The arrival of The Big Short in theaters a
few weeks ago, and its subsequent win at the
88th Academy Awards, has reignited interest
in the causes of the 2008 financial crisis.
The film would have you think that private
greed on Wall Street and a lack of regulation
caused the economic crash.
This is a story that is simple to describe
and easy to believe.
The government likes it because it places
most of the blame on the private sector, and
Hollywood likes it because it is easy to blame
human foibles—like greed—as the source
of much more complicated problems.
But while stories like this might make for
a fun movie, The Big Short fails to align
with the facts.
The reality is that government housing policies
led to a general deterioration in all mortgage
underwriting standards, to the “mortgage
meltdown” of 2007 and 2008, and ultimately
to the market crash that we know as the 2008
financial crisis.
To get an accurate perspective on what led
to the financial crash, we have to wind the
clock back to 1992.
Despite many government subsidies the homeownership
rate in the U.S. had been stalled at 64 percent
for 30 years.
Congress blamed this on two government-sponsored
enterprises or GSEs, Fannie Mae and Freddie
Mac.
These GSEs had government backing but were
also private, profit-making firms, and insisted
on acquiring only prime mortgages.
Thus—it was argued—by insisting on these
underwriting standards, the GSEs left a vast
number of low income Americans frozen out
of the American dream of homeownership.
So, in 1992, Congress adopted a program known
as the “affordable housing goals,” which
required Fannie and Freddie to acquire an
annual quota of mortgages that had been made
to low or moderate income borrowers, without
considering whether the mortgages were prime
loans.
Starting in 1993, 30 percent of all loans
the GSEs acquired in any year had to be made
to home buyers who were at or below the median
income where they lived.
But the Department of Housing and Urban Development,
or HUD, was given authority to raise the goals—and
it did, aggressively.
Between 1993 and 2000, HUD raised the 30 percent
goals to 50 percent, and between 2001 and
2008 it raised the goals to 56 percent.
Thus, by 2008, 56 percent of all mortgages
the GSEs acquired had to be made to borrowers
below the median income of their communities.
Notably, HUD’s relentlessly rising quotas
occurred in both Democratic and Republican
administrations.
Understandably, it was difficult for the GSEs
to meet these quotas and still acquire only
prime loans.
Accordingly, between 1993 and 2008, they began
to accept increasing numbers of nonprime and
other risky mortgages, with low or no down-payments
and from borrowers with poor credit ratings.
By June 2008, before the financial crisis,
more than half of all mortgages in the United
States—31 million loans—were subprime
or otherwise risky, and 76 percent of these
were on the books of various government agencies,
primarily Fannie Mae and Freddie Mac.
The connection between the dramatic rise in
subprime mortgages and the financial crisis
is clear.
Because the government-backed GSEs dominated
the mortgage market, when they reduced their
underwriting standards to meet the affordable
housing quotas, the rest of the market followed.
Soon, borrowers who could have afforded prime
mortgages were getting loans with zero down
payments.
This created an enormous housing price bubble.
It is easy to see why.
If a buyer has $10,000 to buy a home, and
the downpayment required is 10 percent, he
can buy a $100,000 home, but if the downpayment
requirement is reduced to 5 percent, the same
buyer can buy a $200,000 home.
He borrows $190,000 instead of $90,000.
This put great upward pressure on home prices,
causing the bubble.
Also, the buyer now has less investment in
the home and more debt to repay.
So when the bubble began to deflate in 2007,
borrowers found that they owed more than their
homes were worth.
Many of them simply walked away from the home.
Others tried to get lower cost financing but
could not.
The number of defaults was unprecedented.
Fannie later reported that in 2008 it was
exposed to $878 billion in subprime and risky
mortgages, which caused 81 percent of its
losses that year.
Freddie’s percentage exposures and losses
were proportionately the same.
Both organizations were taken over by the
government by the end of that year.
Government blunders then turned the mortgage
meltdown into a financial crisis.
First, the government rescued Bear Stearns,
a Wall Street investment bank, in March 2008,
creating expectations that it would rescue
other big firms if they got into trouble.
But when Lehman Brothers—a firm much larger
than Bear—weakened, the government suddenly
reversed its policy, letting Lehman fail.
This upended the market’s expectations,
creating doubt about the safety and soundness
of every firm.
The result was an unprecedented panic that
we know today as the financial crisis.
Long story short—was there bad behavior
on Wall Street?
Of course there have always been individuals
who take advantage of the system.
But that’s not the issue here.
The 2008 crisis was not caused by Wall Street
“fat cats” taking advantage of loopholes
due to a lack of regulations; they were taking
advantage of market incentives that existed
because of irresponsible government regulations.
