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A student protesting about the financial crisis and against the US Federal Reserve Board demonstrates outside the third and final presidential debate. (Reuters Photo)
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The triggering cause of the current financial crisis in the United States was the decline in housing prices that began in the summer of 2006. This decline in housing prices caused a large increase in foreclosures because many people owned houses with mortgages almost equal to the initial value of the houses. When the values of those houses fell and went below the amount of the mortgages, lenders often foreclosed on borrowers.
Because so many financial institutions owned securities based on these mortgages– so-called mortgage-backed securities (MBS), the large decline in value of these MBS’s led to large losses for their owners. And because so many of the owners were financial firms that held only a tiny percent of the value of their assets in reserve, even a small percentage decline could, and did, destroy almost the whole value, and sometimes the whole value, of the financial firms that held these securities.
Virtually all commentators on parts of the political spectrum agree with these facts as stated. Where they part company, though, is on why this happened and on what should be done about it. Some blame greed, some blame deregulation, and some blame government.
The best evidence is that the problem was triggered by previous government regulation combined with an unrealistic belief on the part of many people that housing prices could only go up. It is important to understand the cause because, if we do not, we are unlikely to choose good solutions. Indeed, the US federal government has, for the last few months, chosen one bad solution after another.
Greed or Self-interest?
| "Saying that 'greed' caused today's problems is like saying that gravity caused the death of someone pushed from the top floor of the Empire State building." - Donald Bourdreau |
One cause we can rule out is greed. It is true that most people most of the time are greedy if, by “greedy,” we mean that they are pursuing their own self-interest.
That is, most people are out mainly to achieve their own goals and not the goals of strangers. So, if greed is such a constant, why is not it one of the causes? The answer is that it is because it is a constant.
You cannot explain why something changed by pointing to something that is constant. To explain why something changed, we need to point to something else that changed.
As Donald Boudreaux, an economics professor at George Mason University, put it: “Saying that ‘greed’ caused today's problems is like saying that gravity caused the death of someone pushed from the top floor of the Empire State building. Some things are sufficiently constant in human affairs–and self-interest, even greed, is among them– that they explain nothing.”
Indeed, one of the founders of economics, Adam Smith, in his famous book The Wealth of Nations argued not only that are people self-interested, but also that this self-interest causes them to do valuable things for their fellow humans. The most famous quote from The Wealth of Nations is Smith’s statement: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest.”
We also can rule out deregulation. Although many people blame deregulation for the financial crisis, they do not make a clear, logical argument for their claim. The main deregulation that occurred during the run-up of house prices was the Gramm-Leach-Bliley Act of 1999, which repealed part of the 1933 Glass-Steagall Act and, thereby, allowed commercial banks and investment banks to merge. But there is no obvious connection between this 1999 deregulation and the problems that later happened in the housing sector.
Government Regulation: the culprit?
There is, however, an obvious culprit. That culprit is regulation.
In 1975, Congress passed the Home Mortgage Disclosure Act (HMDA). This act required mortgage lenders to provide detailed information about mortgage applications. In 1977, the US Congress passed the Community Reinvestment Act, an Act that required banks to lend to the entire geographic area in which they operated.
In 1991, points out University of Dallas economist Stan J. Liebowitz, the HMDA data were expanded to include rejection rates by race. In a study based on these and other data, economists at the Boston Federal Reserve Bank concluded that even after correcting for certain variables associated with creditworthiness, minorities were denied mortgages at a higher rate than whites.
This study was highly influential in persuading policy makers to regulate banks further so that they would lend more to minorities. But in 1998, an article by Theodore Day and Stan Liebowitz on the Boston Fed study’s data found serious errors and inconsistencies.
One example from among many: a bank rejected a mortgage application and yet sold that non-existent mortgage in the second mortgage market. It goes without saying that you cannot sell what does not exist. After “cleansing” the Boston Fed data of errors, Day and Leibowitz found no evidence of racial discrimination in mortgages.
This makes sense: banks that are out to make money have a good reason not to discriminate on the basis of color. If they did, they would miss out on profitable opportunities.
Unfortunately, the Boston Fed study, though thoroughly debunked, led federal regulators to put more pressure on banks to lend to people with weak credit histories and sketchy employment prospects.
“Failure to comply with the Equal Credit Opportunity Act or Regulation B can subject a financial institution to civil liability for actual and punitive damages in individual or class actions. Liability for punitive damages can be as much as $10,000 in individual actions and the lesser of $500,000 or 1 percent of the creditor’s net worth in class actions,” the Boston Fed stated in a manual for lenders based on its own study.
The term for the new lending criteria that the Boston Fed was pushing was “flexible underwriting standards.”
In an incredibly prescient statement in their 1998 article, Day and Liebowitz wrote, “After the warm glow of ‘flexible underwriting standards’ has worn off, we may discover that they are nothing more than standards that led to bad loans.”
Of course, that is what exactly what we have discovered.
Moral Hazard
| Banks were pushed into lending to people with weak credit histories and sketchy employment prospects. |
Spurred by an uncritical acceptance of the Boston Fed study, in 1995, the Clinton administration went further and made a satisfactory Community Reinvestment Act (CRA) rating much harder to obtain. These ratings were important because, without them, banks–one of the more highly regulated industries in the United States–would not be given permission to merge or start new branches.
“The new regulations de-emphasized subjective assessment measures in favor of strictly numerical ones. Bank examiners would use federal home-loan data, broken down by neighborhood, income group, and race, to rate banks on performance,” wrote Howard Husock in a 2000 article in City Journal.
“There would be no more A's for effort. Only results—specific loans, specific levels of service—would count. Where and to whom have home loans been made? Have banks invested in all neighborhoods within their assessment area? Do they operate branches in those neighborhoods?” he continued.
This pushed banks further into making mortgage loans to people who would be unable to pay them.
Another major government program contributed to the problem. Fannie Mae and Freddy Mac are government-sponsored enterprises (GSE’s) that repackage loans and resell them. Fannie and Freddy took on riskier loans during the housing boom and were able to borrow, at a very low interest rate, the funds with which to buy these loans.
The reason is that lenders to the GSE’s assumed—it turned out, correctly—that the US government would guarantee these loans. The term economists use to describe what happened is “moral hazard.”
Because lenders to the GSE’s did not bear much risk in case the GSE’s bore large losses, they had little incentive to be careful in their lending, and the GSE’s had little incentive to be careful in their financial decisions.
It is true that regulation was not the only contributor to the problem. “Financial engineers” on Wall Street and elsewhere “securitized” many of these problem loans and sold them to people who thought they were much less risky than they were. The other major contributor, as previously mentioned, was the view among many people that housing prices could only go up. Regulation might not have been the main contributor, but it certainly did contribute.
The Phony Cure
| Do not be surprised if the financial crisis lasts for years rather than for the few months it likely would have lasted had the Feds stayed out. |
To the extent that regulation contributed to the problem, regulation should be reduced or eliminated.
The Community Reinvestment Act and the Home Mortgage Disclosure Act should be repealed. Also, Fannie Mae, Freddy Mac, and the other GSE’s–all of which create moral hazard–should be disbanded.
Many other regulations that create financial problems should be ended also: usury laws, for example, that restrict the rate of interest that lenders and borrowers can agree on, should be abolished. Indeed, the Federal Reserve Bank itself should be abolished, but the justification for doing that is much longer than there is room for in this article.
Also, the Congress should repeal the bailout and let markets re-price assets to reflect their recently discovered risks. Various policy makers claimed that the justification for Treasury Secretary Paulson’s $700 billion bailout was to offset a credit freeze. But there was never a credit freeze!
Instead, the interest rate on various loans had increased substantially to reflect the risk that lenders perceived. Interest rates are prices. Like other prices, interest rates reflect information that market participants hold.
By trying to support prices of various assets, Paulson and Federal Reserve Chairman Ben Bernanke are taking on the role of central economic planners. And we know from the experience of central economic planning under Communism (in the USSR and elsewhere) and under Fascism (in Italy and under Franklin Roosevelt’s New Deal) that central economic planning does not work.
Paulson and Bernanke may be brilliant men (although their actions of the last month make one wonder.) But no small group of men, no matter how brilliant, can do well by substituting their judgment for the judgment inherent in the marketplace. The market aggregates the judgments of hundreds of millions of people, a very large fraction of whom are spending or betting their own money. The government—or, more precisely, its employees, such as Paulson and Bernanke—is spending or betting other people’s money.
What has made otherwise-skeptical people supportive of the government’s central planning is their fear of another Great Depression.
On a September 23 White House conference call, the chairman of President Bush’s Council of Economic Advisers (who is also my colleague) Ed Lazear told listeners that what really led to the belief in a bailout was credit market conditions the previous Thursday, September 18.
Credit markets, he said, had frozen. I asked him how he could make strong conclusions about the future of the economy based on data from a day or two. His answer was that the negative returns on short-term Treasuries were scary.
Presumably, Bernanke's—and Paulson's—fear was that people looking at negative interest rates will want to pull their money out of banks. In our fractional reserve banking system, each dollar pulled out of the system stands behind multiple dollars of deposits. The result could be a substantial decline in the money supply. That is what happened when the bank runs started in October 1930 and lasted into 1933.
But there are two huge differences between now and then.
First, in September 2008, the FDIC was insuring deposits up to $100,000 (and now, under the bailout, up to $250,000), thus making a bank run unlikely. Second, the Federal Reserve knows that it is the lender of last resort. It already has the power it needs to prevent a contraction of the money supply.
Now, though the US government has put itself even more in the role of central planner of credit markets, do not be surprised if the financial crisis lasts for years rather than for the few months it likely would have lasted had the Feds stayed out.
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