Libertarians and fans of small government, do not abandon all hope. There are lessons to be learned from the financial crisis, and battles to be fought. The first lesson to learn is that the Community Reinvestment Act of 1977 was a mistake. The law forces banks with branches in poor neighborhoods to lend money there–which is to say, to lend money to people with poor credit ratings. This price is exacted from any bank looking for permission to add a branch or buy another bank. The rule is enforced by private community organizations like Acorn.
There are two ways that banks cope with the law’s demands. One is simply by avoiding poor neighborhoods altogether, leaving the business of providing financial services there to pawnshops, check‐cashing outlets and businesses making usurious payday loans. The other is by writing a lot of mortgages. That means issuing subprime mortgages with low down payments and low teaser rates. The monthly payments, that is, start out looking affordable. After a while the loan resets to a much higher rate.
The problems occasioned by the latter approach were compounded by a 1995 law permitting the securitization of subprime loans. Securitizing frees the mortgage originator from an obligation to hold weak loans in its own portfolio and thus makes that originator more indifferent to the risks. Beginning in the late 1990s the White House and Congress also put strong pressure on Fannie Mae and Freddie Mac to buy securities backed by these mortgages. Over the years 2005-07 about 40% of the mortgages that the two enterprises added to their portfolios of single‐family loans were junk loans.
Now that Fannie and Freddie have been nationalized–adding $5 trillion of debt to the government balance sheet–what is the next step? At the moment the U.S. Treasury is trying to restore them to health so that it can send them back into the private sector. This is a mistake. The government should liquidate them.
The two megathrifts are based on a profoundly unsound business model in which their profits accrue to shareholders and executives and their losses accrue to taxpayers. That is a recipe for warped incentives. It’s why Fannie and Freddie stacked giant asset piles atop slim equity cushions. It’s why they went bust when house prices declined.
After auctioning off the assets of Fannie and Freddie, the government should stop playing any role in providing subsidized credit to the general housing market. How, then, will we help low‐income families that want to own their homes? With a narrowly targeted mortgage subsidy. It would be keyed to people’s incomes, rather like food stamps, and it would be a far more efficient way to increase home ownership among poor people than the combination of the Community Reinvestment Act, Fannie and Freddie. The two mortgage giants are allowed to buy loans as big as $625,500. How can that possibly be the way to help poor people? One advantage of a mortgage subsidy is that it would be a line item in the budget rather than a cost imposed on private‐sector banks or a hidden risk imposed on future taxpayers.