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Some Lessons from the Credit Crisis

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.

Lance Freeman | September 23, 2008, 6pm PDT
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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 affordablehomeownership 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.

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