With all the attention to the government’s efforts to deal with the financial crisis, there has been little thought to its ultimate cause. The politicians like to cite greedy investment bankers, incompetent CEOs, and even market innovations such as credit default swaps. Their solutions invariably involve more authority for themselves—more restrictions on the private sector and more regulation. But the most persuasive case for the cause of the financial crisis is the U.S. government itself—the policies that first created the housing bubble and then removed the equity in homes and the capital in the banking system that would have provided a cushion against a meltdown when the bubble burst.
The root of today’s financial crisis can be found in the government’s effort to use the banking and financial system to expand home ownership. There are many good reasons to increase home ownership in our society, but the way to do it was not by distorting the lending decisions of banks and other mortgage market participants. That, however, is the direction the government chose when it imposed the Community Reinvestment Act (CRA) on insured banks in 1977 and an “affordable housing” mission on Fannie Mae and Freddie Mac in 1992. Instead of assisting low income families to become homeowners with direct subsidies, the government—through CRA—required banks to lower their lending standards. Down payments, steady jobs, good credit histories, and income levels commensurate with mortgage obligations were abandoned in favor of “flexible” lending requirements. Bank regulators, required to enforce CRA, approved mortgage loans that would not previously have been acceptable, and demanded that banks do more.
Similarly, under regulations of the Department of Housing and Urban Development (HUD), Fannie Mae and Freddie Mac were required to make affordable housing more plentiful. As HUD’s regulations grew tighter, Fannie and Freddie began to purchase and guarantee larger and larger numbers of subprime and other nontraditional loans in order to meet HUD’s requirements and to keep the support in Congress that permitted them to escape tougher regulation. With these financial incentives for homeowners, banks and other mortgage lenders—easy lending terms and a ready market for mortgages through Fannie and Freddie—a housing bubble was inevitable.
At the same time, other government policies assured that when the bubble began to deflate there would be little equity in homes or capital in banks that would mitigate the resulting damage. Under prevailing mortgage market policies, homeowners were permitted to refinance their homes without any penalty—a benefit rarely available in commercial lending—so that as home values increased and homeowners accumulated equity in their homes they were able to draw out this equity through refinancing. This activity, known as “cash-out refinancing,” made possible the purchase of cars, boats, vacations and other consumer goods—and even drove the stock market to new highs—but inevitably reduced the amount of equity in homes that should have been backing mortgages. Even without refinancing, homeowners were encouraged to borrow against their home equity—in effect to use their homes as savings accounts—because government tax policy made interest on home equity loans tax deductible while interest on credit cards and other consumer loans was not.
Finally, bank regulations specified lower capital requirements for residential mortgages than for other assets. Under the risk-based bank capital rules applicable to U.S. banks, commercial loans must be backed by at least eight percent capital, but residential mortgages require only a four percent capital charge. This created a preference in banks for mortgage lending rather than commercial lending. In addition, by converting their mortgages to mortgage-backed securities banks could reduce the capital charge to 1.6 percent, further enhancing this preference.
Thus, while government policies created the housing bubble by making financing easier and more plentiful, they also encouraged a reduction in the traditional shock absorbers—home equity and bank capital—that would have mitigated a fall in home prices. The result is the unprecedented number of mortgage defaults that have weakened banks throughout the world and caused the financial crisis we now confront.
The remedy for all this is not difficult to imagine. Government can still try to broaden home ownership, but should do it through direct subsidies for low income homeowners rather than distorting the financial system. Government policy could also require that mortgages carry prepayment penalties, which are common in other countries, so that cash-out refinancing is not a free option. Interest on home equity loans should no longer be deductible, and bank capital requirements should be adjusted so that they do not give a preference to mortgage lending over other kinds of financing activity.
Unfortunately, these simple reforms will be difficult to achieve. They involve unpleasant choices for lawmakers, who will not acknowledge their own responsibility for the mortgage meltdown that has weakened the world’s major banks. As usual, their preferred solution is to extend regulation deeper into the private economy—a policy that will add to their own power but does not address the fundamental causes of today’s financial crisis.
Peter J. Wallison is the Arthur Burns Fellow in Financial Policy Studies at AEI.