The Subprime Government Crisis

The Subprime Government Crisis

by Mark Luedtke

I studied several dozen articles to understand the subprime mortgage crisis that exploded into a full-blown credit crisis, and not one of those articles mentioned why lenders make subprime loans in the first place. In case you don't remember, here's the opening paragraph of an article from the Dec. 9, 1993 Los Angeles Times:

WASHINGTON--The Clinton Administration, hoping to generate billions of dollars in new loans for small businesses and residents in poor and minority neighborhoods, on Wednesday unveiled proposed new rules requiring banks and thrifts to aggressively seek new customers in all parts of their communities. Federal regulators will now be much tougher in demanding that financial institutions make credit available to the poor as well as the affluent, said Comptroller of the Currency Eugene A. Ludwig, whose recent travels have taken him from South-Central Los Angeles to a reservation in North Carolina to hear complaints about the lack of credit in low-income areas.

Thanks, Hillary.  Barack Obama also used his "fair housing" law expertise to force banks into making subprime loans.  In a free market, lenders decide the terms of the loan, and whether or not to make a loan, based on risk assessment. But liberals didn't care about risk. It wasn't their money at stake, so they used government to force lenders to make loans to people who had a high risk of defaulting. Today liberals call those same lenders predatory lenders, condemn them for making risky loans, and blame them for the failure of people to replay their loans.

Government can't change the laws of economics, just pervert them, and the consequences are always bad. These lenders didn't want to be saddled with the inevitable losses from defaults, so they bundled those loans with safe loans into mortgage securities and sold them, diffusing the risk into the entire financial system.  But these securities further perverted the free market. All the sudden lenders didn't have to worry so much about risk since they planned to immediately package and sell the loans. Government's perversion of the free market broke down the natural incentive system that normally makes it work so well.

But the subprime crisis is just the tip of the spear of the credit crisis. According to the Mortgage Bankers Association, 45% of foreclosures are on prime mortgages. When Bush took office in 2001 as the economy dove into recession, the Fed lowered interest rates to to stop the decline. As government spending and debt ballooned out of control, the Fed held interest rates artificially low for the entire first half of the decade to make the economy appear stronger than it actually was.

Those artificially low interest rates powered the house flipping craze. You don't have to get up from your TV to see the evidence of how government involvement in the free market perverts our economy to the detriment of Americans. You can't scroll through the channels without running into some show about house flipping. An entire industry was created by artificially low interest rates.

Interest rates are the metric investors use to determine when to borrow and invest money. Artificially low interest rates prompted investors to continue to borrow money and buy houses, artificially driving up home values. The house flipping craze replicated the subprime problem into the mainstream housing market. Mortgage securities weren't just infected with bad subprime loans, they were infected with prime loans for overvalued homes.

Between subprime loans and artificially low interest rates, a correction was inevitable. As the Fed raised interest rates to halt the inflation that had resulted from the artificially low rates, the housing bubble burst spectacularly. Investors were stuck with mortgages that cost more than the value of the homes. Many simply walked away to cut their losses.

The US tax code also played a major role in creating this crisis. The tax code encourages investors to borrow money by allowing investors to deduct interest payments on the borrowed money, so Wall Street firms don't keep a healthy amount of cash to cover a run by their investors.  Low interest rates also encouraged financial institutions to carry more debt.  Without strong cash reserves relative to debt, the financial system becomes a house of cards.

So this credit crisis was caused by at least 3 well-intentioned government policies that perverted the free market. As Friedrich Hayek warned us in The Road to Serfdom, central planning, no matter how well-intentioned, always creates worse problems than the problem it was intended to solve. Socialism is a downward spiral to poverty and tyranny because when central planning inevitably fails, socialists always intrude further into the free market, creating ever worse problems and political unrest. We're living that downward spiral.

When the housing bubble burst, the Fed had to prevent the financial card house from collapse. Government broke it. Government had to prop it up. But government can't fix it.  Thanks to the Fed safety net, financial institutions have less incentive than ever to control risk.  Government shifted that risk to taxpayers.

Now Democrats want more government which will cause more problems, and Republicans want little change.  Neither address the root problem: government.  J.P. Morgan arranged a private bank rescue in 1907 because it was in his own interest. Uncorrupted by government, the free market corrects itself because of natural incentives. The solution is to extricate government and stop the perversion of the free market so those natural incentives will return and repair our financial system. Stop forcing lenders to make subprime loans. Stop holding interest rates artificially low. Adopt the FairTax.