US policies to encourage home ownership promoted risky lending
The US Government requires its agencies and some banks to lend to borrowers with below average incomes. To meet new targets they made risky loans, which resulted in increased housing demand that hid the risk. Other lenders jumped on the bandwagon, creating massive instability.
This claim is made by Peter Wallison, senior fellow at the American Enterprise Institute, who was a member of the Financial Crisis Inquiry Commission (FCIC) created by congress. The ten-member commission eventually produced a majority report, a dissenting report signed by three members, and another dissenting report by Wallison alone containing this argument. All the reports are available at this archive site.  Wallison repeats the basic argument, slightly modified, in this Wall Street Journal op-ed.

Wallison observes that since 1992 the US Federal Government required the mortgage financing agencies "Fannie Mae" and "Freddy Mac" to use a proportion of their funds for borrowers who had below-average income.  Originally the target proportion was set at 30%, but it was raised during the Clinton and second Bush administrations, reaching 55% by 2007.  The Community Reinvestment Act imposed a somewhat similar requirement on some banks to support lower-income borrowers.

This change in lending patterns resulted in both
  • a large increase in the number of risky mortgages, as underwriting standards were lowered to reach the target figures, and
  • beginnings of a housing price bubble, as new buyers entered the market.
At first relatively few borrowers defaulted; rising prices meant that anyone who got into financial trouble could easily sell the house to pay the mortgage.  This presented an illusion that the risky mortgages were actually much safer than previously estimated. Private investors began to demand subprime mortgage-backed securities for their own account.

Wallison uses an estimate by his colleague Edward Pinto that by 2008 over half the mortgages in the US were subprime or weak in some way.  When the housing price bubble ended, mortgages went into default in unprecedented numbers, reflecting the underlying weakness in their underwriting. Investors in mortgage-backed securities panicked as they realized the scale of risks that they faced. The value of mortgage backed securities plummeted.  Institutions that had invested heavily in them failed.

[It is worth noting that the scenario described above is that of Wallison's Wall Street Journal article.  In the earlier FCIC dissent he says that most risky loans were originated in direct response to government regulations, rather than private investor demand.  The difference is significant.  In one case the regulations themselves are to blame. In the other, investors must be guilty of poor judgement, too.
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The Global Financial Crisis »The Global Financial Crisis
Long-term causes of the financial crisis? »Long-term causes of the financial crisis?
Unintended consequences of earlier public policy choices »Unintended consequences of earlier public policy choices
US policies to encourage home ownership promoted risky lending
Many risky loans originated with intent to sell to Fannie or Freddie »Many risky loans originated with intent to sell to Fannie or Freddie
Markets unaffected by these policies experienced bubbles, too. »Markets unaffected by these policies experienced bubbles, too.
Nine out of ten FCIC commissioners disagree »Nine out of ten FCIC commissioners disagree
Number of loans made to satisfy housing policies is overestimated »Number of loans made to satisfy housing policies is overestimated
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