Knowledge Briefs: The Real Cause of The Financial Crisis

Here’s an old entry cross posted from another blog

With everything that’s gone on in the past year and a half you would think that the case against deregulation would be pretty clear to even the most partisan person. After all, call me a “crazy liberal” but it seems like common sense that the government should demand that banks operating as insurance companies have enough money to pay off the “insurance” they’re selling . After all, we demand insurance companies do it. But the more I talk to even the casual conservative the more I hear this myth that the government encouraging lending to low income people who couldn’t pay their mortgages was the cause of our current mess.


So here I find myself, almost a year after the crisis hit its apex, trying to debunk this patently false myth. Of course, we could just do a few seconds of napkin math and figure this out for ourselves. The cost of all the mortgages in the United States + even the most insane interest rates < the estimated 11.96 trillion dollars lost because of this scandal.  But of course, that’s far to simple and straightforward to satisfy people who don’t even believe in evolution. So let’s break it down like C.R. Avery on the piano box

The Myth: The Financial Crisis was caused by banks forced into making bad loans to low income people by the Government

Conservatives love to talk about personal responsibility. That is of course, when it comes time for them to take responsibility for the mistakes they’ve made. The financial crisis at the heart of the economic recession we are in, and primary cause of our sky high unemployment rate, is no different. When you ask Republicans what cause the financial crisis, they don’t hesitate to place the blame on the two groups they love to hate the most. Low income people and the government.  Indeed, they answer so quickly that you’d swear that their response resulted more as a natural reflex rather than a careful and dispassionate examination of the facts. Had they done so, they probably would have realize how patently false this claim is.

The Truth: NO. Government encouraged lending to low income people DID NOT cause the Financial crisis.

The evidence against this myth is pretty cut and dry. Laid out clearly by Robert Gordon in the American Prospect. To help you digest his arguments more efficiently I’ll break them down point by point

1. The Community Reinvestment Act of 1977 was…well enacted in 1977, 30 years before the crisis:

The evidence strongly suggests the latter. First, consider timing. CRA was enacted in 1977. The sub-prime lending at the heart of the current crisis exploded a full quarter century later. In the mid-1990s, new CRA regulations and a wave of mergers led to a flurry of CRA activity, but, as noted by the New America Foundation’s Ellen Seidman (and by Harvard’s Joint Center), that activity “largely came to an end by 2001.” In late 2004, the Bush administration announced plans to sharply weaken CRA regulations, pulling small and mid-sized banks out from under the law’s toughest standards. Yet sub-prime lending continued, and even intensified — at the very time when activity under CRA had slowed and the law had weakened.

2. Non- CRA were responsible for the majority of faulty sub prime loans:

Second, it is hard to blame CRA for the mortgage meltdown when CRA doesn’t even apply to most of the loans that are behind it. As the University of Michigan’s Michael Barr points out, half of sub-prime loans came from those mortgage companies beyond the reach of CRA. A further 25 to 30 percent came from bank subsidiaries and affiliates, which come under CRA to varying degrees but not as fully as banks themselves. (With affiliates, banks can choose whether to count the loans.) Perhaps one in four sub-prime loans were made by the institutions fully governed by CRA.

3. CRA Banks were less likely to engage in dangerous lending:

Most important, the lenders subject to CRA have engaged in less, not more, of the most dangerous lending. Janet Yellen, president of the San Francisco Federal Reserve, offers the killer statistic: Independent mortgage companies, which are not covered by CRA, made high-priced loans at more than twice the rate of the banks and thrifts. With this in mind, Yellen specifically rejects the “tendency to conflate the current problems in the sub-prime market with CRA-motivated lending? CRA, Yellen says, “has increased the volume of responsible lending to low- and moderate-income households.”

Gordon has more information in his article, like warning from various Governors of the Fed, about the unsustainability of the housing bubble, but you’ll have to read the full article for that.

UPDATE: Here’s a lot more compelling evidence debunking this zombie myth

Paul Krugman graphs are more than a thousand words

Blame the poor minorities? How about the wealthy multiple house owners? Yves Smith OF Naked Capitalism reports that wealthy people are the most likely to default on their mortgages

Even governors of the Fed aren’t buying this CRA talking point

The FDIC chairwoman quite clearly says “CRA: NOT GUILTY”

Barry Ritholtz uses reverse logic to debunk the anti-CRA claim

Dainel Gross of Slate a must read article about the bullshit factual inaccuracies with this myth


The Rebounding Economy OR When “Socialism” Works

If you’re looking for some good news about the economy this should be very encouraging:

It is hard to miss the news: the stock market has been on a bit of a roll lately. But with far less fanfare, the credit markets, where the financial crisis began, are also showing signs of a spring awakening.

The revival is tentative and, like the gains in the stock market, which pulled back on Monday, it may well prove fleeting. But analysts say the improvements suggest that investors are starting to get some of their old nerve back, mainly because of sweeping federal efforts to get credit flowing again.

Credit markets and stock markets have largely been riding the same updraft in the last four weeks. A swell of optimism, ignited by the government’s new bailout plans and some positive chatter from banks about their profitability, has lifted shares from their lowest levels in 12 years and rescued credit markets, which had been stumbling back toward the bad old days of last year.

Government intervion into the free market is working?!?! I REFUSE TO BELIEVE THAT! But despite the dogmatic beliefs of certain people on the right this appears to be true.

If the credit market picks up in the United States, that would be a huge step in ending this recession. As the article states, the credit market is the part of the economy most effected by the poor economic climate. When banks and other lending institutions refuse to extend credit people can’t buy houses, small business owners can’t expand their business, and corporations can’t build new projects or buy other businesses. So with credit flowing again, the life line of the economy, there’s a good chance unemployment rates could start to drop and consumer spending began to increase. After all new projects and expanding businesses mean more jobs and ultimately more money flowing through the economy.

One last note, for all the complaints about government intervention, we often overlook one of the biggest benefits. A government guarantee is as good as gold in the private sector. Hate the government all you want but its true. (Treasury bonds anyone?) For all its misgivings, the government has one thing no private business can ever offer. Infinite resources and reliability. So when the government shows a commitment to restarting the credit market, businesses understand that whatever might happen the government will be there to back them up.

Which just goes to show, at their darkest hour, the free market is indeed a socialist.

The Conservative Argument For Regulation

For those of you who haven’t heard of him, Paul Singer is a very conservative man. Just look at his resume. Board member of the preeminent right wing publication Commentary, Chairman of leading free market think tank The Manhattan Institute, and occasional op-ed contributor for the Wall Street Journal.

So imagine my surprise when Mr. free market penned a column in today’s Wall Street Journal which not only places the brunt of the blame for the financial crisis on the private sector, instead of “minority homeowners”, but also calls for an increase of more government regulation.

Holy Crap!

While many of Mr. Obama’s ideas warrant skepticism, conservative opposition to any expanded role for government is a mistake. There is an urgent need for a new global regulatory initiative that addresses the primary cause of the financial collapse: highly leveraged and concentrated positions.

Reform must begin with a regulatory regime focused on “behavior” instead of “systemically important institutions.” Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.

It’s true that monetary policy was too lax for too long, and the government encouraged lending to people who were unlikely to repay their loans. But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.

Holy crap! Happy birthday to me…

The rest of Singer’s article is pretty good. In fact, when compared to the typical conservative argument, Singer provides several specific policy recommendations to fix our current broken system

But his basic point, that the free market can benefit from regulation, is a point worth repeating. What often gets lost in the conversation about regulation is the fact that a regulation is just a law that applies to businesses instead of individuals. But we have laws that govern individuals because without them we’d live in a chaotic society. The same is true for the free market. Can you imagine what would happen if a business just decided that it wouldn’t pay another business for a service rendered. Or if copyright laws didn’t allow pattens on new products? Luckily, you’ll never have to because the government, through regulation, stops these things from happening.