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How Government Contributed to Housing Crisis

America is facing a severe financial crisis, and it's election time.  So it seems everybody is blaming deregulation.  This opinion piece by Russell Roberts explains how government policy mistakes contributed to the housing crisis. They have nothing to do with deregulation. (source: WSJ):

Many believe that wild greed and market failure led us into this sorry mess. According to that narrative, investors in search of higher yields bought novel securities that bundled loans made to high-risk borrowers. Banks issued these loans because they could sell them to hungry investors. It was a giant Ponzi scheme that only worked as long as housing prices were on the rise. But housing prices were the result of a speculative mania. Once the bubble burst, too many borrowers had negative equity, and the system collapsed.

[How the Government Stoked the Mania] David Klein

Part of this story is true. The fall in housing prices did lead to a sudden increase in defaults that reduced the value of mortgage-backed securities. What's missing is the role politicians and policy makers played in creating artificially high housing prices, and artificially reducing the danger of extremely risky assets.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target — 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be "special affordable" loans, typically to borrowers with income less than 60% of their area's median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

Fannie and Freddie also purchased hundreds of billions of subprime securities for their own portfolios to make money and to help satisfy HUD affordable housing goals. Fannie and Freddie were important contributors to the demand for subprime securities.

Congress designed Fannie and Freddie to serve both their investors and the political class. Demanding that Fannie and Freddie do more to increase home ownership among poor people allowed Congress and the White House to subsidize low-income housing outside of the budget, at least in the short run. It was a political free lunch.

The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters — their bottom line and the so-called common good. First passed in 1977, the CRA was "strengthened" in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story, too. In 1997, Bear Stearns did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages.

By pressuring banks to serve poor borrowers and poor regions of the country, politicians could push for increases in home ownership and urban development without having to commit budgetary dollars. Another political free lunch.

Fannie and Freddie and the banks opposed these policy changes at first through both lobbying and intransigence. But when they found out that following these policies could be profitable — which they were as long as rising housing prices kept default rates unusually low — their complaints disappeared. Maybe they could serve two masters. They turned out to be wrong. And when Fannie and Freddie went into conservatorship, politicians found out that budgetary dollars were on the line after all.

While Fannie and Freddie and the CRA were pushing up the demand for relatively low-priced property, the Taxpayer Relief Act of 1997 increased the demand for higher valued property by expanding the availability and size of the capital-gains exclusion to $500,000 from $125,000. It also made it easier to exclude capital gains from rental property, further pushing up the demand for housing.

The Fed did its part, too. In 2003, the federal-funds rate hit 40-year lows of 1.25%. That pushed the rates on adjustable loans to historic lows as well, helping to fuel the housing boom.

The Taxpayer Relief Act of 1997 and low interest rates — along with the regulatory push for more low-income homeowners — dramatically increased the demand for housing. Between 1997 and 2005, the average price of a house in the U.S. more than doubled. It wasn't simply a speculative bubble. Much of the rise in housing prices was the result of public policies that increased the demand for housing. Without the surge in housing prices, the subprime market would have never taken off.

Fannie and Freddie played a significant role in the explosion of subprime mortgages and subprime mortgage-backed securities. Without Fannie and Freddie's implicit guarantee of government support (which turned out to be all too real), would the mortgage-backed securities market and the subprime part of it have expanded the way they did?

Perhaps. But before we conclude that markets failed, we need a careful analysis of public policy's role in creating this mess. Greedy investors obviously played a part, but investors have always been greedy, and some inevitably overreach and destroy themselves. Why did they take so many down with them this time?

Part of the answer is a political class greedy to push home-ownership rates to historic highs — from 64% in 1994 to 69% in 2004. This was mostly the result of loans to low-income, higher-risk borrowers. Both Bill Clinton and George W. Bush, abetted by Congress, trumpeted that rise as it occurred. The consequence? On top of putting the entire financial system at risk, the hidden cost has been hundreds of billions of dollars funneled into the housing market instead of more productive assets.

Beware of trying to do good with other people's money. Unfortunately, that strategy remains at the heart of the political process, and of proposed solutions to this crisis.

Mr. Roberts is a professor of economics at George Mason University and a scholar at the Mercatus Center. His latest book is a novel on how markets work, "The Price of Everything: A Parable of Possibility and Prosperity" (Princeton University Press, 2008).

Easterly: Development doesn’t require big government

Facing the low point of American capitalism, Easterly warns developing countries not to go back to big-government approach proven wrong before (source: WSJ opinion):

Development Doesn't Require Big Government

Poor countries are learning the wrong lessons from the crisis.

Financial meltdown will not cause the U.S. to abandon democratic capitalism, but the outcome is less clear for countries deciding whether capitalism is the best system. In many of these countries the choice is not between light and heavy financial regulation, but between relying on creative individuals or government planners to escape poverty.

Some countries are already taking the wrong prescriptions from recent events. Honduran President Manuel Zelaya told the U.N. General Assembly last month that the lesson of the crash was "the market's laws were demonic, satisfying only the few." Paraguayan President Fernando Lugo said the "market mechanism" and "immoral speculation" were a mistake. Brazilian President Luiz InĂ¡cio Lula da Silva Lula added that speculators have "spawned the anguish of entire peoples" and Brazilians needed "indispensable interventions by state authorities."

We have been here before. Development economics — the study of how poor countries can become rich — was forever cursed by the timing of its birth after the Great Depression. That gave development economics a bias toward relying on governments, rather than markets, to create growth. The early development economists ignored a century and a half of European and North American development through individual enterprise, remembering only that their governments forcefully intervened to stimulate output during the 1930s.

What is widely agreed to be the seminal article in development economics appeared in 1943, calling poor countries "depressed areas." The Economic Journal article by Paul Rosenstein-Rodan, "Problems of Industrialization of Eastern and South-Eastern Europe," concluded that a fourth of the population of these countries was unemployed, and the solution rested in ceding development to the state. Development comes from state-planned investment in all sectors at once, the "Big Push," not reliance on private investors: "An individual entrepreneur's knowledge of the market is . . . insufficient," because he cannot have all the data "available to the planning board."

Similarly, the U.N.'s Depression mindset prompted them to ask an expert commission led by Sir Arthur Lewis in 1950 to prepare a report on unemployment in underdeveloped countries. Its report concluded that "economic progress depends to a large extent upon the adoption by governments of appropriate . . . action," and that political leaders must have a strategy for such growth, reflecting "the facts of each particular case."

Few at the time disagreed. Oxford economics professor S. Herbert Frankel wrote a rare protest in 1952. He believed poor, ordinary people had "peculiar aptitudes for solving the problems of their own time and place," a confidence later vindicated by homegrown success in Botswana, the East Asian tigers, India, Chile, Turkey and China.

Lewis later received a Nobel Prize in Economics. Poor Frankel was basically forgotten.

Development economics still bears the scars of the Depression. A prominent World Bank Growth Commission concluded in May that "fast, sustained growth does not happen spontaneously. It requires a long-term commitment by a country's political leaders," and "each country has specific characteristics and historical experiences that must be reflected" in the leaders' "growth strategy." Some at the U.N. still recommend the discredited Big Push strategy of state-planned investment.

How much poverty has endured because individual entrepreneurs were shunned in favor of the likes of the $5 billion state-owned Ajaokuta Steel Mill in Nigeria, which never produced a bar of steel? Or because African governments spend their time preparing World Bank-required national Poverty Reduction Strategy Reports instead of freeing space for innovators?

We will never know. But we do know that the free market has a long-run track record of creating prosperity — even with the occasional crash. The Depression's deceptive intellectual legacy is that development flows from all-knowing states rather than creative individuals. Here's hoping that the backlash to today's crash will not spawn another round of bad economics for the poor.

Mr. Easterly is professor of economics at New York University, and author of "The White Man's Burden," (Penguin USA, 2006).