Finding the Right Policy

I recommend you read Robert VerBruggen’s disquisition on Peter Wallison’s latest book which takes the position that government actions caused the financial crisis, a subject we’ve discussed around here from time to time. Here’s the meat of Mr. Wallison’s argument:

The story begins in 1992, when the Department of Housing and Urban Development (HUD) decided to impose affordable-housing goals on “government-sponsored enterprises” (GSEs) Freddie Mac and Fannie Mae, institutions that buy mortgages and securitize them to provide liquidity to the market. Historically, Fannie and Freddie had been rather conservative about the loans they acquired, insisting on sizable down payments, good credit histories, and reasonable debt-to-income ratios.

At first the change wasn’t a big deal. In fact, the initial goal–that 30 percent of the GSEs’ loans be to borrowers below the median income of the area they lived in–was below what the GSEs were already doing. There’s nothing inherently wrong with loaning to these “LMI” (low- or moderate-income) borrowers, so long as they demonstrate an ability to pay and a history of meeting their credit obligations.

But the goals, which covered several other categories besides LMI, quickly ramped up. By 2001–at which point the bubble had been expanding for about four years, judging by the Case-Shiller index of home prices–the LMI goal reached 50 percent, and in 2008 it was 56 percent. The goals certainly seemed to work: The GSEs’ loans to the targeted categories closely tracked the percentages they were required to meet.

Wallison does a terrific job of documenting how much of a struggle it was to find enough qualified borrowers. A 2003 Fannie presentation noted that, in the scramble to meet the previous year’s goal, the GSEs “did deals at risks and prices we would not have otherwise done.” Two years later, in another presentation, Fannie complained about “having to compromise credit standards,” deals that were “producing negative cash flow,” and exotic products that “encourage[] continuation of risky lending.”

However, there’s a counterargument, too, something I’ve mentioned occasionally:

Min has noted, for example, that while the federal government owned or guaranteed 67 percent of all mortgages, it was responsible for just 32 percent of serious delinquencies–while private-label securities generated 13 percent of loans and 42 percent of serious delinquencies. Similarly, at a recent event for Wallison’s book, Moody’s analyst Mark Zandi pointed out that, relative to debt outstanding, realized losses on residential mortgages at Fannie and Freddie were just 3 to 4.5 percent, compared with 6 percent for banks and 23 percent for private-label securities. Jason Thomas of the Carlyle Group has written that, while Fannie and Freddie imploded and needed to be placed into conservatorship, had they “simply been required to hold equity capital in roughly the same proportion that banks are, shareholders would have absorbed all of the losses.”

It seems to me that there’s a counter-counterargument. As house prices rose it might be the case that the ever-larger loans became increasingly difficult to secure and that the bubble ended when the market “froze” for lack of ability to purchase the stock that was coming onto the market. I don’t know that’s the case but it would certainly be an interesting avenue for someone to research.

I don’t want to dwell on the “who shot John?” aspect of this question but to turn to a different aspect. What was the actual policy objective of the government’s actions and did they succeed? It seems to me that if the objective was to make lower income people homeowners it was only partially successful and it was a byzantine way of accomplishing the objective. If that were the objective, why not just give them houses?

If, on the other hand, the objective was to saddle lower income people with debt, it was wildly successful and the project is still in full swing in the form of educational loans.

Finally, if the objective was to inculcate financial responsibility in lower income people, it was a complete flop. It might even have been counterproductive. I would go on to question the legitimacy of federal government projects to make better people not just from a moral standpoint but from a practical one. You can improve the human condition but humans are not perfectible and projects intended to solve human problems by perfecting human beings are doomed to failure.