A warning in 2003 about unconstrained mortgage loans

Robert Locke writes:

That investment banking has been abolished in America is a very radical step. (Not even FDR did that; he just forced investment banking to separate from commercial banking with the Glass-Steagal Act.) It means that laissez faire has been admitted unviable—that the free market won’t automatically find itself a viable equilibrium, but will tend to crash and require rescue. The Europeans have won the argument about regulated vs. laissez faire capitalism. American financiers should be on their knees praying to Frankfurt five times a day.

That this crisis would come has been no secret among those paying attention; See Robertson Morrow’s article, “Living in the Bubble” (which I contributed to), published at The American Conservative in 2003.

Morrow wrote:

The principal ways that government subsidizes mortgages are the Federal Housing Administration and the Government Sponsored Enterprises: Ginnie Mae, Fannie Mae, and Freddie Mac. These institutions raise money in the capital markets that is recycled into home mortgages. They are subsidized because government guarantees their debts either explicitly or implicitly.

These federal guarantees encourage people to overextend by making borrowing cheaper than it otherwise would be. As always, when government subsidizes something, we get too much.

American capitalism historically contained constraints on the natural human propensity to borrow. But in the last twenty years, these limits have been systematically destroyed in the name of creating a more efficient financial system. We now have a system with greater technical efficiency but also one that gives borrowers far more rope with which to hang themselves-if they are inclined to try.

Witness the conversion of the humble home mortgage into an exotic and liquid financial instrument plugged into the global money markets. Twenty-five years ago, most mortgages were issued by local banks from money raised through local deposits. Today, most mortgages are marketed by a variety of institutions from national banks like Citibank to mortgage-only companies like Ditech. But the money actually comes, via various intermediaries, from Wall Street and other money markets. Mortgages are bundled into financial instruments that are traded all over the world like stocks or bonds. This conversion has produced a financial system in which it is easier for available capital to flow to people who can pay the best price to use it. The downside is that it has removed the traditional restraints on the propensity to go into debt.

American capitalism was never structured to deliver absolute economic freedom. Rather, it was based on things like the traditional wisdom that debt is a temptation—not something deserving of the neutral attitude implied by value-free modern finance. The American system once focused on the accumulation of wealth. It was a truism of traditional bourgeois culture that owning was better than owing, and all prosperous people believed this.

Posted by Lawrence Auster at October 01, 2008 12:43 PM | Send

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