The 2008 housing crash began with Washington's push for easy mortgages

The standard story of 2008 has a villain, a victim and a moral. The villain is a banker, the victim is a homeowner and the moral is that markets cannot be trusted. It is a clean story. It is also incomplete, and the part it leaves out is the part that determines whether we repeat it.

My claim is not that Wall Street was innocent. It was not. My claim is narrower and, I think, better supported: in the decades before the crash, the federal government pushed lenders, and the two giant government-sponsored mortgage firms in particular, to make more loans to borrowers who could not easily repay them, and then promised to stand behind the results. That policy created the demand for risky mortgages. The private sector, responding to the incentives it was handed, supplied them. If you want to know why the table was set, look at who built the table.

Terms

A government-sponsored enterprise, or GSE, is a privately owned corporation with a public charter. Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) are the two that matter here. They do not make mortgages. They buy them from lenders, bundle them into securities and guarantee the payments, which frees lenders to make more loans.

A subprime loan is a loan made to a borrower with a weak credit history or little documentation, usually at a higher interest rate. A securitization is the process of pooling many loans and selling claims on the pool to investors. Private-label securities are those issued by private firms, not by the GSEs. Conservatorship is a legal arrangement in which a government agency takes control of a company to preserve its assets.

The Community Reinvestment Act of 1977

The first piece of the policy is the Community Reinvestment Act, signed in 1977 by President Carter. Its purpose was to counter the practice of redlining, in which banks refused to lend in certain neighborhoods. The Act requires federally insured banks and thrifts to meet the credit needs of the communities in which they take deposits, including low- and moderate-income neighborhoods, consistent with safe and sound operation. Regulators examine banks for compliance, and a poor record can hold up a merger or the opening of a branch.

I want to be fair here, since this is the part of the story that gets exaggerated. The CRA itself did not require banks to make bad loans. Its text says that lending must be consistent with safe and sound operation, and a large share of the subprime loans of the 2000s were made by lenders who were not covered by the Act at all, such as independent mortgage companies. Scholars on the left and the right have argued about how much the CRA contributed, and the honest answer is: some, but not the main part. The regulations were revised in 1995 to emphasize measurable performance, which gave banks a stronger incentive to show numbers. That is where the pressure grew.

The 1992 law and the affordable-housing goals

The more consequential step came in 1992. Congress passed, and President George H. W. Bush signed in October of that year, the Federal Housing Enterprises Financial Safety and Soundness Act. It created a new regulator for Fannie and Freddie and, crucially, it directed the Department of Housing and Urban Development to set affordable-housing goals: a share of each GSE's mortgage purchases had to go to low- and moderate-income borrowers and to underserved areas.

The goals were modest at first, and then they rose. The initial goal for purchases going to low- and moderate-income families was thirty percent, and over the following years HUD raised that figure repeatedly, to above half of purchases by 2007, with additional sub-goals for the very poor and for underserved areas. A goal is a quota with a polite name. To meet it, the GSEs had to find and buy loans from borrowers with low incomes, and, as the supply of conventional loans to such borrowers ran short, they had to loosen standards: lower down payments, thinner documentation, higher debt-to-income ratios. Both firms also bought mortgages with very small down payments.

Add the implicit guarantee. Everyone in the market understood that, though the GSEs were private companies, the government would not let them fail. That belief let them borrow at lower rates than any private firm, grow to a size that made them central to the entire mortgage market, and take risk with a safety net that the taxpayer owned and did not know about. A firm that earns the profits when it wins and passes the losses to someone else when it loses has every reason to take more risk. The economists' term is moral hazard, and Bailouts and moral hazard, from Chrysler in 1979 to Silicon Valley Bank shows how often it recurs.

By 2008, Fannie and Freddie owned or guaranteed about half of all the mortgage debt in the country. A pair of companies with a government quota and a government backstop was setting the standards for the largest financial market in the world.

Cheap money

The second piece was the price of money. After the 2001 recession, the Federal Reserve cut interest rates to historic lows, and in June 2003 it brought the federal funds rate down to one percent, where it stayed for about a year. Low rates make borrowing cheap and housing appear more affordable, and they pushed investors to look for higher returns than Treasury bills offered. Mortgage-backed securities offered them. Housing prices began a steep climb, and rising prices made every loan look safer than it was, since a borrower in trouble could always sell or refinance at a profit.

Notice that this is a government policy, too, though a different one. The Fed is an agency of the federal government, and its choices are part of the story. A fair account does not pin everything on the housing goals. It says that cheap credit supplied fuel and the housing goals supplied a particular kind of spark.

The private sector joins in

Now to Wall Street, and I intend to be as hard on it as the evidence allows.

From about 2003, private-label securitizers expanded rapidly. Lenders such as Countrywide and others made loans with little or no documentation, adjustable rates that reset higher after two years and no down payment. Investment banks bought the loans, pooled them into securities, sliced the securities into tranches, and sold them around the world. Credit rating agencies, paid by the issuers whose products they rated, stamped many of the top tranches triple-A, the rating of a nearly risk-free bond. Insurers wrote protection on them. Investors, believing the ratings, bought them in size.

Several things were wrong at once. The underwriting was lax and sometimes fraudulent. The ratings were based on models that assumed national home prices would not fall together. The securities were opaque, so that few buyers understood what was in them. And the firms that created them kept thin capital cushions against enormous exposure. None of that was the government's fault in a direct sense, and a conservative should say so without hedging. A banker who knowingly sold bad paper, or a rating agency that knowingly stamped it, deserves blame, and in a few cases got it.

The fair question is how much each cause mattered, and here the answer is genuinely disputed.

What the official inquiry said

After the crash, Congress created the Financial Crisis Inquiry Commission, which reported in January 2011. Its majority, six Democratic appointees, concluded that the crisis was avoidable and was caused mainly by failures of regulation, of corporate governance and of risk management on Wall Street, and held that the affordable-housing goals of the GSEs were not a primary cause. The four Republican appointees split. Three of them, Keith Hennessey, Douglas Holtz-Eakin and Bill Thomas, issued a dissent that attributed the crisis to a mix of causes, including a global credit boom, a bubble in housing, and the failure of the private firms, but did not make the GSEs the central cause. A fourth, Peter Wallison, wrote a separate dissent arguing that government housing policy, and the affordable-housing goals in particular, was the central cause, since it led to millions of weak mortgages in the system.

I would invite the reader to read both documents, since they are public. The disagreement is real. The majority points out that much of the worst lending was done by private firms outside the GSE system, and that the GSEs entered the subprime market late. Wallison replies that the GSEs and other government programs held or guaranteed a large number of non-traditional mortgages, that the private firms were competing to meet the same demand and that the goals changed what the entire market regarded as normal. I think the correct reading is somewhere in the middle, but closer to Wallison than the majority admitted, for a reason I will give below.

September 2008

The end came quickly. By the summer of 2008, housing prices had been falling for two years, delinquencies were climbing and the losses on mortgage securities were mounting. Fannie and Freddie, which held enormous exposure and thin capital, were failing. On September 7, 2008, the Federal Housing Finance Agency announced that it had placed both into conservatorship, and the Treasury committed to support them with capital. A week later, on September 15, Lehman Brothers, a private investment bank, filed for bankruptcy, and the panic that followed brought the financial system to the edge. Congress passed the Troubled Asset Relief Program, signed on October 3.

Mark the order. The two government-sponsored firms went under the federal government's control first. The firm at the center of the housing policy was the first to be taken over. That is not a proof of cause, but it is a fact about which institutions were most exposed.

Weighing the causes

Let me put the weights in numbered premises, and be candid that the weights are judgments and not measurements.

1. Demand for risky loans was real and policy-driven. The affordable-housing goals, the CRA's performance emphasis, the implicit guarantee and the push for homeownership across administrations of both parties created a standing demand for mortgages to borrowers on the margin. I count this as the foundation.

1. Cheap money was the fuel. The Fed's low rates in 2003 and 2004 fed the bubble. This was a monetary decision, separate from the housing goals.

1. Private lenders and securitizers supplied what the market demanded, and went further. Once the demand and the guarantee were in place, private firms rushed in, and some of them committed outright abuses. This was a decisive failure, and it belongs to them.

1. Rating agencies and models failed. The triple-A stamp on weak securities spread the risk worldwide. The agencies were private, but their ratings were written into government rules that required regulated institutions to rely on them.

1. Regulators missed it. Agencies saw, or should have seen, the leverage building up at the banks and the GSEs and did not act.

If I had to rank the causes, I would say the first two set the table and the third and fourth ate the meal. Without the demand and the cheap credit, the private machinery would have had far less to feed on. Without the machinery, the policy would have done less damage.

The steelman and the answer

The strongest case against the thesis of this column, in its defenders' own words, runs like this. Subprime lending exploded in the private market in 2004 to 2006, outside the GSEs and the CRA. Other countries with no CRA and no Fannie Mae had housing bubbles and busts. The loans that failed most spectacularly were made by firms that had no government mandate to make them. So to blame Washington is to let Wall Street off the hook.

I accept the facts, and not the conclusion. Housing bubbles in other countries arose in the same period of cheap global credit, which does not show that policy was irrelevant at home; it shows that the credit boom was broad. And the point about the private lenders cuts both ways. Why were private firms rushing to make loans that they should have known were unsound? One reason is that the GSEs and the government had made the loans respectable, and had created a market that would buy them. Another is that the lenders believed the government would not let the system collapse. Policy shaped the incentives of everyone in the room, including the ones who were not covered by it.

What it means for the next time

The lesson is not that homeownership is bad. It is the best way most families have to build wealth, and conservatives are right to celebrate it. The lesson is that a government cannot manufacture ownership by lowering the standard for it. A mortgage is a promise to pay, and a family that is lent more than it can repay is not helped. It is set up to lose the down payment, the credit rating and the home.

The reforms that follow are not complicated. End the implicit guarantee and make clear who bears losses. Require that those who make and sell loans keep some of the risk. Hold rating agencies accountable. Keep the Fed from pushing rates too low for too long. And stop treating a lower down payment as a policy victory. For the monetary side, see The Fed's dual mandate and the 1977 law that gave it two masters, and for the other side of the housing market, where the price of a home is set by what a city allows to be built, see houston has almost no zoning, and its houses cost less to prove it.

The Founders were wary of a government that tried to manage the economy through the credit system, and Hamilton himself, in his 1790 report on public credit, insisted that honest borrowing means paying what is promised, as Hamilton's 1790 Report on Public Credit and what honest borrowing requires explains. A policy that encourages promises that cannot be kept violates that rule at the household level.

The case in brief

1. Federal policy created demand for loans to borrowers on the margin: the Community Reinvestment Act of 1977, the 1992 law that set affordable-housing goals for Fannie Mae and Freddie Mac, and an implicit government guarantee behind both.
2. The Federal Reserve's one percent federal funds rate in 2003 and 2004 supplied cheap fuel to a housing bubble.
3. Private securitizers, lenders and rating agencies supplied weak loans and false comfort, and their failures were real and decisive.
4. The Financial Crisis Inquiry Commission split on the question, and the best reading weights policy as the setting of the table and Wall Street as the eater of the meal.
5. Fannie and Freddie were placed into conservatorship in early September 2008, before Lehman Brothers failed, and the lesson is that no government can manufacture ownership by lowering the standard for it.

What you can do: read the dissenting statements to the Financial Crisis Inquiry Commission's 2011 report, then ask your representative where they stand on ending the implicit guarantee of the housing finance agencies.