How did we get into this financial mess?

• Author: White, Lawrence H.
• Position: Life in America

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AS POLICYMAKERS confront the ongoing U.S. financial crisis, it is important to take a step back and understand its origins. Those who fault "deregulation, "unfettered capitalism," or "greed" would do well to look instead at flawed institutions and misguided policies. The expansion in risky mortgages to underqualified borrowers was encouraged by the Federal government. The growth of "creative" nonprime lending followed Congress' strengthening of the Community Reinvestment Act, the Federal Housing Administration's loosening of down-payment standards, and the Department of Housing and Urban Development's pressuring lenders to extend mortgages to borrowers who previously would not have qualified. Meanwhile, Freddie Mac and Fannie Mae grew to own or guarantee about half of the U.S.'s 12 trillion-dollar mortgage market. Congressional leaders pointedly refused to moderate the moral hazard problem of implicit guarantees or otherwise rein in their hyperexpansion, instead pushing them to promote "affordable housing" through expanded purchases of nonprime loans to low-income applicants.

The credit that fueled these risky mortgages was provided by the cheap money policy of the Federal Reserve. Following the 2001 recession, Fed Chairman Alan Greenspan slashed the Federal funds rate in unprecedented fashion. This set off what economist Steve Hanke calls "the mother of all liquidity cycles and yet another massive demand bubble."

Mortgage foreclosure rates in the U.S. have risen to the highest level since the Great Depression. The nation's two largest financial institutions, the government-sponsored mortgage purchasers and repackagers Fannie Mae and Freddie Mac, have gone into bankruptcy-like "conservatorship." Several major investment banks, insurance companies, and commercial banks heavily tied to real estate lending have gone bankrupt outright or have been sold for cents on the dollar. Prices and trading volumes in mortgage-backed securities have shrunk dramatically. Reluctance to lend has spread to other markets. To prepare the ground for a return to normalcy in American credit markets, we must understand the character of the problems we currently face and how those difficulties arose.

Some commentators--as well as Pres. Barack Obama and the man he beat out for the White House, Sen. John McCain (R.-Ariz.)--have blamed the current financial mess on greed. Yet, if an unusually high number of airplanes were to crash this year, would it make sense to blame gravity? Greed, like gravity, is a constant. It cannot explain why the number of financial crashes is higher than usual. There has been no unusual epidemic of blackheartedness.

Others have blamed deregulation or (in the words of one Representative) "unregulated free-market lending run amok." Such an indictment is necessarily skimpy on the particulars, because there actually has been no recent dismantling of banking and financial regulations. In fact, regulations were intensified in the 1990s in ways that fed the development of the housing finance crisis. The last move in the direction of financial deregulation was the bipartisan Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act, signed by Pres. Bill Clinton. That Act opened the door for financial firms to diversify: a holding company that owns a commercial bank subsidiary now also may own insurance, mutual fund, and investment bank subsidiaries. Far from contributing to the recent turmoil, the greater freedom and flexibility allowed by the Act clearly has been a blessing in containing it. Without it, JPMorgan Chase could not have bought Bear Steams, nor could Bank of America have purchased Merrill Lynch--acquisitions that avoided losses to Bear's and Merrill's bondholders. Without it, Goldman Sachs and Morgan Stanley could not have switched specialties to become bank holding companies when it became clear that they no longer could survive as investment banks.

The actual causes of our financial troubles were unusual monetary policy moves and novel Federal regulatory interventions. These poorly chosen policies distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions.

Problems first surfaced in "exotic" or "flexible" home mortgage lending. Creative lenders and originators had expanded the volume of unconventional mortgages with high default risks (reflected in nonprime ratings), which are the housing market's equivalent of junk bonds. Unconventional mortgages helped to feed a ran-up in condominium and housing prices. Housing prices peaked and turned downward. Borrowers with inadequate income relative to their debts, many of whom either had counted on being able to borrow against a higher house value in the future in order to help them meet their monthly mortgage payments, or on being able to "flip" the property at a price that would more than repay their mortgage, began to default. Default rates on nonprime mortgages rose to unexpected highs. The high risk on the mortgages came back to bite mortgage holders, the financial institutions to whom the monthly payments were...