What Caused the Housing Crash?

“Problems started at the household level, with poorly-designed mortgage products”, claims Elizabeth Warren, professor of law and member of the newly-formed Financial Products Safety Commission. According to this view, the US housing bubble, where prices of homes increased 125% from 2000 to 2006, was the result of shoddy products sold to an unsuspecting public. Like the general claim of ‘predatory lending’ such a view assumes that people need a government agency to protect them from making bad decisions.
The fall in home prices, which began in 2006 and continues, has so far wiped out perhaps $10 trillion in value. If only there had been some government agency providing oversight, all of this may have been averted, Warren suggests. But there was. It’s called the Federal Reserve. But the Fed did nothing to avert the housing bubble—in fact, former Fed Chair Alan Greenspan made public statements urging people to buy homes with adjustable rate mortgages. What a spectacle: the nation’s foremost economist urging people to commit financial hari-kari.
Sure, there were ‘toxic mortgages’, to use a recently-coined term which seems to have caught on. Mortgage brokers aggressively sold them to people. People were encouraged to lie about their income and assets and they did so eagerly, to get their piece of the American dream: their own home. Fraud and deception proliferate in an atmosphere of denial. Home prices will always go up; you’ll be able to re-finance later at low rates, an army of mortgage brokers said.
But to say the current crisis is the result of bad mortgages is to employ a circular logic. Why did these mortgage products spread and gain dominance? Why did they displace the traditional banker’s strategy of lending conservatively to qualified borrowers? The reason is that the creation of toxic mortgages is the result of the same force that produced the rapid growth in hedge funds, credit-default swaps and other financial derivatives, and massive increases in trading volumes: money creation. Money created out of thin air always creates inflation. But when the price being inflated is a home, it seems to cause a special kind of madness that does not result from the inflation of other prices, like food, gasoline, or medical care.
Money creation is itself the product of two forces: the fractional reserve banking system, and the desire of the government to run large, continuing deficits, which are partly financed by slowly depreciating the currency through inflation. The change in bank policy which made toxic mortgages possible was a relatively new practice of moving money into new categories (such as repos, Eurodollars, collateralized debt obligations, and others) which allowed banks to circumvent the Fed’s required reserve ratio (which ranges from 10% for larger banks to 3% for smaller ones). As the result of this shell game, the actual reserve ratio in US banks fell to an incredible 0.74% at its trough—that’s $0.74 for each $100 deposited (this ratio has since risen, as banks are now in panic mode).
The Fed, which, after all keeps the statistics on bank deposits and lending, certainly must have known, but opted to look the other way. The rewards to financial ‘innovation’ of this kind were great, and the riskier banks bought those who employed more traditional strategies. Mortgage lending became so profitable that banks specialized in it, eschewing deposits altogether, instead obtaining funding by selling the mortgages as securities and making more loans, always more loans.
Given that the housing bubble was caused by money creation, it would be simply silly to think that some commission assigned to prevent bad mortgage products will have an impact. The solution to future asset bubbles is clear: abolish fractional reserve banking.