What went wrong?
The causes of the financial meltdown of 2007-9 continue to be researched and debated by macro economists and financial analysts. It is likely to be years before a definitive analysis becomes widely accepted. Despite that debate, at least one antecedent to that disaster is present in nearly all explanations: government policy measures over many years to expand subsidies to owner occupied housing for poorer Americans were plagued by faulty incentives.
These incentives had very malign consequences for the financial sector of our economy. Under appreciated risks arising from poorly documented mortgage applications grew prodigiously. Mortgage companies were incented to write mortgages for individuals who could neither afford their ultimate financial obligations nor often understand them. Wholesale funding of such faulted mortgages received huge support from monetary policies that promoted world-wide yield searching. Credit rating agencies were suborned by the profitability of creating triple-A credit ratings for mortgage backed securities. Regulations that required many institutional investors to buy only securities with triple-A ratings created disastrous portfolio incentives. GSE’s were incented to expand their guarantees of subprime and Alt-A mortgage paper. Without question, short run political objectives overran prudential common sense.
Thoughtful observers of American political economy should be alarmed how the politics of subsidizing the “poor” to acquire housing is ‘back in the game.’ While no one has demonstrated that weak mortgage underwriting standards truly work to reduce long term poverty, appearing to make more credit available to individuals and families that they may not be able to support has undeniable voter appeal. Politicians operate on a short run electoral cycle. Faulty incentives are ignored or buried under political rhetoric.
In the aftermath of the financial panic, tightened standards on mortgage underwriting were the order of the day in 2011. Regulators insisted on a minimum of a 20% down payment or lenders had to retain a minimum of 5% of the loan if the loan was resold to investors. Prior neglect of such incentives had resulted in a serious financial disaster. It appeared that policy makers were moving in the right direction by focusing on inappropriate incentives for poor financial behavior. Sadly, this reform diet has now proven to be too strict for politicians who observe what appears to be an inadequate restoration of the housing sector. The result is bad incentives for mortgage underwriting are back in play.
Under the new compromise, regulators won’t require a minimum down-payment (20% goes to 0%), and broad exemptions for banks and mortgage issuers to retain portions of these securities will be granted. (Ziebel and Ackerman “Softened Mortgage Rule Advances,” WSJ 6/11/2014). Policy memory seems short indeed. Whatever failures there have been in not modifying many of these defaulted mortgages, remedies for housing’s slow recovery ought not to center on creating bad incentives once again in mortgage underwriting.
Washington now apes the Bourbons of pre-revolutionary France. “They learned nothing and forgot nothing,” said Talleyrand, some forty-odd years after the catastrophe of the French Revolution. With ultimate policy discussions driven by electoral politics rather than sound economic analysis, it is truly remarkable that current-day academic macro economists continue to research the real causes of the Great Recession. Even if economists come to a widely accepted conclusion, it is highly doubtful that policy makers will care, much less alter government policies to prevent such debacles from again occurring. Plus ça change, plus c’est la même chose.