Mark Calabria

The events of September 2008, including the government rescue of Fannie Mae, Freddie Mac and AIG, along with the failure of Lehman Brothers, will go down as some of the most important in American economic history. Unfortunately, the five years since have been a wasted window of opportunity to address the structural flaws in our financial system.

Don’t get me wrong, a lot has been done. Sadly, most of it has been useless or outright harmful. The hours put into financial reform should not be our measure of success, but rather the effectiveness of those reforms and their actual relationship to the causes of the financial crisis. By this measure, it is clear that the Dodd-Frank Act went off track. The Act’s 16 titles and hundreds of pages bear little resemblance to the actual drivers of the crisis.

The narrative behind Dodd-Frank goes like this: predatory mortgage lending drove defaults, which crashed house prices (undermining the value of mortgage- backed securities), which ultimately triggered a run outside the commercial banking system (in entities like Lehman or the money market mutual funds), which caused panic because regulators lacked the tools to resolve these non-banks in the same fashion as banks.

The problem is that this narrative has more holes than Swiss cheese. First, the change in house prices preceded defaults. So unless mortgage defaults caused some Star Trek-style backward ripple in time, it should be clear that the driver of defaults was the decline in house prices.

This decline followed the inevitable increase in interest rates by the Federal Reserve in reaction to a heating economy. Rate changes directly impact housing prices by impacting both affordability and the discounting applied to valuing any asset.

So what did tip America’s economy into crisis? A property bubble. The bubble was driven by loose credit, which burst when credit tightened, and resulted in a market finally out of buyers willing to believe that house prices only go up.

If the problem was a bubble, what has been done to avoid another one? Essentially nothing. In fact, watching the Federal Reserve, it would be easy to conclude it is trying to create new bubbles.

Bubbles rarely occur in markets without some restrictions on supply. That is why the housing boom was concentrated in California, which had significant regulatory barriers to quickly increasing new housing supply. Florida, Arizona and Nevada had similar regulatory obstacles. These regulatory wedges between demand and supply drove the housing crisis, and they have only gotten worse, suggesting the next housing boom and bust could be bigger than the last.

Mark Calabria

Mark A. Calabria, is director of financial regulation studies at the Cato Institute.