Review of Thomas Sowell, The Housing Boom and Busy
Basic Books (2009)
Herbert Gintis
I once gave something I wrote to a colleague for comments. He told me "there is much that is
new here, and much that is true. Unfortunately, that which is new is not true, and that which is
true is not new." I believe the same can be said for this, Thomas Sowell's contribution to
understanding the housing bubble and financial meltdown of the past several years.
The most persuasive parts of the book concern Sowell's critique of the attempt of liberal
legislators and activists in the early 1990's to induce private lending institutions to increase their
lending to minority applicants in the inner city, on grounds that these institutions were engaged
in illegal discriminatory practices. The idea that profit-driven lenders would care about the race,
or any other characteristic, of their clients that did not impact on profitability is highly
questionable, and I do not believe that there has ever been any credible evidence that the banks
were in fact guilty, although the practice of "red-lining" may indeed be illegal even when
profitable. Sowell spends the bulk of this book dredging up this old issue, with the allegation
that the pressure of the government to lower credit standards created a climate of norms and
expectations without which the subprime lending disaster could not have occurred.
It is this allegation, that the financial meltdown was caused by "excessive government
regulation" rather than "greed" or "failure of the free market", that is new and is very likely
untrue (the "greed" alternative is surely incorrect, and the "failure of the free market" should be
seen as a failure of effective regulation of the free market). The free market true-believers, of
whom Sowell is the most credible, were momentarily disarmed by the rapid unraveling of the
US financial system. Former Federal Reserve chairman Alan Greenspan said just last year
"Those of us who have looked to the self-interest of lending institutions to protect shareholder's
equity -- myself especially -- are in a state of shocked disbelief." However, they are coming
back in full force to put the blame squarely on government regulation. Sowell's main charge is
that Fannie Mae and Freddie Mac, which are privately owned, stock-issuing companies, but are
GSEs (government-sponsored enterprises) that are accorded special privileges established by
Federal law, are really responsible for the reckless spate of subprime mortgage lending.
"government agencies not only approved the more lax standards for mortgage loan applicants,
government officials were in fact the driving force behind the loosening of mortgage loan
requirements." (p. 30)
More specifically, "the development of lax lending standards, both by banks and by Fannie Mae
and Freddie Mac standing behind the banks, came not from a lack of government regulation
and oversight, but precisely as a result of governmet regulation and oversight, directed toward
the politically popular goal of home ownership: through "affordable housing"...These lax
lending standards were the foundation for a house of cards that was ready to collapse with a
relatively small nudge." (p. 57) It is important to note that Sowell never substantiates this
charge with any empirical evidence, and in fact they do not square up to the facts. It is true that
the NSEs have special privileges, among which are being exempt from state and local income
taxes, Securities and Exchange Commission requirements and fees, and they have potential
lines of credit with the Treasury of over $2.25 billion. In exchange, the President can appoint
five of their eighteen board members. The most important effect of their Federal charters is,
however, the implicit understanding that the Federal government would never permit Fannie
Mae or Freddie Mac to fail, whatever the state of their portfolio. Sowell's point is that this
implicit guarantee appears to place stockholders in a no-lose situation in which they can take
great risks with subprime mortgages and reap the profits when things go well, but can offload
their losses to the taxpayer when things go bad. Were this true, there is no doubt but that these
the two GSEs would take on otherwise highly unprofitable levels of risk. This is the received
wisdom, but in fact, stockholders have been clobbered by the financial meltdown, and stock
prices in these two institutions have fallen to near zero. Stockholders understood that the
institutions would be saved, but their stock values would not be immune from steep decline.
Moreover, just as housing prices began to increase rapidly several years ago, Federal regulators,
responding to GSE accounting scandals, placed serious restraints on their ability to assume
high-risk debt. Indeed, by definition these GSEs did not engage in subprime lending because
their legal statutes prohibited them from issuing mortgages without substantial down payments
and closely validated assurances concerning family income and wealth. [Professor Russell
Roberts (Economics, George Mason University) commented on this point in personal
communication: "As far back as 1999, Fannie and Freddie were using subprime mortgage
purchases and the purchases of subprime backed MBS to satisfy their HUD requirements to
purchase "affordable" mortgages, a requirement that began in the Clinton administration and
that Bush continued with equal if not greater zeal. This has been documented by both the NYT
and the Washington Post though without much detail. I've read through the annual reports of
Fannie and Freddie where they admit in the early 2000s that subprime mortgages typically
amount to 17% of their book of business--which amounts to hundreds of billions of dollars in
some years. Edward Pinto, former CFO of one of them claimed in Congressional testimony that
they were actually even more involved than this. I am skeptical of both of these claims to some
extent. Informed folks have told me that the annual reports of Fannie and Freddie may be
essentially fictional. And I'm not sure that Pinto's analysis is verifiable or accurate. Either way,
it's clear and undeniable that Fannie and Freddie were non-trivial players in the subprime
market. But how signficant is their involvement? Very hard to tell. While I've suggested that the
above story may be important, it is mitigated (as is Sowell's story) by the fact that Ireland and
Spain and South Africa (I think) also had housing bubbles. Did they have governmentmandated expansion into the low-income sector? I suspect not.
So all of the domestic explanations have to answer the magnitude question. Surely Fannie and
Freddie contributed to the problem. But you have to establish the magnitude.] Indeed, Fannie
Mae and Freddie Mac began to recede from the forefront of mortgage lending when the housing
bubble emerged in the years after 2003. Fannie Mae and Freddie Mac executives panicked
when their positions in mortgage markets began to deteriorate, and they introduce questionably
legal procedures ("expanded approval" for Fannie Mae and "A minus" for Freddie Mac) to
recapture market share. But these efforts were basically unsuccessful because the GSE lenders
were saddled with fixed-rate loan structures. The share of GSEs in the mortgage market faded
rapidly in the latter years of the housing bubble. Note that before being taken over by the
government, the GSEs were private, market-oriented, investor-owned companies, and their
behavior in excessive risk-taken was, if anything, less pronounced that the rest of the private
financial sector. Nor did any Federal legislation, including the Community Investment Act of
1977, require that banks take on subprime assets. As Richard Posner says in his recent book on
the subject, "the pressure exerted by the government to lower lending standards was a case of
pushing on an open door...Banks wanted to make risky mortgage loans.' Indeed, never during
the housing bubble dynamics did they protest that they were forced to behave irresponsibly.
"The critical role of government in the crisis," Posner concludes, was one of permission rather
than encouragement." (p. 242) In other words, the financial meltdown of 2007 and after was a
failure of coherent regulation, not government meddling. Sowell's book, in short, is very useful
for his analysis of the "affordable housing" movement, but only the free-market fundamentalists
will find his analysis of the current crisis appealing. The current crisis is in fact a failure of
appropriate regulation. The finance sector developed over the past decade a number of novel
financial instruments, including credit default swaps, that could be bought, sold, and traded
without the usual constraints (especially limitations on reserve requirements).
The Garn-St. Germain act of 1982, which dropped New Deal era banking constraints, made this
sort of innovation possible, and countries (e.g. Canada) that retained similar controls enjoyed
stable banking sectors despite the US financial crisis. The intense short-sidedness of the
financial sector, itself a product of the industry's incentive structure, plus the power of banks to
shop for auditors who would overlook the shakiness of the newly minted asset-types, allowed
the financial sector to spiral out of control. The idea that the government's entanglement with
GSE's is a key element in precipitating the crisis is just not plausible. Incidentally, Sowell
himself is not a free-market true believer (indeed, no one who has carefully studied modern
economic theory could be), but rather a believer in the proposition that the government is rarely
an effective regulator of the market, so should stay out of regulation under most conditions.
This is not a bad thought, but it does not apply to the financial sector, which has shown itself to
operate well only when regulated well.
Please do not infer from my assessment of Sowell's argument that I am a crusader for heavy
regulation of the financial sector. I am not. I think that countries that dropped New Deal type
regulations in the 1980s were correct to do so (this includes the US and Britain), because this
led to many years of furious innovation and almost full employment. The failure of regulation
occurred in the past decade, where the stupidity and avarice of politicians equalled if not
exceeded that of financial sector operatives. The private sector operatives at least have the
excuse that they were merely doing what competition dictated (I believe this is the case---see
Richard Posner's new book on the topic for a cogent defense), whereas the politicians should
have known better, and their economic advisors should be relegated to teaching in Jr. High
School on the basis of their shockingly poor perspective on the situation. I would love to see
Larry Summers and Alan Greenspan teaching twelve year olds for a few years (Wittgenstein
did it, and it made him a lot more reasonable and creative). For a careful assessment of the
history of financial regulation in the US, see Moss, David A. (2004). When All Else Fails:
Government as the Ultimate Risk Manager. Harvard University Press. ISBN 0-674-01609-2.
http://www.amazon.com/dp/0674016092/. Moss notes that from 1792 to the Great Depression
in 1933, financial crises occurred about every 15 to 20 years. Between 1933 and the mid-1980s
there were no financial crises at all. This period of financial calm was largely the product of
strong financial regulation, starting with the Glass-Steagall Act of 1933 and the Banking Act of
1935. The framers of these measures realized important economic regularities. For instance,
federal deposit insurance would stop the threat of bank runs, but would lead banks to take
excess rist, as they would be undisciplined by their depositors. Hence, these Acts included
safeguards against excessive risk-taking. When these safeguards were largely dismantled in the
1980s and in the current era, the reappearance of financial fragility was assured, starting with
the Savings and Loan debacle of the mid-1980s.
I am not arguing that we need iron-fist financial regulation. Far from it. I am arguing that the
ideologues who believe that no regulation is the best regulation are just as much our enemies as
those who would nationalize the financial system and replace financial experts with Citizens
Councils.