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The Cause of the Housing Crash

Posted by Ender on February 12, 2009

A recent post by our friends at covered the current financial crisis. The analysis brought up a point that has been bothering me for awhile. Whenever you hear about the housing bubble burst it is almost always being talked about as the market failing. You hear about the “greedy” investors on Wall Street causing the meltdown. It seems as though everyone is eager to buy into this theory. The problem with this explanation is that it just simply is not true. There is no market failure in this crash. The crash, as we will see, is the direct result of government intervention in the market.

In 1977, the Community Reinvestment Act was passed. The purpose of this law was to make housing affordable to anyone and everyone. As recent events have proven not everyone should be able to get a mortgage. The law “was used to pressure banks into making loans they would not otherwise have made and to adopt looser lending standards that would make mortgage loans possible for individuals who could not meet the down payment and other standards that had previously been applied routinely by banks and other housing lenders.” (Wallison)by Stanley Kurtz on ACORN and its ties to the CRA, Obama and the Democratic party go here.

A quick side note on the CRA. This Act was pushed for by the now infamous “community organization group” called ACORN. You may remember this group coming up during the 2008 campaign. For a very detailed and well written article

ACORN along with the new law were “able to delay and halt the efforts of banks to merge or expand until they had agreed to lower their credit standards.” (Kurtz) This is the most critical part of the whole operation. The US government “created the necessary conditions for a housing boom by directing investments into the housing sector, requiring banks to make mortgage loans they otherwise would never make.” (Wallison)

In 1993, banking regulators were aggressively attempting to reform the CRA laws. In 1994, Janet Reno said this “[W]e will tackle lending discrimination wherever and in whatever form it appears. No loan is exempt, no bank is immune. For those who thumb their nose at us, I promise vigorous enforcement.” (Wallison) Finally in 1995, the Clinton/Reno efforts came to fruition with a massive overhaul of the CRA. The new rules are the cause of the downturn we are feeling today.

The new and improved CRA took most of the decision making away from the banks when it came to who got loans. Basically, the evaluations were now results based. They looked at how many loans were given not at whether the banks were trying to find qualified customers. An economist writes “[This] can be thought of as a shift of emphasis from procedural equity to equity in outcome. In that, it is not sufficient for lenders to prove elaborate community lending efforts directed towards borrowers in the community, but an evenhanded distribution of loans across LMI [low and moderate income] and non-LMI areas and borrowers.” (Wallison) The banks were now forced to use aggressive or lax lending practices in order to comply with the law.

Now some may say there were not enough defaulting CRA mortgages to cause the industry to implode. This is true. However, Wallison states,”The key question, however, is the effect of relaxed lending standards on lending standards in non-CRA markets. In principle, it would seem impossible—if down payment or other requirements were being relaxed for loans in minority-populated or other underserved areas—to limit the benefits only to those borrowers. Inevitably, the relaxed standards banks were enjoined to adopt under CRA would be spread to the wider market—including to prime mortgage markets and to speculative borrowers. Bank regulators, who were in charge of enforcing CRA standards, could hardly disapprove of similar loans made to better qualified borrowers.” In short, the poison of the CRA spread into non-CRA areas and even into non-housing areas. Wallison goes on to say,”Interest on consumer loans of all kinds—for cars, credit cards, or other purposes—is not deductible for federal tax purposes, but interest on home equity loans is deductible no matter what the purpose of the loan or the use of the funds. As a result, homeowners are encouraged to take out home equity loans to pay off their credit card or auto loans, or to make the purchases that would ordinarily be made with credit cards, auto loans, or ordinary consumer loans. Under these circumstances, homeowners are encouraged not only to borrow against their homes’ equity in preference to other forms of borrowing, but also to extract equity from their homes for personal and even business purposes.”

As if the CRA wasn’t enough government intervention Fannie Mae and Freddie Mac also played a role. These are government sponsored companies, meaning if anything goes wrong with them the taxpayer pays for it. Fannie and Freddie started to purchase the subprime and Alt-A loans (the high risk loans). In 2004, they increased their purchasing of these loans, which caused non-government run businesses to lose market share. This created a large demand for the loans by all the mortgage dealers. Because of “the increased demand from the GSEs and the competition with private-label issuers drove up the value of subprime and Alt-A mortgages, reducing the risk premium that had previously suppressed originations. As a result, many more marginally qualified or unqualified applicants for mortgages were accepted, and these loans joined the flood of junk loans that flowed to both the GSEs and the private-label issuers.” (Wallison)

When the bubble started to burst and home values dropped “about half of all home loans being made in the United States were non-prime loans.” (Wallison)

Due to the government intervention of the CRA, Fannie Mae and Freddie Mac the economy is in the gutter. If the government hadn’t forced the market to make high risk loans there would not have been a problem. If the government hadn’t falsely driven up the value of the sub-prime loans there would not have been a problem. This is the root cause. You cannot attempt to manipulate the market through government regulation without consequences. The free market works for a reason. It calculates value and risk. When you socialize any aspect of process it skews the market. Prior to the CRA, the market knew it should not loan to high risk individuals.

This is why we cannot let people get away with calling this whole mess the result of Wall Street greed. It is the result of people trying to socialize the market. This is also why I was strongly against John McCain running against Barack Obama. McCain did not make this argument once. If there had been someone out there who could articulate the true cause of the economic crisis the outcome would have been different. But instead we sent someone out there who doesn’t even believe in the Free Market. This whole problem is directly tied to the policies the Democrats have been nurturing for about 30 years, the policies of socialism.

4 Responses to “The Cause of the Housing Crash”

  1. hpx83 said

    Ron Paul would have told the truth, had the republicans chosen him to run. Also, for more interesting facts about the housing crisis, I recommend a book I just bought, written by another economist blogger. Check out Captain Capitalism. His book is excellent.

  2. mattbenchener said

    While I agree that the CRA contributed directly and indirectly to the formation and eventual burst of the housing bubble, that argument ignores the CDO and Mortgage-Backed Security collapse that accelerated almost the whole of the downturn. CDOs and MBSs created leveraging on the risk inherent in all loans to nearly insurmountable levels. Investors, specifically investment banks, were leveraged at over 20 times the normal risk level, meaning that once defaults hit, they took over 20x the normal loss. You could argue that if the defaults never occurred then the collapse would never have happened, but defaults always occur in varying measures.

    Most importantly, the presence of CDOs allowed banks to pass much of the risk onto the investors. So, if you can make money on a bad loan without absorbing its risk, wouldn’t you? Definitely–even in absence of the Community Reinvestment Act. This is a very important argument that needs to be forwarded, and I’m afraid that conservatives (which I am) are trying to place the blame fully on liberals, rather than take a hard look at Wall Street’s failure.

  3. hpx83 said

    Of course there were more reason than simply CRA, the subprimes were probably mostly acting as a spark to ignite the keg of explosives. But the theory behind the CRA is worse – because the CRA was used as a means to lowering lending standards all across the scale. There are documents written by Federal banks that openly encourages doing bad loans by not using credit ratings, because this could lead to the discrimination of certain people in certain areas. CRA was used as a way for politicians to decide how money should be managed, instead of banks. There would still have been over-leveraging, but maybe we could have had a standard recession instead of a once-in-a-century-depression coming up.

    But again, you’re right – blame goes all over the place, not just to the CRA.

  4. Ender said

    First, I wasn’t trying to imply the CRA was the only reason behind the collapse, but it was a huge reason that you completely ignored.

    Second, Yes, the CRA alone did not cause the whole thing to crash, The Federal Reserve, Fannie Mae and Freddie Mac all played a role and all have one thing in common: government intervention in the free market. The CRA loosened lending standards, Fannie and Freddie drove up demand for the poor loans, The Fed’s monetary policy fueled the housing bubble.

    Third, I’m not trying to pin this on liberals. I’m trying to pin it on government intervention in the Free Market. Without the government’s involvement does this happen to the extent that we are seeing it? No, of course not.

    Fourth, you said that the bubble was “based on the façade of massive profit with little regard to risk.” Let’s assume this is true, what is your solution? Should the government give each bank a profit goal each year that they cannot exceed? Should the government disallow banks from taking risk? Should there be only one central bank run by the government? Maybe, the government should just outlaw bad decisions?

    I think the lesson here and throughout history is that government involvement creates these situations not the free market.

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