It was not an absence of federal intervention that produced the Great Financial Panic of 2008. Contrary to the assertions of those clamoring for new regulations (see "Is Deregulation to Blame?," page 36), the liquidity shortage and credit freeze that triggered Washington's biggest intrusion into the economy since Richard Nixon's wage and price controls were caused by bad government policy and worse crisis management.
As the housing bubble inflated from 1997 to 2006, banks, fueled by the Federal Reserve, prodded by activists, and egged on by Wall Street, created ever more exotic mortgage loans that pushed up housing prices and extended mortgage debt to families vulnerable to economic downturns. Several layers of financial products were tied to these mortgages. As some of the derivative instruments and underlying mortgages collapsed, collateral damage raced through the entire system.
In 2008 the Bush administration took a series of frantic steps to stop the bleeding. It backed a hostile takeover of the investment bank Bear Stearns. It took over home lending behemoths Fannie Mae and Freddie Mac, an act that put $5 trillion worth of mortgages—more than $1 trillion of which are subprime—on the federal government's books, not to mention the $200 billion it had to commit to guarantee Fannie and Freddie's debts. It made hundreds of billions of dollars available to banks through the Fed's "discount window," its mechanism to make short-term loans to certain institutions, put up $85 billion to take over the insurance giant AIG, and offered another $250 billion to individual banks to rebuild their balance sheets.
In October the administration convinced Congress to authorize
the Treasury Department to spend upward of $700 billion buying up
toxic mortgage-backed securities, most of which contain sizeable
numbers of subprime mortgages. Each step not only failed to calm
the market but seemed to increase the sense of impending doom (also
fanned by sky-is-falling pronouncements from President Bush on
down). After a month of U.S. government action, the mortgage crisis
had grown into a global financial panic, the repercussions of which
we'll be living with for decades.
The Roots of the Crisis
Throughout the 1990s and the early years of this century, both major political parties became intoxicated with the idea of promoting "affordable" housing. By the time the crisis blew up, Congress was mandating that roughly 50 percent of the mortgages issued by Fannie and Freddie go to households making below their area's median income.
Many conservative commentators have blamed the housing mess on the 1977 Community Reinvestment Act (CRA), which essentially required banks to increase lending in low-income areas. While the CRA was a bad law, its role in recent events has been overblown. After all, it was on the books for decades before the bubble began. The law's worst legacy is the permanent network of "affordable housing" advocates that sprang up after it passed. These groups, which were intended to facilitate lending in poor areas, continually called for increased activity by banks and additional government support for affordable housing initiatives. The CRA also helped create a climate in which lending to low-income households was a key metric and condition regulators used in approving bank mergers.
Other, more recent developments played a bigger role in the financial crisis. In 1993 the Federal Reserve Bank of Boston published "Closing the Gap: A Guide to Equal Opportunity Lending." The report recommended a series of measures to better serve low-income and minority households. Most of the recommendations were routine and mundane: better staff training, improved outreach and communication, and the like. But the report also urged banks to loosen their income thresholds for receiving a mortgage. In the years after the report was published, activists and officials—especially in the Department of Housing and Urban Development, under both Bill Clinton and George W. Bush—used its findings to pressure banks to increase their lending to low-income households. By the turn of the century, other changes in federal policy made those demands more achievable.
You can't lend money if you don't have it. And beginning in 2001, the Federal Reserve made sure lots of people had it. In January 2001, when President Bush took office, the federal funds rate, the key benchmark for all interest rates in this country, was 6.5 percent. Then, in response to the meltdown in the technology sector, the Fed began cutting the rate. By August 2001, it was at 3.75 percent. And after the terrorist attacks of September 11, the Fed opened the spigot. By the summer of 2002, the federal funds rate was 1 percent.
The central bank's efforts went so far that, at one point in 2003, we had interest rates below the rate of inflation, or effectively negative. Institutional investors, looking at low yields on Treasury securities, needed a place to park money and earn some kind of return. Mortgage-backed securities became a favorite investment vehicle. Under traditional models, they were very safe and, because of Fed policy, even the most conservative fund could earn better returns than they could on Treasury notes.
Investment houses would bundle individual mortgages from several banks together into bond-like products that they would sell to individual investors. Mortgages historically have been seen as among the safest investments, and the era of rising house values transformed "safe" into "guaranteed returns."
For the first half of this decade, trading in mortgage-backed securities exploded. Their growth provided unprecedented levels of capital in the mortgage market. At the same time, investment houses were looking to replace the healthy fees earned during the dot-com bubble. Mortgage-backed securities had fat margins, so everyone jumped into the game.
The additional capital to underwrite mortgages was a good thing—up to a point. Homeownership expanded throughout most of Bush's presidency. During the last few decades, the American homeownership rate has been around 60 percent of adult households. At the height of the bubble, it reached almost 70 percent. It is clear now that many people who got mortgages at the high-water mark should not have. But Wall Street needed to feed the stream of mortgage-backed securities.
Fannie and Freddie
It's hard to overstate the role Fannie Mae and Freddie Mac played in creating this crisis. Chartered by Congress, Fannie in 1938 and Freddie in 1970, the two government-sponsored enterprises provided much of the liquidity for the nation's housing market. Because investors believed—correctly, it turns out—that Fannie Mae and Freddie Mac were backed by an implicit guarantee from the federal government, the companies were able to raise money more cheaply than their competitors. They were also exempt from federal, state, and local taxes.
The chief mission of Fannie Mae and Freddie Mac was to buy up mortgages issued by banks, freeing up bank money for additional mortgages. Fannie and Freddie would package these mortgages into mortgage-backed securities and sell those on the secondary mortgage market, providing cash to continue the cycle. Even when selling these securities, they often retained the full risk for any default, pocketing a portion of the interest payments in return.