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Getting the Story Right
...After 2000, the national push toward homeownership intensified in three dimensions, leading to a doubling of housing prices in just five years' time. First, the Federal Reserve Board's interest-rate policy drove down the cost of borrowing money to unprecedented lows. Second, a common conviction arose that homeownership should be available even to those who, under prevailing conditions, could not afford it. Finally, private agencies charged with determining the risk and value of securities were exceptionally generous in their assessment of the financial products known as "derivatives" whose collateral resided in the value of thousands of mortgages bundled together. The rating agencies understated the risks from these bundled mortgages by assuming that home prices were simply going to rise forever.

When the housing bubble burst in 2006, the damage to the financial system pushed the global economy into the worst contraction since the Great Depression. In the midst of the pain and suffering that have accompanied financial collapse and economic contraction--over $15 trillion in wealth has been lost by American households alone while, by July 1, more than 6 million job losses had boosted the unemployment rate to 9.4 percent--much of the blame has been placed on unregulated financial markets whose behavior is said to have revealed a terrible flaw in the foundation of capitalism itself.
This was a market failure, we are told, and the promise of capitalism has always been that the self-correcting mechanisms built into the system would preclude the possibility of a systemic market failure. But the housing bubble burst only after government subsidies pushed house prices up so fast that marginal buyers could no longer afford to chase prices even higher. A bubble created by rigged financial markets and a government-sponsored obsession with homeownership is not a result of market failure, but rather, a result of bad public policy. The belief that homeownership, per se, is such a benefit that no amount of government support could be too great and no pace at which home prices rise could be too fast, is the root of the crisis. There was no market failure....

...During Bill Clinton's first term, government housing policy changed substantially. After decades in which liberal politicians and thinkers devoted themselves to arguments for expanding the number of public housing units, the disastrous condition of those units led the president, a "new Democrat," to a dramatic ideological shift in emphasis. No longer would public housing be at the top of the liberal Democratic agenda. Instead, borrowing from conservative ideas about the inestimable benefit of homeownership to the striving poor, the Clinton administration and members of his party in the House and Senate decided to use government power to achieve that aim.

In 1994, the National Homeownership Strategy of the Clinton administration advanced "financing strategies fueled by creativity to help homeowners who lacked the cash to buy a home or the income to make the down payments" to buy a home nonetheless. It became U.S. government policy to intervene in the marketplace by lowering the standards necessary to qualify for mortgages so that Americans with lower incomes could participate in the leveraged purchases of homes.

The goal of expanding homeownership led to the creation of new mortgage subsidies across the board. The loosening of standards became the policy of Fannie Mae and Freddie Mac, the pseudo-private government-sponsored enterprises that bought mortgages from originating lenders. A particular change in the tax law in 1997 encouraged many households to make buying and improving a home the primary vehicle by which they enhanced net worth. By eliminating any capital gains tax on the first $500,000 of profits from the sale of an owner-occupied residence once every two years, Washington encouraged enterprising American families to purchase homes, fix them up, resell them, and then repeat the process. Flipping became a financial pastime for millions because this special advantage created a new incentive--which did not exactly fit the model of encouraging people to remain in a stable home for many years and thereby help to stabilize the neighborhood around them....

...The housing bubble was thus a fully rational response to a set of distortions in the free market--distortions created primarily by the public sector. The heads of large financial institutions, as Prince's remark suggested, recognized the risk-taking subsidy inherent in public policy, but felt they had no choice but to play along or fall behind the other institutions that were also responding rationally to the incentives created by government intervention.

The housing collapse and its painful aftermath, including that $15 trillion wealth loss for U.S. households (so far), do not, therefore, represent a market failure. Rather, they represent the dangerous confluence of three policy errors: government policy aimed at providing access to homeownership for American households irrespective of their ability to afford it; the Fed's claim that it could not identify bubbles as they were inflating but could fix the problem afterward; and a policy of granting monopoly power to rating agencies like Standard & Poor's, Moody's, and Fitch's to determine the eligibility of derivative securities for what are supposed to be low-risk portfolios, such as pension funds....

...There really is not any question of which approach is factually correct: right on the front page of the Times edition of December 21 is a chart that shows the growth of homeownership in the United States since 1990. In 1993, it was 63 percent; by the end of the Clinton administration, it was 68 percent. The growth in the Bush administration was about 1 percent. The Times itself reported in 1999 that Fannie Mae and Freddie Mac were under pressure from the Clinton administration to increase lending to minorities and low-income home buyers--a policy that necessarily entailed higher risks. Can there really be a question, other than in the fevered imagination of the Times, of where the push to reduce lending standards and boost homeownership came from?

The fact is that neither political party, and no administration, is blameless; the honest answer, as outlined below, is that government policy over many years caused this problem. The regulators, in both the Clinton and Bush administrations, were the enforcers of the reduced lending standards that were essential to the growth in homeownership and the housing bubble.

There are two key examples of this misguided government policy. One is the CRA. The other is the affordable housing "mission" that the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac were charged with fulfilling. As originally enacted in 1977, the CRA vaguely mandated regulators to consider whether an insured bank was serving the needs of the "whole" community. For sixteen years, the act was invoked rather infrequently, but 1993 marked a decisive turn in its enforcement. What changed? Substantial media and political attention were showered upon a 1992 Boston Federal Reserve Bank study of discrimination in home mortgage lending. This study concluded that, while there was no overt discrimination in banks' allocation of mortgage funds, loan officers gave whites preferential treatment. The methodology of the study has since been questioned, but, at the time, it was highly influential with regulators and members of the incoming Clinton administration; in 1993, bank regulators initiated a major effort to reform the CRA regulations.

In 1995, the regulators created new rules that sought to establish objective criteria for determining whether a bank was meeting CRA standards. Examiners no longer had the discretion they once had. For banks, simply proving that they were looking for qualified buyers was not enough. Banks now had to show that they had actually made a requisite number of loans to low- and moderate-income (LMI) borrowers. The new regulations also required the use of "innovative or flexible" lending practices to address credit needs of LMI borrowers and neighborhoods. Thus, a law that was originally intended to encourage banks to use safe and sound practices in lending now required them to be "innovative" and "flexible." In other words, it called for the relaxation of lending standards, and it was the bank regulators who were expected to enforce these relaxed standards.

The effort to reduce mortgage lending standards was led by the Department of Housing and Urban Development through the 1994 National Homeownership Strategy, published at the request of 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 who lacked the cash to buy a home or to make the payments." Once the standards were relaxed for low-income borrowers, it would seem impossible to deny these benefits to the prime market. Indeed, bank regulators, who were in charge of enforcing CRA standards, could hardly disapprove of similar loans made to better-qualified borrowers.

Sure enough, according to data published by the Joint Center for Housing Studies of Harvard University, the share of all mortgage originations that were made up of conventional mortgages (that is, the thirty-year fixed-rate mortgage that had always been the mainstay of the U.S. mortgage market) fell from 57.1 percent in 2001 to 33.1 percent in the fourth quarter of 2006. Correspondingly, subprime loans (those made to borrowers with blemished credit) rose from 7.2 percent to 18.8 percent, and Alt-A loans (those made to speculative buyers or without the usual underwriting standards) rose from 2.5 percent to 13.9 percent. Although it is difficult to prove cause and effect, it is highly likely that the lower lending standards required by the CRA influenced what banks and other lenders were willing to offer to borrowers in prime markets. ...

...Fannie and Freddie used their affordable housing mission to avoid additional regulation by Congress, especially restrictions on the accumulation of mortgage portfolios (today totaling approximately $1.6 trillion) that accounted for most of their profits. The GSEs argued that if Congress constrained the size of their mortgage portfolios, they could not afford to adequately subsidize affordable housing....

...The decline in underwriting standards is clear in the financial disclosures of Fannie and Freddie. From 2005 to 2007, Fannie and Freddie bought approximately
$1 trillion in subprime and Alt-A loans. This amounted to about 40 percent of their mortgage purchases during that period. Moreover, Freddie purchased an ever-increasing percentage of Alt-A and subprime loans for each year between 2004 and 2007. It is impossible to forecast the total losses the GSEs will realize from a $1.6 trillion portfolio of junk loans, but if default rates on these loans continue at the unprecedented levels they are showing today, the number will be staggering. The losses could make the $150 billion savings and loan bailout in the late 1980s and early 1990s look small by comparison....

...In a very real sense, the competition from Fannie and Freddie that began in late 2004 caused both the GSEs and the private-label issuers to scrape the bottom of the mortgage barrel. Fannie and Freddie did so in order to demonstrate to Congress their ability to increase support for affordable housing. The private-label issuers did so to maintain their market share against the GSEs' increased demand for subprime and Alt-A products. Thus, the gradual decline in lending standards--beginning with the revised CRA regulations in 1993 and continuing with the GSEs' attempts to show Congress that they were meeting their affordable housing mission--came to dominate mortgage lending in the United States....