What Really Happened?

Our ongoing financial turmoil began in the mortgage market. Real-estate loans at commercial banks grew at a remarkable 12.26 percent compound annual rate over the four-year period from the midpoint of 2003 to the midpoint of 2007.[1] The expanded volume of mortgages—notably including an unusually large share of mortgages with “nonprime” ratings—fueled a run-up in condo and house prices to unprecedented heights, followed by a sharp decline. (Was this a “bubble” in prices? Yes, in the sense that the price path was unsustainable; no, in the sense that it was not entirely self-feeding.) Default rates on nonprime mortgages and adjustable-rate mortgages rose to unexpected highs, reducing cash flows to lenders. Financial firms holding securitized mortgage bundles (aka “mortgage-backed securities”) saw the expectation of continuing reductions in cash flows reflected in declining market values for their securities. Uncertainty about future cash flows impaired the liquidity (re-salability) of their securities.

Among the prominent results: the nation’s two largest mortgage finance institutions, the government-sponsored Fannie Mae and Freddie Mac, have gone into bankruptcy-like “conservatorship.” Major investment banks, insurance companies, and commercial banks have gone bankrupt outright (or have been sold for cents on the dollar) because of their heavy exposure to real estate lending. Prices and trading volumes in mortgage-backed securities have shrunk dramatically. Doubts about the value of mortgage-backed securities have led naturally to increased doubts about the solvency of institutions heavily invested in those securities, making it hard for those institutions to borrow at accustomed rates.

So what made the mortgage market boom and bust?

What Didn’t Happen

The housing-finance boom and bust are not the results of a laissez-faire monetary and financial system. We didn’t have one. The boom and bust happened in a system with an unanchored government fiat money and extensive legal restrictions on financial intermediation. Nor have we had banking and financial deregulation since the bipartisan Financial Services Modernization Act (the Gramm-Leach-Bliley Act), signed by President Clinton in 1999. Far from contributing to the recent turmoil, moreover, that act has clearly been a blessing in containing it by allowing acquisitions, such as the acquisition of Bear Stearns by JPMorgan Chase or of Merrill Lynch by Bank of America, that have shielded bondholders from losses.

What Happened

There is no doubt that private miscalculation and imprudence made matters worse for more than a few lending institutions and individual borrowers. (One can’t explain an unusual cluster of errors by citing greed, which is always around, just as one can’t explain a cluster of airplane crashes by citing gravity. Anyway, the greedy aim at profits, not losses.) Such mistakes help to explain which firms have run into the most trouble. But to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects. The actual causes of our financial troubles were unusual monetary policy moves and novel federal regulatory interventions. Regulatory distortions intensified in the 1990s. Poorly chosen public policies distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions.

We can group most of the unfortunate policies under two main headings: (1) Federal Reserve credit expansion that provided the means for unsustainable mortgage financing, and (2) mandates and subsidies to write riskier mortgages. The enumeration of regrettable policies here is by no means exhaustive.

Providing the Funds: Federal Reserve Credit Expansion

In the recession of 2001, the Federal Reserve System under Chairman Alan Greenspan began aggressively expanding the U.S. money supply. Year-over-year growth in the M2 monetary aggregate rose briefly above 10 percent, and remained above 8 percent entering the second half of 2003. The expansion was accompanied by the Fed’s repeatedly lowering its target for the “federal funds” (interbank short-term) interest rate. The fed funds rate began 2001 at 6.25 percent and ended the year at 1.75 percent. It was reduced further in 2002 and 2003, reaching in mid-2003 a record low of one percent, where it stayed for a year. The real Fed funds rate was negative—meaning that nominal rates were lower than the contemporary rate of inflation—for two and a half years.

How do we judge whether the Fed expanded more than it should have? One venerable norm for making fiat central bank policy as neutral as possible toward the financial market is to aim for stability (zero growth) in the volume of nominal expenditure. [2] Second-best would be a predictably low and steady growth rate of nominal expenditure. A useful measure of nominal expenditure is the dollar volume of final sales to domestic purchasers (GDP less net exports and the change in business inventories). During the two years from the start of 2001 to the end of 2002, final sales to domestic purchasers grew at a compound annual rate of 3.6 percent. During 2003, the Fed’s acceleration of credit began to show up: the growth rate jumped to 6.5 percent. For the next two years, from the start 2004 to the end of 2005, the growth rate was even higher at 7.1 percent, nearly a doubling of the initial rate. It then backed off, to 4.3 percent per annum, from the start of 2006 to the start of 2008. But the damage from an unusually rapid expansion of nominal demand had been done. [3]

A more standard way for evaluating whether the Fed was overly expansive is the “Taylor Rule,” the formula devised by economist John Taylor of Stanford University for estimating what federal funds rate would be consistent, conditional on current inflation and real income, with keeping the inflation rate at a chosen target. As calculated by the Federal Reserve Bank of St. Louis, the Fed from early 2001 until late 2006 pushed the actual federal funds rate well below the estimated rate that would have been consistent with targeting a 2 percent inflation rate for the PCE deflator. The gap was especially large—200 basis point or more—from mid-2003 to mid-2005. [4]

The excess credit thus created went heavily into real estate. From mid-2003 to mid-2007, while the dollar volume of final sales of goods and services was growing at a compounded rate of 5.9 percent per annum, real-estate loans at commercial banks were (as already noted) growing at 12.26 percent. [5] Credit-fueled demand both pushed up the sale prices of existing houses and encouraged the construction of new housing on undeveloped land. Because real estate is an especially long-lived asset, its market value is especially boosted by low interest rates. The housing sector thus exhibited a disproportionate share of the price inflation predicted by the Taylor Rule. (House prices are not, however, included in standard measures of price inflation.)

The Fed’s policy of lowering short-term interest rates not only fueled growth in the dollar volume of mortgage lending, but had unintended consequences for the type of mortgages written. By pushing very-short-term interest rates down so dramatically between 2001 and 2004, the Fed lowered short-term rates relative to 30-year rates, making adjustable-rate mortgages (ARMs) increasingly cheap relative to 30-year fixed-rate mortgages. Increasing numbers of new mortgage borrowers were drawn away from mortgages with 30-year rates into ARMs. The share of new mortgages with adjustable rates, only one-fifth in 2001, had more than doubled by 2004. Many borrowers who took out ARMs implicitly counted on the Fed to keep short-term rates low for as long as they held the mortgage. They have faced problems as their monthly payments have adjusted upward. The shift toward ARMs has compounded the mortgage quality problems arising from the regulatory mandates and subsidies described below.

The excess investment in new housing has resulted in an overbuilt housing stock. Assuming that the federal government does not follow proposals (tongue-in-cheek or otherwise) to buy up and then torch excess houses and condos, or to admit a large number of new immigrants, house prices and activity in the U.S. housing construction industry are going to remain depressed for a while. Correspondingly, the book value of existing financial assets based on housing need to be written down and losses recognized to allow a soundly based recovery. No matter how painful the adjustment process, delaying it only delays the economy’s recovery.

Mandates and Subsidies to Write Risky Mortgages

In 2001, the share of existing mortgages classified as “nonprime” (subprime or the intermediate category “Alt-A”) was below 10 percent. By 2006 it had risen to 23 percent. Meanwhile the quality of loans within the nonprime category declined, because a smaller share of nonprime borrowers made 20 percent down payments on their purchases. [6]

The federal government fostered the expansion in risky mortgages to under-qualified borrowers in several ways. It is hard to judge how much each of these contributed, but all worked to loosen lending standards.

First, the Federal Housing Administration over the years progressively loosened its down payment requirements on FHA mortgages. By 2004 the down payment requirement on the FHA’s most popular program had fallen to only 3 percent. [7] Private lenders felt compelled to offer lower down payments on non-FHA loans. Mortgages with very low down payments have had very high default rates.

Second, Congress strengthened the Community Reinvestment Act. The CRA had initially, from its passage in 1977, merely imposed reporting requirements on commercial banks. Amendments in 1995 empowered regulators to deny a bank with a low CRA rating permission to merge with another bank—at a time when the arrival of interstate banking made such approvals especially valuable—or even to open new branches. In response to the new CRA rules, some banks joined into partnerships with community groups to distribute millions in mortgage money to low-income borrowers previously considered non-creditworthy. Other banks took advantage of the newly authorized option to boost their CRA rating by purchasing special “CRA mortgage-backed securities,” that is, packages of disproportionately nonprime loans certified as meeting CRA criteria and securitized by Freddie Mac. Federal Reserve Chairman Ben Bernanke aptly commented in a 2007 speech that “recent problems in mortgage markets illustrate that an underlying assumption of the CRA—that more lending equals better outcomes for local communities may not always hold.”[8]

Third, the Department of Housing and Urban Development pressured lenders for “affordable housing” loans. Beginning in 1993, HUD officials began bringing legal actions against mortgage bankers that declined a higher percentage of minority applicants than white ones. To avoid legal trouble, lenders began relaxing their down-payment and income qualifications.[9]

Fourth and likely most important, implicit taxpayer guarantees allowed the dramatic expansion of the government-sponsored mortgage buyers Fannie Mae and Freddie Mac, at a time when Congress and HUD were pushing Fannie and Freddie to promote “affordable housing” through ever-expanding purchases of non-prime loans to low-income applicants. The two mortage giants grew to hold or guarantee around $5 trillion in mortgages, about half of the entire U.S. market. Institutional investors were willing to lend to the government-sponsored mortgage companies cheaply, despite the risk of default that would normally attach to private firms holding such highly leveraged and poorly diversified portfolios, because they were sure that the Treasury would repay them should Fannie or Freddie be unable. (It turns out that they were right.) Congress pointedly refused to moderate the moral hazard problem of implicit guarantees or otherwise to rein in the hyper-expansion of Fannie and Freddie. Warnings about Fannie and Freddie, and efforts to rein them in, came to naught because the two giants had cultivated powerful friends on Capitol Hill.

A 1992 law, as described by Bernanke, “required the government-sponsored enterprises, Fannie Mae and Freddie Mac, to devote a large percentage of their activities to meeting affordable housing goals.”[10] HUD set numerical goals for Fannie and Freddie: for the year 2000, 50 percent of their financing was to go to below-median-income borrowers; for 2005 the target rose to 52 percent. Additional goals required that increasing shares of lending go to borrowers with income under 60 percent of the median for their areas. [11]


The housing boom and the aftermath of its bust arose from market distortions created by the Federal Reserve, the government backing of Fannie Mae and Freddie Mac, the Department of Housing and Urban Development, and other federal interventions. We are experiencing the unfortunate results of perverse government policies, compounded in some degree by private mistakes.

The remedy for private business mistakes is bankruptcy. The remedy for the mistaken government monetary and regulatory policies that have produced the current financial train wreck is to identify and undo policies that distort housing and financial markets, and dismantle failed agencies whose missions require them to distort markets. We should be guided by recognizing the two chief errors that have been made. Cheap-money policies by the Federal Reserve System do not produce a sustainable prosperity. Hiding the cost of mortgage subsidies off-budget, as by imposing “affordable housing” regulatory mandates on banks and by providing implicit taxpayer guarantees on Fannie Mae and Freddie Mac bonds, does not give us more housing at nobody’s expense.

Lawrence H. White is the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis and an adjunct scholar at the Cato Institute. This piece summarizes his recent Cato Briefing Paper, “How Did We Get Into This Financial Mess?


[1] Federal Reserve Bank of St. Louis FRED database, series REALLN. Real Estate Loans at All Commercial Banks, http://research.stlouisfed.org/fred2/series/REALLN?cid=100. My thanks to George Selgin for drawing my attention to this series.

[2] George Selgin, Less Than Zero: The Case for a Falling Price Level in a Growing Economy (London: Institute of Economic Affairs, 1997).

[3] Federal Reserve Bank of St. Louis FRED database, Series FSDP, Final Sales to Domestic Purchasers, http://research.stlouisfed.org/fred2/series/FSDP?cid=106.

[4] Federal Reserve Bank of St. Louis, Monetary Trends, October 2008, p. 10.

[5] Federal Reserve Bank of St. Louis FRED database, series FINSAL and REALLN, year-over-year percentage changes. http://research.stlouisfed.org/fred2/series/FINSAL?cid=106, http://research.stlouisfed.org/fred2/series/REALLN?cid=100.

[6] William R. Emmons, “The Mortgage Crisis: Let Markets Work, But Compensate the Truly Needy,” The Regional Economist (July 2008).

[7] John Berlau, “The Subprime FHA,” The Wall Street Journal, October 15, 2007. 

[8] Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” March 30, 2007. 

[9] Dennis Sewell, “Clinton Democrats are to Blame for the Credit Crunch,” The Spectator, October 1, 2008.

[10] Bernanke, op. cit.

[11] Russell Roberts, “How Government Stoked the Mania,” Wall Street Journal, October 3, 2008.

Also from this issue

Lead Essay

  • In the first of this month’s four accounts of the causes of the financial crisis, Lawrence H. White, the F.A. Hayek Professor of Economic History at the University of Missouri, St. Louis, makes his case. White argues that the housing boom and bust, and the resulting meltdown of financial markets, cannot have been the result of a laissez-faire monetary and financial system, since we never had one. Nor can deregulation have been the cause, since the most recent relevant deregulation has probably helped contain the turmoil. While admitting that “private miscalculation and imprudence made matters worse,” White argues that “to explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects.” He points to two such distorting sets of policies: the overexpansion of the money supply by the Fed, and government mandates and subsidies to write riskier mortgages.

Response Essays

  • In our second anatomy of the financial crisis, William K. Black, associate professor of economics and law at the University of Missouri, Kansas City, says that key to the crisis was perverse compensation schemes that put the incentives of executives at odds with the interests of creditors and shareholders. Drawing on his concept of “control fraud,” Black argues that a failure of regulation encouraged executives to meet short-term earnings goals and to capture large bonuses by encouraging fraudulent mortgages — even when it could be foreseen that this might lead to the destruction of the firm. “When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud — and control fraud causes greater financial losses than all other forms of property crime combined,” Black writes. Fannie and Freddie cannot have been the culprits, Black argues, because they were guilty of less mortgage control fraud than their fully private counterparts. “ ‘Modern finance’ has failed the market test,” Black concludes. “Its policies optimize the environment for control fraud and create perverse dynamics that create recurrent financial crises.”

  • The housing boom and bust stands behind the financial turmoil of 2008. Therefore, in our third analysis of the financial crisis, University of Chicago economist Casey B. Mulligan explores various hypotheses about its underlying causes. Was it changes in tastes and technology? Public policy? Investor “exuberance”? Mulligan describes some of the empirical tests that would be needed to settle the question, and argues that at least part of the answer is already clear. Most of the housing boom, Mulligan finds, was based in expectations about the future, rather than in demand, supply, or subsidies during the boom. Mulligan says that additional empirical tests — especially about the aggregate wealth effects of the boom and bust — would help us form a more educated guess about whether boom expectations were based more to changes in tastes, changes in technology, or exuberance. But those tests have not been done, and therefore, Mulligan concludes we cannot yet reliably predict the future economic damage from the housing boom and bust, or formulate beneficial financial industry regulation.

  • Our fourth and final anatomist, J. Bradford DeLong, notes that “in the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion,” and lays out five reasons why this value might fluctuate. “Savings has not fallen through the floor. We have had no little or no bad news about resource constraints, technological opportunities, or political arrangements.” Therefore, DeLong says, we’re left with changes in the discounts for liquidity, default, and risk. The housing crash has increased default risk significantly, but central banks have actually pumped up liquidity. Almost the entire drop of the value of global capital, DeLong argues, comes from an “increase in the perceived riskiness … of income from capital.” The problem, DeLong says, is that “our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level that has led to ten times the total losses in financial wealth of the impulse.” However, DeLong is confident that Larry White’s story — focusing on the money supply and government policy to encourage bad home loans — cannot be the right one.