Free Our Markets
Page 23
Before the Taxpayer Relief Act of 1997 was passed, capital gains on the pizzeria and the house would be taxed at the same rate of 20%. In that case, which option would give you the most profit, after taxes are taken from you?
Before Taxpayer Relief Act of 1997
Pizzeria
House
Profit = Capital Gain
$200,000
$180,000
Less capital gains tax (20%)
$40,000
$36,000
After-tax profit
$160,000
$144,000
After a 20% tax on your anticipated $200,000 gain on the pizzeria, you would be left with $160,000; after the same 20% tax on the gain of $180,000 you anticipate from investing in the house, however, you would be left with only $144,000. Your calculations of expected profits would still lead you to invest in the pizzeria, the option that creates the most value for others. Profit-and-loss feedback is doing its job.
How about after the passage of the Taxpayer Relief Act of 1997? Now you pay no tax on any capital gains on the house (up to $250,000, or $500,000 for a couple).
After Taxpayer Relief Act of 1997
Pizzeria
House
Profit = Capital Gain
$200,000
$180,000
Less capital gains tax (20%)
$40,000
$0
After-tax profit
$160,000
$180,000
Now the privileged tax treatment of housing would reverse your incentives. Investing in the pizzeria would yield you $160,000 after capital gains tax, while investing in the house would yield you the full $180,000 gain, untaxed. Now your profit-and-loss calculations, distorted by the differential tax treatment, would lead you to invest in housing, even though doing so would create less new value for others than the alternative. The Profit-and-Loss Guidance Principle is interfered with; the signal is distorted; the incentives are fouled up.
So it was for thousands of people after 1997. Not by chance, housing prices started their remarkable long rise around 1997, as is visible in Figure 9.1. The special treatment of capital gains on residences drew additional buyers into the bidding for houses, so prices rose. These prices were no longer free-market prices communicating the relative scarcity or abundance of productive resources; they were prices also communicating politicians’ desire to take credit for expanding home ownership. As prices increased, people noticed and began to invest in housing. These distorted housing prices fouled up coordination of the economy.
Again, this intervention was not likely a major cause of the housing boom and bust, but it seems likely to have kicked off the boom and it certainly fed the boom’s intensity.
Intervention #2 - Subsidizing Housing via Fannie Mae and Freddie Mac
Undoubtedly a major cause of the housing boom and bust was the government’s deep intervention into housing markets via Fannie Mae and Freddie Mac. These two “government-sponsored enterprises” (GSEs), these “housing giants,” had various privileges, but we will consider just the most significant: They could borrow huge amounts of money because the government guaranteed their debts. In combination with the “affordable housing” goals Congress set for them (we’ll discuss those next), this privilege sucked vast amounts of money—and the investable resources that money represents—into housing. Those resources would have been better used on other things. The consequence was too many houses at prices too high and too many mortgages at interest rates too low.
Some Background on Fannie Mae and Freddie Mac
Founded by Congress in 1938 and 1970, respectively, to promote housing by creating a nationwide secondary market for mortgages, Fannie Mae (properly the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) are large—huge—intermediaries that channel the wealth of institutional investors into housing in the ways we discussed in Chapter 8.
They sell bonds to (meaning, borrow money from) large institutional investors and use that money to invest in mortgages in three different ways. First, they buy mortgages from banks and other mortgage originators and hold those mortgages themselves, earning the principal and interest payments. Second, they buy mortgages from banks and other mortgage originators and bundle those mortgages into mortgage-backed securities which they sell to institutional investors, charging a fee for collecting the mortgage payments and passing them through. Third, they buy mortgage-backed securities created and sold by private-sector intermediaries such as Bear Stearns or Bank of America, earning the principal and interest payments from the mortgages in the bundle.
One other way in which Fannie and Freddie promote housing in the U.S. is by guaranteeing mortgages. In exchange for a payment, they guarantee to the banks (or other mortgage originators) the mortgage payments they are owed. As long as Fannie and Freddie guaranteed mostly sound mortgages, they earned money on these guarantees, because relatively few well-qualified borrowers defaulted on their mortgages.
Fannie and Freddie’s special privileges (described below) allowed them to grow way beyond the size any private firm without such privileges could reach. By the first decade of the 2000s they had a hand in more than 40 percent of the residential mortgages in the country, because they either owned them outright or had bundled them into mortgage-backed securities they had issued.
The government’s guarantee of Fannie’s and Freddie’s obligations was only implicit until September 7, 2008. That is, it was nowhere a legal commitment in writing. Rather, everyone involved understood and expected that if Fannie and Freddie got into trouble by buying and guaranteeing a lot of mortgages on which the house buyers did not make their scheduled payments, and if that trouble got so bad that their income should fall short of what they needed to pay their bondholders and the holders of their mortgage-backed securities, the federal government would step in, take from taxpayers as much as needed, and pay the creditors.
As things turned out when the housing boom turned to bust, Fannie and Freddie had made many bad decisions, their income was not sufficient to pay what they owed, and the federal government did cover the shortfall with taxpayer money. As we’ll soon see, Fannie and Freddie had been positively directed by Congress to guarantee and buy shaky loans.
Figure 10.1 gives a picture of the long rise and sudden fall in Fannie and Freddie’s financial health.
Figure 10.1 Net Worth of Fannie Mae and Freddie Mac
By September 7, 2008, Fannie and Freddie were bankrupt, so the federal government took them into “conservatorship.” (This is a euphemism for government takeover, nationalization; the two largest companies in the U.S. housing finance industry are now government-run.) That day Fannie and Freddie’s “implicit guarantee” became explicit. Since then the federal government has paid out taxpayers’ money to the large institutional investors that bought Fannie and Freddie’s bonds or mortgage-backed securities. The total amount transferred from taxpayers to those investors won’t be clear for many years, if ever, but as of July 2011, Standard and Poor’s estimated “the total taxpayer cost to keep the GSEs [government-sponsored enterprises] solvent at about $280 billion.”
As we have emphasized, in a free market regulated by the discipline of profit and loss, enterprises that destroy value long enough disappear from the economic landscape for want of customers and investors. A truly private intermediary in the mortgage-financing business that had done as bad a job of investing as Fannie and Freddie would have disappeared by 2008. Loss in a free market is the great terminator of unsound investment. But housing in the U.S. is not a free market, and government intervention continues today to spare Fannie and Freddie from the termination they deserve. As of this writing, Fannie and Freddie are still borrowing money at low rates and they continue to buy and guarantee most new mortgages.
Consequences of Fannie’s and Freddie’s Non-Market Status
The consequences of Fannie’s and Freddie’s government guarantees are dire. The guarantees dis
tort the interest rates—a crucial price—that Fannie and Freddie have to pay their borrowers. That distortion leads in turn to distortions in mortgage interest rates, the demand for housing, and housing prices. These distorted prices foul up the profit and loss calculations of investors and home buyers. Altogether these interferences with the operation of the Price Coordination Principle and the Profit-and-Loss Guidance Principle helped cause the tremendous overbuilding of houses and overinvestment in mortgages of the housing boom.
As we saw in Chapter 8, in a free market the return to saver/lenders (and the intermediaries they employ) depends ultimately on the profitability of the borrower/spenders to whom they lend. Loans tend to go to those projects, whether new homes, new tractors, new hospitals, or new runways, that investors expect to create enough new value to cover the principal and interest payments that must be paid at market-determined interest rates.
But in the presence of Fannie and Freddie’s guarantee, investors are eager to make loans (indirectly) to house buyers even when the investors do not expect the new homes to create enough value for buyers to cover principal and interest payments. Indeed, many lenders to Fannie and Freddie, and buyers of their mortgage-backed securities, don’t even bother to check on the quality of the mortgages Fannie and Freddie buy or guarantee. Rather, their profit and loss calculations depend heavily on their expectation that the government will pay them with taxpayers’ money if the mortgages go bad.
Let’s do a thought experiment to show how Fannie and Freddie’s guarantee affects the decisions of saver/lenders: Suppose you are the manager of your college’s endowment fund, and you have $100,000 to invest. You are eager to get the best possible deal for your college, taking both risk and return into account. To keep it simple, suppose you have two options to choose from: Hospital Corporation of America (HCA) is selling $100,000 bonds paying 5.5 percent interest to finance a new hospital. Fannie Mae is selling $100,000 bonds to finance new mortgage purchases. Now, what interest rate would Fannie Mae have to offer to induce you to buy their bonds instead of the bonds of HCA?
It would depend on the riskiness of each, of course. So to simplify the thought experiment, suppose somehow or other you determine that the hospital and the mortgages are equally likely to pay off, so HCA and Fannie Mae are equally likely to pay you your principal and interest. The key difference is that if HCA can’t pay you, you might not get paid at all, because they are a private company with no government guarantee. If Fannie Mae can’t pay you, however, the government will, with taxpayers’ money. How much would that guarantee be worth to you (again, the guarantee was implicit until September, 2008, and explicit thereafter)?
* * * * *
Different people would value that guarantee differently of course; the key point is that Fannie and Freddie’s government guarantees let them borrow at lower interest rates than they otherwise would have to pay. If you said you’d lend to Fannie Mae instead of HCA if they offered you as much as 5 percent interest, you would be in the ballpark with actual institutional investors during the housing boom. Typically, Fannie and Freddie could sell their bonds paying interest rates a bit less than half a percentage point lower than their private-sector counterparts did.
Notice how price communication is being blocked here. In a free market, saver/lenders would in effect say to Fannie Mae and Freddie Mac, “If you want to borrow my money you are going to have to pay me a higher interest rate to compensate me for the risk that those mortgages won’t all pay off.” The interest rate—the price of borrowing—would communicate what people know about the riskiness of housing. But in the presence of the government guarantee, saver/lenders say in effect, “Nearly zero risk that I won’t get paid? Great! I’ll accept a lower rate and still lend you the money.”
Free market prices communicate what everybody knows about the value of a good. A free market interest rate on Fannie and Freddie’s bonds would communicate what people know about the risk that Fannie and Freddie might not be able to pay them back. But in the presence of the government’s guarantee, that knowledge disappears from the interest rate. (The only risk represented in the interest rates Fannie and Freddie had to pay before September, 2008, was the risk that maybe, just maybe, the government would not bail them out if they got in trouble. Even that risk has now disappeared.)
Because of the government guarantee, the profit and loss calculations of Fannie, Freddie, and their investors are all based on a wrong price, because the price—the interest rate the investors charge and Fannie and Freddie pay—“tells a lie” about the underlying risk. With the operation of the Profit-and-Loss Guidance Principle fouled up by the faulty price, all involved are eager to devote resources to housing, even when those resources could be used to create more value in other areas of the economy instead.
What about mortgage interest rates, the most important prices in the housing market? Fannie’s and Freddie’s low borrowing costs distort those in turn. We can see why as we continue our thought experiment.
Let’s imagine again that Hospital Corporation of America (HCA) and other large enterprises like them are selling bonds paying 5.5 percent interest to finance their various projects. This time, however, we exclude Fannie and Freddie from the thought experiment entirely. Instead, this time, you, the reader, represent the private-sector investment bank Bear Stearns. Suppose that you are buying mortgages and packaging them into mortgage-backed securities (MBSs), which you sell to large saver/lenders. (Of course your MBSs have no government guarantee.) Suppose also that you are buying these mortgages from mortgage originators who only originate and sell; they do not hold onto any mortgages they originate. Suppose as well that you have found that you need one percentage point out of the principal and interest payments coming in from the mortgages to cover your expenses (of bundling those mortgages into MBSs, selling them to investors, handling collections of principal and interest payments, making payments out to investors, and so on) and leave a little for your own profit. For example, if the mortgages in a particular bundle pay interest of about 8 percent, after you deduct the one percentage point from that to cover your expenses, the highest interest rate you could pay on a MBS made up of those mortgages (and still break even) would be 7 percent. Finally, suppose that the large saver/lenders who are in the market for the bonds consider your MBSs and HCA’s bonds to be equally risky.
Once you have digested the implications of those conditions, consider this question: Under those conditions, what is the lowest mortgage interest rate the mortgage originators you work with would be able to offer?
* * * * *
In a free-market setting, you, representing Bear Stearns, along with other “private-label” mortgage securitizers, must offer at least 5.5 percent interest on your non-guaranteed MBSs in order to make them competitive with the bonds of HCA and other enterprises outside the housing sector. Accordingly, 5.5 percent is the lowest interest rate you can offer on your MBS and still sell it. You require one percentage point of the income from the mortgages to cover expenses. That means the mortgages must pay you a minimum of 6.5 percent for you to make any money. And that in turn means that you won’t buy any mortgages that pay appreciably less than 6.5 percent (the pool must average at least 6.5 percent). If you won’t buy mortgages for less than 6.5 percent, the mortgage originators won’t originate them for less, so 6.5 percent (or very nearly) is the lowest that mortgage interest rates can go.
This 6.5 percent (or higher) mortgage interest rate reflects all the relevant factors in the market for investable resources: the supply of savings from saver/lenders and the investable resources they represent, the desire of various borrower/spenders to borrow these savings in order to purchase or hire investable resources, and the judgments of all parties as to the riskiness of the various enterprises and mortgages. That 6.5 percent mortgage interest rate is a market price based on all the relevant knowledge of all the market participants. As such it has an important story to tell. It tells would-be homebuyers not to buy a house unless they a
re willing and able to pay 6.5 percent interest on whatever amount they borrow, because otherwise the resources would be more valuably used elsewhere (e.g. on a new hospital building, runway, or whatever).
Now let’s change the thought experiment by substituting Fannie Mae for Bear Stearns, keeping everything else the same except that we allow for Fannie’s government guarantee, and we assume that that guarantee means they can borrow for half a percentage point less than can their private-sector competitors for funds (funds representing investable resources). Now what would be the lowest mortgage interest rate the mortgage originators would offer?
* * * * *
The same arithmetic would apply, but starting from Fannie’s and Freddie’s lower borrowing rate of 5.0 percent instead of 5.5 percent. Assuming the same 1 percent to cover expenses, Fannie could afford to buy mortgages paying only 6.0 percent instead of 6.5 percent, so mortgage originators could lower the rates they charge, thereby drawing more house buyers into the market, and still sell the mortgages. Mortgage interest rates could fall another 0.5 percentage points. House buyers who would have had to pay 6.5 percent in a free market must pay only 6.0 percent (in our example) when the government guarantees Fannie’s and Freddie’s obligations with taxpayers’ money.
As the thought experiment shows, Fannie’s and Freddie’s artificially lower borrowing costs reduce mortgage interest rates in general. Indeed, this is a main purpose of Fannie Mae and Freddie Mac. The legislators and interest groups promoting housing, such as realtors and mortgage bankers, want interest rates lower than the free market rate so that more people will buy houses, and the houses will be bigger. Their aim is not really to help more people own houses, but to increase business and income for themselves by increasing the demand for housing and raising housing prices. It’s another ugly instance of the negative side of the Incentive Principle: the intervention is used by special interests to benefit themselves at the expense of others.