Causes of the Financial Meltdown
Our current financial crisis is not the result of “deregulation run wild” or “the excesses of capitalism,” as some have claimed in recent weeks. On the contrary, government took many actions that worsened our problems with clumsy moves to manipulate the economy and markets.
- The Federal Reserve and Easy Money: For years, the Federal Reserve (which controls the money supply) set interest rates that were exceedingly low, especially from the period after September 11, 2001 until 2005. These low interest rates made it easy for individuals and businesses to borrow money, even those with sketchy credit histories or little income. This helped to create an enormous bubble in home prices that we have seen burst in stunning fashion recently.
- Fannie Mae and Freddie Mac: Fannie Mae and Freddie Mac were, until recently, government-sponsored enterprises that operated as private companies with the implicit backing of the American taxpayer. Because of their cozy relationship with the Treasury and their patrons in Congress, Fannie and Freddie took on much more risk than any truly private company could. That paid off when the housing market was on the rise, but declining housing prices led to the collapse of many of their investments and an eventual takeover by the federal government.
- Hastily-designed Accounting Rules: After the Enron accounting scandal, Members of Congress acted with extraordinary speed to create a huge new web of regulations. One of those, called mark-to-market accounting, forces institutions to record the market value of their assets rather than the income they produce. This is fine in many instances, but depressed housing prices mean that some assets based on mortgages have a much lower value on paper than in reality. The accounting rules then force banks and other investors to “write down” their value, in some cases to the point of insolvency.
- Harmful Lending Mandates from Congress: The Community Reinvestment Act (CRA), originally passed in 1977 and revised in the 1990s, requires banks to “meet the needs” of all types of borrowers in their communities. It was originally meant to combat racial discrimination, but quickly turned into a vehicle for the “affordable housing” goals of many in Congress. In plain English, that means that the federal government effectively strong-arms banks to extend loans to low- and moderate-income individuals, some of whom are unable to repay them.
- “Dirty” Tax Code: Our income tax code is filled with hundreds of credits, exemptions, and deductions, some of which are directly aimed at promoting home ownership and lowering its costs. Some of these provide powerful selling points on behalf of home ownership for individuals who might not otherwise be in the market.
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