The causes of such an enormous financial crisis were many and varied. But while several factors, such as government accounting rules, complex financial instruments, and faulty risk management systems, played a role during the crisis, at its heart was the historic collapse of the U.S housing market.
So how did the housing market collapse so spectacularly? Beginning largely in the 1990s, the federal government dramatically lowered mortgage-underwriting standards and pushed real interest rates below zero, while various state and local governments artificially reduced housing supply through onerous zoning regulations. The result was an enormous run up in asset prices that eventually burst, taking with it all the financial instruments and institutions that depended upon them.
In response to the crisis, the largest piece of legislation ever written, the Dodd-Frank Act, was passed by Congress and signed by President Obama on July 21, 2010. Perhaps most astonishingly, however, is the fact that while Dodd-Frank imposed nearly $40 billion worth of new regulatory costs on the industry, it wholeheartedly failed to deal with the root cause of the crisis—the government’s meddling in the housing market. A decade on from the financial crisis, this problem has not been solved. If anything, the federal government’s role in the housing system has only become more entrenched.
This series of blog posts will examine why federal and state governments came to dominate America’s housing system, and how that expansion ultimately lead to the financial crisis. It will then examine the steps taken—or not taken—since the crisis to address these problems. Finally, it will conclude with some reform recommendations for how private capital and free enterprise can replace the government’s central role in the housing system.
America’s Infatuation with Housing—For Some
The story of the housing bubble dates far back into American history. Following the end of post-Civil War Reconstruction in 1877, federal and state governments spent nearly another century promoting and enforcing an overt policy of racially segregated housing.
Specifically, the federal government’s role took off in the early 20th Century under Woodrow Wilson, himself a fervent racist. Terrified by the Russian Revolution of 1917, federal government officials believed that in order to deter the rise of communism, the government could make white Americans good capitalists by making them homeowners, and thus invested in the system of private property.
Yet Wilson’s campaign had achieved little by the time Franklin Delano Roosevelt took office in 1933. The Great Depression was wreaking havoc on the economy, with over 9,000 banks failing between 1930 and 1933. As my colleague John Berlau and I detail in a study of the era, the fundamental causes of the bank failures during the 1930s was the structural fragility of the banking system induced by government policy. A prohibition on nationwide branch banking forced banks to be small, undiversified, and tied to their local economies, so when the Depression hit, they failed along with their local economies.
Nevertheless, with the Depression looming, the Roosevelt administration created a swath of new government organizations to shore up the housing market, such as the Home Owners’ Loan Corporation, the Federal Housing Administration, and the Federal National Mortgage Association, commonly known as Fannie Mae. While each organization played a different role, they collectively worked to ensure that both new and old neighborhoods would be racially segregated. The Federal Housing Administration’s role, for example, was to insure properties and buyers that met certain qualifications. With reduced risk, banks would offer lower interest rates, making ownership more affordable to working-class families. As a result, private banks would rarely provide financing for projects uninsured by the FHA.
One of the requirements of FHA insurance, however, was that the purchasers were not African-American, even if they were creditworthy, or that a white purchaser was not moving into an African-American neighborhood. This was the infamous “redlining” of neighborhoods, whereby regions dominated by African-Americans were deemed uninsurable by the federal government. The FHA would instruct banks to stay clear of areas with “inharmonious racial groups” and recommend to cities that they enact racially restrictive zoning. New Deal public housing projects were largely the same. Race determined the program’s design, with buildings segregated by race or excluding African-Americans entirely. While white Americans were reserved prime housing land, the areas zoned for blacks were quite the opposite, often next to industry and high-polluting areas.
After World War II, government financing spurred the suburbanization of America, dominating new housing. Yet it was only in 1962 that FHA ceased financing racially segregated housing when President John F. Kennedy issued an executive order prohibiting the use of federal funds to support racial discrimination. This was followed up with the Fair Housing Act of 1968 that prohibited future discrimination. But the damage was already done. As Richard Rothstein wrote in his book, “The Color of Law: A Forgotten History of How Our Government Segregated America”:
[F]ederal, state, and local governments purposely created segregation in every metropolitan area of the nation… The government was not following preexisting racial patterns; it was imposing segregation where it hadn’t previously taken root.
Decades of racist government mortgage policy established a cycle of poverty and exclusion for African-Americas that lasts to this day. The racial homeownership gap has barely changed for 40 years. In 1976, 44 percent of African-American families owned their own home. By 2016, that rate had fallen by 2 percent. Whereas white homeowners were granted subsidized, prime housing, leading to wealth accumulation for decades to come from homeownership, African-Americans were denied the same privileges. Unable to own their own home and forced into poor quality neighborhoods, African-Americans missed generations of wealth building opportunities.
As I will discuss in Part II, it is within this context that government policymakers, looking to rectify the problems of state and federal government segregation, sought to expand opportunities for low-income and minority residents by religiously pushing for greater intervention in the housing market.