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Government Policies and the Financial Crisis
The current financial crisis is not--as some have said--a crisis of capitalism. It is in fact the opposite, a shattering demonstration that ill-considered government intervention in the private economy can have devastating consequences. The crisis has its roots in the U.S. government's efforts to increase homeownership, especially among minority and other underserved or low-income groups, and to do so through hidden financial subsidies rather than direct government expenditures. The story is an example, enlarged to an American scale, of the adverse results that flow from the misuse and manipu-lation of banking and credit by government. When this occurs in authoritarian regimes, we deride the outcome as a system of "policy loans" and note with an air of superiority that banks in these countries are weak, credit is limited, and financial crises are frequent. When the same thing happens in the United States, however, we blame "greedy" people, or poor regulation (or none), or credit default swaps, or anything else we can think of--except the government policies that got us into the disaster. ...

...The two key examples of this policy are the CRA, adopted in 1977, and the affordable housing "mission" of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. As detailed below, beginning in the late 1980s--but particularly during the Clinton administration--the CRA was used to pressure banks into making loans they would not otherwise have made and to adopt looser lending standards that would make mortgage loans possible for individuals who could not meet the down payment and other standards that had previously been applied routinely by banks and other housing lenders. The same pressures were brought to bear on the GSEs, which adapted their underwriting standards so they could accept the loans made under the CRA and other loans that did not conform to what had previously been considered sound lending practices. Loans to members of underserved groups did not come with labels, and once Fannie and Freddie began accepting loans with low down payments and other liberalized terms, the same unsound practices were extended to borrowers who could have qualified under the traditional underwriting standards. It should not be surprising that borrowers took advantage of these opportunities. It was entirely rational to negotiate for a low-down-payment loan when that permitted the purchase of a larger house in a better neighborhood. ...

...There is very little data available on the performance of loans made under the CRA. The subject has become so politicized in light of the housing meltdown and its effect on the general economy that most reports--favorable or unfavorable--should probably be discounted. Before the increases in housing prices that began in 2001, reviews of the CRA were generally unfavorable. The act increased costs for banks, and there was an inverse relationship between their CRA lending and their regulatory ratings.[7] One of the few studies of CRA lending in comparison to normal lending was done by the Federal Reserve Bank of Cleveland, which reported in 2000 that "respondents who did report differences [between regular and CRA housing loans] most often said they had lower prices or higher costs or credit losses for CRA-related home purchase and refinance loans than for others."[8] Much CRA lending after 2000 occurred during a period of enormous growth in housing values, which tended to suppress the number of defaults and reduce loss rates.

The important question, however, is not the default rates on the mortgages made under the CRA. Whatever those rates might be, they were not sufficient to cause a worldwide financial crisis. The most important fact associated with the CRA is the effort to reduce underwriting standards so that more low-income people could purchase homes. Once these standards were relaxed--particularly allowing loan-to-value ratios higher than the 20 percent that had previously been the norm--they spread rapidly to the prime market and to subprime markets where loans were made by lenders other than insured banks. The effort to reduce mortgage underwriting standards was led by the Department of Housing and Urban Development (HUD) through the National Homeownership Strategy published in 1994 in response to a request by President Clinton. Among other things, it called for "financing strategies, fueled by the creativity and resources of the private and public sectors to help homeowners that lack cash to buy a home or to make the payments."[9] Many subsequent studies have documented the rise in loan-to-value ratios and other indicators of loosened lending standards.[10]...

...When the history of this era is written, students will want to understand the political economy that allowed Fannie and Freddie to grow without restrictions while producing large profits for shareholders and management but no apparent value for the American people. The answer is the affordable housing mission that was added to their charters in 1992, which--like the CRA--permitted Congress to subsidize LMI housing without appropriating any funds. As long as Fannie and Freddie could credibly contend that they were advancing the interests of LMI homebuyers, they could avoid new regulation by Congress--especially restrictions on the accumulation of mortgage portfolios, totaling approximately $1.5 trillion by 2008, that accounted for most of their profits. They could argue to Congress that if the mortgage portfolios were constrained by regulation, they could not afford to subsidize affordable housing.[16] In addition, the political sophistication of Fannie Mae's management enabled the company to serve the interests of key lawmakers who could and did stand in the way of the tougher regulation that might have made the current crisis far less likely.[17]...

...By 1997, Fannie was offering a 97 percent loan-to-value mortgage, and by 2001, it was offering mortgages with no down payment at all. By 2007, Fannie and Freddie were required to show that 55 percent of their mortgage purchases were LMI loans and, within this goal, that
38 percent of all purchases were from underserved areas (usually inner cities) and 25 percent were purchases of loans to low-income and very-low-income borrowers.[19] Meeting these goals almost certainly required Fannie and Freddie to purchase loans with low down payments and other deficiencies that would mark them as subprime or Alt-A....