Is Capitalism really to be blamed for the Subprime Crisis?

Not a day passes by when we do not read or hear about the failures of capitalism in the US and how it led to the subprime crisis (which in turn went on to become a global financial crisis). But is capitalism really to be blamed? Or was it poor political intervention that led to all this? Lets see:

Historically it was observed in the US that low-income people and minorities were not granted sufficient home loans (mortgages) due to their poor ability to repay those loans. However repeated policy interventions over the years have altered this, leading to dangerous consequences.

Intervention # 1: The government decided to enact the Community Reinvestment Act (CRA) in 1977, which basically forced the banks and other regulated mortgage lenders to lend more to the low income and minority mortgage applicants. As it did not make a lot of economic sense lending to the poor, banks complied reluctantly to avoid regulatory scrutiny. Hence mortgages to the poor (subprime mortgages) remained a small portion of the overall mortgage market and did not pose a systemic risk.

Intervention # 2: To counter this, in 1992, the Department of Housing and Urban Development set targets for Fannie Mae and Freddie Mac to purchase low-income loans for sale into the secondary market. With Government Sponsored Enterprises (GSE) like Fannie and Freddie ready to buy up their subprime loans, banks started lending out enthusiastically.

Intervention # 3: As if this was not enough, an amendment to the CRA was passed in 1995 - permitting securitization of these loans. This changed everything. Securitization basically meant that these subprime loans could be bundled together with virtually anything and sold off to other investors. From the late 1990s into 2005, the subprime share of mortgage lending exploded from about 5-6% to over 20%.

This was all good till home prices were going up and interest rates were low. But once both these things reversed in 2007, people started defaulting on subprime mortgages and with subprime mortgages now being a big part of the overall mortgage market, this posed a systemic risk to the whole economy.

In a capitalist system it is difficult to see how mortgages would be given to people who cannot afford them. However, combine capitalism with political intervention and you have the perfect ingredients for a crisis. As the famous economist Milton Friedman said - just about every economic and social ill that confronts the US could be traced to misguided federal policies and their unintended consequences.




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This post presents a point of view which differs from conventional wisdom. Apart from being a good read (hopefully), it can be a good starting point to help readers, preparing for CAT (IIM) or other MBA interviews, think differently. Since the data / facts for these posts are derived from a host of sources and websites, readers are advised to cross-check the authenticity before using them anywhere.