Regulation and the subprime mortgage crisis

For free market advocates, it will come as no surprise that the subprime mortgage crisis was largely the result of government mismanagement of the economy. With the growing popularity of Bernie Sanders, I wanted to take a look at how socialism specifically caused the recent Great Recession and comment on what we should have learned going forward.

A significant housing bubble was inflated, in part due to the low interest rate at the Federal Reserve Bank. When the federal funds rate, the interest charged on interbank loans, is low, this encourages more borrowing between banks. Under a free market, this rate would be set by the supply and demand of loanable funds. The Fed sets this rate through a process know as open market operations. If the rate is higher than the target rate, the Fed creates more money to drive the rate down.

Under free market interest rates and without a outside agency that can create money out of thin air, interests rate reflect the value of money. Under this system, banks try to make loans to the most credit worthy applicants, those at the lowest risk of default. As the Fed injects money into the banking system to reduce the federal funds rate, banks are forced to make loans to less and less credit worthy applicants. This is one which in which the Federal Reserve creates unstable economies.

As the number of poor credit borrowers increases, the banking system becomes more unstable. A higher number or risky borrowers means a higher percentage of defaults. Since lenders depend on the payments streams from borrowers to pay their obligations, if too many defaults occur banks can pay depositors and a bank panic ensues.

One way to protect themselves from the risks of default is to sell the debt. One of the investments created from bank lending is mortgage backed securities. By pooling together multiple mortgages, the security can reduce the risk of loss. Because mortgages are backed by real property, even those mortgages that default can be foreclosed on and a portion will still be paid, further decreasing risk.

Under normal circumstances, mortgage back securities are a good investment tool. But in the ’00s, with low interest rates fueling a housing bubble, the riskiness of these securities grew.

Another problem was also looming. Bank lending was disproportionately going to whites and Asians but not to blacks and Hispanics. The reason is that blacks and Hispanics tended to have much poorer credit and are more likely to be unemployed. There have been accusations that banks would deny loans higher income blacks and Latinos while granting loans to non-Hispanic whites. This disproportionate lending lead to more government scrutiny which resulted in decreased lending standards. Since loans were already being passed on to third parties to be included in mortgage back securities, banks were more willing to make risky loans.

While all this is happening, housing prices were increasing. There is an inverse relationship between housing prices and interest rates which means the low mortgage rates spurred by the low federal funds rate pushed up housing prices. Risky loans were considered less risky because the rising house prices made it seem that even if there was no down payment and the borrower defaulted, the value of the house would continue to rise ensuing that the loan could be repaid with the funds from a foreclosure.

Because the system was unstable, a large number of homes were in default. Owners of mortgage back securities lost money, including many funds that were legally required to invest in only triple A rated investments. The best of these investments was the mortgage backed securities.

What should we take from this? The Federal Reserve deserves a significant amount of the blame. The housing bubble was the direct result of the low interest rates that the Fed used to attempt to get the economy out of the prior recession.

The culmination of multiple governmental failures lead to the Great Recession. And unlike when there is a failure under the free market, when government regulation fails, no one is held accountable. Yes, some banks acted poorly in response to the situation the government created. This is not the free market or capitalism’s fault. These banks should have been allowed to fail. The bailouts created a moral hazard problem that guarantees that next time the government fails, it will be worse.

If government is supposed to represent the will of the people, regulation reflects socialism. This means that the Great Recession can be blamed on socialism. We should have learned that giving a group of people the power to control the economy who cannot be held accountable when the fail is a terrible idea. Instead, many Americans are turning to Bernie Sanders. Sanders does not want to fix the problem because he does not want to know what caused the problem.

And when the next recession hits, will the people finally call for more economic freedom or will they demand that those responsible be given even more power.

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