Since Americans began celebrating Labor Day 129 years ago (1887), we have gathered with friends and family on the first Monday in September to celebrate and remember the collective social and economic achievements of American workers. However, how has the current financial environment of the US changed the commercial milestones commended by our annual end of summer gatherings?
Historically, government oversight has sought to protect the American workforce and the individual laborer. However, Many economists suggest that specific government policies served as the actual precursor to the 2008 subprime meltdown and subsequent financial crisis. In an attempt to pinpoint the catalyst for the economic catastrophe of the past decade, a more diligent investigation of events must be undertaken.
Although noble intent prompted various lending legislations, a direct correlation between governmental interference and the open banking system led to the eventual collapse of the country’s lending infrastructure in 2008. A retroactive inspection of three separately conceived acts provides some insight into how individual financial motivations sometimes outweigh honorable intentions by government agencies. More specifically, the Fair Housing Act, the Community Reinvestment Act, and the Home Mortgage Disclosure Act represent three distinct legislative measures formulated with honorable intentions, yet when combined, these three acts helped set the foundation for one of the worst financial catastrophes in US history. Government overregulation helped to induce the eventual 2008 housing market collapse through many unconnected and seemingly noble legislative acts.
Step 1: Reveal Unfair Lending Practices
The Home Mortgage Disclosure Act (HMDA) was passed in 1975 and required lenders to report the data on borrowers and to indicate lending by race explicitly. Originally conceived to force compliance with federal mandates against discrimination, the HMDA ultimately revealed data showing that loan approval rates were higher for white applicants than for minority candidates.
After lawmakers had come to the “revelation” that lending was not always fair, it became apparent to them that additional legislation must overstep the natural parameters of the free credit market.
Step 2: Pass Legislation to Mandate Equal Lending Practices
The Community Reinvestment Act (CRA) of 1977 loosely required regulators to determine whether a federally insured bank was serving the needs of a community’s entire demographic. This was a result of the previously passed HMDA, which revealed that loan officers gave whites preferential treatment. Therefore, the logical response was to legislate guidelines for diverse lending practices, forcing loan officers to offer previously unattractive loans into minority communities.
Over the next two decades, insiders recognized that many of the credit offers were not equating to actual loan originations. So, in 1995 new rules were established to codify objective criteria for determining whether a bank was meeting CRA standards. Banks had to show that actual loans required some inherently high-risk borrowers. These new regulations prompted the invention and implementation of innovative and flexible lending practices, which varied from traditional lending standards to meet the requirements of lower income borrowers. Therefore, congressional acts formerly drafted to encourage banks to use safe and sound practices in lending now required them to be “innovative” while simultaneously exposing lenders to higher levels of risk.
Although some of the “innovative” loan structures targeted borrowers with less traditional qualifications, the lower lending standards required by the CRA ultimately influenced the terms that banks and other lenders were willing to offer to borrowers in prime markets. Preserving notions of self-serving tendencies in a free market, most borrowers will choose a debt structure with a small upfront cash requirement, allowing the borrower to buy a larger home for the same initial investment. The banks’ new “innovative” loan structures offered buyers with the ability to maximize leverage of new loans, but with increased leverage comes increased risk – something that the markets did not adequately perceive until home prices stalled.
It was the spreading of looser lending standards that substantially altered the credit availability for mortgages, the speculation in housing, and ultimately the bubble in home prices. It was only a matter of time before the housing bubble exploded.
Step 3: Force Lenders to Abandon Sound Underwriting Standards
The Fair Housing Act (FHA) makes it unlawful for lenders to determine lending standards based on "race, color, national origin, religion, sex, familial status or handicap." The FHA attempted to abate longstanding discriminatory lending practices among banks. Because many minority communities posed greater underwriting risks to established lenders, the lack of credit issuance by mainstream financial institutions in underserved communities left a void in the marketplace where high-cost lenders to develop minority-focused lending practices. Many financial institutions exploited the lack of mainstream lenders in minority markets through the perpetuation of high cost or flexible loan structures.
In an attempt to address this longstanding type of discrimination, additional legislation insured that HUD would guaranty mortgages issued to high-risk qualifying borrowers. However, this practice to insure against default virtually eliminated sound underwriting and oversight. This laid the foundation for unscrupulous real estate and mortgage companies to exploit minority markets. The unregulated and government insured conditions set in motion by the FHA allowed predatory lending to thrive in the subprime market. By the 2000s, many predatory adjustable, high-risk loans had morphed to include "exotic" or "creative" attributes like artificially low introductory rates, interest-only mortgages, exploding adjustable rates, pre-payment penalties to preclude refinancing. The aggregation and securitization of these high-risk subprime loans created a seemingly limitless supply of funds that proved to be too hard for profit-motivated firms to avoid.
Lessons learned from over-regulation
It is critical that historic U.S. housing policies focused on protecting America’s workforce do not unintentionally destroy it. Congressional Acts such as the Home Mortgage Disclosure Act, the Community Reinvestment Act, and the Fair Housing Act serve as the root cause of the 2008 financial crisis. While greedy investment bankers, incompetent rating agencies, irresponsible housing speculators, shortsighted homeowners, and predatory mortgage firms all played a part, these perpetrators were merely following the economic incentives that government policies laid out for them.
For the celebration of the 2016 Labor Day, let’s all remember that it is the laborers of this country that provide the catalyst for growth. There are no legislative acts, creative debt instruments or billionaire bankers that can debunk the work ethic inherent in the American Labor force. Happy Labor Day. Let’s learn from the past and march towards tomorrow.