Rooting Out the Reason for the Bailout

Rich Tucker
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Posted: Sep 26, 2008 6:30 PM
Rooting Out the Reason for the Bailout

It’s a favorite game in Washington: Politicians want to identify the “root causes” of a crisis, usually so they can excuse bad behavior and spend more of our tax money.

Poverty’s a problem? Too many of our leaders want to find the “root cause.” It can’t be something simple, such as, “Individuals are making poor decisions” (having children out of wedlock, dropping out of school). No, the “root cause” must be “there aren’t enough federal welfare programs; let’s create some more.”

Yet this week, as the Bush administration and lawmakers are racing to pass a $700 billion bailout plan for Wall Street, few seem interested in digging into the real root causes of the financial meltdown.

Oh, sure, everyone’s ready to talk about root causes, but only if they can identify their own root. “There’s no getting away from the fact we have to go after the root cause here and try to rewrite these mortgages,” Sen. Hillary Clinton announced on CNN. But as the New York Democrat later admitted, “I think that everybody has to take responsibility.”

And indeed, “everybody” does, because this is the ultimate non-partisan disaster. Over the decades, the federal government entangled itself in the mortgage market, because policymakers of both parties decided it was a good idea for Washington to encourage home ownership.

The problem isn’t limited to the bad mortgages that Sen. Clinton mentioned. The root goes deeper than that. It’s that the government encouraged -- even forced -- lenders into making bad mortgages. And, again, this was a non-partisan policy position.

It was President Bill Clinton’s administration that set a goal of having 67.5 percent homeownership by 2000, a goal that was eventually exceeded, but only after lending standards were relaxed.

President Bush pushed even farther. In 2004 he asked lawmakers to eliminate the down payment normally required for FHA loans. Federal Housing Commissioner John Weicher told USA Today the proposal was the “most significant FHA initiative in more than a decade.” It certainly was, as it eliminated the very feature that had traditionally kept bad credit risks from obtaining loans.

Mortgage lending took what presidential candidate Barack Obama called a “reckless and unsustainable turn,” economics professor Stan Liebowitz wrote in the New York Post, “because of regulation -- regulation driven by liberals and progressives, not free-market ‘deregulators.’”

The federal Community Reinvestment Act (passed during the Carter administration and amended during the Clinton administration), Liebowitz writes, tossed aside “traditional lending requirements such as requiring a down payment or limiting mortgage payments to 28 percent of income.” These requirements, according to requirements issued by the Boston branch of the Federal Reserve, were “arbitrary” and “outdated.”

The new policy “worked.” Home-ownership rates jumped, starting in 1995. Of course, with more buyers chasing (roughly) the same number of housing units, prices started soaring, as the law of supply and demand would predict.

Eventually prices rose too high, creating the bubble that popped last year (as all financial bubbles do, eventually). On the way up, government-sponsored enterprise Fannie Mae bragged in a 2002 report that it had succeeded in “fundamentally altering the terms upon which mortgage credit had been offered in the United States from the 1960s through the 1980s.” The company called that “mortgage innovation,” but it was an innovation that eventually caused today’s collapse.

The reason this is a non-partisan problem is that, if we were in year eight of the Gore administration, with a Democrat Congress elected in 2002 with 61 senators, it’s difficult to see what would be different.

Washington would have kept the mortgage interest deduction in place. It would have insisted banks lend to people who are bad credit risks.

The solution isn’t going to be politically popular. The federal government shouldn’t try to encourage growth in the housing market. It should wind down its involvement, and that should include a gradual phasing out of the mortgage interest deduction. As a bonus, that would be the critical first step down the road to a true flat tax rate. If the housing occupancy rate drops in a free market, so be it.

The government is the “root cause” of today’s housing crisis, and less government interference is the long-term answer.