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 How Did We Get intoThis Financial Mess? 
by Lawrence H. White
 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. He is the author of 
Competition and Currency, Free Banking in Britain
 , and
The Theory of Monetary Institutions
.
No. 110
 As policymakers confront the ongoing U.S.financial crisis, it is important to take a step backand understand its origins. Those who fault“deregulation,”“unfetteredcapitalism,”or“greed”would do well to look instead at flawed institu-tionsandmisguidedpolicies.The expansion in risky mortgages to under-qualifiedborrowerswasencouragedbythefederalgovernment. The growth of “creative” nonprimelending followed Congress’s strengthening of theCommunity Reinvestment Act, the Federal Hous-ing Administration’s loosening of down-paymentstandards, and the Department of Housing andUrbanDevelopment’spressuringlenderstoextendmortgagestoborrowerswhopreviouslywouldnothavequalified.Meanwhile,FreddieMacandFannieMaegrew to own or guarantee about half of the UnitedStates’$12trillionmortgagemarket.Congression-alleaderspointedlyrefusedtomoderatethemoralhazard problem of implicit guarantees or other-wisereinintheirhyperexpansion,insteadpushingthem to promote “affordable housing” throughexpanded purchases of nonprime loans to low-incomeapplicants.The credit that fueled these risky mortgageswas provided by the cheap money policy of theFederal Reserve. Following the 2001 recession,Fed chairman Alan Greenspan slashed the fed-eral funds rate from 6.25 to 1.75 percent. It wasreduced further in 2002 and 2003, reaching a record low of 1 percent in mid-2003—where itstayed for a year. This set off what economistSteve Hanke called “the mother of all liquidity cyclesandyetanothermassivedemandbubble.”The actual causes of our financial troubleswere unusual monetary policy moves and novelfederal regulatory interventions. These poorly chosenpoliciesdistortedinterestratesandassetprices, diverted loanable funds into the wronginvestments,andtwistednormallyrobustfinan-cial institutions into unsustainable positions.
November18,2008
Executive Summary
Cato Institute•1000 Massachusetts Avenue, N.W.•Washington, D.C. 20001•(202) 842-0200
 
Introduction
Mortgage foreclosure rates in the UnitedStates have risen to the highest level since theGreat Depression. The nation’s two largestfinancial institutions, the government-spon-sored mortgage purchasers and repackagersFannie Mae and Freddie Mac, have gone intobankruptcy-like “conservatorship.” Severalmajorinvestmentbanks,insurancecompanies,and commercial banks heavily tied to realestatelendinghavegonebankruptoutrightorhave been sold for cents on the dollar. Pricesandtradingvolumesinmortgage-backedsecu-rities have shrunk dramatically. Reluctance tolend has spread to other markets. To preparethe ground for a return to normalcy in American credit markets we must understandthecharacteroftheproblemswecurrentlyfaceandhowthoseproblemsarose.
What
 Didn’t 
Happen
Some commentators (and both presiden-tial candidates) have blamed the currentfinancial mess on greed. But if an unusually high number of airplanes were to crash thisyear, would it make sense to blame gravity?No. Greed, like gravity, is a constant. It can’texplain why the number of financial crashesis higher than usual. There has been nounusual epidemic of blackheartedness.Othershaveblamed deregulationor(inthewordsofonerepresentative)“unregulatedfree-market lending run amok.” Such an indict-ment is necessarily skimpy on the particulars,because there has actually been no recent dis-mantlingofbankingandfinancialregulations.Regulations were in fact intensified in the1990s in ways that fed the development of thehousing finance crisis, as discussed below. Thelastmoveinthedirectionoffinancialderegula-tion was the bipartisan Financial ServicesModernization Act of 1999, also known as theGramm-Leach-Bliley Act, signed by PresidentClinton.Thatactopenedthedoorforfinancialfirmstodiversify:aholdingcompanythatownsa commercial bank subsidiary may now alsoown insurance, mutual fund, and investment-banksubsidiaries.Farfromcontributingtotherecent turmoil, the greater freedom allowed by theacthasclearlybeenablessingincontainingit.Withoutit,JPMorganChasecouldnothaveacquired Bear Stearns, nor could Bank of  America have acquired Merrill Lynch—acquisi-tionsthatavoidedlossestoBear’sandMerrill’sbondholders. Without it, Goldman Sachs andMorgan Stanley could not have switched spe-cialties to become bank holding companieswhenitbecameclearthattheycouldnolongersurviveasinvestmentbanks.
What
 Did 
Happen—andWhy?
The actual causes of our financial troubleswereunusualmonetarypolicymovesandnov-elfederalregulatoryinterventions.Thesepoor-ly chosen public policies distorted interestrates and asset prices, diverted loanable fundsinto the wrong investments, and twisted nor-mallyrobustfinancialinstitutionsintounsus-tainablepositions.Let’s review how the crisis has unfolded.Problemsfirstsurfacedin“exotic”or“flexible”home mortgage lending. Creative lenders andoriginators had expanded the volume of unconventional mortgages with high defaultrisks(reflectedinnonprimeratings),whicharethe housing market’s equivalent of junkbonds. Unconventional mortgages helped tofeed a run-up in condo and house prices.House prices peaked and turned downward.Borrowers with inadequate income relative totheirdebts,manyofwhomhadeithercountedonbeingabletoborrowagainstahigherhouse valueinthefutureinordertohelpthemmeettheirmonthlymortgagepayments,oronbeingableto“flip”thepropertyatapricethatwouldmore than repay their mortgage, began todefault.Defaultratesonnonprimemortgagesrosetounexpectedhighs.Thehighriskonthemortgages came back to bite mortgage hold-ers, the financial institutions to whom themonthly payments were owed. Firms directly 
2
The causes of ourfinancial troubleswere unusualmonetary policy moves and novelfederal regulatory interventions.
 
holding mortgages saw reduced cash flows.Firms holding securitized mortgage bundles(often called “mortgage-backed securities”)additionallysawtheexpectationofcontinuingreductions in cash flows reflected in decliningmarket values for their securities. Uncertainty aboutfuturecashflowsimpairedtheliquidity (resalability)oftheirsecurities.Doubts about the value of mortgage-backedsecuritieslednaturallytodoubtsaboutthe solvency of institutions heavily invested inthosesecurities.Financialinstitutionsthathadstockeduponjunkmortgagesandjunk-mort-gage-backedsecuritiesfoundtheirstockpricesdropping. The worst cases, like CountrywideFinancial, the investment banks LehmanBrothers and Merrill Lynch, and the govern-ment-sponsored mortgage purchasers FannieMae and Freddie Mac, went broke or had tofind a last-minute purchaser to avoid bank-ruptcy. Firms heavily involved in guaranteeingmortgage-backed securities, like the insurancegiant AIG, likewise ran aground. Suspectfinancialinstitutionsbeganfindingitdifficulttoborrow,becausepotentiallenderscouldnotconfidently assess the chance that an institu-tion might go bankrupt and be unable to pay themback.Creditflowsamongfinancialinsti-tutions became increasingly impeded by suchsolvencyworries.Given this sequence of events, the expla-nation of our credit troubles requires anexplanation for the unusual growth of mort-gage lending—particularly nonprime lend-ing, which fed the housing bubble that burst—leading in turn to the unusual number of mortgage defaults, financial institutioncrashes, and attendant credit-market inhibi-tions.Thereisnodoubtthatprivatemiscalcula-tion and imprudence have made mattersworse for more than a few institutions. Suchmistakes help to explain which particularfirms have run into the most trouble. But toexplain
industrywide
errors, we need to identi-fypolicydistortionscapableofhavingindus-trywide effects.We can group most of the unfortunatepolicies under two main headings: (1) FederalReserve credit expansion that provided themeans for unsustainable mortgage financing,and (2) mandates and subsidies to write riski-er mortgages. The enumeration of regrettablepoliciesbelowisbynomeansexhaustive.
ProvidingtheFunds:FederalReserveCreditExpansion
Intherecessionof2001,theFederalReserveSystem, under Chairman Alan Greenspan,began aggressively expanding the U.S. money supply.Year-over-yeargrowthintheM2mone-tary aggregate rose briefly above 10 percent,andremainedabove8percententeringthesec-ondhalfof2003.Theexpansionwasaccompa-nied by the Fed repeatedly lowering its targetfor the federal funds (interbank short-term)interestrate.Thefederalfundsratebegan2001at6.25percentandendedtheyearat1.75per-cent.Itwasreducedfurtherin2002and2003,inmid-2003reachingarecordlowof1percent,where it stayed for a year. The
real 
Fed fundsratewasnegative—meaningthatnominalrateswerelowerthanthecontemporaryrateofinfla-tion—for two and a half years. In purchasing-power terms, during that period a borrowerwas not paying but rather gaining in propor-tion to what he borrowed. Economist SteveHankehassummarizedtheresult:“Thissetoff themotherofallliquiditycyclesandyetanoth-ermassivedemandbubble.”The so-called Taylor Rule—a formula de- vised by economist John Taylor of StanfordUniversity—provides a now-standard methodofestimatingwhatfederalfundsratewouldbeconsistent, conditional on current inflationand real income, with keeping the inflationrate to a chosen target rate. The diagrambelow, from the Federal Reserve Bank of St.Louis, shows that from early 2001 until late2006 the Fed pushed the actual federal fundsrate below the estimated rate that would havebeen consistent with targeting a 2 percentinflationrate.AfortioritheFedheldtheactu-alrateevenfartherbelowthepath,consistent-ly targeting stability in nominal income (see
3
Intherecessionof 2001,theFederalReserveSystembeganaggressively expandingtheU.S.money supply.
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