Was the crisis "actually imposed by the government?"
I was going to do an original post tonight, but the questions and comments are too much of a temptation, so I'll start right in.
Aodhan, you ask, "how significant was the government's inadvertent 'role' here in precipitating the crisis by pursuing the political goal of fostering home ownership?" Thomas Sowell, in The Housing Boom and Bust, has concluded that complex financial bets "went bad" only because "the government had exerted pressure over time on many lenders to make loans to the uncreditworthy" so that they could buy houses ( as you paraphrase Sowell). Financial instruments like credit-default swaps, of course, depended on those loans' performance, so they failed and brought down the financial system.
Thanks for the question.
Sowell is right -- to a point. American politicians' blind support of universal home ownership helped transform housing into the most destructive bubble we've seen in our times.
We learned from the 1920s that government should control borrowing for speculation. Before the 1929 stock-market crash, people could borrow nearly 100 percent of the money they needed to purchase stocks. The stock exchange and lenders thought this practice was perfectly safe (you'll read some unintentionally funny quotes illustrating this point early in my book!). After all, lenders could seize and sell stock instantly if a customer stopped paying.
Problem is, though, that you can sell stock instantly at the price you want until you can't, just as you can sell a house within a week at the price you want until you can't.
We learned the first lesson back then. To this day, thanks to Depression-era rules, the Fed and SEC forbid people from borrowing more than 50 percent against their stock portfolios. That rule is not to protect the stock purchasers. They can still lose all of their money; they can even lose some borrowed money if stocks fall fast enough.
The rule is to protect their lenders, and, more important, the financial system. Without such protection, lenders would curtail credit after a stock bust in order to cover their own heavy loan losses, exacerbating a recession.
In housing, down payments work like these limits on borrowing work in the stock market. Requiring a purchaser to put 10 or 20 percent down on a home doesn't eliminate the risk of prices going up or down. But it limits such price moves so that the economy can absorb them.
Requiring buyers to maintain 20 percent down payments -- or even 10 percent -- over the past 15 years would have averted many problems. It's true that many poor people would not have been able to buy houses. But, by the same token, many poor people who had already saved up to purchase their homes would not have found themselves victimized by mortgage brokers who pressured them into taking all of the equity out of their homes; they would have had to leave a cushion there of non-borrowed money to protect against any downturn. Many middle-class people would not have been able to afford McMansions, and many rich people would not have been able to afford two or three or five houses.
House prices could not have risen to the extent that they did, because as they rose, fewer and fewer people would have been able to come up with the down payment, dampening demand. When a (smaller) bubble burst, fewer people would have had a reason to walk away from their homes; they would have still had some equity, even if that equity had fallen far from 20 percent.
Down payments would have alleviated the fraud problem, too. If you don't have to put any money down, you'll say anything on a mortgage application. You are less likely to risk your own money behind your lie.
Why did down-payment requirements begin to disappear in the Nineties, when they were all that tethered house prices to reality? Politicians and regulators should have seen that people were borrowing to speculate with the value of the roof over their head.
Politicians failed to act, but not just because they wanted poor people to be able to buy houses. Rather, rising home prices solved middle-class problems. People could pull money out of their homes and buy lots of stuff. They didn't have to worry so much about their kids' education or their retirements.
Washington studiously ignored the housing bubble's potent dangers not to "help" the poor, but to "help" two-income families who loved seeing their paper wealth rise with every home sale on their block.
As for government impositions like the Community Reinvestment Act, which Cas mentions here -- yes, the CRA and other home-lending mandates were and are problems. But the government continually expanded "affordable-housing" requirements only because both Democrats and Republicans thought that "markets" were solving social problems with only the gentlest of nudges -- magic! Affordable housing was politically popular because nobody had to pay for it.
And what about those complex financial instruments? The only thing complex about them is that bankers and traders devised them, too, to escape old-fashioned limits on borrowing.
If you want to make a bet on the direction of oil prices on a regulated exchange, you've got to put some cash down. This requirement works the same way a down payment does. But if you were AIG in 2005, and you wanted to bet, through a "complex" derivative, that housing prices would never fall, you could do so -- and commit to potentially tens of billions of dollars in payouts if you were wrong -- with no cash down upfront.
What if AIG had to wire $10 billion in cash to an exchange for every $100 or even $200 billion that it made in bets? Its executives would have felt the risk that the money wouldn't come back, rather than consider it as an abstract notion, and they would have asked real questions.
If AIG had made the bad bets and failed, anyway, it could have gone bankrupt. Markets would have known that the rules had required AIG to put some cash down to cover at least some of the losses. The rule would have muted the panic.
The lack of "down payments" in financial markets, in fact, magnified the original problem multi-fold. Through synthetic derivatives, financial actors could take one $300,000 mortgage and spin $1 million worth of risk out of it, creating financial products whose value depended on the value of that one mortgage. There was no room for error.
If we had applied old rules to new markets -- in housing as well as derivatives -- we would be talking about something else tonight!