What Caused the Financial Crisis

6. Housing Initiatives and Other Policy Factors

Chapter 6 Housing Initiatives and Other Policy Factors PETER J. WALLISON The current financial crisis is not—as many have said—a crisis of capitalism . It is in fact the opposite: a demonstration that well-intentioned government intervention in the private economy can have devastating consequences. The crisis has its roots in the U.S. government’s efforts to increase home ownership, especially among minority, low-income, and other underserved groups, through hidden financial subsidies rather than through direct government expenditures. Instead of a government subsidy, say, for down-payment assistance to low-income families, the government used regulatory and political pressure to force banks and other government-regulated or -controlled private entities to reduce lending standards, so more applicants would have access to mortgage financing. The two key instances of this policy are the Community Reinvestment Act (CRA), adopted in 1977, and the affordable-housing ‘‘mission ’’ adopted by Congress in the 1990s as a responsibility of the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. Amendments to the CRA in the early 1990s pressured banks into making loans they would not otherwise have made. Together, the tighter CRA requirements and the affordable-housing regulations imposed on the GSEs substantially reduced the standards that had to be met to qualify for a mortgage. The number of CRA loans was not large, but they required banks to devise ways of lending to people Housing Initiatives and Other Policy Factors 173 who would not previously have qualified for a mortgage. Once Fannie and Freddie began accepting loans with low down payments and other liberalized terms, the same unsound standards were extended to borrowers who could have qualified under the traditional underwriting standards. In addition, federal regulations encouraged bank lending for housing in preference to other lending, and tax policy favored borrowing against (and thus reducing) the equity in a house. These policies were effective in the sense that they achieved some of the intended results. Between 1995—when lending quotas based on the CRA became effective—and 2005, the proportion of American households that owned their own home rose from 64 percent, where it had been for about twenty-five years, to 69 percent (Vlasenko 2008). A measure of the unintended results of federal policy, however, is that home prices doubled between 1995 and 2007; and that the housing bubble was composed—to an unprecedented degree—of subprime and other nonprime and risky loans. Banking-capital regulations and the deductibility of interest on home-equity loans made a crisis inevitable once this housing bubble collapsed. The Community Reinvestment Act As originally enacted in 1977, the CRA was a vague mandate for regulators to ‘‘consider’’ whether a federally insured bank was serving the needs of its entire community. The ‘‘community’’ was not defined, and the act stated only that it was intended to ‘‘encourage’’ banks to meet community needs. This encouragement included the denial of applications for mergers and acquisitions to banks judged to be in violation of the Act. The Act also stated, however, that serving community needs had to be done within the context of safe and sound lending practices. Although the Act was adopted to prevent ‘‘redlining ’’—the practice of refusing loans to otherwise-qualified borrowers in low-income areas—it also contained language that included small business, agriculture, and similar groups among the community interests that banks had to serve. With all its ambiguities, the CRA was invoked relatively infrequently when banks applied for permis- 174 Peter J. Wallison sion to merge or needed other regulatory approvals, until the Clinton administration decided to strengthen the Act.1 This decision was probably due to the substantial amount of media and political attention that had been paid to the Boston Federal Reserve Bank 1992 study (Munnell et al. 1992) of discrimination in home mortgage lending. The study concluded that while there was no overt discrimination in the allocation of mortgage funds, more subtle forms of discrimination led to better treatment of white applicants by loan officers as compared to minority-group applicants. The methodology of the study has since been questioned (e.g., McKinley 1994), but at the time of its publication, it seems to have been highly influential with regulators and members of the incoming Clinton administration. In 1993, bank regulators initiated a major effort to reform the CRA regulations. Some of the context in which this was occurring can be...