How did legislative acts and regulatory policies impact the mortgage industry and create our current financial crisis?
Rewarding Bad Behavior – The Mortgage Crisis
Mortgage lending has exploded into the news lately and for good reason. The once safe and profitable bank practice of mortgage lending has led to the decline and demise of several major financial institutions. The semi-government agencies of Fannie May and Freddie Mac have come under intense scrutiny for their role in the mortgage mess. Wall Street investors and bank officers have also taken an extraordinary amount of heat. Borrowers who took out “liar” loans and the brokers who sold them are not immune from the blame storm either. However, the people who should receive the most blame for the problem are getting the least.
The key question to ask is:
“What is the root cause of the sub-prime mortgage crisis?”
The common answer is GREED.
- Greedy bankers
- Greedy lenders
- Greedy brokers
- Greedy investors
- and Greedy borrowers
If you accuse enough people of being greedy, and politicians and the news media say it often enough, people believe it, like it, and are not willing to investigate any further. Case closed – the argument is complete. Not so fast though. This argument is a False Logical argument and stinks of Red Herring and reeks of an Appeal to Popularity. Greed is merely a symptom rather than the problem.
All those greedy people acted that way because there were incentives for greedy behavior and penalties for pragmatic behavior. “What kind of idiot would reward risky lending and borrowing?” you ask. The only kind of people capable of making decisions that turn out so badly are politicians – of course. Until 1977 banks had been making mortgage loans primarily to qualified buyers. Default rates were low and the risk minimal. Mortgages were safe and profitable. Under the enlightened administration of Jimmy Carter and a Democrat controlled Congress the Community Reinvestment Act (CRA) was signed into law. This act pressured banks to lend to unqualified borrowers in risky areas. In other words CRA was enacted specifically to help one group. The law was only enforced for about four years because under Reagan and George H.W. Bush the law was ignored but not repealed. This was a missed opportunity. Under Clinton the law’s impact was revived and enhanced through additional legislation and bureaucratic regulation. Banks then had to provide evidence at CRA audits that they were providing risky loans to risky borrowers (though they probably did not refer to them in those terms at the audits). Banks that did not comply with CRA and the other mandates had limitations imposed on them that made expansion and growth difficult.
In this way banks that wanted to expand and grow had to pursue bad business practices to satisfy politicians. Banks that made risky loans were rewarded and those that didn’t were penalized. It should be no surprise then that greedy behavior broke out since the way to business growth and personal advancement lay in gaming the system. Roadblocks were put up for banks that made pragmatic and non-greedy decisions. The fast lane wide open for banks that made ever riskier loans to ever riskier borrowers. The system was propped up by increasing home values. When home values declined the crutch fell out and the system crashed to the ground. By not looking at the long term consequences of CRA, nor its impact on other groups, politicians managed to create a monster that brought great pain to us all.
Did anyone other than us notice the politicians pointing their fingers in every direction except toward themselves?
Nourishing a weed
A gardening simile would go a long way toward clarifying this issue. Politicians, mostly Democrats but with some help from Republicans, enacted and enhanced CRA. We’ll liken CRA to a weed. Politicians planted the weed. Rather than realize their mistake and use weedkiller on it they nourished the weed instead. They watered the weed. They protected it from predators. They produced enough “fertilizer” (Average Joe’s know that fertilizer is most commonly some form of manure) to make the weed grow to heroic proportions. The giant weed eventually overshadowed the rest of the plants in the garden and weakened or killed them off. Politicians laid the blame for the damaged garden on everything but their weed. Sadly enough this weed is still in the garden though it has been weakened. Politicians are now in the process of reviving this weed.
Steady job vs. Betting the horses
The mortgage industry prior to 1977 could be likened to a steady job with weekly paychecks. Nothing flashy and nothing very risky. Lending practices after CRA got regulatory teeth could be likened to earning a living by betting on horse races. Everything is at risk. Obviously banks have a much better chance of making long term profits if they receive the “steady paycheck” of safe mortgages vs. “betting profits” of risky mortgages. However legislation rewarded the “bettors” by provoking them to bet even more and by giving the impression that any losses they incurred would be covered by the government. Just as it is impossible to make a safe living by betting on horse races is was also impossible to make safe revenue by making risky mortgage loans.
Two important things to keep in mind:
- Legislation was the root cause of this financial problem. If banks were not rewarded for risky lending and penalized for pragmatic lending we would not have a sub-prime mortgage crisis on our hands now.
- Politicians created and exacerbated the problem for their own gain (bragging rights about all the people they were helping and the votes they were reaping). They refuse to acknowledge their role in the affair and they even believe that their “assistance” is crucial to the cure.
When politicians believe they have an economic solution – expect your wallet to get a little lighter and the problem to get a whole lot worse.