Believes primary cause of financial crisis was U.S. government housing policy
What Caused the Financial Crisis?
George Santayana is often quoted for the aphorism that “those who cannot remember the past are condemned to repeat it.” Looking back on the financial crisis, we can see why the study of history is so often contentious and why revisionist histories are so easy to construct. There are always many factors that could have caused an historical event; the difficult task is to discern which, among a welter of possible causes, were the significant ones—the ones without which history would have been different. Using this standard, I believe that the sine qua non of the financial crisis was U.S. government housing policy, which led to the creation of 27 million subprime and other risky loans—half of all mortgages in the United States—which were ready to default as soon as the massive 1997–2007 housing bubble began to deflate. If the U.S. government had not chosen this policy path—fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high-risk residential mortgages—the great financial crisis of 2008 would never have occurred.
Initiated by Congress in 1992 and pressed by the U.S. Department of Housing and Urban Development (HUD) in both the Clinton and George W. Bush administrations, the U.S. government’s housing policy sought to increase home ownership in the United States through an intensive effort to reduce mortgage underwriting standards. In pursuit of this policy, HUD used (i) the affordable housing requirements imposed by Congress in 1992 on the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices Initiative” for subprime lenders and mortgage banks to encourage greater subprime and other high-risk lending. HUD’s key role in the growth of subprime and other high-risk mortgage lending is covered in detail in Part III.
Ultimately, all these entities, as well as insured banks covered by the CRA, were compelled to compete for mortgage borrowers who were at or below the median income in the areas in which they lived. This competition caused underwriting standards to decline, increased the numbers of weak and high-risk loans far beyond what the market would produce without government influence, and contributed importantly to the growth of the 1997–2007 housing bubble.
When the bubble began to deflate in mid-2007, the low-quality and high-risk loans engendered by government policies failed in unprecedented numbers. The effect of these defaults was exacerbated by the fact that few, if any, investors—including housing market analysts—understood at the time that Fannie Mae and Freddie Mac had been acquiring large numbers of subprime and other high-risk loans in order to meet HUD’s affordable housing goals.
Alarmed by the unexpected delinquencies and defaults that began to appear in mid- 2007, investors fled the multi-trillion-dollar market for mortgage-backed securities (MBS), dropping MBS values—especially those MBS backed by subprime and other risky loans— to fractions of their former prices. Mark-to-market accounting then required financial institutions to write down the value of their assets—reducing their capital positions and causing great investor and creditor unease. The mechanism by which the defaults and delinquencies on subprime and other high-risk mortgages were transmitted to the financial system as a whole is covered in detail in Part II.
In this environment, the government’s rescue of Bear Stearns in March of 2008 temporarily calmed investor fears but created a significant moral hazard; investors and other market participants reasonably believed after the rescue of Bear that all large financial institutions would also be rescued if they encountered financial difficulties. However, when Lehman Brothers—an investment bank even larger than Bear—was allowed to fail, market participants were shocked; suddenly, they were forced to consider the financial health of their counterparties, many of which appeared weakened by losses and the capital writedowns required by mark-to-market accounting. This caused a halt to lending and a hoarding of cash—a virtually unprecedented period of market paralysis and panic that we know as the financial crisis of 2008.