I’ve already discussed the nature of the housing bubble, as well as the conditions that led to its start all the way back in 1995 (if you want the holistic view of things you may want to read those two posts first). Now it’s time to talk about what the actions were that appear to have set this whole bubble up.
The major change in US housing policy that occurred in 1995 was a revision to the Community Reinvestment Act (CRA). This revision was championed by Bill Clinton and passed by a Republican Congress. A true example of bipartisanship. The original CRA was passed in 1977 as an initiative of Jimmy Carter (what could go wrong). It was created in an attempt to make housing available to low-income persons who could not previously get banks to even talk to them about taking out a large mortgage.
The problem, as the Clinton administration saw it, with the CRA is that it had no teeth. It basically told banks that they should think about giving loans to people in low-income neighborhoods, but didn’t really force them to. The concepts for change, then, that the government tackled in 1995 (as noted by the GAO) were:
1) CRA enforcement insufficiently encouraged lending to low and moderate income individuals and communities.
2) The CRA was applied too subjectively.
3) The CRA generated excessive paperwork.
The end product of the revised CRA basically included the carrot and the stick for banks regarding low-income lending:
The Carrot: Fannie Mae (FNMA), A Government Sponsored Enterprises (GSE), had their mandates changed to coincide with the CRA change. FNMA essentially subsidizes the housing market by purchasing mortgages from lenders. They are able to borrow essentially at the same rate as the Federal Government, and use the money to purchase the mortgages. This props up profits and ensures the housing market stays liquid. In 1995, their goals were changed to include 40%+ of their purchases would go to LMI (low and moderate income) loans. This essentially ensured that lending institutions would have a market to sell their LMI loans to.
The Stick: If banks in subjected areas did not comply (make enough loans to required demographics) the government could impose penalties such as limiting expansion, shutting down branches, or even pulling FDIC insurance from banks. Essentially, if a bank did not hand out enough low-income loans they faced the stagnation of their business or even their own ruin. Non-compliance was not an option.
The argument is often made that the government never mandated that banks issue Sub-Prime loans (i.e. loans to those with less-than-prime credit). Technically, they did not. However, consider the position of a bank trying to comply: You must issue a certain number of loans to low-income individuals. You will certainly issue them to those with decent credit first. However, those with decent credit are a small subset of low-income individuals. If you can’t find enough of those individuals (which they often couldn’t) then you are stuck having to sell to the sub-prime market or risk the wrath of the government.
Heck, it doesn’t even matter if they could find enough people with great credit who fit the government requirement. The point is that we made a market where there was none previously and made sure that it was lucrative to be in that market. The sudden (and enduring) spike in demand from new buyers is what drove housing prices up drastically. Once we started that roller coaster, it was just a matter of time until everyone and their brother tried to make some money off of it. That’s what a bubble IS.
Our housing mess started with the best of intentions. We distorted the market in a dramatic way in order to try to help people achieve the American Dream. Unfortunately, large-scale actions always have unintended consequences.