Who are the villains of the mortgage mess?

Today’s question: Who’ve been the real heroes and villains in Congress when it comes to housing policy? Previously, Abromowitz and Mitchell discussed whether Washington should give tax breaks to homeowners.

De-regulators brought us the meltdown
Point: David M. Abromowitz

Dan,

You invoked on Monday the widely circulated myth that our national foreclosure crisis and “Wall Street meltdown” stem from “government intervention” that promotes affordable home ownership. Like most urban legends, this one falls apart under close examination. The real story is just the opposite -- deregulation and non-intervention pulled us into the abyss.

Throughout the 1990s, federally regulated banks slowly expanded lending to low- and moderate-income families, partly due to more serious enforcement of the Community Reinvestment Act of 1977. That law simply requires that banks taking deposits from low- to moderate-income communities actually try to meet the credit needs of residents in those areas. Fannie Mae and Freddie Mac backed more loans to low- to moderate-income borrowers who could be responsible homeowners if allowed somewhat more flexible credit scoring and terms. The result? A strong increase in home ownership rates by the late 1990s, especially among low- to moderate-income and minority borrowers.

But these were still “prime” loans, conforming to national underwriting guidelines and income verification. Banks reserved capital for losses and were accountable for safe and sound underwriting. Not surprisingly, a careful staff review of 500 large banks in 2000 by the Federal Reserve showed that lending under the Community Reinvestment Act was neither riskier nor less profitable than other home mortgage lending.

Then came the explosion after 2000 in subprime loans by unregulated mortgage companies. These were high-cost loans with inadequate underwriting to borrowers with poorer credit histories. By 2005-06, subprime mortgages were nearly half of all loans made to home buyers. The vast majority of these loans were to higher income -- not low- to moderate-income -- borrowers.

Did government mandate this subprime surge to aid less-than-wealthy borrowers? No. And it would seem bizarre to think that the government forced Bear Stearns and other Wall Street investment banks to pocket billions in historically high profits by bundling millions of these “innovative products” into pools laxly given the highest credit ratings for sale to investors worldwide -- yet many conservative commentators would have you believe this.

Instead, the Bush administration and its free-market orientation, assisted by a Republican-controlled Congress advocating the same principles, systematically dismantled or under-enforced a range of rules the could have prevented the situation spiraling out of control. The referees who were supposed to be on the field calling fouls and keeping the mortgage game fair were told to go sit on the sidelines.

As my colleagues and I have described in greater detail, this happened in many ways. Take the Federal Reserve’s failure in 2001, despite many warnings by consumer and other watchdog groups, to ban mortgage company practices such as charging high origination fees, providing little disclosure of the risks of adjustable interest-rate resets and retaining no risk after selling loans. This past July -- seven years too late and after millions of loans had gone to foreclosure -- the Fed finally invoked the Home Ownership and Equity Protection Act of 1994 and barred those “unfair, abusive or deceptive home mortgage lending practices.”

Similarly, the Office of the Comptroller of the Currency in 2003 overrode efforts by states to protect their consumers from predatory mortgage lending. The Securities and Exchange Commission in 2004 permitted Wall Street investment banks -- the primary creators of the loan pools now dubbed “toxic mortgage assets” -- to vastly increase their “leverage ratio,” borrow more money and lend more to mortgage brokers generating more subprime loans.

Yes, our government aided and abetted the housing market meltdown. But it did so by promoting its view of the best of what the free market could do. In many ways, the era of 2001-06 was intended to be the dress rehearsal for a pageant demonstrating that we no longer needed government involvements like Fannie Mae, Freddie Mac, the Federal Housing Administration or a regulated bank mortgage market system; the unregulated mortgage broker-Wall Street axis would do just fine, thank you. Unfortunately, we are all stuck with watching the pageant having turned into a colossal flop.

David M. Abromowitz is a lawyer and a senior fellow at the Center for American Progress Action Fund.

Republicans and Democrats both deserve blame
Counterpoint: Daniel J. Mitchell

We have both been asked to identify the heroes and villains in Congress. David, you conveniently dodge this question and instead make the rather novel claim that the turmoil in financial markets somehow is the result of deregulation. Yet the financial services industry is probably the most heavily regulated sector of the American economy, saddled with hundreds of laws, thousands of regulations and a plethora of government agencies. If red tape were the answer, this problem never would have happened.

You also argue that fraud has occurred, and this certainly is true, but because we both agree that criminal behavior should be punished, it’s not clear what this has to do with either regulation or the topic we are supposed to discuss. Last but not least, you want more rules and regulation governing disclosure, ostensibly to protect consumers. But the existing policies already have created a jumble of legalese that even highly sophisticated borrowers have trouble grasping, so it is far from apparent how this would help. A far better approach would be sweeping deregulation, replacing all the current clutter with a simple, easy-to-understand disclosure form, such as the one proposed by Alex Pollock of the American Enterprise Institute (pdf).

Now to the issue at hand. To assign blame, it is first necessary to understand what caused the problem. At the risk of oversimplification, let’s touch on three main causes of the financial turmoil and identify the culprits in the political world:

Problem No. 1-- easy-money policy from the Federal Reserve: In an ideal world, the Federal Reserve provides the liquidity needed to enable commerce but avoids excess liquidity to avoid either rising prices (which happens when excess money bids up consumer prices) or bubbles (which happens when excess money bids up asset prices). The Fed clearly failed in this regard, as evidenced by unsustainably low interest rates earlier this decade.

Culprits: Almost every single politician deserves a share of the blame. The political class likes easy money. In the early stages, inflation feels good. Voters feel like they have more money in their pockets and borrowers (who always outnumber lenders) like the artificially low interest rates. And that is why very few voices were raised against the Federal Reserve’s policy.

Problem No. 2 -- corrupt subsidies from Fannie Mae and Freddie Mac: These government-sponsored enterprises were created explicitly to distort the flow of capital and encourage over-investment in residential real estate. Responding in part to campaign contributions (a clear conflict of interest), politicians dramatically expanded the power of Fannie and Freddie in recent years, thus creating widespread systemic risk because of the implicit (now explicit) government guarantee.

Culprits: Many politicians from both parties were recipients of campaign contributions from the Fannie and Freddie slush funds, though Democrats had their hands much deeper in the cookie jar. The Bush administration has a very dismal economic record, but the White House does deserve some credit for having tried to rein in Fannie and Freddie earlier this decade. Opponents, led by Democrats Barney Frank in the House and Chris Dodd in the Senate, blocked reforms that would have saved huge amounts of money for taxpayers.

Problem No. 3 -- the Community Reinvestment Act: Politicians imposed numerous regulatory burdens on financial institutions, but “affordable lending” requirements such as those imposed as a result of the Community Reinvestment Act were among the most perverse. In effect, banks were extorted into making loans to people who were not credit worthy. This added to the bubble and expanded systemic risk. It’s also worth noting that poor people were victimized by this government policy, because many of them were lured into houses they could not afford.

Culprits: President Carter presumably deserves some of the blame because many of these policies were first imposed during his dismal reign, primarily with support from Democrats. But the so-called affordable-lending requirements were expanded during the Clinton and the current Bush administrations, so the GOP is not without blame.

Daniel J. Mitchell is a senior fellow at the Cato Institute, where he is an expert on tax reform and supply-side tax policy.