James d. Gwartney

rates
(?)
 for subprime loans
(?)
 range from seven to ten times the parallel rates for conventional
loans to prime borrowers. Predictably, the growing share of loans to those with weaker credit
eventually led to higher default and foreclosure rates.
Both Congress and the presidential administrations of Bill Clinton and George W. Bush
were highly supportive of these regulatory policies and took credit for the initial increase in
home ownership they helped to generate. As the policies eroded mortgage-lending standards,
making credit more readily available for risky loans, the initial effects seemed positive. The
demand for housing increased, housing prices soared during 2001–2005, and there was a boom
in the construction industry.

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Exhibit 6: Subprime Mortgages as a Share of the Total, 1994–2007
40
35
30
25
20
15
10
5
0
13.2
9.2
25
32.2
33.6
18.1
4.5
Year
1994
2000
2002
2004
2005
2006
2007
Share of Mortgage Originated
During Y
ear (percent)
Source: The 1994–2000 data are from Edward M. Gramlich, Financial Services Roundtable Annual Housing Policy
Meeting, Chicago, Illinois, 21 May 2004. The 2002–2007 data are from the Joint Center for Housing Studies of Harvard
University, The State of the Nations Housing 2008, 
https://www.jchs.harvard.edu/research-areas/reports/state-nations-
housing-2008
. Loans with incomplete documentation and verification, known as Alt-A loans
(?)
, are included in the
subprime category. Studies indicate that most of the Alt-A loans were to subprime borrowers.
But the artificially created housing boom was not sustainable. By 2004–2005,
approximately half of all mortgages were either subprime (including those with incomplete
documentation) or loans against the equity people had in their homes. As soon as prices
leveled off and then began their decline during the second half of 2006, the house of cards
came crashing down. The foreclosure and mortgage default rates
(?)
immediately began to
rise. All of this occurred well before the recession
(?)
, which did not start until December 2007.
Of course, the collapse of the housing industry eventually spread to the rest of the economy,
and the bad mortgages generated huge financial problems in banking and finance both in the
United States and abroad. By summer 2008, Fannie Mae and Freddie Mac were insolvent.
Their operations were taken over by the government and the American taxpayer was left with
approximately $400 billion of bad debt.

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The interest rate policies of the Federal Reserve System also contributed to the Great
Recession of 2008–2009, as we will explain in the following element. But one thing is clear:
The political allocation of credit and accompanying regulatory erosion of lending standards
channeled a lot of financial capital into projects that should never have been undertaken. Many
homebuyers were incentivized to purchase more housing than they could afford, and that was a
major contributing factor in the housing boom and subsequent bust, and the recession it helped
generate.
Although the specifics were different, the United States was not the only country where
misguided government policies created a crisis in the housing market in the years just before
2010. Between 2007 and 2010 average house prices fell by approximately 35 percent in
Ireland and by half or more in Dublin. Following the crash of the “Irish housing bubble,”
evaluation by outside experts, including senior finance ministry officials from Canada and
Finland, attributed the overheated market to a combination of excessively low interest rates set
by the European Central Bank (ECB), massive increases in Irish government spending
encouraged by higher than expected property tax revenue, and, especially, a government policy
that attempted to encourage home ownership by allowing mortgages for 100 percent of a
home’s purchase price, just like in the United States. Corruption also played a role.
(33)
 Similar
policies in Spain created precisely the same result during the same time frame.
When governments are heavily involved, allocation of investment is inevitably
characterized by favoritism, conflict of interest, inappropriate financial relations, and various
forms of corruption. When actions of this type occur in other countries, they are often referred
to as crony capitalism
(?)
. Historically, the government has played a larger role in the allocation
of investment in other countries than in the United States, but the American experience with
government allocation of investment funds for housing illustrates that crony capitalism occurs
in the United States as well. Regardless of the label, political allocation of capital imposes
a heavy cost on citizens.

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