Posted by
Dave Smith on Tuesday, September 23, 2008 12:44:28 AM
The descriptions have ranged from "meltdown" to the oft-used "crisis",
but whatever one calls it, the US financial sector is a mess. The
government has responded by facilitating the breakup of a former Wall
Street titan (Bear Stearns) allowing another to fail (Lehman Brothers),
a bailout of an insurance giant (AIG), and a takeover of two
"government sponsored entities" (Fannie Mae and Freddie Mac). Much of
this is an extension of what started as the so-called "subprime
contagion" -- the defaulting of mortgage loans made to higher credit
risks, coupled with an overall bursting of the housing price bubble.
The activist government response is predictable, as is the political
rhetoric: the situation is most commonly blamed on a
lack of government regulation and overzealous capitalists on Wall Street.
The
common storyline is that those greedy capitalists need to be more
effectively reigned in, lest they hungrily feed on the economically
powerless like vampires at a blood drive. The conventional wisdom,
especially with the campaign rhetoric, is that mortgage companies were
using "predatory lending practices" to prey on unsuspecting consumers,
herding them into loans they couldn't afford -- all in the name of
profit.
But is the conventional storyline correct? To
paraphrase a famous Reagan quotation, is the government part of the
solution or part of the problem? Is our current problem the result of
too little regulation of the market, or of too much? Was this current
mess a surprise, or was it preventable?
One explanation of the
mortgage-market crash proposed by free market-oriented commentators is
that banks were given "encouragement" from the government to make more
loans to low-income, high-risk home buyers -- those sub-prime
mortgages. They were also encouraged to loan money with looser rules
on down payments, dropping the amount required to secure the loan. A
story in the
New York Times from 1999 provides some potential explanation:
the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders. The
action ... will encourage
those banks to extend home mortgages to individuals whose credit is
generally not good enough to qualify for conventional 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...
''Fannie Mae has expanded home ownership for millions of families in
the 1990's by reducing down payment requirements,'' said Franklin D.
Raines, Fannie Mae's chairman and chief executive officer.
...By expanding the type of loans that it will buy, Fannie Mae is hoping
to spur banks to make more loans to people with less-than-stellar
credit ratings.
...In July, the Department of Housing and Urban Development proposed that
by the year 2001, 50 percent of Fannie Mae's and Freddie Mac's
portfolio be made up of loans to low and moderate-income borrowers.
Last year, 44 percent of the loans Fannie Mae purchased were from these
groups.
Even within that same article was the following warning that seems 9 years ahead of its time (emphasis added):
''From the perspective of many people, including me, this is another
thrift industry growing up around us,'' said Peter Wallison a resident
fellow at the American Enterprise Institute. ''If they fail, the
government will have to step up and bail them out the way it stepped up
and bailed out the thrift industry.''
Others repeated that warning later. As detailed by
Cafe Hayek, a George Mason economist had this to say in 2001 about Fannie and Freddie (emphasis added):
These privileges do more than just give the GSEs a funding cost
advantage, they also reinforce the perception of a federal guarantee on
GSE debt obligations. In order to avoid a federal bailout like the one
we saw with the savings and loan industry, policymakers may want to
consider a variety of alternatives, including privatization of one or
more of the GSEs.
Further warning was detailed in
this article from
Business Week in 2002 (emphases added):
And mortgage lenders
are willing to oblige, even in the case of buyers who might not have
qualified before. The average downpayment has dropped to only 5% to 10%
over the past decade rather than the 10% to 20% it was in the past,
according to Doug Perry, a first vice-president at mortgage lender
Countrywide Home Loans Inc. Under the right conditions, Countrywide is
even willing to lend homebuyers 103% of the value of their new home to
cover their closing costs, too.
In part, the aggressive tactics
of mortgage lenders have been made possible by the automated
underwriting systems developed in recent years by the Federal National
Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation (Freddie Mac). These two government-created companies buy
70% of new mortgages in the U.S. and repackage them as mortgage-backed
securities, which they then sell to investors.
The new underwriting systems being used by Fannie Mae and Freddie Mac,
which are analogous to the credit-scoring systems used by banks, allow
for higher loan-to-income ratios than in the past to encourage home
buying. That's good for borrowers, but the relaxed ratios could pose
serious problems in the future. For one, there is already evidence that
defaults are rising, particularly at the low end of the market...
...Moreover, investors
in mortgage-backed securities have always assumed that the two mortgage
companies are backed by an implicit government guarantee that investors
would be bailed out in the event of big mortgage defaults.
Ultimately,
the Clinton Administration pursued a policy to increase home ownership
among low-income families by increasing the incentives for banks to
make high-risk loans, putting the taxpayers on the line. This policy
fit in well with President Bush's "ownership society" philosophy, so
the problem is a bipartisan one. And, of course businesses saw the
opportunity to reap profits with minimal risk -- the government would
give them the incentive to make loans they might not otherwise have
made with lower down payments, with the implicit guarantee that if
things came tumbling down the government would bail them out.
That's
not free market capitalism. It might go against the conventional
"wisdom" and greed was certainly involved, but greed is not the same as
rational self interest; government intrusion in the marketplace fuels
the former, while the latter is the basis of a free market -- a free
market distorted by the government.