Government ignorance is no excuse for another dreadful financial crisis

Government ignorance is no excuse for another dreadful financial crisis
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The New York Times featured a weekend editorial by Ben Bernanke, Timothy Geithner and Henry Paulson, the three former government officials who were the major financial policymakers before and after the 2008 financial crisis. The column was intended as a retrospective view of the meltdown, which the authors called a “classic financial panic.” It was unnerving, however, to realize that these three important federal officials charged with keeping the economy stable while they were in office still have no idea what caused this disastrous event in our history.

“Although we and other financial regulators did not foresee the crisis,” the authors write, “we moved aggressively to stop it.” This of course is commendable, but given their important financial positions, one would imagine that in the ensuing 10 years they would have given some thought to what they missed and why they missed it. Instead, the best they could do was to say that the reforms adopted in the Dodd Frank Act of 2010 have made the financial system “significantly more resilient.”

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Resilient against what? They do not say, but this is a key question. The failure or near failure of many financial institutions was not an act of God. It arose from something else. The weakness seen across financial institutions was an effect of the crisis rather than its cause. The American people would be justified in wanting to know why there was a crisis in the first place, not just that the system will better survive the next one.

In fact, there was an underlying cause of the 2008 financial crisis, even if those who navigated that turbulent period did not recognize or prepare for it. Much of the story is that housing prices rose sharply from the 1990s through the 2000s. Meanwhile, construction costs, a closely related business, remained essentially stable. This means that housing prices were responding to a different and powerful stimulus, a relentless pressure brought about by government housing policies.

Beginning in 1992, under a program known as the affordable housing goals, the two government backed mortgage companies, Fannie Mae and Freddie Mac, were directed to make more credit available to would be homeowners who were at or below the median income where they lived. The initial quota for these loans was 30 percent, which meant that 30 percent of all loans Fannie and Freddie acquired each year from loan originators had to be made to borrowers at or below the median income.

But during the Clinton and Bush administrations, the Department of Housing and Urban Development gradually raised the quota so that by 2008, more than 50 percent of all loans Fannie and Freddie acquired had to be made to these below median borrowers. To meet this quota, Fannie and Freddie had to reduce their underwriting standards, particularly the 10 percent to 20 percent down payments they had traditionally required. Borrowers below median income could not consistently provide down payments of this size, so Fannie and Freddie cut their down payment standards, first to 5 percent, then 3 percent, and eventually 0 percent. Fannie and Freddie dominated the housing finance market, so when they lowered their down payment requirements, lenders followed suit.

Low down payments, however, drive up housing prices. If a family has saved $10,000 to buy a home, and the down payment requirement is 10 percent, the family can buy a $100,000 home. But if the down payment is reduced to 5 percent, the family can buy a $200,000 home with the same $10,000 by borrowing $190,000. Not only did this larger debt make them riskier credits, but the additional borrowing that allows them to bid for the higher cost home puts strong upward pressure on housing prices.

By 2008, housing prices had reached such levels that no amount of concessionary lending could make homes affordable. Buyers dropped out of the market and home prices began to fall. Refinancing a mortgage became impossible and buyers who could not meet their obligations began to default. This reduced home values even for families who were meeting their mortgage obligations. It also dried up market liquidity, forced layoffs, sharply reduced consumer spending, weakened banks and other financial firms, created a severe recession, and threw Fannie and Freddie into bankruptcy at cost to taxpayers of $186 billion.

This is all well known. What is not understood is that by blaming the financial crisis on insufficiently resilient banks, Congress at the time avoided the need to reform the housing finance system. Today, as a result, that system is functioning in substantially the way it functioned before the crisis. Housing prices are again rising as quickly as they did then. Indeed, the highest rate of increase is occurring for the lowest price homes, exactly the opposite of what a sensible housing policy would produce.

Accordingly, without a halt or reform of current government housing policies, there is likely to be another financial crisis in our future, again caused by a government dominated housing finance system that is pushing up home prices through mindless concessionary lending. This is all because, for the last 10 years, we have failed to investigate or understand the true causes of the 2008 financial crisis.

Peter J. Wallison is a senior fellow at the American Enterprise Institute. He is the author of “Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why it Could Happen Again.” He served as general counsel of the Treasury Department under President Reagan.