.... To call the housing and credit crisis a failure of the free market or the product of unregulated greed is to overlook the myriad government regulations, policies, and political pronouncements that have both reduced the "freedom" of this market and channeled self-interest in ways that have produced disastrous consequences, both intended and unintended. Let me briefly recap goverment's starring role in our little drama.
For starters, Fannie Mae and Freddie Mac are "government sponsored enterprises". Though technically privately owned, they have particular privileges granted by the government, they are overseen by Congress, and, most importantly, they have operated with a clear promise that if they failed, they would be bailed out. Hardly a "free market." All the players in the mortgage market knew this from early on. In the early 1990s, Congress eased Fannie and Freddie's lending requirements (to 1/4th the capital required by regular commercial banks) so as to increase their ability to lend to poor areas. Congress also created a regulatory agency to oversee them, but this agency also had to reapply to Congress for its budget each year (no other financial regulator must do so), assuring that it would tell Congress exactly what it wanted to hear: "things are fine." In 1995, Fannie and Freddie were given permission to enter the subprime market and regulators began to crack down on banks who were not lending enough to distressed areas. Several attempts were made to rein in Fannie and Freddie, but Congress didn't have the votes to do so, especially with both organizations making significant campaign contributions to members of both parties. Even the New York Times as far back as 1999 saw exactly what might happen thanks to this very unfree market, warning of a need to bailout Fannie and Freddie if the housing market dropped.
Complicating matters further was the 1994 renewal/revision of the Community Reinvestment Act of 1977. The CRA requires banks to to make a certain percentage of their loans within their local communities, especially when those communities are economically disadvantaged. In addition, Congress explicitly directed Fannie and Freddie to expand their lending to borrowers with marginal credit as a way of expanding homeownership. What all of these did together was to create an enormous profit and political incentives for banks and Fannie and Freddie to lend more to riskier low-income borrowers.
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The final chapter of the story is that in 2004 and 2005, following the accounting scandals at Freddie, both Freddie and Fannie paid penance to Congress by agreeing to expand their lending to low-income customers. Both agreed to acquire greater amounts of subprime and Alt-A loans, sending the green light to banks to originate them. From 2004 2003 [corrected on 10/19/08] to 2006, the percentage of loans in those riskier categories grew from 8% to 20% of all US mortgage originations. And the quality of these loans were dropping too: downpayments were getting progressively smaller and more and more loans carried low starter interest rates that would adjust upward later on. The banks were taking on riskier borrowers, but knew they had a guaranteed buyer for those loans in Fannie and Freddie, back, of course, by us taxpayers. Yes, banks were "greedy" for new customers and riskier loans, but they were responding to incentives created by well-intentioned but misguided government interventions. It is these interventions that are ultimately responsible for the risky loans gone bad that are at the center of the current crisis, not the "free market."
The current mess is thus clearly shot through and through with government meddling with free markets, from the Fed-provided fuel to the CRA and land-use regulations to Fannie and Freddie creating an artificial market for risky mortgages in order to meet Congress's demands for more home-ownership opportunities for low-income families. Thanks to that intervention, many of those families have not only lost their homes, but also the savings they could have held onto for a few more years and perhaps used to acquire a less risky mortgage on a cheaper house.
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If only, you think, Obama can win and we can clean out the corrupt Republicans and put ethical, well-meaning folks in place. Think again. For one thing, almost every government intervention at the root of this crisis took place with a Democratic president or a Democratic-controlled Congress in place. Even when the Republicans controlled Congress, President Clinton worked around it to change the rules to allow Fannie and Freddie into the higher-risk loan market. My point here is not to pin the blame for the current crisis on the Democrats. That blame goes around equally. My point is that hoping that having the "right people" in power will avoid these problems is both naive and historically blind.
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