Talking points on the housing bubble

By Sandy Ikeda

Last week I spoke to a standing-room-only crowd of students and faculty about the current economic and financial turmoil.  I shared the podium with three of my colleagues, who range all the way from far to the left of Barack Obama to very, very far to the left of Barack Obama.  Needless to say, they all blamed, to a greater or an even greater degree, “the free market.”

Now, I do think it’s possible in principle for wide-spread mal-investments to occur in an unfettered market.  (F.A. Hayek writes about the possibility in his Monetary Theory and the Trade Cycle, which you can read online here.)  But enormous speculative bubbles, of the sort we’ve just witnessed in the housing market, are typically the result of government interventions and policies.

So in my talk on this highly complex issue I tried to make three points:  (1) the immediate cause of the financial panic on Wall Street was the housing bubble with its sudden rise in mortgage defaults; (2) the free market, which stands for minimal government and the absence of privilege or discrimination, did not create this bubble; and (3) government (and Fed) policy and pressure did, by undermining lending standards across the board and pushing lending rates artificially low.

This blog has already referenced Russell Roberts’s fine collection of blog posts on the problem, and if you’re already familiar with the issues then obviously there will be nothing new here for you.  But I think it might be useful to have a list of “names and dates” that make the above case.  The following is not meant to be exhaustive (e.g., it doesn’t even mention important international factors), but is only an outline of the major legislation and policies relevant to the housing bubble.

(Caveat:  My expertise in economics is not in finance, but I did study a lot of this stuff at one time.)



1913:    An act of Congress creates the Federal Reserve System, America’s first true central bank, to act as the government’s bank and as a lender-of-last resort for its members.

1920s:    The Fed quickly discovers that by buying and selling Treasury obligations (i.e., “open-market operations”) it can increase and decrease the supply of money and credit and thereby manipulate market rates of interest.  The Fed inflated the money supply by 60% in the 20s, which resulted in economic boom as well as systemic malinvestment, and rampant speculation on margin on Wall Street.  (Sound familiar?)  The best account of the episode is Murray Rothbard’s America’s Great Depression.

:  As we know, the economy then crashed and burned.  But that was a necessary stage in the economic recovery from the previous decade’s massive malinvestments, as producers tried to re-align their decisions with consumer preferences.  Unfortunately, a slew of policies, such as the Fed’s 30% contraction of the money supply, and legislation, such as the Smoot-Hawley tariff, delayed recovery for twelve years.

:  FDR creates the Federal National Mortgage Association (“Fannie Mae”), which is charged with buying and insuring residential mortgages in order to lower interest rates and promote home ownership.  Home ownership rises from 43% in 1949 to 62% in 1960.

1970:  Congress creates the Federal Home Loan Mortgage Corporation (“Freddie Mac”) that, together with a re-constituted Fannie Mae, bundles home mortgages into “mortgage-backed securities” (MBSs) for sale to investors.

•    Fannie and Freddie are known as Government Supported Enterprises (GSEs).

•    By 2008 Fannie and Freddie had issued more than 60% of MBSs, of which they themselves held $1 trillion and insure about 50% of all MBSs.

•    The perception that the federal government guarantees Fannie and Freddie’s viability further lowers the cost of risk and increases their profit margin, on the order of about $2 billion per year, as estimated by the Congressional Budget Office and the Treasury Department.

•    This implicit guarantee is realized in part, when beginning in 2006 rising loan defaults jeopardize Fannie and Freddie and prompts President Bush to nationalize them in August 2008.

:    Congress passes the Home Mortgage Disclosure Act (HMDA), requiring lenders to provide detailed information about mortgage applicants.

:  Jimmy Carter signs the Community Reinvestment Act (CRA), requiring banks to conduct business across the entirety of geographic areas in which they operate, in an attempt to combat “redlining.”

1991: Bill Clinton expands HMDA to include comparisons of rejection rates by race.

1992:    The Boston Fed promotes the government’s mandate to increase home ownership, specifically among minorities, by advocating a relaxation of lending standards, including:

•    Eliminating a lack of credit history as a barrier.
•    Permitting a lower share of income than the standard (28/36) on mortgage payments.
•    Permitting lower down payment and closing costs.
•    Nontraditional sources of income are OK, including unemployment benefits.
•    Banks can be punished by fines if HMDA data show higher rejection rates of minorities.

(One of my colleagues at this point accused me of blaming minorities for the housing crisis.  Be very careful, people will play this card!  Clearly, the responsibility for the crisis lies not in the intended beneficiaries of the CRA, but to the CRA itself and to the lax standards that it later encouraged across the entire mortgage market, both prime and sub-prime.)

Beginning in 1992
:  Fannie and Freddie were encouraged to purchase “affordable” mortgages from banks – i.e., mortgages that followed “flexible lending standards” to promote the goals of the CRA.

•    Pressure from Congress and presidents Clinton and Bush helped promote the “subprime” market.  (Note:  You could underwrite subprime paper even before deregulation of 1999.)

•    Congress and the Administration pressure Fannie & Freddie to accept a growing percentage of their portfolios in subprime mortgages and also MBSs, of which by 1992 they held over $1 trillion.

•    Home ownership rises from around 64% in 1994 to 69% in 2005.

From 1998 to 2006
:  There’s a great housing boom in the US.  Prices rise from just under $60K to over $90K (in 1983 dollars), owing in large part to “flexible standards” and the Fed’s interest-rate policy.

•    The “Federal Funds Rate,” which the Fed targets by using open-market operations, plunged from around 6% in January 2001 to 1% in January 2004.

•    While this was largely in response to the recession and 9/11, it also reinforced Congress and the President’s goal of expanding home ownership and fueling the ongoing housing boom.

2006:  In the third quarter of that year, defaults and “foreclosures started” began their sudden climb for prime (from around 0.16% of loans made to 0.43% in Q4 2007) and subprime mortgages (from around 1.5% to 3.7%) AT THE SAME TIME.  Thus, contrary to conventional wisdom, subprime defaults did not precipitate the prime-market defaults.

•    Stan Liebowitz shows that it was in the market for adjustable-rate loans, particularly in low-income areas, that foreclosures were the most dramatic.  These are the kind of loans that speculators prefer because of their low initial rates (with low or no money down owing to the “flexible standards” which were becoming the practice across the industry) and because speculators expect to re-sell (or “flip”) the houses before the rates were set to increase.

•    In percentage terms, the increase in foreclosure rates was significantly higher for prime adjustable loans (69%) than for subprime adjustable loans (39%).

2008: Investment banks and other financial institutions that, after years of encouragment from the government and GSEs, hold a significant part of their assets in MBS with defaulting loans — such as Bear Stearns, Lehman, AIG, Fannie and Freddie — see their asset values plummet and go belly up. Panic races across the rest of the Wall Street, the Dow Jones crashes again and again. In the midst of the panic, the government nationalizes a significant and ever growing percentage of the financial market.

So here’s the short version:  (1) Government legislates and the Fed helps to implement flexible standards in the mortgage industry in conformity with the CRA.  (2) Throughout the 1990s and early 2000s, government pressures Fannie and Freddie to purchase an increasing proportion of MBSs and subprime loans (based on flexible standards), while at the same time (perhaps unintentionally) loosening traditional lending standards across the board.  (3) From 2001 to 2004 the Fed deliberately drives interest rates down (as much as 5 percentage points).  (4) This all fuels in a speculative housing boom beginning in 1998, financial innovations on Wall Street based on MBSs and other derivatives in the early 2000s, and a housing bust in 2006.  (5) This in turn precipitates an historic financial collapse and equally historic bail-out in September 2008.

Greed and speculation are obviously an integral part of this story.  (They are as constant as gravity in ANY politico-economic system.)  Given the scope and depth of involvement in it by government institutions and policies, however, blaming our current woes on “the free market” is nonsense.


I drew on many sources in putting this timeline together, but the following were my principal ones:

Stan Liebowitz, “Anatomy of a train wreck.” [pdf]

Roger Congleton, “Notes on the financial crisis and the bail out.” [pdf]

Sandy Ikeda Guest-Blogging at Market Urbanism

When the New York Sun decided to shut down its press, the biggest loss to the blogosphere was Sanford Ikeda’s Culture of Congestion blog. At the Sun, Sandy blogged about cities, economics, politics, and related subjects.

Sandford Ikeda is an Associate Professor of Economics at SUNY Purchase. Professor Ikeda is the author of Dynamics of the Mixed Economy: Toward a Theory of Interventionism, involved with the Katrina Project at the Mercatus Center at George Mason University, and Past President of the Society for the Development of Austrian Economics.

Much of Sandy’s work and blog posts has overlapped with Market Urbanism’s topics, and viewpoints. Sandy is also a fellow resident of Brooklyn, and admirer of cities. Naturally, I was very honored and excited that Sandy accepted my offer to publish his posts at Market Urbanism while he explores the many options available to him in the blogging world.

I am certain Market Urbanism readers will enjoy Sandy’s contributions.

The Moral Case Against Rent Control

In Market Urbanism’s four part series on rent control, I avoided the topic of the morality of rent control, as I intended to address the economic issues and leave the morality to others. Thankfully, J. Brian Phillips of the Ad Hoc Committee for Property Rights is an expert on the subject. In his blog, he linked to the recent Retail Rent Control post, and took the time to address the moral issue:

But the real issue isn’t political. The real issue is moral. A large part of the public sees nothing wrong with forcing others to provide for their wants and desires. And there is a steady stream of politicians all too eager to propose laws to grant them their wishes. They think that their wishes can somehow transform reality, that if they pass a law with the intention of creating affordable widgets, affordable widgets will result. They think that politicians are nothing more than genies who can grant their wish simply by writing a law. It doesn’t work that way. Reality is not malleable to one’s wishes.

He makes plenty of good points, so I recommend reading the whole post. He concludes:

Each individual has a moral right to live for his own happiness. He has a right to the fruits of his labor. He has a right to pursue his values without intervention from others, so long as he respects their mutual rights. Human beings are not sacrificial animals.

Also, here’s another another article on the morality of rent control: Why Rent Control is Immoral by Michael S. Berliner, Ph.D.

The morality issue belongs as a prominent part of the rent control discussion, but is seldom heard among all the progressive anti-market rhetoric.

Retail Rent Control

Thanks to Bill Nelson for tipping me off to the article from The Villager (NYC): Retail rent control?

A city councilmember planned to introduce a bill this week that will require small businesses and landlords to submit to arbitration in negotiating lease renewals if both parties can’t agree on a fair rent.

The far-reaching measure, sought by Upper Manhattan Councilmember Robert Jackson and deemed by some as a form of commercial rent control, would set regulated increases not subject to landlords’ whims.

The language of the proposed legislation — which mirrors a similar bill introduced in 1988 that fell one vote short of Council approval — looks to preserve small businesses in the current commercial landscape by prohibiting both short-term lease renewals and “rent gouging by greedy landlords.”

According to the measure, lease renewals would be set at a minimum of 10 years unless otherwise agreed upon, and arbitration would only be triggered if either party disputes the law’s set rent-increase rates. Those rates, the proposed plan indicates, allow for no more than a 3 percent rent increase the first year; no more than a 15 percent increase by the last year of the lease over the previous lease; and no more than 3 percent incremental increases each year of the lease.

The legislation would be applied on a case-by-case basis to all commercial tenants across the city, including manufacturing businesses, nonprofit organizations, performing arts and theater groups, retail establishments, service businesses and professional medical offices.

When asked about the measure’s chances of success, Jackson’s chief of staff, Susan Russell, said she believes “the provisions are reasonable,” but acknowledged the language is subject to tweaking. “I think that this is something that’s worth sitting down at the table and talking about,” she added.

Supporters claim that, in the current climate, small businesses can’t survive because real estate speculators artificially inflated property costs over the years, allowing landlords to seek astronomical rents.

“You cannot allow unchecked speculators to control any segment of your economy for 25 years and not expect people to suffer,” said Steve Null, a former small-business owner who helped write the current bill and the original measure in the ’80s. In the period between then and now, he said, 137,000 small businesses in the city have been issued eviction notices, not including the about 200,000 to 300,000 businesses “that didn’t want to fight and just walked away.”

“I don’t know a businessperson in New York City that would ever recommend a friend to open a business in New York City,” Null added. “It is so anti-small business that the odds of them surviving would be very slim. … This bill is going to bring that dream back.”

I encourage Mr. Null and Councilman Jackson to read Market Urbanism’s series on residential rent control and then decide if their ideas for commercial rent control will really help small businesses.

To name a few, there are many ways this proposal is actually “anti-small” business:

  • It will discourage developers from providing mixed-use retail in their projects, actually eroding the supply of retail space.
  • It will discourage property owners from rehabilitating their buildings to encourage retail growth.
  • In areas where retail rents are close to apartment rents, owners may convert mixed-use retail space to residential, further decreasing the stock of available retail space.
  • Loss of supply, higher initial rents, and disinvestment (poor maintenance) of the rent controlled space will actually help the larger retailers compete with the squeezed-out small businesses.
  • This type of arrangement will favor chain stores who usually sign long-term, triple-net leases for their space which won’t burden landlords with fears of being trapped by rent controlled mom-and-pop tenants.

The bottom line: rent control may marginally benefit the existing small businesses and large chain stores, but only at the expense of new entrepreneurs and expanding small businesses.

The Real Deal (April 2008): Activisits push zoning changes, rent control for retail


J. Brian Phillips linked to this post and emphasizes the moral aspects of rent control, and aspect I leave for experts like him.

Market Meltdown and Bailout Videos

Wow! This market is a mess.

As a great follow up to his posts at CafeHayek on government’s intervention in the housing market, Russell Roberts discusses the situation and bailout with


Here’s the video from an Economics forum discussion at MIT (my Alma mater) on Wednesday: The US Financial Crisis What Happened? What’s Next?

And another forum at USC. [HT Richard’s Real Estate and Urban Economics Blog]

Cook County (Chicago) Sheriff Won’t Evict in Foreclosures

Cook Co. sheriff won’t evict in foreclosures from Associated Press

Cook County Sheriff Tom Dart says he’s ordered his deputies to stop taking part in evictions of properties that have been foreclosed upon.

Dart says the change goes into effect Thursday. He says the decision comes because many of those being evicted are people who’ve been faithfully paying rent and didn’t even know about the foreclosures.

Dart says he thinks he’s the first sheriff in a major metropolitan area to stop such evictions during what’s become a major foreclosure crisis around the nation.

Dart says the number of mortgage foreclosures in Cook County has skyrocketed this year and that he expects that number to climb much higher.

It’s really tragic that renters who have otherwise valid lease contracts, lose that right because of their landlords’ failure. But, I don’t have the same sympathy for the defaulters themselves.

What do you think will result from this move? Will banks stop foreclosing in Chicago without the rule of law on their side? Will defaulters squat?

Glaeser: Let Housing Prices Fall

Ed Glaeser gives three compelling reasons why the government should end their infatuation with high housing prices. (Nonetheless, some of the same politicians speak through the other side of their mouths about promoting housing affordability):
Why We Should Let Housing Prices Keep Falling

There is a superficial attractiveness to policies that seem to promise an end to falling housing prices, but there are three reasons why these proposals don’t make much sense to me.

First, the government has no business trying to make housing less affordable to ordinary Americans.

There is no reason to hope that middle-class Americans should pay more for any basic commodity, whether that commodity is coffee or oil or housing. Government should be fighting to reduce supply-side barriers and make housing cheaper, not trying to inflate prices artificially.

Second, most of these proposals seem likely to be expensive failures. The government just doesn’t have the tools to rewrite the laws of supply and demand. If the cost of building a home in Las Vegas is $150,000, and there are no restrictions on building, then all the credit policies or bailouts in the world aren’t going to permanently keep prices above $150,000.

Finally, these policies all have the common feature of getting the government further entrenched in the operation of the housing market, and this creates all sorts of long-term market problems. I would have thought that recent events at Fannie Mae and Freddie Mac, for example, would have made Americans recognize the costs of having government-sponsored enterprises play mortgage lender to the nation. I would have hoped that the history of public housing would have made us wary about spending huge amounts of tax dollars to get into the business of public property management. The current crisis may imply a need for more federal regulation of lending, but it does not suggest that the federal government should be subsidizing more borrowing.

We do need action to fix our banking system, but we don’t need quixotic policies aimed at pushing up housing prices. I suspect these policies have some appeal because they seem to help homeowners (like myself) as well as financiers. Still, the government can’t repeal the laws of supply and demand in the housing market. The price decline should remind homeowners, and home buyers, that housing should never be seen as a short-term speculation, but rather as a place to live, and hopefully to enjoy, for the long run.

Many politicians love high housing prices because it allows them a chance to offer “solutions” to the high prices. Unfortunately, those “solutions”, have brought us rent control, public housing, and a whole affordable housing bureaucracy, which have done little to systemically solve the problem. Nonetheless, we don’t hear any of the politicians who champion affordability cheering because of the lower housing prices.

Let’s give a little credit to the housing market for correcting itself, enabling new people to afford homes they couldn’t afford three years ago, and let’s avoid creating more problems (and “solutions”) by artificially re-inflating housing prices. And hey, what about the renters?

Sun Sets on Culture of Congestion

The New York Sun has decided to close up shop. To Market Urbanists, the greatest casualties are Sandy Ikeda’s blog, Culture of Congestion and Ed Glaeser’s articles. Sandy’s work has inspired me to read Jane Jacobs’ books (starting with The Death and Life of Great American Cities), and I plan to post some of my thoughts on what I’ve read so far. If you haven’t already, please check out the archives of Sandy’s and Ed’s writings.

Ed Glaeser has begun to write articles for the NY Times’ Economix blog. Hopefully, Culture of Congestion will rise again soon.  I’ll keep you posted.

Also, check out: Batesline – Sun sets