Economic bubbles are a repetitive historical reality, as are their precipitous bursting and the resultant downturns. Here’s a history of some of the major ones that have occurred; there are others.
But there’s something about the current situation that is sui generis, as far as I can tell: it began with legislation designed to create a financial reality that would reflect our desire to end what was perceived as social and racial bigotry, and to achieve more economic parity. This does not appear to have been true of previous bubbles, which were not the result of deliberate social engineering.
In this piece, Thomas Sowell outlines how the real estate bubble began. Although it started during the Carter administration with the Community Reinvestment Act of 1977, that was just a general statement about banks needing to serve their communities. The Act didn’t really result in any major drive to change the way lenders made mortgage loans.
In fact, the language of the law was quite careful. The idea was to “encourage” lenders:
to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operation of such institutions.
Of course, these twin goals are always in conflict, almost by definition. For example, I might have a “credit need,” but if I’m not a good financial risk those needs will just have to go unfulfilled if lenders are going to operate in a manner that is “safe and sound.”
This isn’t rocket science. It isn’t even arcane financial knowledge. It is one of the most basic premises of our financial system. And yet it was violated with impunity during the Clinton era (and this continued in the Bush administration) when the old adage “a chicken in every pot” was replaced with “a home for every citizen.”
How did this happen? It occurred under the guise of nondiscrimination. The notion was that, if banks were not lending in equal amounts to the poor—and especially African-Americans and Hispanics—the reason wasn’t that they were following “safe and sound” financial practices. It had to be about about racism.
Here’s how it worked in the 90s, according to Sowell:
What HUD wanted were numbers showing that mortgage loans were being made to low-income and moderate-income people on a scale that HUD expected, even if this required “innovative or flexible” mortgage eligibility standards.
In other words, quotas were imposed– and if some people didn’t meet the standards, then the standards need to be changed.
Both HUD and the Department of Justice began bringing lawsuits against mortgage bakers when a higher percentage of minority applicants than white applicants were turned down for mortgage loans.
Nowhere have I read any indication that the government cared whether those minority applicants who were turned down were in fact poorer loan risks than candidates who were approved for loans.
There is no doubt that this used to happen—just as there is no doubt that minority (read: African-American or Hispanic) students used to be discriminated against in the university admission process. But, just as affirmative action for the latter came to mean equality of outcome rather than equality of opportunity, so the percentages of minorities receiving mortgages became the standard by which discrimination was judged, rather than whether the denial of a particular mortgage was actually racially motivated rather than economically motivated. The unfairness was assumed by the unequal numbers.
Of course, the fact that loan standards ultimately had to be relaxed in order to accommodate low-income minority applicants is the clearest evidence of all that the earlier loan denials were likely to have been the result of sound economic practices rather than discrimination, at least in the vast majority of cases. But by that time the goal had changed from the prevention of intentional racial discrimination to the prevention of all racial inequality, even if it were based on sound economic reasoning rather than any purposeful racial discrimination.
It’s certainly possible that there was some small amount of intentional racial discrimination going on as well, somewhere in all those loan denials. But if so, the proper remedy would have been to find the cases in which minority applicants with the proper financial and credit history were being denied loans that white people with exactly the same finances would have been granted. Forcing banks to make bad loans to achieve racial parity—that is, equality of outcome—is bad business. But the need to achieve the appearance of racial equality was considered far more important than the preservation of the banking system.
As I wrote yesterday, these governmental regulations were not the whole problem. But they were the springboard for the whole problem, which was an enormous blossoming of bad loans as the housing bubble starting to grow. Then the risk was spread by derivatives and other instruments to nearly every corner of our financial system.
Some interesting questions: would banks and mortgage companies have come up on their own with “creative” financing, had they not first tasted the fruit of that forbidden tree by government order and found it to be sweet in an era of continually rising real estate prices (and indeed, would prices have risen so precipitously without the government jumpstart)? Would lenders still have forgotten the most basic rules of lending, and surrendered to the siren song of the “math guys,” who reassured the more staid banker types that all would be well, since their computer simulations decreed it?
I don’t know the answer; no one does. But there is little doubt that in the beginning there was the affirmative action loan by government decree, breaking time-honored rules of lending.
And presently we have something similar: the affirmative action real estate bailout. Now the impetus is not primarily to achieve racial equality, although that’s still in there somewhere. Now it’s about continuing home ownership for those who cannot afford it.
Bailout proponents point out that things are so bad now that to let these people lose their homes would cause a cascade of events that would harm us all financially. They also like to paint such people as the innocent prey of predatory lenders, although we have no idea how numerous or rare such cases may be.
The argument on the other side is that people should not be rewarded for bad financial decisions. Bailout naysayers also predict that the mortgage bailout (as well as all the other huge bailouts that preceded it) will only temporarily postpone the agony by taking money from those who were more financially prudent (and/or future generations) and giving it to those who were not. Better to let banks renegotiate mortgages with homeowners in order to forestall widespread foreclosures (which don’t benefit banks much either, when housing prices are low), using time-honored financial standards to determine which homeowners are good bets and which are not. Governmental intervention is only likely to blow the housing bubble up once again—and we all know what ultimately happens to bubbles.
One of the basic financial practices that was jettisoned in the 90s was the idea of the 20% down payment on a house. This not only reduced a homeowner’s mortgage payments, but it gave the bank a certain amount of non-refundable income from the transaction. In the event of a foreclosure due to the buyer’s failure to meet payments, the bank would only have had to recoup 80% of the purchase price in order to come out even.
This constituted a sort of insurance for banks even if the loan ended up going bad. The end of the practice meant trouble for banks, especially in a climate in which housing prices fall and foreclosures become commonplace—such as now.
The dream of equality of opportunity for all has become a kind of nightmare, escalated to the point where equality of opportunity is not enough. Equality of outcome, which has been the goal of liberals for some time, is a very slippery slope. Down it we all now slide.
[ADDENDUM: How many of the defaults are voluntary?]
