I apologize up front, but this post is a bit longer than a typical one. I do think the subject involves some thought. The 2008 financial crisis was a major event, causing many at the time to equate its impact with the early days of the Great Depression. Many commentators and other self-proclaimed experts stated we were witnessing a crisis of capitalism, proof that our free market system was inherently unstable. The only calming influence could come from government, and these officials claim their efforts prevented a complete meltdown of the world’s financial system. This idea has won popular acceptance among those in academia and the media. The crowning achievement of this regulatory effort was the Dodd-Frank Act. This is founded on the notion that the only solution for the unstable financial system is government regulation.
Of course, we will never know what would have happened if no government intervention occurred. But it is possible to understand what some of the causes of the crisis were, and if those line up with the reasons behind enacting the regulation.
These new government regulations have slowed economic growth and increased the cost and decreased the availability of capital for business expansion, which they will in the future. This may be a legitimate trade-off, in which we sacrifice economic freedom and growth for stability. But if the crisis did not stem from a lack of regulation, we may have needlessly restricted the growth that most Americans want.
It is still not clear if a lack of regulation was a factor in the 2008 crisis, but there is compelling evidence that the financial crisis was a result of the government’s own housing policies. These policies were based on an idea, which is still very popular among some, that underwriting standards in housing finance are discriminatory and unnecessary. Of course, this idea runs contrary to the idea of the mortgage investor who wants a surety of repayment of his principal with some interest, and thus, wishes to divide up good credit risks from poor ones. This reckless attitude toward the rapid expansion of credit, without regard to eligibility, is what caused the insolvency of Fannie Mae and Freddie Mac.
The Federal Government’s foray into housing began in 1934, with the establishment of the Federal Housing Administration (FHA). It insured mortgages up to 100%, but it also required a down payment of at least 20% or more. The FHA operated with very few delinquencies for 25 years. But during a serious recession in 1957, Congress began to loosen the standards to increase housing’s growth. Down payments were lowered to just 3% between 1957 and 1961. This resulted in a boom in FHA insured mortgages, followed by a bust in the late 1960s. This pattern keeps recurring, and no politician tends to remember the past mistakes. Mortgage standards are loosened, prices bubble, followed by a crash. The taxpayers cover the government’s losses, and most of the people who are hurt are those who purchased houses in the bubble years. They find when the bubble deflated, they could not afford their homes or, as in the most recent crisis, the drop in value was too great, and this exceeded the obligation to continue making payments, so they walked away.
In the 1970s and 80s, Freddie and Fannie learned from experience what underwriting standards kept delinquency and default low. They generally required down payments of 10-20%, good credit histories from borrowers and low debt-to-income ratios for the new mortgages. Mortgage defaults stayed less than 1% in normal times and slightly higher in a recession. Homeownership remained around 64% despite those higher standards.
This changed in 1992 when Congress enacted “affordable housing” goals for Freddie and Fannie. Before 1992, these firms dominated the housing finance market, especially after the savings and loan industry failure. Freddie and Fannie’s role, as originally envisioned and as developed until 1992, was to conduct secondary market operations to create a liquid market for mortgages. They could not directly make mortgages, but could buy them from direct lenders. This provided cash for lenders and encouraged home ownership by making more funds available for mortgages. Even though these entities were shareholder owned, they were chartered by Congress and granted government privileges, such as exemptions from state and federal taxes and from SEC rules. The president appointed members to their board of directors and they had a $2.25 billion line of credit from the US Treasury. Investors began to believe Fannie and Freddie were government-backed and would be rescued by the government if they ever encountered financial hardship. These entities also dominated the housing finance market with their ability to borrow at rates slightly higher than the US Treasury. From this position, they set underwriting standards for the entire industry, and few lenders would make mortgages that could not qualify for sale to Freddie and Fannie.
Community activists for years had hounded these firms, arguing that their underwriting standards were so restrictive, they were keeping many low and moderate income families from buying houses. Since these Government Sponsored Enterprises (GSEs) had government support, this gave Congress a basis for intervention, and in 1992, quotas were established for Freddie and Fannie to meet regarding loans to low and moderate income borrowers. The initial quota was 30%. These totals increased to a high of 56% in 2008.
Now in order to meet these quotas, the GSEs had to reduce their underwriting standards. As early as 1995, they were buying mortgages with as little as 3% down, and in 2000, they were buying mortgages with nothing down. At the same time, other standards were loosened, such as taking on riskier borrowers with poor credit in order to find the subprime and other non-traditional mortgages necessary to make the affordable housing quotas. Cash-out refinances sprung up as housing prices soared in the wake of the money that was being pumped into the housing market. As a result of loosening the credit standards, by 2008, just prior to the crisis, 56% of all mortgages in the US, 32 million loans, were subprime or otherwise low quality. Of all these loans, 76% were on the books of government agencies. At the same time, demand for Freddie and Fannie securities remained strong, as the investors believed purchasing one of their mortgage backed bonds was as safe as a US Treasury note.
Again, all this cash began to flood into the housing market and pushed prices up at abnormal rates. Before the 1990s, housing prices tended to follow the rate of inflation and a rate of increases in real wages. As people had more money at their disposal, they could afford a more expensive house. Yet, once the loosening of underwriting standards began in the 1990s, housing prices increased three-fold until the crash. During this same period, real wages increased at a modest 2% annually. Clearly, this created a bubble in the market.
Weaknesses in the housing market are hidden when the bubble is inflating. As housing prices rise, it is possible for borrowers who have high amounts of debt service in relation to their income to either refinance or sell their home for more than the existing principal amount owed on the mortgage. Potential mortgage investors see nice yielding loans, with delinquencies and defaults at levels depressed beyond norms. Many begin to discount the risks of investing in subprime mortgages, and more money pours into the system.
As with any bubble that feeds on itself when it inflates, it also exacerbates the problem when the bubble implodes. Housing prices began to fall rapidly, making it impossible to refinance to get out of debt payment trouble, or sell the house and retire the principal owed on the mortgage. Underwriting standards are raised, as losses cause creditors to not lend to riskier applicants. Many borrowers just walk away from the mortgage, knowing that in many states the lender has recourse only to the home itself. So, delinquencies and defaults shot up to unprecedented levels. Investors fled the mortgage-backed market, which drove prices on these securities down and interest rates up.
Since mortgage-backed securities were held by many financial institutions, the drop in value of these securities was disastrous to their capital and earnings. Since 1994, banks were required to use a “fair value accounting” in establishing the balance sheet value of their assets and liabilities. This required investments to be marked-to-market and reflected at current market values instead of the historical cost. So a credit union may have a mortgage-backed issuance that was still making interest payments regularly, in which they were forced to reduce the value of the asset in order to follow GAAP. The reduction in the asset value is countered by investment losses, which eats away at capital levels. This began to hinder financial institutions’ ability to lend money. Investment firms also had to write down significant portions of their private mortgage-backed securities portfolios, creating large drops in earnings. When Lehman Brothers declared bankruptcy, a panic ensued, where financial institutions would not even lend to each other on an overnight basis, for fear they would not have adequate cash for panicky deposits when they came to get it.
So, to summarize, the most recent financial crisis was not caused by insufficient regulation or by an unstable financial system. It was precipitated by the government tinkering with housing policies that caused the dominant institutions in the trillion dollar housing market, namely Fannie Mae and Freddie Mac, to reduce underwriting standards. The lax standards spread to the market and created an enormous bubble, where more than half of the mortgages were subprime or weak. When the bubble popped, mortgages failed in record numbers, driving down housing prices and the values of mortgage-backed securities, which caused some financial institutions to be unstable and possibly insolvent.
So what would be a proper response to the crisis? The answer would be to change the direction of the US housing finance system away from the kind of government control that lent on quotas, instead of lending based upon prudent underwriting standards. Blame should be removed on the Realtors, appraisers, lenders, title companies, and mortgage brokers from causing the crisis and placed directly where it needs to be, on the government. As long as control of the housing finance market is subjected to the whims of narrow political imperatives, instead of sound underwriting and the efficiency of the free market, we will continue to have the potential for future housing bubbles and subsequent busts.
Given these facts that the government was a main cause in the financial crisis, further regulation by the same government is not the salvation the economy needs. The Dodd-Frank Act has created vast new regulatory restrictions. This has created uncertainty and drained the appetite for well-thought out risk-taking that once made the US financial system the most successful in the world. It has also increased the cost of a financial institution to operate. Economic growth will continue to be restricted, and capital will be restrained until the American people realize the financial crisis did not occur because of insufficient regulation. Only then can adequate steps be taken to remove the draconian restrictions present in laws such as Dodd-Frank.