A History Lesson

The current financial crisis started in the market for subprime mortgages and then spread to other parts of the economy.   As usual, our politicians are blaming everyone but themselves and are saying the current crisis proves the need for more government regulation.  I agree that new regulations are needed, but the truth is that well-intended but misguided government regulations started the avalanche that snowballed into the current crisis, which is now threatening the entire economy.   If there is anything we should learn from history, it is that well-meaning legislation frequently has unintended consequences.

Let’s take a little history lesson.  The following article, which appeared in The New York Times on September 30, 1999, explains the genesis of the problem we are facing today.   Portions of the article have been omitted to conserve space. 

Fannie Mae Eases Credit to Aid Mortgage Lending 

By Steven A. Holmes 

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.  Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

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Jeff Jacoby, a columnist for The Boston Globe, provided his perspective on the causes of the financial crisis in a column published on September 28, 2008, which stated in part as follows:

While the mortgage crisis convulsing Wall Street has its share of private-sector culprits,…. they weren't the ones who "got us into this mess."  Barney Frank's talking points notwithstanding, mortgage lenders didn't wake up one fine day deciding to junk long-held standards of creditworthiness in order to make ill-advised loans to unqualified borrowers.  It would be closer to the truth to say they woke up to find the government twisting their arms and demanding that they do so - or else.

The roots of this crisis go back to the Carter administration. That was when government officials, egged on by left-wing activists, began accusing mortgage lenders of racism and "redlining" because urban blacks were being denied mortgages at a higher rate than suburban whites.

The pressure to make more loans to minorities (read: to borrowers with weak credit histories) became relentless.  Congress passed the Community Reinvestment Act, empowering regulators to punish banks that failed to "meet the credit needs" of "low-income, minority, and distressed neighborhoods."  Lenders responded by loosening their underwriting standards and making increasingly shoddy loans.  The two government-chartered mortgage finance firms, Fannie Mae and Freddie Mac, encouraged this "subprime" lending by authorizing ever more "flexible" criteria by which high-risk borrowers could be qualified for home loans, and then buying up the questionable mortgages that ensued.

As long as housing prices kept rising, the illusion that all this was good public policy could be sustained.  But it didn't take a financial whiz to recognize that a day of reckoning would come…. [Frank’s] fingerprints are all over this fiasco.  Time and time again, Frank insisted that Fannie Mae and Freddie Mac were in good shape.  Five years ago, for example, when the Bush administration proposed much tighter regulation of the two companies, Frank was adamant that "these two entities, Fannie Mae and Freddie Mac, are not facing any kind of financial crisis."   When the White House warned of "systemic risk for our financial system" unless the mortgage giants were curbed, Frank complained that the administration was more concerned about financial safety than about housing.

Now that the bubble has burst and the "systemic risk" is apparent to all, Frank blithely declares: "The private sector got us into this mess."  Well, give the congressman points for gall.  Wall Street and private lenders have plenty to answer for, but it was Washington and the political class that derailed this train.   If Frank is looking for a culprit to blame, he can find one suspect in the nearest mirror.

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Would more government regulations have prevented the current crisis?  Writing in The Los Angeles Times on October 2, 2008, J.D. Foster, a fellow at The Heritage Foundation, said:

Europeans have been rather smug about our troubles, but they're now looking at failures of their own major financial firms, nationalization of their banks and threats of a banking panic.  It turns out their heavier regulatory hand was no defense against the current crisis.  Nor did their regulators fare better in ferreting out the gathering dangers. 

Today's financial troubles have many fathers in Washington, on Wall Street and, yes, even on Main Street. (Ask anyone who lied on a mortgage application.)  As the crisis recedes, Americans will need to understand what went right and what went wrong with private behavior, public policy and our regulatory system.  More than ever, we'll need careful, thoughtful analysis -- not Washington's usual high-pitched rants. 

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There is plenty of blame to go around, but it is clear that our current problems started when government decided to interfere with the private economy.  Well-intended government policies are a principle—if not the major—cause of the current financial mess.    Now the same members of Congress who adopted these policies will be passing new laws designed to prevent future problems.   I wonder how many new unintended problems will be caused by the new laws and regulations soon to be imposed on private enterprise (or what used to be referred to as private enterprise).