[This is part of a series, which is introduced in the posting titled “Unintended Consequences” here.]
There is a lot of blame to spread around for the housing crisis we are still experiencing and the accompanying financial crisis. The main stream stories mostly point at rapacious rich bankers. I donâ€™t doubt that greed played a large role â€“ but we always have the potential for greed to interfere with the efficient flow of the economy. What enabled greed to cause so much trouble this time? I have heard of some options and will expand on these as time goes along:
U.S. government policies were explicitly designed to encourage home ownership. At first this supported standard loans to generally credit-worthy buyers â€“ but in the form of 30 year fixed rate mortgages with no pre-payment penalty. That put all the risk on the bankâ€™s shoulders and little on the homeownersâ€™. Then the government began pushing for more and more loans to ever more marginal buyers â€“ those the market would not serve because they were too risky. If you increase the risk of your portfolio of loans, lending to ever more risky borrowers, it only should be expected that more and more loans would default. [Edit 2011-02-08:] Arnold Cling has a nice post on EconLog about Peter Wallison‘s work on Freddie and Fannie’s role in the housing crisis. His conclusion: They were the main cause.
US v Canada â€“ Canada did not have the magnitude of housing crisis the United States did, by a long shot â€“ why? Possible answers: no government guarantees (check on that), no 30 year loans, pre-payment penalties were allowed. 10 or 20% down was the norm. Presto, no housing crisis! A coincidence? I think not.
The next thing Iâ€™d like to research is the rules that encouraged credit default swaps. This is a dense topic so Iâ€™d welcome any pointers anyone has to offer.
Update July 3, 2011: George Will has an excellent book review of â€œReckless Endangerment,â€ a book by Gretchen Morgenson and Joshua Rosner which describes how the government pushed policies that led to the housing crisis. [HT Don Boudreaux on Cafe Hayek.]