“Yeah, right!” will come a retort from some. “That’s the kind of free market fundamentalism that caused the housing bubble and the financial crisis of 2008!”
Really? Let’s take a close look.
Part III
The Housing Boom and Financial Crisis
Housing prices stopped their dramatic, decade-long ascent in 2006. They declined slowly in 2007; they fell fast in 2008. Lots of home owners fell behind on their mortgage payments. The Wall Street investment bank Bear Stearns was holding a huge inventory of shaky mortgages it planned to bundle into mortgage-backed securities (MBSs); but with mortgage delinquency rising sharply, suddenly no investors would buy mortgage-backed securities. In March, 2008, Bear Stearns failed.
A shudder went through the financial world. The New York Federal Reserve bank bailed out Bear Stearns’ creditors by marrying the company off in a shotgun wedding to JP Morgan Chase—on the condition that the New York Fed put taxpayers on the hook for thirty billion dollars’ worth of bad assets that JP Morgan Chase would not accept.
In September, Wall Street investment bank Lehman Brothers, also deep in mortgage-backed securities, failed. But this time, against expectations, no bailout occurred. In the words of Peter Wallison,
[I]nvestors panicked. They withdrew their funds from the institutions that held large amounts of privately issued MBSs, causing banks and others, such as investment banks, finance companies and insurers—to hoard cash against the risk of further withdrawals. Their refusal to lend to one another in these conditions froze credit markets, bringing on what we now call the financial crisis.
Thousands of healthy small businesses suddenly could not get routine loans for normal operations. Business fell off, employees got laid off. The “Great Recession of 2008,” which had officially begun in December of 2007, deepened. Unemployment shot up, rising to ten percent by mid-2009. Economic distress made it still harder for many homeowners to pay their mortgages; delinquencies and foreclosures mounted. Millions watched their main asset, their house, lose value. The stock market plummeted, falling twenty-four percent in a two-week period, taking families’ retirement and college funds down with it.
Why? What caused the turmoil? Who or what is to blame?
Two widely held answers are: 1) human greed and 2) lack of regulation. On the first of these, economist Lawrence H. White has quipped that blaming the financial mess on greed is like blaming an airplane crash on gravity. Greed (or at least, in a gentler term, self-interest) is always present in human affairs, else how would we ever get pencils? What we need to figure out is why in this case the spontaneous order that channels self-interest into the creation of pencils, houses, mortgages, and other valuable goods and services got so fouled up.
A strong statement of the second answer was offered by economist Paul Samuelson in 2009 (at one time Samuelson, an advocate of government intervention, wrote a Newsweek column every other week, alternating with noted free market advocate Milton Friedman):
And today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution. This prevailing ideology of the last few decades has now been reversed. Everyone understands now, on the contrary, that there can be no solution without government.
Professor Samuelson is entirely mistaken. As I argued in Part II, a free market system does regulate itself. The financial turmoil we have been going through results from restrictions on, not the presence of, economic freedom. In this case, as in most, Reagan’s slogan does apply: government privileges, mandates, monopolies, bailouts, and restrictions were the problem. But readers must not take my judgment on this; they must use their own.
In this Part III, I offer arguments and evidence to help readers make up their own minds as to whether economic liberty or economic restrictions are to blame for the housing boom and bust and the financial turmoil that followed. This powerful, painful case study shows how interference with the Price Coordination Principle, the Profit-and-Loss Guidance Principle, and the Incentive Principle makes everyone poorer.
It is gravely important that we understand whether too much freedom or too little caused the financial and economic mess America got itself into in the first decade of the 21st century. If we misunderstand, we’ll make the same kinds of mistakes, perpetuate our difficulties, and bring more problems on ourselves in the future. I fear this is, in fact, what we are doing.
The first goal of Part III is easy: to make clear that the housing boom and bust and the financial mess that followed were not caused by free markets. There is no proof here that interventions caused the mess; it is conceivable, as some have argued, that the problem was not too much intervention, but too little. But the problems cannot have been a consequence of free markets, because the markets were not free: there was extensive government intervention in housing, mortgage, and banking markets.
A second goal is to explain in terms of the three principles laid out in Part I how these interventions disturbed or obstructed the spontaneous ordering processes of the economy. We’ll see how special tax treatment and subsidization of housing distorted housing prices away from their free-market levels, so that prices “told a lie” about housing values. We’ll see how the Federal Reserve’s creation of new money and Congress’s implicit guarantee of the debts of Fannie Mae and Freddie Mac distorted interest rates away from their free-market levels, so that interest rates “told a lie” about resource availability and the risks of housing. We’ll see that government guaranteed not just Fannie Mae and Freddie Mac’s debts, but also bank deposits and loans to large financial institutions. These guarantees shielded investors from the possibility of losses, and thereby blocked profit and loss from rewarding value-creating investments and punishing unwise investments. We’ll see how government regulators’ lack of profit-and-loss feedback blocked discovery of better standards and practices for reducing risk in banking and insurance. And we’ll see how the incentives of most participants in the system, from house buyers to lenders, investors, and regulators, were distorted by the pervasive intervention.
A third goal is to introduce free-market alternatives to these interventions, and explain how free-market institutions, processes, and incentives would have spared us all the loss and turmoil by fostering balanced, sustainable improvements in our standard of living.
Chapter Eight
Mortgage-Making in a Free Market
What went wrong? How did the housing market get so out of control, and why did the problems in housing spill over into banking and lending?
In order to understand how government intervention caused the housing boom and bust and the resulting financial fiasco, we’ll first identify the elements of American housing finance that are market-based, that we would expect to see in a truly free market. Having done that, we’ll see more clearly in the following chapters that the housing boom and bust occurred in a far from free market. A wide variety of government interventions—we’ll focus on the main culprits—interfered with the principles of spontaneous economic order, fouling up price signaling, distorting profit-and-loss feedback, and creating perverse incentives.
Direct Mortgage Financing
In the great majority of cases, a buyer finances the purchase of a home by getting a mortgage from a bank (or a savings-and-loan association [S&L]—when we speak of banks, we’ll mean S&L’s, too). The bank, of course, gets that money from depositors who put their money in the bank in savings accounts, checking accounts, certificates of deposit (CDs) and the like. In exchange for giving the homebuyer the money for the purchase, the bank gets the homebuyer’s promise to pay that money back and pay interest on the borrowed sum. Importantly, the mortgage contract also specifies that the bank becomes legal owner of the house if the homebuyer does not keep his part of the bargain by paying back the principal and interest as promised.
Three types of actors play different roles in the process: Before there can
be any money to lend, someone has to save that money. First, then, are the saver/lenders. These are individuals and organizations of all sorts—businesses, churches, foundations, clubs, etc.—that save some of their money in savings and checking accounts and CDs. At the other end of the process are the borrower/spenders, in this case those who want to borrow money to buy a house. Acting as intermediaries are the banks. A bank’s role is intermediation; the bank saves borrower/spenders the hassle of finding people willing to lend them money, and spares saver/lenders the hassle of finding creditworthy people to borrow their money. Banks specialize in bringing together borrower/spenders and saver/lenders. They make money by charging homebuyers and other borrower/spenders a slightly higher rate of interest than they pay the lender/savers who put their money in the bank.
These three basic roles—borrower/spenders, intermediaries, and saver/lenders—are played in most borrowing and lending. Note that as banks earn profits and accumulate their own wealth, they can and do become saver/lenders in their own right, lending directly for themselves without any other intermediary.
The mortgage itself is essentially an IOU; it’s a record of the agreement between the bank and the homebuyer. Figure 8.1 gives a fictitious example, stripped to essentials.
Mortgages may be of either the fixed rate or adjustable rate variety. In a fixed rate mortgage, the rate of interest is fixed at the outset. Fixing the rate has the advantage of making the size of the mortgage payments completely predictable for both the homebuyer and the bank. Most mortgages are fixed-rate—virtually all of them were until the late 1970s when high inflation spurred the development of adjustable rate mortgages.
Figure 8.1 A Basic Mortgage Contract
MORTGAGE CONTRACT
I, Howard Baetjer Jr. owe
Columbia Bank
$100,000 at an annual interest rate of 7%.
I promise to pay $665.30 each month
in principal and interest for 30 years
or the bank gets the house.
Signed Howard Baetjer Jr.
An adjustable rate mortgage (ARM), as the name suggests, has aninterest rate that changes or “resets” at specified intervals (often once a year) to keep it in line with other interest rates. The purpose of the adjustment is to protect the homebuyer from having to keep paying a relatively high mortgage payment if interest rates in general fall, and to protect the bank from having to keep accepting a relatively low mortgage payment if interest rates in general rise. The interest rate adjusts so that borrowers pay and lenders receive something close to the going rate of interest.
There is a danger to borrowers in adjustable rate mortgages. That is, the monthly payment generally rises after the initial period; the initial interest rate is set relatively low to make the ARM attractive in comparison with a fixed rate mortgage. But the interest rate (and hence the mortgage payment) usually increases after the initial period, and it may increase further at subsequent resets. Some people get carried away by the attractiveness of the initial low monthly rate (sometimes called a “teaser rate”) and don’t seriously consider their ability to pay the higher rates that may come later; they commit themselves to paying what they may not be able to afford. (Sad to say, many people made this mistake during the housing boom.)
When borrowers fall behind on the interest and principal payments agreed to in their mortgage contracts, they are said to be in default. The default rate is the proportion of mortgages of a given category on which their borrowers are behind in their payments.
When a borrower is in default deeply enough or long enough, the bank that holds the mortgage may foreclose on the mortgage; that is, the bank exercises its right to take over ownership of the house. Banks generally don’t like to foreclose because they are in the business of lending money, not managing and selling houses; but they do it when they must. Normally on foreclosure, the bank sells the house at auction; after auction expenses and legal costs, the bank may end up with a loss on the mortgage overall.
A sound mortgage loan is one that is likely to be paid off as agreed. Various factors reduce the risk of default and increase the soundness of a mortgage loan. Among these soundness factors are:
The ratio of the monthly mortgage payment to the borrower’s monthly income: The less a mortgage payment takes out of a borrower’s monthly income, the less trouble the borrower may have paying.
Having less other debt: The less other debt a borrower has to pay off, the more income will be left over to pay the mortgage.
Having good credit history: This speaks for itself. Those with good credit history are “prime” borrowers.
Completeness of documentation: The more documentation a borrower can and will provide of her income, job, assets, and other debt, the less likelihood of fraud and the more sound the loan.
Living in the house: People generally care more about paying their mortgage on a house they live in than on a house they rent to others or intend to resell soon.
Ratio of loan amount to value of the house (LTV): As the bust following the housing boom progressed, this factor showed itself to be very important. The lower the ratio, the more sound the loan. Until the early 1990s, banks traditionally loaned homebuyers no more than eighty percent of the purchase price. Home buyers were required to put twenty percent down—to pay twenty percent of the price of the house out of their own resources. Under these circumstances, homeowners try hard to keep up with their mortgage payments lest they lose their equity—their ownership stake—in the house.
For example, a couple that puts $20,000 down and borrows $80,000 to buy a $100,000 house would lose the house and their $20,000 if the bank were to foreclose. Furthermore—and this is crucial to understanding the housing boom and bust—until and unless the price of the house were to fall by 20 percent (by historical standards a very large decrease), the couple would be able to sell their house for more than they owe on it. Hence they would want to stay current on their payments and avoid foreclosure.
By contrast, if a bank loans a homebuyer a very large portion of the purchase price, say, ninety-seven or even one hundred percent (not uncommon in the housing boom), then the homebuyer has little or nothing of his own to lose if he can’t make his payments and the bank forecloses—he has little “skin in the game.” For example, suppose a bank lends a buyer $98,000 for the purchase of a $100,000 house. On such a loan, it takes a decrease in the market value of the house of only a little over two percent for the homebuyer to owe more than the house is worth. In such cases the homebuyer is said to be “under water,” and he has an incentive to “walk away” from the house—to stop making payments and let the bank foreclose. (Of course doing so means he breaks his promise to pay; this will hurt his credit. Most people, admirably, keep their promises to pay even when they do go “underwater.”)
Soundness factors are used to identify borrowers with good credit. A prime mortgage is one made to a prime borrower, that is, someone with good credit. A subprime mortgage is one made to a subprime borrower, someone whose credit is not so good. For banks, making subprime loans is not necessarily unwise, even though they recognize that a greater proportion of subprime borrowers than prime borrowers will probably be unable to make their payments. Banks compensate for this by charging a higher interest rate to subprime borrowers, so that the larger interest payments from subprime borrowers who do make their payments compensate for the expected losses from those who don’t.
There are degrees of mortgage riskiness that are not captured by the distinction of prime v. subprime. A mortgage loan made to a borrower with a credit history that puts her in the prime category may still be a risky or foolish loan if it is below standard in one or more of the other soundness factors in the list above. The term “Alt-A” is used to categorize mortgages that meet some but not all the criteria of a sound, high-quality loan.
Indirect Mortgage Financing
The bank or S&L that makes a mortgage loan can hold onto that loan and keep the interest and principal payments for itsel
f. Many banks, especially S&L’s, do this, accumulating “portfolios” of mortgages. Out of the mortgage payments they receive they pay the interest they owe their depositors. If mortgage-making were no more complex than this, then only banks would hold mortgages, and the only investment money available to lend to house buyers would be the deposits small saver/lenders put in their bank checking accounts, savings accounts, and CDs.
Like pencil-making, however, mortgage-making can become very complex, and the increased complexity allows large sums of investment money to flow to house buyers. The key is that a bank can sell some or all of the mortgages it originates, thereby selling the right to the interest and principal payments on those loans. Banks often do sell mortgages—the loan on the first house I ever bought was sold within a month—on what is known as the secondary market for mortgages. Banks use the proceeds to make other investments, perhaps more mortgage loans or loans of other kinds. As long as a bank can keep selling the mortgages it receives from the house buyers it lends to, it can keep lending to more house buyers with the proceeds.
This secondary market for mortgages has become very large; indeed most mortgages are now sold after they are originated. The secondary market in mortgages allows savers/lenders much larger than the average bank depositor to loan their funds (indirectly) to homebuyers. These large savers/lenders we’ll call institutional investors; they are organizations with a lot of wealth that they need to keep invested. Examples include university endowments, insurance companies, pension funds, mutual funds and the like.
Big institutional investors could conceivably lend to homebuyers directly by issuing new mortgage loans themselves, but it makes no sense for insurance companies, college endowments and the like to develop the skills and facilities necessary to do mortgage lending. Less directly, they might buy individual mortgages on the secondary market, but again, they would need to go outside their own specialties to identify, purchase, and keep track of many individual mortgages. Accordingly, big institutional investors who invest in housing almost always do so through a different set of intermediaries that buy the mortgages for them. These intermediaries are non-depository financial institutions. Investment banks and hedge funds are “non-depository” because they do not take deposits into checking and savings accounts.
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