Can you blame the poor?

The conventional wisdom surrounding the real estate bubble (at least amongst conservatives) is that congressional meddling forced banks to loan money to the unqualified. The increase in the number of now qualified loan recipients increased the demand for housing, which drove up the prices. When these mortgage-holders were unable to make payments, as the free market knew they wouldn't, the foreclosures sent a shock wave through the industry, tightening up requirements, reducing demand, and thus reducing prices.

The problem here is that this explanation violates the laws of supply and demand. If banks were simply being forced to loan to people that were not qualified, then the result would be that mortgages would be generally less profitable, and there would be less mortgages available, shrinking the amount of money spent on mortgages, not increasing it. What the government was engaging in was classic price fixing. You cannot charge more than "x" for this loan. In every other industry this inevitably results in shortages. When the price of rent is fixed too low, people stop building apartment buildings, and a shortage of living space results. In every industry, price fixing results in shortages.

If the government made mortgage-lending less profitable by forcing banks to increase the amount of risky loans they made, then the amount of capital available to mortgage loans should have dried up quickly. Banks should have shut their windows and said, "Sorry, we are only able to loan out x-million dollars this quarter, and we have already met that limit." Capital, after all, is a scarce resource.

Ahhhh... but when the money can be borrowed from the Federal Reserve at scandalously low interest rates, the supply of capital is inexhaustable.

In the world of sanity and freedom, the risk associated with investing is reflected in the interest rates (and the ability to secure a loan, of course), and the interest rates are a reflection of the supply of capital, and the supply of capital is the sum total of real savings, and real savings is a reflection of the consumers willingness to save now in order to spend later.

As borrowers take out loans to purchase houses, the prices of homes go up. When entrepeneurs see housing prices rise they exclaim, "Ah ha! Prices are on the rise, perhaps I should invest in real estate?" But as more money is taken out of the supply of capital, the interest rates go up. The entrepeneur despairs, "Real estate is rising, yes, but the interest rate is higher than the rise in prices. Now is not the time to invest. I will find some other market that is not being fully satisfied."

But if the banks have at their disposal an inexhaustable supply of capital at below market rates, a government encouraging them to grant bad loans to people that can't pay, and a government sponsored enterprise promising to purchase every bad loan that is made, all of the stops have literally been pulled out. All of the natural impediments to rampant speculation have been removed. The result is obvious. Home prices continue to rise because the interest rate fails to respond. It is easy to blame the Fed for failing to respond correctly to the rise in prices, but the real failure is central planning in general. Why attempt to replicate the market interest rates when you can simply allow the market to determine its own rates?

Fun fact - "Pulling out all the stops" refers to pipe organs which use "stops" to restrict airflow which alter the sound of the organ and restrict volume. Pulling out all the stops maximizes the volume.