Saturday, December 20, 2008

Government policies and the financial crisis

Peter J. Wallison, the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute, has written an analysis of the current financial crisis titled Cause and Effect: Government Policies and the Financial Crisis. Here are some excerpts.
Expansion of homeownership could be a sound policy, especially for low-income families and members of minority groups. The social benefits of homeownership have been extensively documented; they include stable families and neighborhoods, reduced crime and delinquency, higher living standards, and less depreciation in the housing stock. Under these circumstances, the policy question is not whether homeownership should be encouraged but how the government ought to do it. In the United States, the policy has not been pursued directly--through taxpayer-supported programs and appropriated funds--but rather through manipulation of the credit system to force more lending in support of affordable housing. Instead of a direct government subsidy, say, for down-payment assistance for low-income families, the government has used regulatory and political pressure to force banks and other government-controlled or regulated private entities to make loans they would not otherwise make and to reduce lending standards so more applicants would have access to mortgage financing.
Many culprits have been brought before the bar of public humiliation as the malefactors of the current crisis--unscrupulous mortgage brokers, greedy investment bankers, incompetent rating agencies, foolish investors, and whiz-kid inventors of complex derivatives. All of these people and institutions played their part, of course, but it seems unfair to blame them for doing what the government policies were designed to encourage. Thus, the crisis would not have become so extensive and intractable had the U.S. government not 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 have made, requiring the GSEs to purchase the secondary mortgage market loans they would never otherwise have bought, encouraging underwriting standards for housing that were lower than for any other area of the economy, adopting bank regulatory capital standards that encourage bank lending for housing in preference to other lending, and adopting tax policies that favored borrowing against (and thus reducing) the equity in a home.

As a result, between 1995 (when quotas based on the CRA became effective during the Clinton administration) and 2005, the homeownership percentage in the United States moved from 64 percent, where it had been for twenty-five years, to 69 percent; in addition, home prices doubled between 1995 and 2007. In other words, the government is responsible for the current crisis in two major respects: its efforts to loosen credit standards for mortgages created the housing bubble, and its policies on bank capital standards and the deductibility of interest on home equity loans made the current crisis inevitable when the bubble collapsed. This Outlook will explore the strong relationship between the intervention of the U.S. government in the housing market and the worldwide financial crisis that has resulted.

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