March 28, 2008, INVESTORS BUSINESS DAILY. http://www.investors.com/editorial/editorialcontent.asp?secid=1502&status=article&id=291507506135021
Blame Federal Gov't, Not The Fed, For Subprime Mortgage Problems
BY JEFFREY ROGERS HUMMEL AND DAVID R. HENDERSON
Investors Business Daily
Many prognosticators on the economy blame the Federal Reserve for the
current subprime crisis. But a careful look at the evidence shows
that monetary policy, whatever its faults, did not cause the subprime
mess. At least part of the blame is on the feds, not the Fed.
Why do people judge the Federal Reserve, whether under Alan Greenspan
or Ben Bernanke, to be a major cause of the subprime bust? They note
how low interest rates were from 2002 through 2004 and make the
classic mistake of using interest rates to judge monetary policy. If
interest rates are low, they reason, monetary policy must have been
excessively expansionary.
Years ago, Milton Friedman pointed out one problem with this
reasoning by emphasizing the distinction between nominal and real
rates. Nominal rates can be low because expected inflation is low, an
indicator of tight monetary policy.
A second problem is that interest rates also can change as a result
of real factors involving supply and demand. In short, the market
ultimately determines interest rates.
While central banks are big enough players in the loan market (and
the quintessential noise traders to boot) that they can somewhat push
rates up or down, globally integrated financial markets reduce that
ability.
Greenspan is therefore correct when he attributes the unusually low
interest rates early this decade to a massive flow of savings from
emerging Asian economies and elsewhere.
The better way to judge monetary policy is by the monetary measures:
MZM, M2, M1 and the monetary base. Since 2001, the annual year-to-
year growth rate of MZM fell from over 20% to nearly 0% by 2006.
During that time, M2 growth fell from over 10% to around 2%, and M1
growth fell from over 10% to negative rates.
The Fed most directly controls the monetary base. Its year-to-year
annual growth rate since 2001 fell from 10% to below 5% in 2006 and
now is 2%. Also, nearly all of the growth of the monetary base went
into currency, much of which is held abroad.
The banking deregulation of the early 1980s admittedly attenuates the
Fed's control over the broader monetary aggregates. But when all the
measures agree, the message is clear: Monetary policy was not
expansionary.
To see how the government contributed to the subprime mess, we must
look at the feds, not the Fed. The feds helped create the problem in
three main ways.
First, the federal government contributes to what economists call
moral hazard -- that is, people taking risks because they know that if
things turn out badly, someone else will bear a large portion of the
cost.
The federal government's semiautonomous mortgage agencies -- Fannie
Mae, Freddie Mac and Ginnie Mae -- all buy and resell mortgages. Of
the more than $12 trillion in mortgages in existence, one-third of
them are owned by, or were securitized by, Fannie Mae, Freddie Mac,
Ginnie Mae, the Federal Housing and Veterans Administration, plus
other government agencies that subsidize mortgages.
Although Fannie Mae and Freddie Mac are no longer government
agencies, their status as government-sponsored enterprises causes
people who buy their repackaged loans to assume an implicit federal
government guarantee. Also, to the extent government views large
lending companies and banks as "too big to fail," it contributes to
moral hazard.
For the market economy to function well, it needs to be a profit
system and a profit-and-loss system, with the losses being the
penalty for bad decisions.
The second way the feds contributed to the subprime mess was with a
little-noted change in regulations by the comptroller of the currency
in December 2005 that acted as the trigger.
Financial planner Less Antman has pointed out that the comptroller
started requiring banks to require minimum payments on credit card
balances, causing increases of at least 50% for most cards and as
much as 100% on others. Many people who hold subprime mortgages are
people for whom a higher monthly payment on a credit card would be a
problem.
Imagine that you're such a person and that before you always made
sure you made your mortgage payments. With the new regulation, you
instead make your credit card payment but miss your mortgage payment,
a widely observed transformation in the traditional American
delinquency pattern.
Thus the comptroller's apparently small change in regulations had the
unintended effect of causing some mortgage borrowers to default.
The third federal contributor to the subprime crisis is the Community
Reinvestment Act. This act, first passed in 1977 and beefed up in
1995, requires banks to lend to high-risk areas that they otherwise
would avoid. Those banks that fail to comply pay fines and have more
difficulty getting approval for mergers and branch expansions.
As Stan Liebowitz, a University of Texas economist, has pointed out,
a Fannie Mae Foundation report enthusiastically singled out one
mortgage lender that followed "the most flexible underwriting
criteria permitted." That lender's loans to low-income people had
grown to $600 billion by 2003.
Its name? Countrywide, the largest U.S. mortgage lender and one of
the lenders in the most trouble for its lax lending practices.
How ironic, then, that the same federal government, and many of its
boosters, now attack Countrywide for following the very policies the
government wanted earlier.
Without any further bailouts, the government could reverse some of
the steps that led to this debacle. Will it? Not likely.
Hummel is an assistant professor of economics at San Jose State
University. Henderson, a research fellow with the Hoover Institution
and an associate professor of economics at the Naval Postgraduate
School, is the editor of The Concise Encyclopedia of Economics.