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The collapse of the U.S. housing market which led to the great recession of 2008-9 could have been averted with better technology. The financial disruption from a collapse in housing prices quickly spread from Wall Street to Main Street. Frightened by falling house prices and job losses, consumers cut back their shopping and businesses their investing. Meanwhile financial markets, overloaded with mortgage-backed securities and rapidly depreciating hedges, began to fail. In a desperate attempt to rescue faltering banks and other major lenders the government stepped in with massive bailouts.

It serves to review the basics to avoid a repetition. Lenders face a challenge evaluating borrowers before funding a loan, and after a loan is issued. Hidden information known only to borrowers which materially impacts their ability to meet the terms of a loan can steer lenders to over-issue or underprice loans—i.e. the problem of “adverse selection.” Borrowers might also be inclined to take bigger risks after being issued a loan which may be hard for lenders to observe, also leading to over-issuing or underpricing loans—i.e. the problem of “moral hazard.”

Lenders need ways to acquire and process information about borrowers to set suitable terms for loans, and to monitor those loans after they are issued. Credit agencies, banks, and other lenders collect data to generate scores that predict default risks. In theory, financial instruments—stocks, bonds, mortgage-backed securities, collateral debt obligations (CDOs), etc.— allow individual creditors (in some cases even countries) to diversify risks across a multitude of household and business borrowers.

In the years leading up to the financial crisis mortgage loans were often issued with little or no documentation. The reason is that creditors (both banks and mortgage companies) collected fees to issue mortgages, but only needed to retain a fraction of them, and so were not terribly concerned about default risks. In any case, recent history pointed to sustained increases in housing prices. The loans were bundled into CDO’s, etc. and sold to unsuspecting buyers around the world who mostly failed to perform due diligence, often relying on flawed scoring by rating agencies.

It is tempting to blame the financial crisis on Wall Street, greedy bankers and market failures. Clearly, predatory mortgage brokers, greedy investment bankers, incompetent rating agencies, overly optimistic investors, shortsighted homeowners, and financial innovators of complex derivatives all played a role in the crisis. But it is a mistake to blame them for doing largely what government policies were designed to encourage.

Capitalism is not the culprit. In fact, well-intentioned U.S. government monetary and housing policies may have been at the root of the crisis. John Taylor of Stanford University offers convincing empirical evidence that “government actions and interventions caused, prolonged, and worsened the financial crisis.” Several key U.S. policies to increase home ownership played a role. Designed to address alleged discrimination, and to protect minorities and reduce income disparities, these well-intentioned policies may have contributed to some devastating unintended consequences.

Government housing policies forced financial institutions to relax mortgage underwriting standards. Sub-prime mortgages were thus offered to individuals with low incomes, poor credit, and even zero down payments. A 2002 government report hailed this as “mortgage innovation.” Soon everyone had access to these risky “innovations.” With a relatively stable housing supply, the wild speculation (house flipping) from growth of subprime mortgages that followed led to exploding demand, contributing to an unsustainable housing bubble.

Two Government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, played a crucial role in government guarantees of subprime mortgages. In the 1990s, the U.S. Department of Housing and Urban Development (HUD) directed the GSEs to sharply increase mortgage financing to the poor. To further increase lending, they were encouraged by Congress to expand their loan portfolios and buy mortgage-backed securities, including those backed by risky sub-prime mortgages. The expansion of Fannie Mae and Freddie Mac funded a dramatic growth in subprime and adjustable-rate mortgages. As the financial crisis hit, the two companies owned or guaranteed roughly half of all residential mortgages in the country.

As mortgage lending increased, the demand for housing increased, contributing to a housing bubble that started in the 1990s. From 2000 to 2003 the bubble was further fueled by the Federal Reserve’s expansionary monetary policy which led to short-term interest rates as low as 1%.

House prices finally stalled in 2006, partly due to a return of higher interest rates. Under U.S. law, a home owner with little or no equity whose house price falls below the value of their mortgage can walk away from their financial obligations. The subsequent collapse in housing prices and decline in value of mortgage securities rocked the global financial system, and led to the global financial crisis. In 2008 Fannie Mae and Freddie Mac both failed and had to be nationalized.

The lesson is that lax regulation and oversight of markets played a role in the global financial crisis, but so too did lax regulation and oversight of government policies. New rating agencies have since emerged, such as Crediture, to apply advanced data analytic techniques to acquire and process information and monitor loans, which should help avoid future global financial crises.

Francois Melese, Ph.D.

Author Francois Melese, Ph.D.

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