Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Did A Fair Lending Law Cause the Financial Crisis?

Financial Crisis

Over at Alternet, Joshua Holland takes me to task for arguing that the Community Reinvestment Act contributed to the financial crisis by encouraging banks to adopt lax lending standards.

Despite Holland’s title—CNBC Editor Launches Sloppy,Dishonest Attack on AlterNet in Defense of Wall Street—I don’t think there’s actually that much distance between us.

Holland—who I mistakenly called Hollander in my post, probably because I had a chum in elementary school called Josh Hollander—argues that it wasn’t bad mortgage lending practices that caused the financial crisis and subsequent economic downturn. He’s absolutely right about that.

In order for loose mortgage lending to become a full-blown financial crisis, several other things had to happen.

As I explained back in 2009:

Just to make things clear, I think that to really blow things up we needed low interest rates, the growth of securitization, a glut of foreign savings pouring into the US, a lack of yield from other asset classes, ratings agencies operating with minimal knowledge but lots of optimism, a faith in the ever-rising housing market, high oil prices, consumers looking to flip high-interest unsecured debt into lower-interest home-equity debt, a short-term federal budget surplus eating into the availability of Treasury debt, Fannie and Freddie’s mixed mission, the evaporation of profits from investment banking and brokerage, unrestrained shareholder demand for high profit margins, off-balance sheet financial innovations such as SIVs, unconvincing and non-influential risk managers, risk-pricing of MBS based on CDS pricing, a White House dedicated to expanding low-income and minority home ownership for partisan political reasons, economists touting the positive externalities of home-ownership, a poor understanding that heterogeneous populations have different responses to market movements and over-reliance on centralized and automated mortgage underwriting.

That’s quite a mouthful, I know.

To put it more simply, I think it is a mistake to characterize the financial crisis as a “market failure” or a “crisis of capitalism.” It was brought about by the collision—or perhaps collusion—of regulators and bankers that led to too much exposure to mortgage-related risks.

The most important cause of this was likely the shared view of regulators and bankers that mortgage-securities and derivatives were not very risky.

Even more simply: the problem was an overcrowded trade. If just a few banks had decided to go hog wild in the mortgage market, we would have had bank failures but not a crisis. But the fact is that the balance sheets of almost every major financial institution in the US were heavily exposed to mortgages. It was homogenization that caused the crisis.

We’re seeing the same thing unfold in Europe, by the way. Regulators and bankers there took the not-unreasonable view that the sovereign debt of European governments was nearly risk-free. So the balance sheets of European banks are overflowing with sovereign debt, which regulations required them to hold as capital against the supposedly risky-loans.

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