In “How Did We Get Into This Financial Mess?”, (White, L. H. (2008, November 18). How did we get into this financial mess? CATO Institute Briefing Papers, (110), 1-12.) Lawrence H. White makes a strong case, supported by many, that both the Fed’s monetary policy and the increasing political use of the Fed’s regulatory powers led directly to the recent “subprime mortgage crisis,” a.k.a. “mortgage meltdown.” The credit expansion policies of the Fed, combined with “mandates and subsidies to write riskier mortgages” were the primary culprits. The acquisitions allowed via deregulation actually kept the crisis from being even worse, and greed—described by White as a “constant”—“can’t explain why the number of financial crashes is higher than usual.”
During the 2001 recession the Fed began expanding the money supply by reducing the discount rate from 6.25%, down to a record-low 1% by mid-2003. The difference between the discount rate and what was recommended by the well-respected Taylor rule for a 2% inflation-rate (the usual Fed target) “was especially large—200 basis points or more—from mid-2003 to mid-2005.”
With the real rate being lower than inflation for two and a half years, “a borrower was not paying but rather gaining in proportion to what he borrowed.” The result was that from mid-2003 to mid-2007, “real estate loans at commercial banks were growing at 10-17 percent” as compared to a 5 to 7 percent growth in goods and services. Since the market value of real estate increases as interest rates decrease, home prices were on the rise.
In addition, as the discount rate went down, the rates on adjustable-rate mortgages became even lower relative to 30-year mortgages. The 30-year rate dropped from 6.97% in 2001 to 5.84% in 2004, while the rate for ARMs dropped from 5.84% to 3.90%, meaning ARMs were 1.13% cheaper in 2001, but 1.94% in 2004. Therefore, anyone buying a home saw it not just as a home, but as a great investment because of the steadily-increasing prices, and they could finance it at ever-lower rates with the (soon-to-be-proven dangerous for many) adjustable rate mortgage.
**The other major factor causing the mortgage crisis was the political influence on the Fed’s regulatory process, and political policies and pressures which pushed banks to write ever-riskier mortgages. In 2001 less than 10% of existing mortgages were subprime. Due to the rapidly increasing subprime market (34% of mortgages written in 2006 were subprime), the percentage of existing subprime mortgages more than doubled, to 23%. Further, the typical 20% down payment was giving way to a lower down payment. In 1934, when the Federal Housing Administration was founded, banks considered 20% low, but over the years began reducing their requirement to 20%. The FHA gradually reduced its down-payment requirement, reaching as low as 3% by 2004. **
The Community Reinvestment Act (CRA), which in 1977 merely imposed reporting requirements on banks to inform the government how much lending they did into the communities from which they received deposits, became much more of a pressure-tool used against banks. In 1989 the information became public, and in 1995 regulators could deny banks with low CRA-approval ratings the valuable ability to merge with other banks, or even open new branches.
With the ratings of these “private” lending institutions ratings now made public, **“[g]roups like ACORN (Association of Community Organizations for Reform Now) began actively pressuring banks to make loans under the threat that otherwise they would register complaints in order to deny the bank valuable approvals.” **
**Under the pressure, some banks “joined into partnerships with community groups to distribute millions in mortgage money to low-income borrowers previously considered non-creditworthy,” **while others boosted their rating by purchasing mortgage-backed securities, which were “packages of disproportionately nonprime loans certified as meeting CRA criteria and securitized by Freddie Mac.”
Starting in 1992, Congress and the Department of Housing and Urban Development began pressuring Fannie Mae and Freddie Mac to put more emphasis on affordable housing for low- and moderate-income buyers. In fact, HUD gave them an explicit target in 1996—42% of their loans had to go to low-income borrowers, and that target increased to 52% by 2005. Furthermore, by 2005, 20% of all mortgages funded by Fannie and Freddie had to be to borrowers with less than 60% of the median income for their area. To fund all this new activity they had to borrow on a large scale from the financial markets, but the markets had no problem doing so because of the implicit backing of the U.S. Treasury.
Congress was warned repeatedly by many, including William Poole, president of the St. Louis Federal Reserve Bank., that the federal backing of Fannie and Freddie meant that the companies did not have to face the rigors of “market discipline.”
The Bush administration pushed for more oversight of Fannie and Freddie. Congress however, who by that time had many members who were too close to Fannie and Freddie, did nothing. Representative Barney Frank (D-MA), in fact, not only defended Fannie and Freddie, but said the push for affordable housing hadn’t gone far enough. He said Fannie and Freddie were financially sound, and even vehemently dismissed the notion that they had any federal backing, explicitly or implicitly.
White concludes that “[w]e are experiencing the unfortunate results of perverse government policies,” and points out that the distortions of the free market system induced “by the Federal Reserve, government backing of Fannie Mae and Freddie Mac, the Department of Housing and Urban Development, and the Federal Housing Authority” prevented market forces from providing a more “sustainable prosperity.”
