Some Lessons from the Credit Crisis

Lance Freeman's picture

The on-going foreclosure and subsequent credit crisis should offer important lessons for housing policy and public policy more broadly. Chief among these lessons might be the falsity of the notion that government regulation is always bad. But some conservative commentators cling to the dogma that government intervention is the root of all evil. An explanation being offered by some is that government intervention in the form of Community Reinvestment Act encouraged irresponsible lending and led to the subsequent housing bust. Walter Williams writes "These financial problems are not market failures but government failure. The Community Reinvestment Act of 1977 is a federal law that intimidated lenders into offering credit throughout their entire market and discouraged them from restricting their credit services to low-risk markets " On the face of it this makes no sense. If the banks were so intimidated by CRA why did they wait nearly a quarter of a century to go overboard and start making irresponsible loans? Furthermore, many of the most abusive predatory lending was undertaken by weakly regulated mortgage brokers who had little to fear from CRA. Thus, it is important that the policies that encouraged affordable homeownership not be gutted due to the excesses of the subprime frenzy.

Another lesson to be distilled from the on-going crisis is the intellectual bankruptcy of fixating on the supply side to resolve our economic/financial problems. As of this writing congress is considering a program that would bailout financial institutions by buying their ad debt. I don't think anyone could argue with the objective. Something surely needs to be done to restore confidence in the credit markets.

But why not focus on helping distressed homeowners first? It is the inability of many homeowners to pay their mortgages that is the root of the current problem. Because financial institutions are not certain how borrowers will default on their mortgages they are unsure of the worth of their mortgage backed securities. Consequently, no one wants to lend these institutions money or invest in them because a cloud of bad debt hangs over their balance sheets. Institutions such as AIG that insured these mortgage backed securities are not sure how much they are going to be on the hook for. And so on up the food chain.

A comprehensive program that helped homeowners would introduce some certainty into our credit markets. Martin Feldstein offers a plan whereby the federal government would lend homeowners at risk of negative equity 20% of the value of their mortgage. Creditors would have to reduce the principal by a corresponding 20%. This would preclude many homeowners from falling "upside down" and should slow down defaults and consequently restore more confidence in the housing and subsequently credit markets. There are other ways of helping distressed homeowners. The point is that by helping the homeowners the financial system can also be stabilized.

In addition, helping homeowners directly would help stem the tide of foreclosures afflicting many communities. Foreclosures tend to cluster in certain neighborhoods often the most disadvantaged ones. Foreclosed houses often sit vacant making tempting targets for vandals and criminal and ultimately lead to depressed values in surrounding properties.

But the current focus appears to be on the other side of the food chain, institutions holding the bad debt. Other than a myopic fixation on the supply side, I cannot see why homeowners are not the first in line for assistance.

Lance Freeman is an associate professor of Urban Planning at Columbia University.



Not so credit crisis

The frenzy that has taken Washington by storm needs some clarification. As a Real Estate broker, I regularly tune into the daily grind of market research. The truth of the matter is the xburbs are suffering because of high commuting costs which speak to more affordable housing closer to the urban centers; or is it something else. For home owners, the urban centers by large part are immune to the catastrophic effects of job loss. Mainly because job loss is less acute as it is easier to find another job if you live near the job creation areas. The fact is cities like San Francisco have not only seen price stability but it is a hot market with rising prices in some areas.

The credit crisis, the State of California's budget woes, and cities and counties fiscal problems are all due to the failure of property tax revenues, and sales tax revenues as people move out. Bailing out Wall Street based banks is simply not going to do anything for those problems. The fact of the matter is manufacturing is being stifled at every turn. Prop 69, and AB32 have all but made it impossible for manufacturing businesses to compete in California. Without manufacturing, meaningful jobs are absent. Japan in the 1980's learned this lesson and made manufacturing the forefront of their economy and not the financial services sector. Look at Japan today.

Many would wonder why a Realtor ® is worried about these things. With the jobs goes real estate value. With real estate value goes my way to make a living. I am not interested in speculation. The irony is, this market today is full of short selling mindset speculators betting prices will continue to go down.

I beg the question to all you bright planning experts: Name me 10 industry based jobs that can begin in rural cities in California. I also encourage all you planning experts to join with me and begin rural city coops. We need to take our expertise to these rural cities because outside of agriculture, they are starving for any kind of entrepreneurship. In some areas of agriculture, people are dying form heat prostration. So in effect to do nothing is to be complicit in this.

According to the Department of Agriculture:

“We must all hang together, or assuredly we shall all hang separately.”
Benjamin Franklin, at the signing of the Declaration of Independence

“Mr. Franklin was an expert on the benefits of group action. Among his many accomplishments, he helped found the Philadelphia Contributionship for the Insurance of Houses from Loss by Fire, a cooperative fire insurance company established in 1752.

The business has been conducted so efficiently over the years that it is still operating today.”

Think about that. An enduring business model absent of corporate greed and owned by the very users of the product. Simply brilliant!

The credit crisis is the machinations of the super wealthy. I for one have no problem seeing existing law take care of the lot of it. Lending fraud has very stiff penalties. The FBI has begun to deal with this, let them finish in all the banking sectors.

Right Track

I agree with one point you made: Banking (no pun intended) our economy on the financial sector is a bad idea. The economic base of our country has continuously become more and more dominated by the financial sector, and now we're paying for it.

This is because the wealth that it has created in the past years is an ARTIFICIAL wealth that exists only on stock tickers. What we must focus on now is building SUSTAINABLE wealth that will not only dig us out of this hole, but empower more individuals and families and small businesses, and spread the distribution of risk out further. That way, the likelihood of something like this happening decreases, and if it does, we are bailing out real people and not a handful of organizations that handle everybody's money.

That is something everyone can understand. That's something everyone can get behind. That way we don't have Joe scratching his head, saying "I don't understand, HOW DID THIS HAPPEN?" and a government telling him that the best course of action is to sink $1 Trillion into Wall Street and not Main Street, or High Street, or any other street.

I'm not saying that what the President and Congress have decided to do is wrong. I believe it is a necessary evil because of how we've structured our economy. But we need to look beyond a bailout strategy and look for a real prescription to what's really wrong here. If one method fails to work, let's not up the dosage. Let's take a clinical look at what is causing problem, and seek a preventative cure that we can bank our future on.

Here is why

You have some decent points, but the absence of redlining, while good in many ways, also contributed to bad (financially speaking) loans.

But, your criticism of the supply side is missing something. It's actually not defaulting mortgages that are causing *this problem*. That was the root of the problem - too much leverage by individuals and banks. But, here is the issue now - very little financing available for anyone. Why? Even if borrowers paid their debt service, banks/lenders are screwed. The value of the securities backed by the mortgages have plummeted and not just because of default, but rather market perception and risk. Risk is being re-priced in the market and banks are required (by the SEC) to mark-to-market the value of their scurities (aasets). Since nobody wants to buy these MBS at almost any price, they lower the asset total for a bank and increase the debt since liabilities are unchanged. Thus, the only way to come up with cash is to liquidate which has been impossible or find a buyer for the company. The Fed has infused liquidity, but it can only go so far.

Helping homeowners is great, in theory, but it won't solve the financial crisis we're in. The best thing the governemt can do is let people out of bad loans with no huge credit ding (especially if they were improperly advised). The next thing is to make all financial advisory serviecs carry a fiduciary responsibility punishable by civil penalty. This will take care of all the bad advice since you would be on the hook for a default on an interest-only ARM.

Finally, the Treasury may indeed, have to buy these securities, but it can be a money maker if it's done right. They can buy at big discounts and sell the securities later when the liquidity of the market returns and they can also convert many of these into warrants and then profitably sell stock over time. It's not ideal, but your plan won't help the financial system and we would probably end up in a severe recession.


As I understand it, it wasn’t until the mid ‘90’s, when ACORN (represented by one Barack Obama) filed lawsuits, demanding that the mortgage companies start making loans to people who really shouldn’t be getting them. I’m sure everyone remembers the brouhaha over “redlining,” etc.

I would also note that there were those in Congress who pointed out the problems with these loans and companies (particularly Fannie Mae and Freddie Mac) in 2003 and 2005, but we were assured by certain (Democratic) members of Congress that all was well. The video of Rep. Frank is particularly revealing.

I have some sympathy for using the money to help homeowners directly (I’m way upside down on my own house, though I don’t have an adjustable rate mortgage), but I have real reservations about the government getting so deep into what should be strictly a private sector problem. I’m confident that if the government (and particular organizations who exist solely through extortion from the government) had stayed out of it, this problem never would have come up.

Also, a question: How would getting a loan from the government for 20% of the mortgage value help? Unless you are thinking more along the lines of a grant?

Partisanship and bad policy

Excellent comment, Lance. I wish somebody would publish some real analysis of the data in order to put to rest this nonsense about the CRA (or lending to low-income homeowners) being a significant cause of the credit crisis. This is a good example of the way partisan politics can drive policy discussion into confusion. A lot of the bad moves in urban and housing policy of the last couple of decades seem to have been the result of partisan political maneuvers that become efforts to discredit policy associated with the other party, and only partly for any real ideological or principles reasons.

Then these partisan maneuvers get picked up and turned into popular myths that have a half-life well beyond the election cycle. So now the CRA has been linked to a nationwide conspiracy of ACORN, black militants, and other radicals interested in undermining American capitalism. (e.g. Rush Limbaugh's recent encyclopedic indictments of the left, left-leaning, and people of color). What concerns me is not only that these conspiracy theories from the wacko fringe are getting mainstream attention, but that this kind of nonsense-- in blatant contradiction of the facts, if anybody bothered to look-- poisons the policy environment for a long time. Maybe we can't have a reasoned discussion of these issues right now, given the toxic political environment created by the right's current tactics, but we certainly need to get prepared to have more fact-based discussion of housing policy as the efforts to "rescue" the economy from the credit crisis continue. No matter who wins the election in November.

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