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What Really Happened?
...The housing-finance boom and bust are not the results of a laissez-faire monetary and financial system. We didn’t have one. The boom and bust happened in a system with an unanchored government fiat money and extensive legal restrictions on financial intermediation. Nor have we had banking and financial deregulation since the bipartisan Financial Services Modernization Act (the Gramm-Leach-Bliley Act), signed by President Clinton in 1999. Far from contributing to the recent turmoil, moreover, that act has clearly been a blessing in containing it by allowing acquisitions, such as the acquisition of Bear Stearns by JPMorgan Chase or of Merrill Lynch by Bank of America, that have shielded bondholders from losses....

...In the recession of 2001, the Federal Reserve System under Chairman Alan Greenspan began aggressively expanding the U.S. money supply. Year-over-year growth in the M2 monetary aggregate rose briefly above 10 percent, and remained above 8 percent entering the second half of 2003. The expansion was accompanied by the Fed’s repeatedly lowering its target for the “federal funds” (interbank short-term) interest rate. The fed funds rate began 2001 at 6.25 percent and ended the year at 1.75 percent. It was reduced further in 2002 and 2003, reaching in mid-2003 a record low of one percent, where it stayed for a year. The real Fed funds rate was negative—meaning that nominal rates were lower than the contemporary rate of inflation—for two and a half years....

...The excess credit thus created went heavily into real estate. From mid-2003 to mid-2007, while the dollar volume of final sales of goods and services was growing at a compounded rate of 5.9 percent per annum, real-estate loans at commercial banks were (as already noted) growing at 12.26 percent...

...The federal government fostered the expansion in risky mortgages to under-qualified borrowers in several ways. It is hard to judge how much each of these contributed, but all worked to loosen lending standards.

First, the Federal Housing Administration over the years progressively loosened its down payment requirements on FHA mortgages. By 2004 the down payment requirement on the FHA’s most popular program had fallen to only 3 percent. [7] Private lenders felt compelled to offer lower down payments on non-FHA loans. Mortgages with very low down payments have had very high default rates.

Second, Congress strengthened the Community Reinvestment Act. The CRA had initially, from its passage in 1977, merely imposed reporting requirements on commercial banks. Amendments in 1995 empowered regulators to deny a bank with a low CRA rating permission to merge with another bank—at a time when the arrival of interstate banking made such approvals especially valuable—or even to open new branches. In response to the new CRA rules, some banks joined into partnerships with community groups to distribute millions in mortgage money to low-income borrowers previously considered non-creditworthy. Other banks took advantage of the newly authorized option to boost their CRA rating by purchasing special “CRA mortgage-backed securities,” that is, packages of disproportionately nonprime loans certified as meeting CRA criteria and securitized by Freddie Mac. Federal Reserve Chairman Ben Bernanke aptly commented in a 2007 speech that “recent problems in mortgage markets illustrate that an underlying assumption of the CRA—that more lending equals better outcomes for local communities may not always hold.”[8]

Third, the Department of Housing and Urban Development pressured lenders for “affordable housing” loans. Beginning in 1993, HUD officials began bringing legal actions against mortgage bankers that declined a higher percentage of minority applicants than white ones. To avoid legal trouble, lenders began relaxing their down-payment and income qualifications.[9]

Fourth and likely most important, implicit taxpayer guarantees allowed the dramatic expansion of the government-sponsored mortgage buyers Fannie Mae and Freddie Mac, at a time when Congress and HUD were pushing Fannie and Freddie to promote “affordable housing” through ever-expanding purchases of non-prime loans to low-income applicants. The two mortage giants grew to hold or guarantee around $5 trillion in mortgages, about half of the entire U.S. market. Institutional investors were willing to lend to the government-sponsored mortgage companies cheaply, despite the risk of default that would normally attach to private firms holding such highly leveraged and poorly diversified portfolios, because they were sure that the Treasury would repay them should Fannie or Freddie be unable. (It turns out that they were right.) Congress pointedly refused to moderate the moral hazard problem of implicit guarantees or otherwise to rein in the hyper-expansion of Fannie and Freddie. Warnings about Fannie and Freddie, and efforts to rein them in, came to naught because the two giants had cultivated powerful friends on Capitol Hill.

A 1992 law, as described by Bernanke, “required the government-sponsored enterprises, Fannie Mae and Freddie Mac, to devote a large percentage of their activities to meeting affordable housing goals.”[10] HUD set numerical goals for Fannie and Freddie: for the year 2000, 50 percent of their financing was to go to below-median-income borrowers; for 2005 the target rose to 52 percent. Additional goals required that increasing shares of lending go to borrowers with income under 60 percent of the median for their areas. [11]...