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Shining a Light on the Cause of the Great Recession

February 9, 2015 in Economics

By Richard W. Rahn

Richard W. Rahn

What do you think was the primary cause of the Great Recession — too little government regulation or dictates by the government to banks and other mortgage lenders, requiring them to lend to the unqualified?

Peter J. Wallison, former general counsel of the U.S. Treasury Department and White House counsel to President Reagan, who was also a member of the congressionally authorized Financial Crisis Inquiry Commission, has just published a book, “Hidden in Plain Sight,” in which he clearly documents what caused the financial crisis and why it is likely to happen again. For this act of detailed scholarship and truth-telling, he has come under fierce attack by many of those who were, in part, responsible for the crisis.

The Wallison narrative is straightforward. Traditionally, community banks made mortgage loans to customers and then kept and serviced the loans. The banks obviously wished to be repaid, so they only lent to those they considered good credit risks and who were able to make a reasonable down payment on the house, around 20 percent.

Expanded homeownership has been considered a social good, and measures to increase homeownership have been strongly encouraged by homebuilders, realtors, bankers and the political class. In order to increase the pool of lendable funds, many decades ago Congress set up Fannie Mae, and subsequently Freddie Mac, to buy mortgages from banks, thus enabling the banks to make more mortgage loans. For many years, Fannie and Freddie would only buy high-quality mortgages.

All seemed to be going well, but then “community activists” started complaining that low-income and minority consumers had much lower rates of homeownership and this was “unfair.” As a result, in 1992 Congress started passing “affordable housing goals” and over the years continued to increase those goals. The banks were told to make an increasing percentage of their loans to buyers who would not normally qualify, and Fannie and Freddie were in turn pressured or required to buy more and more of these nontraditional or subprime mortgages. Down payment requirements became easier and easier, and finally, in many cases, zero. Credit and employment history requirements became less and less strict, finally leading to the “no-doc” loan.

The Federal Reserve provided the necessary money expansion to accommodate all of the new mortgages. The community banks liked it because of the fat fees and the fact they could dump the bad paper on Freddie and Fannie, which in turn put many of these bad loans into mortgage-backed securities that they and the big banks sold on the world …read more

Source: OP-EDS

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