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John R. Lott Jr.: Financial Markets Are in a Mess

Financial markets are in a mess.

Securities giant Bear Stearns, saddled with sub-prime loan debt teetered on the verge of collapse last week. The drumbeat in the media and among Democrats is that we are supposedly either in or near a recession. Even the positive news is reported with claims that it is an aberration.

Politicians always seem to know better. Not satisfied with telling people what types of light bulbs to use and the size of cars they can drive, politicians in Washington have decided to replace financial markets and try legislating away the laws of supply and demand.

Last week congressional democrats introduced regulations to stop what they complained were "wild interest rate hikes" on credit cards. Before that Hillary Clinton advocated a 90-day moratorium on foreclosures and a five-year freeze on interest rates for sub-prime mortgages.

Yet, price controls don’t solve the problems with high interest rates. If people want to borrow more money than is available, interest rates rise, both to attract more to lend and insure that those who need what scarce money there is, are the ones who get to borrow it. If regulations prevent interest rates from going up, you get shortages and credit rationing.

The current mortgage crisis arose because loans were made with virtually nonexistent underwriting standards. There was no verification of income or assets, little assurance of the ability to pay the mortgage, and little or no down payment. So, with rules like these, who wouldn’t have expected defaults? In January, the Federal Reserve stepped in proposing strict regulations on what conditions should be met before loans would be allowed.

Democrats criticized the rules as not going far enough in determining when loans could be made.

But if lending money to people with so little credit worthiness were so obviously such a boneheaded mistake that even non-bankers see it, why would people who had billions of dollars at stake and years of experience lend out money this way?

To critics the answer seems simple: Greed.

Yet, no matter how greedy you are, would you think that loaning money to people who are likely to default with little collateral in their property was the way to riches? Would you lend your money out that way?

Obviously, no.

So, why did they make the loans? Government regulation.

Some of the very people who are now advocating new regulations were the same ones that forced through the regulations over a decade ago that caused the problems that we are facing today.

This all started back in 1992, when a Boston Federal Reserve study claimed to find evidence of racial discrimination. The Fed later used the study to produce a manual for mortgage lenders that: “discrimination may be observed when a lender’s underwriting policies contain arbitrary or outdated criteria that effectively disqualify many urban or lower–income minority applicants.”

So what is on the list of Fed’s “outdated criteria”? Such “discriminatory” factors as the borrower’s credit history, income verification, and the size of the mortgage payment relative to income.

But it turns out that the original study was mistaken.

Economists discovered that there were errors in the data the study used. Some minorities were listed as having wealth up to hundreds of times greater than they actually had, making it look like wealthy minorities were being turned down for loans. When the data errors were corrected minorities with the same financial background as whites had been at no disadvantage in getting mortgages.

There was an expected consequence of these easier loans: minorities were hit by higher foreclosure rates. Ironically, people who point to these higher rates as evidence of discrimination don’t understand that the regulations setup to make it possible to get loans without the qualifications also meant that they are more likely to default.

Indeed, two academics, Professors Ted Day and Stan Liebowitz at the University of Texas at Dallas, who criticized the Fed policy back in 1998, warned : “After the warm and fuzzy glow of ‘flexible underwriting standards’ has worn off, we may discover that they are nothing more than standards that lead to bad loans … these policies will have done a disservice to their putative beneficiaries if … they are dispossessed from their homes.”

Nor is this the first time that the government has created these problems. Most economists believe that the Savings and Loan collapse in the 1980s was due to federal deposit insurance. The government charged all banks the same rate for insurance, no matter how risky their investments.

Banks that made riskier investments didn't pay a higher insurance premiums and could afford to offer higher interest rates than their competitors and attract depositors. But while these banks grew, they were also more likely to go bankrupt. It was akin to government flood insurance that encouraged people to keep on rebuilding their houses next to rivers that flood.

The “new” solutions such as a moratorium on foreclosures will have just as certain consequences. They will make lending money riskier, scaring away those willing to lend money, and raising mortgage rates.

One might hope that the mess that politicians have already made of the financial system would give them some humility. Yet, the pattern is all too familiar. Government regulations generate problems that lead to calls for even more regulation. Will politicians get the blame that they deserve for the financial mess that they created?

*John Lott is the author of "Freedomnomics" and a senior research scientist at the University of Maryland. Lott recently consulted with the Independence Institute on changes in D.C. crime rates.