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Housing Finance and the 2008 Financial Crisis
...Before looking at the origins of the financial crisis, it is useful to dispose of some of the faulty theories put forward to explain the mess. Some commentators have blamed deregulation for the financial meltdown of 2008. One member of Congress blamed “unregulated free-market lending run amok.” Such an indictment is necessarily skimpy on the particulars, because there has actually been no recent dismantling of banking and financial regulations. Regulations were, in fact, intensified in the 1990s in ways that fed the development of the housing finance crisis, as discussed below.

Some critics of deregulation point to the bipartisan Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act, as a source of recent problems. But that act opened the door for financial firms to diversify: a holding company that owns a commercial bank subsidiary may now also own insurance, mutual fund, and investment bank subsidiaries. Far from contributing to the recent turmoil, the greater freedom allowed by the 1999 act has been a blessing in containing the fallout. Without it, JPMorgan Chase could not have acquired Bear Stearns, nor could Bank of America have acquired Merrill Lynch—acquisitions that avoided losses to Bear’s and Merrill’s bondholders. (It is not the Act’s fault that the Fed sweetened the Bear Stearns acquisition at taxpayer expense and forced Bank of America to acquire Merrill Lynch when the bank wanted to scotch the deal). Without it, Goldman Sachs and Morgan Stanley could not have switched specialties to become bank holding companies when it became clear that they could no longer survive as investment banks....

...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 repeatedly lowering its target for the federal funds (interbank short-term) interest rate. The federal funds rate began 2001 at 6.25 percent and ended the year at 1.75 percent. It was reduced further in 2002 and 2003, and reached a low in mid-2003 of 1 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. In purchasing-power terms, during that period a borrower was not paying but rather gaining in proportion to what he borrowed. Economist Steve Hanke has summarized the result: “This set off the mother of all liquidity cycles and yet another massive demand bubble.”

The Taylor Rule—a formula devised by economist John Taylor of Stanford University—provides a standard method of estimating what federal funds rate would be consistent, conditional on current inflation and real income, with keeping the inflation rate to a chosen target rate. From early 2001 until late 2006, the Fed pushed the actual federal funds rate below the estimated rate that would have been consistent with targeting a 2 percent inflation rate.1 A fortiori, the Fed held the actual rate even further below the path, consistently targeting stability in nominal income. The gap was especially large—200 basis point or more—from mid-2003 to mid-2005.

The demand bubble 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 5 percent to 7 percent, real estate loans at commercial banks were growing at 10–17 percent....

...The Fed’s policy of lowering short-term interest rates not only fueled growth in the dollar volume of mortgage lending, but had unintended consequences for the type of mortgages written. By pushing very-short-term interest rates down so dramatically between 2001 and 2004, the Fed lowered short-term rates relative to 30-year rates. Adjustable-rate mortgages (ARMs), typically based on a one-year interest rate, became increasingly cheap relative to 30-year fixed-rate mortgages. Back in 2001, non-teaser ARM rates on average were 1.13 percent cheaper than 30-year fixed mortgages (5.84 percent vs. 6.97 percent). By 2004, as a result of the ultralow federal funds rate, the gap had grown to 1.94 percent (3.90 percent vs. 5.84 percent)....

...The International Monetary Fund corroborated the view that the Fed’s easy-credit policy fueled the housing bubble. After estimating the sensitivity of U.S. housing prices and residential investment to interest rates, IMF researchers found that “the increase in house prices and residential investment in the United States over the past six years would have been much more contained had short-term interest rates remained unchanged.”...

...The expansion in risky mortgages to underqualified borrowers was an imprudence fostered by the federal government. As elaborated in the paragraphs to follow, there were several ways that Congress and the executive branch encouraged the expansion. The first way was loosening down-payment standards on mortgages guaranteed by the Federal Housing Administration. The second was strengthening the Community Reinvestment Act. The third was pressure on lenders by the Department of Housing and Urban Development. The fourth and most important way was subsidizing, through implicit taxpayer guarantees, the dramatic expansion of the government-sponsored mortgage buyers Fannie Mae and Freddie Mac; pointedly refusing to moderate the moral hazard problem of implicit guarantees or otherwise rein in the hyperexpansion of Fannie and Freddie; and increasingly pushing Fannie and Freddie to promote affordable housing through expanded purchases of nonprime loans to low-income applicants....

...Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low- and moderate-income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target—42 percent of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50 percent in 2000 and 52 percent in 2005.

For 1996, HUD required that 12 percent of all mortgage purchases by Fannie and Freddie be “special affordable” loans, typically to borrowers with income less than 60% of their area’s median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down....

...The hyperexpansion of Fannie Mae and Freddie Mac was made possible by their implicit backing from the U.S. Treasury. To fund their enormous growth, Fannie Mae and Freddie Mac had to borrow huge sums in wholesale financial markets. Institutional investors were willing to lend to the government-sponsored mortgage companies cheaply—at rates only slightly above those on the Treasury’s risk-free securities and well below those paid by other financial intermediaries—despite the risk of default that would normally attach to private firms holding such highly leveraged and poorly diversified portfolios. The investors were so willing only because they thought that the Treasury would repay them should Fannie or Freddie be unable. As it turns out, they were right. ...