Editorial: Risky loans and ethanol

Jan. 26, 2009
Before making any more fuel choices, Congress and the new administration of Barack Obama should compare a past governmental foray into the energy market with the mortgage industry’s disastrous unraveling.

Before making any more fuel choices, Congress and the new administration of Barack Obama should compare a past governmental foray into the energy market with the mortgage industry’s disastrous unraveling.

The mortgage catastrophe, which has crushed credit markets in general and catalyzed global recession, has roots in governmental activism. As a source of economic distortion wrought by exuberant governance, it’s analogous to the ever-worsening problems associated with fuel ethanol.

The mortgage market collapsed at least partly because the government encouraged lending to home buyers who couldn’t afford the loans. The motives seemed beneficent: promoting home ownership; boosting construction; and ending geographic discrimination in lending decisions. Yet the consequences are widespread and dire.

Forms of encouragement

Pressure to make low-quality loans took several forms, described in a November 2008 report by Lawrence H. White, professor of economic history at the University of Missouri-St. Louis and adjunct scholar of the libertarian Cato Institute. White lists:

  • A lowering of down-payment standards on mortgages guaranteed by the Federal Housing Administration.
  • Strengthening of the Community Reinvestment Act (CRA), which promotes lending in low-income areas.
  • Pressure by the Department of Housing and Urban Development on lenders to make risky mortgages.
  • Subsidization, through implicit taxpayer guarantees, of the expansion of Fannie Mae and Freddie Mac, mortgage buyers sponsored by the federal government.
  • Refusal to moderate the “moral hazard” of implicit guarantees—that is, the incentive on lenders to take undue risk—or to curb the growth of Fannie Mae and Freddie Mac.
  • Pressuring Fannie Mae and Freddie Mac to promote “affordable housing” by expanding their purchases of high-risk loans made to low-income applicants.

Observers wanting to blame deregulation for the mortgage crisis try to steer attention away from these developments. Some, for example, argue that loans certified by the CRA represent a fraction of troublesome lending and that no evidence exists that they contributed to the mortgage meltdown. What form that evidence might take is unclear. What is clear is that the CRA was one in a series of steps the government took to expand risky lending on a scale the market would not have done alone. Most of those steps occurred well after the deregulation of financial institutions.

Fuel ethanol, too, has followed a sequence of self-reinforcing moves characterized by deviant consequences. Bewitched by corn growers and distillers, past Congresses and administrations plus a number of states have decided that adding ethanol to gasoline yields benefits justifying generous tax credits. The benefits, mainly having to do with air quality and supply extension, fall subject to habitual exaggeration. And the perverse consequences are too frequently ignored.

It wasn’t enough for Congress to create a fuel market for ethanol with tax credits for blenders. Politicians felt obliged to enlarge the market with volume mandates. When the mandates spawned a gold rush as another gasoline oxygenate fled the market for legal reasons that Congress wouldn’t fix, lawmakers expanded the market again to sop up the excess supply.

Meanwhile, corn prices predictably jumped, pushing up food prices worldwide and feedstock costs for ethanol plant operators. Yes, other forces acted on grain prices at the same time. But to deny that the mandates had meaningful influence on food prices, as the ethanol lobby does, is ridiculous. And the mandates grow each year.

More problems

Other problems have developed. Falling gasoline prices have further damaged ethanol plant economics. Falling fuel consumption and low sales of 85% ethanol blends have placed in question the ability of the gasoline market to absorb ethanol in mandated amounts. Ethanol supporters therefore want Congress to raise the blending level beyond the 10% level considered safe for vehicle engines not made to accommodate the corrosive additive. They must hope consumers don’t notice the btu-adjusted premium at which ethanol has been selling to wholesale gasoline.

One costly intrusion thus leads to another as government responds to problems it created with market activism it never should have undertaken. It happened in the mortgage business. It’s happening in the fuels business. The cycle needs to stop.