The 2008 financial crisis was a major event, perhaps the most severe financial breakdown in modern history. At the time, many commentators said that we were witnessing a crisis of capitalism, proof that the free market system was inherently unstable.
Government officials who participated in efforts to mitigate its effects claim that their actions prevented a complete meltdown of the world’s financial system, an idea that has found acceptance among academic and other observers, particularly the media. These views culminated in the enactment of the Dodd-Frank Act – indeed a law like no other – that is founded on the notion that the financial system is inherently unstable and must be controlled by more government regulation.
We will never know, of course, what would have happened if these emergency actions had not been taken, but it is possible to gain an understanding of why they were considered necessary: that is, the causes of the crisis.
Why is it important at this point to examine the causes of the crisis? After all, it’s five years in the past, and Congress and financial regulators have acted, or are acting, to prevent a recurrence. Even if we can’t pinpoint the exact cause of the crisis, some will argue that the new regulations now being put in place under Dodd-Frank will make a repetition unlikely.
Perhaps, but these new regulations have almost certainly slowed economic growth and the recovery from the post-crisis recession and will continue to do so in the future.
If regulations this pervasive were really necessary to prevent a recurrence of the financial crisis, then we might be facing a legitimate trade-off in which we are obliged to sacrifice economic freedom and growth for the sake of financial stability. But if the crisis did not stem from a lack of regulation, we have needlessly restricted what most Americans want for themselves and their children.
The real causes of the financial crisis
It is not at all clear that what happened in 2008 was the result of insufficient regulation or an economic system that is inherently unstable. On the contrary, there is compelling evidence that the financial crisis was the result of the government’s own housing policies. These policies, as I will describe them, were what caused the insolvency of the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, and ultimately the financial crisis.
The seeds of the crisis were planted with the enactment by Congress in 1992 of what were called “affordable housing” goals for Fannie Mae and Freddie Mac. Before 1992, these two firms dominated the housing finance market, especially after the federal savings and loan (S&L) industry – another government mistake – had collapsed in the late 1980s.
The GSEs’ role, as initially envisioned and as it developed until 1992, was to conduct what were called secondary market operations, to create a liquid market in mortgages. They were prohibited from making loans themselves, but they were authorized to buy mortgages from banks and other lenders. Their purchases provided cash for lenders and thus encouraged home ownership by making more funds available for more mortgages.
Although Fannie and Freddie were shareholder-owned, they were chartered by Congress and granted numerous government privileges. For example, they were exempt from state and local taxes and from SEC regulations. The president appointed a minority of the members of their boards of directors, and they had a $2.25 billion line of credit at the Treasury. As a result, market participants believed that the two GSEs were government-backed, and would be rescued by the government if they ever encountered financial difficulties.
This widely-assumed government support enabled them to borrow at rates only slightly higher than the U.S. Treasury itself, and with these low-cost funds they were able to drive all competition out of the secondary mortgage market for middle-class mortgages – about 70 percent of the $11 trillion housing finance market. Between 1991 and 2003, the GSEs’ market share increased from 28 percent to 46 percent. From this dominant position, they were able to set the underwriting standards for the market as a whole; few mortgage lenders would make middle-class mortgages that could not be sold to Fannie or Freddie.
Over time, the GSEs had learned from experience what underwriting standards kept delinquencies and defaults low. These required down payments of 10 to 20 percent, good credit histories for borrowers and low debt-to-income ratios after the mortgage was closed. These were the foundational elements of what was called a prime loan or a traditional mortgage, and they contributed to a stable mortgage market through the 1970s and most of the 1980s, with mortgage defaults of generally less than 1 percent in normal times and only a few percent in rough economic waters. Despite these strict credit standards, the homeownership rate in the United States remained relatively high, hovering around 64 percent for the 30 years between 1964 and 1994.
The effect of the affordable housing goals
In a sense, the GSEs’ government backing and market domination was their undoing. Community activists had had the two firms in their sights for many years, arguing that the GSEs’ underwriting standards were so tight that they were keeping many low and moderate income families from buying homes. The fact that the GSEs had government support gave Congress a basis for intervention, and in 1992, Congress directed the GSEs to meet a quota of loans to low and middle income borrowers when they acquired mortgages. The initial quota was 30 percent. In any year, at least 30 percent of the loans Fannie and Freddie acquired had to be made to low and moderate income borrowers – defined as borrowers at or below the median income in their communities.
Although 30 percent was not a difficult goal, the Department of Housing and Urban Development (HUD) was given authority to increase the goals, and Congress cleared the way for far more ambitious requirements by suggesting in the legislation that downpayments could be reduced below five percent without seriously impairing mortgage quality. In succeeding years, HUD raised the goal, with many intermediate steps, to 42 percent in 1996, 50 percent in 2000, and 56 percent in 2008.
Although it was relatively easy for Fannie and Freddie to find prime borrowers when the goal was 30 percent, they were much more difficult to find as the quota increased, and especially when it reached and then exceeded 50 percent. In order to meet these ever-increasing goals, Fannie and Freddie had to reduce their underwriting standards. In fact, that was explicitly HUD’s purpose, as many statements by the department at the time made clear. As early as 1995, the GSEs were buying mortgages with 3 percent down payments, and by 2000 Fannie and Freddie were accepting loans with zero down payments.
At the same time, they were also compromising other underwriting standards, such as borrower credit standards, in order to find the subprime and other non-traditional mortgages they needed to meet the affordable housing goals.
These new easy credit terms spread far beyond the low-income borrowers that the loosened standards were intended to help. Mortgage lending is a competitive business; once Fannie and Freddie started to reduce their underwriting standards many borrowers who could have afforded prime mortgages sought the easier terms now available so they could buy larger homes with smaller downpayments.
As result of the gradual deterioration in loan quality over the preceding 16 years, by 2008 – just before the crisis – 56 percent of all mortgages in the U.S. – 31 million loans – were subprime or otherwise low quality. Of this 31 million, 76 percent were on the books of government agencies or institutions like the GSEs that were controlled by government policies. This shows incontrovertibly where the demand for these mortgages originated.
The great housing bubble and its collapse, 1997-2007
With all the new buyers entering the market because of the affordable housing goals, housing prices began to rise. By 2000, the developing bubble was already larger than any bubble in U.S. history, and it kept rising until 2007, when – at nine times larger than any previous bubble – it finally topped out and housing prices began to fall.
With the largest housing bubble in history deflating in 2007, and more than half of all mortgages made to borrowers who had weak credit or little equity in their homes, the number of delinquencies and defaults in 2008 was unprecedented. One immediate effect was the collapse of the market for mortgage-backed securities that were issued by banks, investment banks and subprime lenders, and held by banks, financial institutions and other investors around the world.
These were known as private label securities (PLS) or private mortgage-backed securities (PMBS), to distinguish them from mortgage backed securities issued by Fannie and Freddie. Investors, shocked by the sheer number of mortgage defaults that seemed to be underway, fled the market for private label securities; there were now no buyers, causing a sharp drop in market values for these securities.
This had a disastrous effect on financial institutions. Since 1994, they had been required to use what was called “fair value accounting” in setting the balance sheet value of their assets and liabilities. The most significant element of fair value accounting was the requirement that assets and liabilities be marked to market, meaning that the balance sheet value of assets and liabilities was to reflect their current market value instead of their amortized cost or other valuation methods.
Accordingly financial firms were compelled to write down significant portions of their PMBS assets and take losses that substantially reduced their capital positions and created worrisome declines in earnings. When Lehman Brothers, a major investment bank, declared bankruptcy, a full-scale panic ensued in which financial institutions started to hoard cash. They wouldn’t lend to one another, even overnight, for fear that they would not have immediate cash available when panicky investors or depositors came for it.
This radical withdrawal of liquidity from the market was the financial crisis.
Thus, the crisis was not caused by insufficient regulation, let alone by an inherently unstable financial system. It was caused by government housing policies that forced the dominant factors in the trillion dollar housing market, Fannie Mae and Freddie Mac, to reduce their underwriting standards. These lax standards then spread to the wider market, creating an enormous bubble and a financial system in which well more than half of all mortgages were subprime or otherwise weak.
When the bubble deflated in 2007 and 2008, these mortgages failed in unprecedented numbers, driving down housing values and the values of mortgage-backed securities on the balance sheets of financial institutions. With these institutions looking unstable and possibly insolvent, a full-scale financial panic ensued when a large financial firm, Lehman Brothers, failed.
Given these facts, further regulation of the financial system through the Dodd-Frank Act was a disastrously wrong response. The vast new regulatory restrictions in the act have created uncertainty and sapped the appetite for risk-taking that had once made the U.S. financial system the largest and most successful in the world.
What, then, should have been done? The answer is a thorough reorientation of the U.S. housing finance system away from the kind of government control that makes it hostage to the imperatives of government – that is, providing benefits to constituents – rather than the competition and efficiency imperatives of a market system. This does not mean no regulation, but it does mean only regulation that is necessary when the self-correcting elements in a market system fail.
If the American people come to recognize that the financial crisis was caused by the housing policies of their own government, rather than insufficient regulation or the inherent instability of the U.S. financial system, Dodd-Frank will be seen as an illegitimate response to the crisis. Only then will it be possible to repeal or substantially modify this repressive law.
Peter J. Wallison is the author of Hidden in Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Can Happen Again, to be published in January 2015 by Encounter Books