Forum Post: Stop Blaming Banks

Before any reforms, there must be an accurate diagnosis of what caused the banking crisis. It was the housing bubble, and there is plenty of blame to go around.

Long ago, Congress decided to promote home ownership (out of all proportion to home ownership in, say, Europe). They made mortgage interest tax-deductible, which is basically a subsidy to mortgage lenders, and for good measure they created – not one, but two – taxpayer-backed mortgage lenders, FNMA and FRMC. More recently, Congress started pressuring lenders to lower their credit standards and make mortgages available to ever-riskier borrowers.

Contrary to popular belief, banks are not in business to make bad loans and collect foreclosed property. They lose a ton of money when that happens. That’s why all the hassle about credit scores and loan-to-value ratios. Mortgage originators, on the other hand, don’t care what happens after the sale closes. The housing bubble produced many fast-buck brokers, but these are not the legendary fat cat bankers. They are small-time crooks.

Most of the people now having problems with their mortgage payments are presumably honest people who have had some setback. Many, however, were complicit in foisting bad loans onto the mortgage lenders. They may have lied about their financial status, or accepted terms that they knew were untenable. No one should have accepted negative amortization, for instance – borrowers or lenders.

When housing prices stopped going up, the dodgy loans became bad loans and the bad loans choked off the liquidity in the banking system. Banks must borrow from other banks to survive and, after AIG failed, the interbank loans started to dry up. Everyone knew that there was a huge exposure to bad debt but, because the mortgages had been securitized and resold, no one knew for sure who was holding it.

So, the bubble burst. The cascading effect of counterparty risk and vanishing liquidity was exactly like a bank run – those depression-era photos of people lining up outside the banks, only to discover that their savings are gone. The Federal Reserve had to step in and provide cash, and the FDIC did the hard work of unwinding hundred of banks that weren’t “too big to fail.” To those that were, the Treasury made the infamous TARP loans. Otherwise, the financial system would have collapsed – in America and probably around the world.

Avoiding “too big to fail,” in the future, is certainly a good policy goal. So are bringing back Glass-Steagall, and making Sheila Bair the Treasury Secretary. The mortgage interest deduction should be scrapped, and Ms. Bair should unwind FNMA and FRMC. Punitive action against the banks, though – like Dodd-Frank – will simply push one more industry out of America and into China.