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.)
LEGISLATIVE & POLICY TIMELINE
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.
1929-33: 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.
1938: 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.
1975: Congress passes the Home Mortgage Disclosure Act (HMDA), requiring lenders to provide detailed information about mortgage applicants.
1977: 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]