What Caused the Financial Crisis?
George Santayana is oft en quoted for the aphorism that “Those who cannot
remember the past are condemned to repeat it.” Looking back on the financial crisis,
we can see why the study of history is often so contentious and why revisionist
histories are so easy to construct. There are always many factors that could have
caused an historical event; the difficult task is to discern which, among a welter of
possible causes, were the significant ones—the ones without which history would
have been different. Using this standard, I believe that the sine qua non of the
financial crisis was U.S. government housing policy, which led to the creation of 27
million subprime and other risky loans—half of all mortgages in the United States—
which were ready to default as soon as the massive 1997-2007 housing bubble began
to deflate. If the U.S. government had not chosen this policy path—fostering the
growth of a bubble of unprecedented size and an equally unprecedented number of
weak and high risk residential mortgages—the great financial crisis of 2008 would
never have occurred.
Initiated by Congress in 1992 and pressed by HUD in both the Clinton and
George W. Bush Administrations, the U.S. government’s housing policy sought to
increase home ownership in the United States through an intensive effort to reduce
mortgage underwriting standards. In pursuit of this policy, HUD used (i) the
affordable housing requirements imposed by Congress in 1992 on the government sponsored
enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the
policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices
Initiative” for subprime lenders and mortgage banks, to encourage greater subprime
and other high risk lending. HUD’s key role in the growth of subprime and other
high risk mortgage lending is covered in detail in Part III.
Ultimately, all these entities, as well as insured banks covered by the CRA,
were compelled to compete for mortgage borrowers who were at or below the median
income in the areas in which they lived. Th is competition caused underwriting
standards to decline, increased the numbers of weak and high risk loans far beyond
what the market would produce without government influence, and contributed
importantly to the growth of the 1997-2007 housing bubble.
When the bubble began to deflate in mid-2007, the low quality and high
risk loans engendered by government policies failed in unprecedented numbers.
The effect of these defaults was exacerbated by the fact that few if any investors—
including housing market analysts—understood at the time that Fannie Mae and
Freddie Mac had been acquiring large numbers of subprime and other high risk
loans in order to meet HUD’s affordable housing goals.
Alarmed by the unexpected delinquencies and defaults that began to appear
in mid-2007, investors fled the multi-trillion dollar market for mortgage-backed
securities (MBS), dropping MBS values—and especially those MBS backed by
subprime and other risky loans—to fractions of their former prices. Mark-to-market
accounting then required financial institutions to write down the value of
their assets—reducing their capital positions and causing great investor and creditor
unease.
