debate would be labeled as wanting the economy to fail. The government now owned hundreds of billions in bad debt, which meant instead of letting the companies pay for their own foolish bets, the taxpayers would. The case of the 2008 crisis and the recession was one of socialism for the rich. And democrats, who think that they have choices, were presented with two presidential candidates who agreed on the bailout and stimulus bills.

I am not an economist, but I do recommend the book Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods. Obviously, one book is not definitive, and all books I have read on this subject make good points. This one cogently argues the government’s role in the debacle was enormous. Its author is from the Austrian school of economics. The Austrian school predicted the crash (not to mention those of 1929 and 2000) based on evidence and basic economic principles. Either way, it is obvious that “the free market” and lack of regulation did not exist to cause this crisis. It was caused by the alliance of big business and big government, of a political system that rewards liars and thieves.

Many people, Occupy Wall Street protesters most vocally, blame the corporations for the crash. But corporations were doing what the government told them to. They blame corporations for accepting the bailout money. But if someone had trillions of dollars to give you, would you say no? That money only existed because it had been stolen from taxpayers in the first place.

And though some people—those who watch the news—think things are getting better, they are not. There will be no economic recovery, as the ruling class has already stolen it.

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