Federal Deregulation

Celebrated libertarian thinker Richard A. Posner, a judge of the United States Court of Appeal for the Seventh Circuit, called the financial crisis “a crisis of capitalism rather than a failure of government.”

Conservatives like to beat up on Fannie Mae and Freddie Mac—the federally sponsored companies that own or insure a large fraction of the nation’s mortgages and are among the financial enterprises whose risky practices contributed to the crisis. Fannie Mae invented mortgage-backed securities, though it backed the securities that it issued only with prime mortgages…Had they not had shareholders and highly compensated managers, they would not have taken as many risks as they did because they would not have had the same profit opportunities. Their behavior mirrored that of the banking industry as a whole, which is no surprise given their private character.

Conservatives also claim that the Community Reinvestment Act of 1977, and amendments made to it in the 1990s, contributed to the financial crisis. The act requires the federal bank regulatory authorities to encourage banks to lend money to people who are poor credit risks because they have modest incomes…But the laws did not actually require the banks to make risky loans, and there is a lack of convincing evidence that the laws were responsible for a substantial amount of the risky lending made during the housing bubble.

The critical role of the government in the crisis was one of permission rather than of encouragement. By having over a period of decades largely deregulated banking, and credit generally, the government inadvertently allowed the rational self-interest of private actors—bankers, mortgage brokers, real estate salesmen, homeowners, and others—to bring on a financial crisis that the government was unable to prevent from molting into a depression. A profound failure of the market was abetted by governmental inaction.

For over seven decades, a federal regulatory framework separated commercial banking from investment banking. Beginning in the early 1980s, a combination of ownership liberalization and financial deregulatory reforms would press forward the de facto disintegration of Depression-era banking reforms. Therefore, the history of financial deregulation is an instructive place to begin when reviewing the origins and collapse of the subprime mortgage market.

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