Roots of the Financial Crisis

This post is in response to a question by "M" in a comment to Two Views on Housing Policy. M asked for my take on a ReasonTV production, Peter Wallison on the Roots of the Financial Crisis. Wallison believes that government actions were largely responsible for the housing bubble and the ensuing financial crisis. The culprits were the Community Reinvestment Act in 1977, signed by President Carter, and strengthened during the Clinton administration by the Interstate Banking and Branching Efficiency Act of 1994 to encourage lending in under served areas, and Fannie Mae and Freddie Mac, the government sponsored agencies (GSEs) which were tasked with increasing home ownership in general but particularly in under served areas.

The ReasonTV production posted on the Powerline blog was a response to a New York Times hit piece on the Bush administration titled, White House Philosophy Stoked Bonfire. The authors go out of their way to focus on administration failures while deflecting blame from others. For example, the authors comment,

The president did push rules aimed at forcing lenders to more clearly explain loan terms. But the White House shelved them in 2004, after industry-friendly members of Congress threatened to block confirmation of his new housing secretary.

The obvious questions are which members of Congress? and Why were they trying to block the confirmation of a new housing secretary? Could it me that these members of Congress did not view him as friendly to their pro GSE agenda?

While I understand the frustration of my fellow blogers at such investigative reporting, but I have not found a consensus among economists writing about the financial crisis that agrees with Wallison's position. In a useful article, Brad Delong says that all explanations involve a "great deal of hand waving," and I certainly agree, but common bits and pieces seem to be surfacing.

The views expressed by Wallison are shared by others, but many assign the GSEs a small role of just another business organization whose weak internal standards or minimum capitalization were overwhelmed by events. I am somewhere between the two groups but closer to the latter. I believe that while correctly documenting the decline in underwriting standards at the GSEs, and the spread of those lower standards, that they overstate their role in the the financial crisis.

I would begin my analysis with Glaeser and Gyourko who demonstrate that policies of local governments in restricting the supply of housing inflated prices in the coastal areas of California, New York, Massachusetts, and a few other areas. The strong demand with the restricted or inelastic supply interacted to dramatically raise prices.

The private sector stepped in, developing subprime loans and new securitized products to meet a market segment blocked by law from the GSEs. The Congress eased GSE lending standards and the Clinton administration and later the Bush administration mandated that the GSEs provide more loans to under served markets. The new policies were designed to help buyers who did not qualify under traditional standards; they stimulated demand further inflating the bubble. But the crisis is not limited to the United States or solely due to government policy. The competition escalated. Prior to the bursting of the bubble, the private sector was gaining market share previously held by the GSEs.

Underwriting standards deteriorated worldwide and it takes a huge leap of faith to believe that other countries copied our policies carried out through the GSEs. Brunnermeier suggests that an expansion of the "originate and distribute" market organization whereby banks or other originators make loans, and then sell the loans through securitization as MBSs and CDOs was a cause of the decline in standards. Lenders passed on risk to buyers who believed that the diversification of risk that these instruments offered were sufficient to make more thorough investigation unwarranted. This explanation works for a worldwide crisis much better than the GSE explanation.

The fed also kept interest rates low. James Hamilton of Econbrowser suggests that the GSEs, the private sector and the Fed were engaged a game of chicken

And I think the obvious answer is that investors were happy to lend to the GSEs because they thought that, despite the absence of explicit government guarantees, in practice the government would never allow them to default. And which part of the government is supposed to ensure this, exactly? The Federal Reserve comes to mind. I'm thinking that there exists a time path for short term interest rates that would guarantee a degree of real estate inflation such that the GSEs would not default. The creditors may have reasoned, "the Fed would never allow aggregate conditions to come to a point where Fannie or Freddie actually default." And the Fed says, "oh yes we would." And the market says, "oh no you wouldn't."

This has been a very short explanation of the financial crisis that has left out credit default swaps, rating agencies, and many other mortgage market participants. When all is said and done, I am a supporter of markets and believe that they are almost always a better way to organize economic activity than top-down government organization. I cannot excuse their nearsighted behavior. As Delong writes, and oh how I wish I had written it first,

as your mother says: “If Freddie jumps off a cliff is that a good reason for you to follow him?”