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Government Actions Encouraged: Wall Street's Risky Business

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Many observers blame the current financial crisis on a breakdown of private markets.  A more careful look shows that government policy, step by step, led to the current crisis. 

First, Fannie Mae and Freddie Mac were created to help provide mortgages for people who didn’t qualify for conventional mortgages.  As government-sponsored enterprises (GSE), they rapidly grew to where their debt was nearly half the size of the federal government’s debt. 

As long as housing prices rose, they could handle their debt.  When prices fell, they rapidly became insolvent.  This wasn’t a surprise.  Experts had warned that they might collapse, but low-interest loans to poorly qualified buyers were too popular for Congress to rein in those lenders. 

In part their popularity was due to the mortgages, but it was also because the GSEs used profits generated from their favored status in the “market” to make campaign contributions and offer high-paying jobs to congressional staffers.  They purchased political support. 

A related problem began with the Community Reinvestment Act (CRA) of 1977.  If lenders wanted to expand their lending, they had to balance their loans to financially secure buyers with loans to buyers who did not meet the conventional mortgage criteria. 

The push to extend mortgages to less qualified buyers was amplified by the Home Mortgage Disclosure Act (HMDA), passed in 1975 and expanded in 1991 to require lenders to report rejection rates by race.  Lenders were put on notice that their lending practices would be examined for evidence of bias, with violators facing the possibility of fines as high as $500,000. 

The CRA was broadened in 1995, allowing the securitization of sub-prime mortgage loans.  Securitization combines a large number of loans into a security that can then be sold.  The idea was that while some loans might default, most would not, so the securities would spread the risk and make it safe to hold portfolios of sub-prime loans. 

An obvious drawback is that the originating lenders had little incentive to consider mortgages’ long-term prospects because the loans are held only a short time before they’re sold off and securitized. 

A third factor in this crisis was easy-money policy adopted by the Federal Reserve Bank early in the decade to mitigate the effects of an incipient recession exacerbated by the after-effects of the September 11, 2001 terrorist attacks. 

Low rates meant lower-cost mortgages, further enabling people to buy houses.  But the increased demand pushed prices up, and many buyers wouldn’t have qualified for mortgages except for the relaxed standards. 

Worse, many borrowers used variable-rate mortgages.  The idea was that in a rising housing market, owners who couldn’t afford to refinance if the rates rose could always sell and turn a profit. 

As long as interest rates remained low and housing prices rose, the problems were hidden.  From 2004 to 2006, however, the Fed boosted the Federal Funds rate to 5.25 percent, pushing up mortgage rates and bringing the artificial housing boom to an end. 

Those mortgage-backed securities, so attractive when interest rates were low and housing prices were rising, lost their luster quite abruptly when conditions changed.  Firms that held lots of them found themselves in trouble.  AIG, which insured such mortgages, foundered and was effectively nationalized. 

The current crisis has two root causes.  First, the federal government tried to extend home ownership to people who formerly wouldn’t have qualified for mortgages.  This vastly increased the risk, which was hidden because mortgages were quickly resold, bundled, and “securitized.”  Second, the Fed’s artificially low interest rates enabled the mortgage-backed security market to grow rapidly. 

So government policy, not the free market, created much of the current financial crisis.  Market participants aren’t blameless, however.  Nobody forced Wall Street’s large investment banks to take big risks.  They willingly accepted such risks in pursuit of bigger profits. 

Why should the government now support the firms that made risky bets and lost?  To do so would forever change our financial markets, which can work only if firms that accept risk in the pursuit of profit also suffer the loss if the market turns against them. 

To bail out firms that made risky bets and lost would mean, at best, supporting managed capitalism and, at worst, the nationalization of financial markets.  The long-term harm would far exceed any short-term financial stability a bailout might bring. 

Randall G. Holcombe is DeVoe Moore Professor of Economics at Florida State University and Senior Fellow of the James Madison Institute in Tallahassee. 

This commentary originally appeared in Volume 3 of "What's a Free Marketeer to Think."
Click here to read the entire volume.

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