Tuesday, February 17, 2009

Government and Business

What caused the sub-prime credit crisis? Liberals say that it was a combination of predatory lenders and lax regulators enabled by President Bush's laisseze-faire policies. Conservatives say that the Community Reinvestment Act forced banks to issue loans to people who should never have been home-owners. A recent column in Forbes by Peter J. Wallison and Edward J. Pinto supports the conservatives' argument and supplies facts and figures to support their contention.

The point of the Community Reinvestment Act was to increase home ownership rates among minorities. Using this act as a base, the Clinton administration took action against several major banks. The banks were accused of redlining areas. The banks argued that they were not excluding minorities (this would be difficult since loan applications do not include race). The problem was that a disproportionate number of minority members didn't meet traditional standards for getting a loan. The government told the banks to change their standards. They also ordered Fannie Mae and Freddie Mac to start increasing the number of loans they serviced for these groups.

Sidebar - Fannie Mae and Freddie Mac were created during the Depression to free up bank resources. Banks issue mortgages then sell them to Fannie Mae and Freddie Mac. These entities are Government Sponsored Enterprises (GSEs) created by the government and are guaranteed lower-than market interest rates.

As ordered, the banks dropped most of the traditional restrictions on loans. Previously you had to have a substantial down payment and the amount you could borrow was based on your income. These restrictions were dropped and the bank regulators were instructed to be sure that the banks were sticking to the new standards. In other words, the problem wasn't that there were no regulators, the problem was that they were pushing the wrong regulations.

What about predatory lenders? Yes, they existed but they only amounted to 5% of all mortgages. The GSEs were a bigger problem since they were willing to buy low quality loans. Forbes points out that nearly 20% of Fannie Mae's loans in 2001 and 2002 were to people below the traditional minimum credit score.

The Bush administration bought into the Clinton-era policies that increasing home-ownership was always a good thing. Home-owner rates increased by 3.3% under Clinton and 1.7% under Bush. Even Barney Frank, a long-time supporter of affordable housing loans now admins that many of these people would have been better off renting.

Eventually the bubble burst. For decades the home ownership rates and the mortgage default rates had been stable. This new influx brought an unprecedented wave of defaults which dragged down house values which is leading to even more defaults.

The whole thing started with the government telling banks to alter their business practices in order to meet a social goal.

This is important because, under President Obama, the government is likely to be involved in an expanding number of businesses. Obama and the Democrats have already taken control of executive pay for banks and warned them that, from now on, conventions can only be held in boring cities.

In the next few days GM and Chrysler will be asking for more money. Democrats are anxious to take over their businesses, also. Many are suggesting that Detroit should be mandated to make smaller cars and/or hybrids. Again, the desire for social policy is likely to supersede good business.

Many Democrats believe that the current economic problems refute Reagan and the idea of small-government. A closer look at our problems shows that it was government interference in markets that brought us where we are now and that further tampering is likely to make things worse.

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