The history and causes of the financial crisis

UPDATE from this morning's Oz:

Johan Norberg,
on his blog JohanNorberg.net, points out the Democratic intervention that caused
the financial crisis

SOME milestones in the prehistory of the crisis. 1933: As part of the New Deal, investment banks are stopped from also acting as commercial banks (which would have given them bank deposits and more stability). 1938: As part of the New Deal, president (Franklin D.) Roosevelt creates Fannie Mae and in 1970 Congress creates Freddie Mac. With their implicit government guarantees they can offer cheaper loans and expand until they dominate the American mortgage market. 1989: The American government step(s) in and pay(s) for the savings and loan crisis, which sets a precedent. 1995: The Community Reinvestment Act is revised so that banks and thrifts are forced to give home loans to low and moderate-income households as well. In return they are allowed to repackage and sell those sub-prime risks to others, which Bear Stearns pioneers in 1997. 2001-03: Instead of letting the market get rid of bad businesses and loans after the dotcom bubble and 9/11, the (Federal Reserve reduces its rate from 6.5 per cent to 1 per cent (with) a dramatic expansion of the money supply, which creates a real estate bubble.

Mae and Mac ran leverage ratios that exceeded 60 to one (cheered on by the Democrats) to keep giving loans to people who could not really afford it. It only took more traditional interest rates for the bubble to burst. The independent investment
banks that did not have access to bank deposits collapsed and almost brought the whole system down. All those who now think that the solution is to give more powers to politicians, authorities and central banks should look at what they did with the powers they already had.

While the dominant discourse has been about the greed of the banks and so-called "market failure" in relation to the sub-prime loans that seem to be the basis of the current financial crisis, are things that simple?

Greed certainly has been a factor here, but so has been well-intentioned government policy in the US.

I'll guarantee to you that, nine times out of ten, situations of so-called "market failure" are in fact the almost inevitable consequences of governments distorting markets to achieve some social, environmental or other goal which, however laudable in theory, flies in the face of economic reality.

Much of the current crisis was caused by government policy in the US to increase home ownership rates amongst minorities and low-income earners.

As I say, a laudable goal.

The genesis of this goes at least as far back as 1977 and the signing into law by President Jimmie Carter of the Community Reinvestment Act which required banks to lend to "under-served populations," ie those with poor credit ratings, or face penalties.

This was extended by Bill Clinton in 1995 with the government underwriting what would become to be known as sub-prime loans. The Clinton Administration put pressure on the mortgage underwriter Fannie Mae to increase lending to low income earners. (It's only fair though to mention though that Fannie Mae stock holders also wanted to do this to increase the phenomenal profits it was making at the time.)

As this article notes, "Now we know that Holmes and Wallison had this dead right. As long as Fannie Mae and Freddie Mac bought subprime paper, lenders continued to profit from them, pushing them to make more and more loans to unqualified borrowers with no risk to themselves. Meanwhile, rather than manage the GSEs with fiscal discipline as first priority, Raines and his executives ran it as a political organization, looking to distort the market for political ends. When critics tried to point this out, Raines’ defenders — mostly Capitol Hill flacks raking in contributions from Fannie/Freddie sources — called critics and regulators bigots."

Indeed, one Barack Obama back in 1994 "sued Citibank on behalf of a client who charged that the bank “systematically denied mortgages to African-American applicants and others from minority neighborhoods.”" (Even though only a first term senator, Mr Obama is the second biggest receiver of funds from Freddie Mac and Fannie Mae is the US Senate. He chose a former head of Fannie Mae to help him pick his vice-presidential running mate and a former CEO of Freddie Mac is one of his advisors.)

But the market was already working. While more loans were still being made to white Americans, "in the previous five years, mortgages awards to Hispanics jumped 87%, to African-Americans by 71%, and Asians 46%...which proved that a rising tide [the economic boom of the 1990s] indeed lifted all boats, without government intervention to impose “fairness”."

When you have "a solution in search of a problem," you know something is wrong and is going to end badly.

So it was government intervening in and thus distorting the market, trying to legislate for "fairness," "equity," "social justice" or "social inclusion," that bears substantial responsibility for the mess that the markets are in now.

Oh - for the record. The Bush Administration proposed a substantial tightening of the regulations governing the housing finance industry back in 2003, but was opposed and stymied by congressional opposition.

In 2005 John McCain co-sponsored the Federal Housing Enterprise Regulatory Reform Act, which amongst other things provided for more oversight of Freddie Mac and Fannie Mae.

But Fannie and Freddie's friends defeated it, and again when it was reintroduced just last year.