The Government

Even the briefest study of the history of financial markets shows that they are prone to boom-and-bust cycles unless governments carefully regulate them. Thus, it's not surprising that the housing bubble was made possible by a complete failure of government at all levels to properly monitor and regulate many different areas. Here were some of the key events:

  • During the 1990s, the Clinton administration pushed Fannie and Freddie to support more lending in low-income communities and used the Community Reinvestment Act to encourage (some would say coerce) banks to do the same.
  • In April 1998, the President's Working Group on Financial Markets brought together Alan Greenspan, Treasury Secretary Robert E. Rubin, and Securities and Exchange Commission (SEC) Chairman Arthur Levitt Jr., all of whom—according to a report in the Washington Post8— successfully pushed Brooksley E. Born, the head of the Commodity Futures Trading Commission, to abandon her efforts to regulate derivatives, including credit default swaps. These derivatives subsequently exploded in size and were a major contributor to the credit crisis.
  • In 1999, Congress repealed the Glass-Steagall Act, thereby allowing commercial and investment banks to exist under one roof and paving the way for the creation of "too big to fail" behemoths like Citigroup.
  • Congress, primarily Democrats, protected Fannie and Freddie from various efforts to rein in their growth and better regulate them. Consequently, they became massively overleveraged, which led to their downfall. In addition, their willingness to buy dodgy loans and securities based on such loans was an important contributor to the bubble.
  • The Bush administration and the Federal Reserve under Chairman Alan Greenspan were strong proponents of letting the private sector monitor itself, with a minimum of government regulation.

This New York Times article summarizes the Bush administration 's role:9

"From his earliest days in office, Mr. Bush paired his belief that Americans do best when they own their own home with his conviction that markets do best when let alone.

He pushed hard to expand home ownership, especially among minorities, an initiative that dovetailed with his ambition to expand the Republican tent—and with the business interests of some of his biggest donors. But his housing policies and handsoff approach to regulation encouraged lax lending standards.

Mr. Bush did foresee the danger posed by Fannie Mae and Freddie Mac, the government-sponsored mortgage finance giants. The president spent years pushing a recalcitrant Congress to toughen regulation of the companies, but was unwilling to compromise when his former Treasury secretary wanted to cut a deal. And the regulator Mr. Bush chose to oversee them— an old prep school buddy—pronounced the companies sound even as they headed toward insolvency.

As early as 2006, top advisers to Mr. Bush dismissed warnings from people inside and outside the White House that housing prices were inflated and that a foreclosure crisis was looming."

• Eliot Spitzer, who at the time was the governor of New York, blamed the Bush administration for yet another reason in a Washington Post column:10

"Even though predatory lending was becoming a national problem, the Bush administration looked the other way and did nothing to protect American homeowners. In fact, the government chose instead to align itself with the banks that were victimizing consumers.

' . . Individually, and together, state attorneys general of both parties brought litigation or entered into settlements with many subprime lenders that were engaged in predatory lending practices. Several state legislatures, including New York's , enacted laws aimed at curbing such practices.

What did the Bush administration do in response? Did it reverse course and decide to take action to halt this burgeoning scourge? As Americans are now painfully aware, with hundreds of thousands of homeowners facing foreclosure and our markets reeling, the answer is a resounding no.

Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye.

  • In response to the European Union's threat in 2002 to regulate the foreign subsidiaries of the Wall Street firms, the SEC in 2004 adopted an oversight plan—but then made it voluntary! Soon afterward, the Wall Street firms took on substantially more leverage, which contributed to their downfall. As former SEC Chairman Christopher Cox admitted in September 2008, "The last six months have made it abundantly clear that voluntary regulation does not work.' ' The program "was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily. The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate" of the program, and "weakened its effectiveness."11
  • Alan Greenspan essentially said that fixed-rate mortgages were too expensive and many Americans were foolish to prefer them, which gave the mortgage industry a green light to promote the risky adjustable-rate mortgages that have now gotten millions of homeowners into so much trouble, when he praised their virtues in this speech on February 23, 2004:12
  • R]ecent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.

American homeowners clearly like the certainty of fixed mortgage payments. This preference is in striking contrast to the situation in some other countries, where adjustable-rate mortgages are far more common and where efforts to introduce American-type fixed-rate mortgages generally have not been successful. Fixed-rate mortgages seem unduly expensive to households in other countries. One possible reason is that these mortgages effectively charge homeowners high fees for protection against rising interest rates and for the right to refinance.

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest-rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

In summary, politicians from both parties as well as regulators took a number of actions that contributed to the conditions for a bubble. Then, as things started to get crazy, they failed to recognize what was happening and take steps to address the problem—and, in some cases, they even exacerbated it.

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