

If the Basel requirements hadn’t been promulgated as local law in most countries, banks would have had very little incentive to use these techniques to such an extent, reserving them only for “niche” purposes. Instead, they would have kept more direct investments in their assets portfolios. In that case, the first signs of weakness from some type of assets, like real estate mortgages, would have provided an early signal to financial institutions that it was time to reshuffle their portfolios, and the potential losses of the financial system would have been much lower.



Good regulation should compel banks to disclose fully the primary investment vehicles in their asset portfolios and the exact levels of their liabilities, but leave them free to choose the right level of equity and the types of investments they put in their assets. Combined with the elimination of the tax distortion mentioned above, this should lead to much better market information about the financial health of banks, forcing the weakest among them to borrow at higher interest rates and to reinforce their equity level against the risk they assume in their portfolios.

Distortions in Mortgage and Real Estate Markets • Special advantages granted to Fannie Mae and Freddie Mac



As Congressman Ron Paul and others noted from the very beginning of the new century, the special credit line and other fiscal privileges granted by the federal government to government-sponsored entities (falsely seen as private companies) like Fannie Mae and Freddie Mac amplified the risk of the creation of a real estate bubble that could heavily damage the US financial system when it burst.



These guaranties provided by Washington to GSEs allowed them to borrow money at rates close to those obtained by the federal government itself for its own bonds, giving Fannie and Freddie an unfair advantage over purely private banks. Worse, special accounting rules granted them by their supervising authority (the HUD), allowed them not to fully disclose their off-balance operations and to over-leverage their balance and off-balance liabilities 80 times more than their equity.



Had Fannie and Freddie been under the common law of private institutions, they couldn’t have borrowed so much money at such low rates to finance such risky operations. No financial institution should be granted special rights. Fannie and Freddie must be liquidated and abolished. Loan refinancing must be turned into a purely private business, as it is in many countries.



• Special constraints placed on Fannie Mae and Freddie Mac



All these advantages provided to Fannie and Freddie were not granted with no strings attached. Fannie and Freddie, since 1992, were forced to contribute to the refinancing of loans attributed to low-revenue families. The percentage of these loans was gradually increased, by law, from 40% in 1992 to 56% in 2008. (7)



Since an internal scandal put pressure on the two GSEs, threatening their existence through congressional action, they tried

(successfully) to justify their privileges with a huge increase in the refinancing of loans for low-income families from 2004 to 2007. A press investigation showed that they didn’t do it directly, but mostly indirectly, through the purchase of large amounts of bonds collateralized by risky loans made by other institutions. Congressional testimony showed that Fannie’s and Freddie’s managers, though aware of the unorthodox nature of their actions with regard to the risk level their companies were bearing, couldn’t resist the political pressure to “take more loans.” These “juggernaut policies” contributed to the over-leveraging of GSE balance sheets mentioned above.



This shows how harmful it can be to maintain so-called private companies under political pressure because of the privileges they are granted: politicians tend to subordinate economic imperatives to their political agenda. No company should be forced by the state to engage in dangerous behaviours.



• Community Reinvestment Act



The CRA was a law aimed at preventing “discrimination” against visible minorities by lending institutions. CRA provisions forced banks to lower their lending standards toward these minorities. CRA loan delinquency rates have not been much higher than the rates for other loans, and this gives momentum to CRA defenders. But the drawbacks of the CRA were hidden elsewhere. The law submitted bank mergers and acquisitions to the oversight of several agencies with the power to block the deals if they were not “CRA compliant.”



This forced small banks that kept their good habits of “serious lending” (there were many of them) to remain small. It also forced bigger banks that wanted to benefit from the 1994 and 1999 deregulation laws (Riegle-Neale and Gramm-leach-Bliley) to build great nationwide networks, in order to lower their loans’ underwriting standards.



These deregulations should have been economically positive, since they repealed older texts from the 1920s and 30s that prevented banks from practicing accurate risk diversification. However, the reinforcement of CRA regulations in 1995 turned them into risky moves, because banks that wanted to take advantage of them could only do so by adopting riskier lending behaviours.



Since the purportedly large differences in lending approval rates between communities have been proven less significant by several studies, debunking the myth of “racist banks.” these CRA provisions should be repealed. Banks should be free to select mortgage applicants according to their own rating standards.



• Smart Growth Policies and similar land-use regulatory restrictions



Although very few observers have noted this, the real estate bubble was highly uneven geographically throughout the USA (and Canada, too). In fact, price escalation was huge in about a dozen states, but nearly nonexistent in others, even if there was a huge demand in those states too. The three fastest-growing areas of the USA—Atlanta, Dallas, and Houston—didn’t experience the same real estate bubble as big cities like Los Angeles, or midsized ones like Portland. If demand had been the sole factor behind real estate price hikes, Houston and Atlanta should have been the most expensive metro areas in the country. They remained among the cheapest. So the bubble should also be explained from the supply side of the equation.



The different behaviours between these two kinds of markets arise from land-use regulations. The Brookings Institute has classified metro area regulations into two categories: prescriptive regulations, which make it difficult for land owners to turn non-constructible land into land that can be developed; and conversely, responsive regulations, which are aimed at keeping enough land available to meet demand for new housing units.



The housing bubble basically only occurred in areas with prescriptive regulations, (8) generally referred to as “smart growth policies,” or, in two cases (Arizona and Nevada), in areas where local power actually owns the land and decided to reduce land sales to developers in order to raise their financial revenues through higher land prices.



The total value of originated mortgages increased from $5,200 billion in 2000 to $12,000 billion at the peak of the bubble. More than 80% of the mortgage escalation occurred in areas with “smart growth” and equivalent policies. This means that if the whole country had enacted the same land-use regulations as Atlanta or Houston, the total exposure of the financial system to mortgage risk would have been reduced by about $4,000 billion. (9) This would certainly have made the current crisis much less severe.



But there is more. If the whole country had been a “no bubble can even get started” area, as Nobel Prize-winner Paul Krugman formulated it, the behaviour of lenders and borrowers would have been completely different. It would have been much more difficult to persuade borrowers to jump recklessly onto the easy credit bandwagon, and lenders would have found it much less interesting to take homes as guarantees for high-risk loans.



This would have avoided many “borrow against equity” mortgages aimed, not at purchasing a home, but at using continually growing home prices to finance flat screens, SUVs, and other goodies. Growth rates in the USA would thus have been less spectacular, but also less artificial.



When studied in detail, environmental and agricultural concerns against urban surface expansion, a.k.a. “sprawl,” appear to be widely exaggerated. Smart growth policies, aimed at providing a government response to these exaggerated fears, have produced extremely harmful unintended consequences, and imperceptible benefits. Smart growth policies must be repealed. This can be easily justified by the fact that most are clearly violating property rights, whatever the Supreme Court has said in recent rulings. Conclusion: Restore Markets! Markets are imperfect because human beings are. All the state interventions in free market mechanisms described above were supposed to bring corrections to unavoidable market imperfections. They were supposed to provide us with safer banks, better access to consumer goods for the poor, better-performing companies and economies, better use of space, and better social side effects. None of the intended goals of these interventions have been achieved. But by destroying the “natural” defences of markets against failure, they wrought havoc on the world economy.



It’s time for politicians to ask themselves why state regulations of land, finance and money failed so miserably, and if we should not replace them with a few market-based mechanisms that would be more efficient in achieving their stated goals.



