Opinion: Market failure? 'I don't think so'

Many economists and policy makers are stating that the current financial crisis demonstrates that markets and capitalism are flawed and must be regulated and controlled, if not destroyed. But to make the argument requires a willful disregard of facts, according to William Boyes, a professor of economics at the W. P. Carey School of Business. "The role of bankers and other market players in causing the current crisis is undeniable," he writes, "but none of them would have undertaken their actions had it not been for the massive role played by government."

It is now taken for granted that markets and capitalism are flawed and must be regulated and controlled, if not destroyed. My colleagues in the economics profession are widely drawn to this attitude. The public discussion of the current debacle includes more references to market failure than to market success. Evidently, the message from the current economic crisis is clear — "It is the end of capitalism."

Barney Frank tells us that "the private market got us into this mess, the government will have to get us out." Even former Ayn Rand supporter and former Fed Chairman Alan Greenspan joined the market-failure parade. Bashing markets is politically popular. But to make the argument requires a willful disregard of facts.

The role of bankers and other market players in causing the current crisis is undeniable, but none of them would have undertaken their actions had it not been for the massive role played by government. The trigger for the financial meltdown was the U.S. subprime housing fiasco — a pure example of government failure and regulatory policy run amok.

Barney Frank in the House and Chris Dodd in the Senate along with Henry Cisneros, the top housing official in the Bill Clinton administration during the 1990s, pushed for loosened mortgage lending restrictions so first-time home buyers could qualify for loans they could never get before. The goal of the Democrats was to boost home ownership in the United States.

Reacting to these and other more significant policy changes, lenders such as Countrywide Financial in California set up units to service these so-called borrowers. When it went under, Countrywide had $170-billion in mortgage assets, most of them subprime. It was encouraged in this activity by the Clinton Administration, Barney Frank and Chris Dodd.

In fact, Clinton's HUD director Henry Cisneros served on Countrywide's board until it was acquired by Bank of America, and Chris Dodd and members of Fannie Mae and Freddie Mac executive corps received below-market special mortgage loans from Countrywide. The idea that the mortgage collapse is the product of unscrupulous agents and lenders roaming the country in a deregulated market searching for ignorant buyers is overwhelmed by the facts.

Deliberate government policies were enacted to destroy mortgage lending standards and socialize risk. It begins, in the 1970s, with the idea that U.S. mortgage lending practices prevented home ownership among low income and certain racial groups as a result of racial discrimination. The solution? Relax lending standards. The 1977 U. S. Community Reinvestment Act forced banks to lend equally to all geographic areas, regardless of risk.

It was argued that traditional income-to-loan ratios of 28 to 36 percent should not apply to low-income individuals. Lenders should not discriminate against certain sources of income, such as short-term unemployment insurance benefits. Government Sponsored Agencies (GSEs) Fannie Mae and Freddie Mac were forced by the Democrats to increase the percentage of "affordable loans" they made.

The Housing and Urban Department gave the GSEs a target of 42 percent of assets in the mid-1990s. The target increased to 50 percent in 2000 and 52 percent in 2005. In addition, for 1996 HUD required that 12 percent of all mortgages purchased by GSEs be special affordable loans — income less than 60 percent of the median in the area — then 20 percent in 2000, 22 percent in 2005 and 28 percent in 2008.

Politicians in Congress fueled the explosion. The incestuous relationship between Congress and the GSEs has not been made clear. For years, Fannie Mae and Freddie Mac — right up to their multi-trillion-dollar bankruptcy and seizure by the U.S. government earlier this year — roared out of control. They funded politicians' interests, kept mortgage interest rates low and became government-backed agencies for trillions of dollars in risky mortgage lending.

Look at who received the greatest contributions from the GSEs and you will see who was unwilling to rein them in. Between 1995 and 2007, the combined balance sheet of Fannie Mae and Freddie Mac, including Mortgage Backed Securities (MBS), rose from $1.4 trillion to $4.9 trillion, an annual increase of almost 15 percent. About $1 trillion of Fannie/Freddie activity involved exposure to subprime and lower-grade mortgages.

In 2004, then-Fed Chairman Alan Greenspan warned of the looming risk in the government-backed mortgage lenders. Fannie and Freddie, he said, were taking on trillions in mortgage assets without properly accounting for, or charging for, the risk embedded in the new lax lending standards. In 2005, Greenspan explicitly warned of "systemic risk" if the two operations failed to change their ways. John McCain introduced legislation to restrict the activities of these agencies; it was defeated by the democrats, including Barack Obama.

The loosened standards meant that investors could purchase several homes without having any "skin in the game." Housing prices shot up. This gave rise to even greater use of credit, as speculators and buyers piled onto a machine that seemed to offer no risk and guaranteed gains. Not all funding came via government and regulatory overreach.

Hundreds of billions were raised through new mortgage-based securities and other risk-distribution vehicles by private players, as these mortgages, issued under no lending standards, were packaged and then sold as AAA-rated securities. AAA rating? Who gave them this sterling rating? Essentially the government did. There are only three rating organizations approved by the SEC: S&P, Moody's and Fitch.

These three earn money by favorable ratings. Lack of genuine market competition in the ratings business meant that the ratings firms became part of the social program. The new mortgage myth claimed that subprime mortgages issued under lax standards to low-income Americans were no more risky than prime mortgages, especially when they were packaged into large agglomerations. Ratings inflation ensued, with AAA and other high ratings accorded to all manner of high-risk mortgage products.

Investment houses became part of the regulatory imperative. A sales pitch from Bear Stearns, circa 1998, tells investors that the old mortgage lending rules have been replaced and that mortgages granted under Community Reinvestment Act provisions are as safe as prime mortgages. "Do we automatically exclude or severely discount loans [with poor credit scores]? Absolutely not," said Bear Stearns.

Crucial to the story is the role of another U.S. government agency, the Federal Reserve under Alan Greenspan. Greenspan's low-interest rate policy, which brought the Fed funds rate to 1 percent through much of 2003, helped push home values up even higher. As values rose, the lax lending standards started to look even better. Everything seemed to be working so well that rating agencies, Fannie, Freddie, investment dealers, bankers and buyers became even more aggressive and more confident in the new flexible lending standards.

The mortgage and financial crisis now sweeping the world is the result of unintended consequences brought on by government policy and regulation. What we are witnessing today is a growing pyramid of government failures. It is not a failure of free markets; it is a failure to have free markets. Solving the problem by enlarging government's role in the economy is the road to socialism, not the road to salvation.

Opinion by William Boyes, professor of economics at the W. P. Carey School of Business.