Comments and observations on social and political trends and events.

Monday, September 22, 2008

The Unquestioned Premises Behind the Financial Crisis

While it is disturbing to watch the financial debacle unfold, it is even more disturbing that the true culprits escape notice: faulty premises.

Faulty premise #1: egalitarianism. There are different versions of egalitarianism. For instance, our political system rests on the idea that all people should be treated equal in terms of rights, due process, etc. However, economic egalitarianism strives to ensure equality in terms of equal pay, living conditions, etc. The extreme version of this is captured in this quote by Karl Marx: “From each according to his abilities, to each according to his needs.” Naturally in America this belief fundamentally contradicts the idea of meritocracy, rags-to-riches, and the America dream.

Economic egalitarianism lies behind the Left’s continual efforts to “correct” the “evils” of capitalism and under girds redistributing money from taxpayers to the “underprivileged” via welfarism. [Note how the use of this term implies that the folks who have done well don’t really deserve it, that they are privileged. A privilege being a special favor dispensed by someone.]

Eventually the Left dreamed up a new tact: instead of cash handouts, why not provide easy credit?

The Office of Thrift Supervision (a government agency I never heard of before researching this post) describes the purpose of the Community Reinvestment Act, a key law in this scenario.

History of the Community Reinvestment Act

The CRA was enacted in 1977 to encourage financial institutions to help meet the credit needs of their communities, including low- and moderate-income neighborhoods, consistent with safe and sound lending practices. It extends and clarifies the longstanding expectation that financial institutions will serve the convenience and needs of their local communities. The CRA and its implementing regulations require federal financial institution regulators to assess the record of each bank and savings association in helping to fulfill their obligations to the community and to consider that record in evaluating applications for charters or for approval of mergers, acquisitions and branch openings. The federal financial institution regulators are the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and the Office of Thrift Supervision.

The law provides a framework for financial institutions and community organizations to work together to promote the availability of credit and other banking services to underserved communities. Under its impetus, banks and savings associations have opened new branches, provided expanded services, adopted more flexible credit underwriting standards and made substantial commitments to state and local governments or community development organizations to increase lending to underserved segments of local economies and populations.

I added emphasis in the second paragraph. The banks adopted “more flexible underwriting standards” no doubt because this is the only way they could comply with the law’s criteria.

Howard Husock of the Manhattan Institute elaborates.

The Trillion-Dollar Bank Shakedown That Bodes Ill for Cities

Howard Husock

The Clinton administration has turned the Community Reinvestment Act, a once-obscure and lightly enforced banking regulation law, into one of the most powerful mandates shaping American cities—and, as Senate Banking Committee chairman Phil Gramm memorably put it, a vast extortion scheme against the nation's banks. Under its provisions, U.S. banks have committed nearly $1 trillion for inner-city and low-income mortgages and real estate development projects, most of it funneled through a nationwide network of left-wing community groups, intent, in some cases, on teaching their low-income clients that the financial system is their enemy and, implicitly, that government, rather than their own striving, is the key to their well-being.

During the seventies and eighties, CRA enforcement was perfunctory. Regulators asked banks to demonstrate that they were trying to reach their entire "assessment area" by advertising in minority-oriented newspapers or by sending their executives to serve on the boards of local community groups. The Clinton administration changed this state of affairs dramatically. Ignoring the sweeping transformation of the banking industry since the CRA was passed, the Clinton Treasury Department's 1995 regulations made getting a satisfactory CRA rating much harder. The new regulations de-emphasized subjective assessment measures in favor of strictly numerical ones. Bank examiners would use federal home-loan data, broken down by neighborhood, income group, and race, to rate banks on performance. There would be no more A's for effort. Only results—specific loans, specific levels of service—would count. Where and to whom have home loans been made? Have banks invested in all neighborhoods within their assessment area? Do they operate branches in those neighborhoods?

The reason why I say egalitarianism is a faulty premise is that it violates the basic facts of reality. People are unequal in talents, ambition and, yes, in credit risk. The Left capitalizes on our sympathy for people who are less well off. However, the fact that enough people defaulted on their loans to trigger the tsunami of financial failures should be proof enough of the futility of rewriting reality to meet the desires of egalitarians.

Faulty premise #2: the belief that it is the proper role of government to “level the playing field” by manipulating interest rates and encouraging “flexible credit underwriting standards” in order to achieve egalitarian goals. By trying to suspend the basic laws of economics the CRA and other measures distort the signals normally transmitted by the market.

Recall what happened in the 1970s when former President Nixon imposed price controls to stem inflation? As is usual with price controls Nixon’s created shortages of goods as the prices set by government were below the point set by demand. Forcing banks to provide credit to people who normally wouldn’t qualify leads to increased demand for loans. However, there is one key difference. In dealing with material commodities price controls lead to shortages if the government sets the price below the market clearing level. However since money and credit can be easily created at the government’s whim the supply increases to meet the escalating demand.

Meanwhile the management of Freddie Mac and Fannie Mae highly leveraged their organizations with almost no oversight and built a precarious house of cards that was susceptible to the cold wind of falling home prices.

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