The Government's Role in the Housing Bubble

(Note:  I realized after writing this that it came off like a grand theory of everything.  My argument is not that the government, all by its little lonesome, caused the housing bubble; it's that these things, along with many decisions in the private sector, helped create it.  Bubbles are a feature of asset markets, and I don't think that getting rid of either government or free markets could cure us of them.)

I never would have guessed that years in, we'd still be debating the role of the government in the housing bubble. Conservatives are still pinning most of the blame on the Community Reinvestment Act, while liberals are saying that there's no evidence that government played any significant role--unless, perhaps, it was all the fault of Alan Greenspan.

As it happens, I think that the government did play a role. A big role. But I think it's rather subtler, and thus, rather more problematic, than most people on either side are discussing.

To me, the unsung villain of the mortgage crisis is the 30-year fixed rate self-amortizing mortgage with no prepayment penalty.  This hothouse creature is beloved of liberals, who like any product that gives the consumer the power to shaft banks whenever it is to their advantage.  And it is beloved of conservatives because it smacks of sober citizens taking on modest, stable obligations they can meet.

But this product is about as stable as a nitroglycerine shot with a TNT chaser.  The 30 year fixed rate mortgage was ultimately at the heart of the Savings and Loan crisis.  Yes, yes, deregulation set the stage for the ultimate denouement--but the Savings and Loans were deregulated in such a haphazard fashion in part because they were being slowly driven into bankruptcy by their huge collection of low-interest, long-term real estate loans, in an environment where Paul Volcker had briefly driven short-term interest rates up to 20%.  While fraud and abuse were certainly rampant, the enormous scope of the problem was not due to S&L officers suddenly becoming more thievish, or regulators more tolerant of thievery, but because everyone in the industry was flopping as wildly a a beached sturgeon in an attempt to keep their banks solvent atop large portfolios of low-interest loans.  Meanwhile, whenever interest rates dropped, people would refinance, meaning that even the high-interest loans they did make didn't help much.

The answer to this, as you may recall, was . . . the creation of the massive private market in mortgage bonds.  In an environment with a floating currency and considerable worrries about inflation, the only thing that can neutralize the risks of the 30-year mortgage is laying them off to as large a pool as possible.  MIchael Lewis chronicles what happened next in the still-terrifyingly-relevant Liar's Poker.

Moreover, this product exists, as far as I can tell, only because of massive government intervention into the markets, a point that Reihan Salam and Chris Papagianis made in their recent, excellent piece.  Until the Great Depression, the mortgage was a very, very different product.  There was no amortization, and down-payments were often massive--half or more of a home's value.  They lasted perhaps 3 or 5 years, and were rolled over if borrowers could not meet the balloon payment.  The default crisis of the 1930s resulted from the inability to roll those loans, and so the government stepped in, causing the fifteen year self-amortizing loan to proliferate.  This process was especially accelerated by the VA loans that were offered to returning veterans.  Eventually, the payment terms stretched out to allow more and more people to buy homes.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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