Free Our Markets

by Howard Baetjer Jr

  And it all has been at others’ expense. The Price Coordination Principle cannot be ignored this way without interfering with overall coordination in society and therefore overall well-being. A mortgage interest rate reduced by Fannie’s and Freddie’s government guarantee no longer reflects all the relevant realities in the market for investable resources; it no longer reflects the full risk of default. This distorted price of 6.0 percent interest (in our example) tells a misleading story. It says to homebuyers who can afford 6.0 percent but not 6.5 percent, “Come along and buy! There are enough investable resources to go around!” But there aren’t. The demand from additional buyers for new homes draws resources into housing and out of tractors, pizzerias, new runways, or whatever project does not get built because a distorted mortgage interest rate has drawn resources into housing.

  The hundreds of billions of dollars in debts to Fannie’s and Freddie’s creditors that the government has been covering with taxpayers’ money since Fannie and Freddie went bankrupt represent hundreds of billions of dollars’ worth of wasted resources. Fannie and Freddie directed those resources into housing that created no net value when those same resources could have been used instead for a huge variety of other projects—tractors, pizzerias, research centers, runways—that would have created value.

  The careful reader will have noticed that nothing in this section about Fannie Mae and Freddie Mac can explain by itself the housing boom of 1997 to 2007 and the financial fiasco that followed. Fannie and Freddie, with their implicit guarantees, had been around for many years before the boom and bust. For the first decades of their existence they acted responsibly, dealing mostly in high-quality, low-risk mortgages, so that there was no need for the government to make good on its implicit guarantee. In normal years their special privileges surely channeled a lot of resources into housing that would have created more value in other sectors of the economy, but that means just unfortunate waste, not a full-on boom in housing. What was different in the boom? How did Fannie and Freddie’s privileges lead not just to housing prices higher than otherwise, but to rising house prices? What happened so that not just too much investment was flowing into housing, but an increasing wave of investment?

  The answer is that Fannie and Freddie’s privileges interacted catastrophically with still another government intervention into housing, an effort supported widely in Congress by both the Clinton and Bush administrations. The effort promoted what was called, ironically now in hindsight, “affordable housing.” To that we now turn.

  Intervention #3 - “Affordable Housing” Mandates

  The popular justification for “affordable housing” mandates is to make it possible for more lower-income people to buy homes than would be able to in a free market, by helping them receive mortgages they would have been denied without government intervention.

  The “affordable housing” mandates imposed on Fannie and Freddie, in combination with their government guarantees, cut Fannie and Freddie loose from regulation by market forces. Instead of responding to profit-and-loss guidance to buy and guarantee mortgages only while taking moderate risk, they responded to political incentives to buy and guarantee mortgages willy-nilly so as to please politicians. Their imprudent lending, allowed to go on and on without apparent limit by the government’s guarantee to their lenders, fed the housing boom and increased the riskiness of the borrower pool.

  The “affordable housing” mandates started gently and ramped up over time. In the years before and during the housing boom, the Department of Housing and Urban Development (HUD) required Fannie Mae and Freddie Mac to purchase increasing proportions of “affordable housing” mortgages. In the words of Russ Roberts,

  In 1993, 30 percent of Freddie’s and 34 percent of Fannie’s purchased loans were loans made to individuals with incomes below the median in their area. The new regulations required that number to be at least 40 percent in 1996. The requirement rose to 42 percent in 1999 and continued to rise through the 2000s, reaching 55 percent in 2007. Fannie and Freddie hit these rising goals every year between 1996 and 2007.

  In order to meet these mandatory targets, Fannie and Freddie loosened their lending standards for loans they bought and guaranteed, and for the loans in the mortgage-backed securities they bought. Banks and other mortgage originators, knowing they could sell lower-quality loans to Fannie and Freddie, lowered the soundness standards they required of borrowers. Increasingly they made loans to borrowers with lower credit scores, with higher ratios of their mortgage payments to their monthly incomes, with less (or no) documentation of their incomes (this reduction in standards was an invitation to fraud), with higher ratios of other debt to their incomes, and with smaller down payments. These smaller down payments led to higher loan-to-value (LTV) ratios, which make default more likely, especially in the event of a decrease in the market value of the house (as discussed in Chapter 8).

  This loosening of standards meant a flood of lower-quality loans to new homebuyers likely to have difficulty paying them back. The availability of those loans greatly increased the demand for housing, pushing up housing prices and feeding the boom. The higher prices reinforced the growing impression that “housing prices always go up,” thereby spurring still more speculative buying and still higher prices in a self-fulfilling spiral. The rising prices misled many lenders about the riskiness of these mortgages. As more and more years went by in which subprime and otherwise below-traditional-standards mortgages stayed out of default, the illusion grew that these mortgages were actually sound, so standards eroded further. Mortgage loans that during the boom appeared to promise acceptable risk-adjusted returns turned out to have negative returns once house prices started to fall.

  While housing was booming, all this loosening of standards seemed beneficial. After all, more people who previously would have been denied loans with which to buy a house now received them. The home-buyers were happy, the realtors were happy, the mortgage originators were happy, the advocates for under-privileged groups were happy, and the politicians were happy. Unhappily for everyone, though, it could not last. Once the boom turned to bust, it became clear that shockingly many recipients of these “affordable housing” loans could not afford them.

  Not everyone was misled. On September 30, 1999, New York Times reporter Steven A. Holmes presciently wrote the following:

  In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.…

  Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

  In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates—anywhere from three to four percentage points higher than conventional loans….

  In moving, even tentatively into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s.

  Let’s sum up this discussion of interventions in housing finance by noting how it illustrates the negative side of the Incentives Principle first introduced in Chapter 3 and brought home with many examples in Chapter 5, including the case of hairdresser licensing. Government intervention always runs the danger of getting captured by particular groups and used in their own special interest at others’ expense. All the apparatus of government intervention into housing finance�
��the tax-advantaging of capital gains on housing, Fannie and Freddie’s existence as agencies for funding housing, their government guarantees, and the regulatory mandates on Fannie and Freddie to buy large quantities of “affordable housing” loans—were an irresistible temptation to politicians, advocates of low-income housing, mortgage bankers, the National Association of Realtors, and the officers of Fannie and Freddie themselves. For politicians, funneling money into housing let them promote a politically popular goal without having to pay for it with taxes. For the advocates of low-income housing it was a way to get money for their cause without having to earn it or persuade donors to give it. For mortgage bankers, it meant lots of fees and profits, at least while the boom lasted. For the National Association of Realtors it meant a nationwide boom in their business. For the officers of Fannie and Freddie it meant huge salaries and bonuses while the boom lasted.

  Each of these groups undoubtedly has a public interest explanation for its role in the fiasco. As late as September of 2003, Congressman Barney Frank was making the case for the good that Fannie and Freddie were doing for low-income people. He said, “I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing....” In February of 2004, Senator Chris Dodd said of the work Fannie and Freddie were doing, “this is one of the great success stories of all time.” It is ironic that these are the two members of Congress whose names are on the financial regulation law that was passed in response to the financial mess, that loads a great many new restrictions on a wide variety of financial dealings but—and it would be astonishing if it weren’t the work of politicians—has nothing to say about restricting the dealings of Fannie Mae and Freddie Mac.

  We would all be much better off if the government simply had no authority to intervene in housing or mortgage lending, either to subsidize or to restrict.

  Chapter Eleven

  Why the Boom Got So Big

  While Congress can and does privilege housing with various policies, as we saw in the last chapter, those policies are probably insufficient, by themselves, to have caused the housing boom. The exclusion from taxes of capital gains on housing, Fannie and Freddie, and the “affordable housing” policies all channeled investment dollars toward housing, but they don’t explain the remarkable size of the torrent. Why did so many dollars flow to housing? Two main interventions go a long way toward answering this question: One of these is the government’s monopolization of money through the Federal Reserve System (“the Fed”). The Fed misused this monopoly privilege to put too much new money in the hands of investors, many of whom invested it in the red hot housing market. The other damaging intervention is the government’s habit of bailing out lenders with taxpayers’ money; doing so took away the caution investors would otherwise have felt before lending so heavily into that market. Both culprits interfere with price coordination and profit-and-loss guidance, and set up perverse incentives for special interests.

  Intervention #4 – Too Much Money

  The central bank of United States—the Federal Reserve System—created more new money than it should have, especially in 2001-2004. This was a fundamental cause of the boom itself, and therefore of the bust that had to follow. All this new money had to go somewhere—those who received it were eager to spend or invest it in something. Many chose to invest in housing. Some loaned it directly to new house buyers as mortgage loans; some loaned it to house buyers indirectly by buying mortgage-backed securities. This new money fueled the boom.

  It is important to understand that the Fed intentionally manages the supply of money in the economy and does so largely through the banking system. The Fed does not have complete control over the money supply, because the actions of banks and the general public affect the money supply, too; but the Fed has by far the greatest influence. By manipulating the money supply the Fed also affects interest rates, though it cannot tightly control them. (See Appendix A for a more detailed description of how this works.)

  To manage the money supply, the Fed generally buys or sells U.S. Treasury securities from banks or other institutional investors. When the Fed wants to increase the money supply, it buys some of these securities with brand new money. When the Fed wants to reduce the supply of money in the economy, it sells some of those securities. The money banks pay the Fed for those securities is thereby taken out of the economy.

  By manipulating the money supply the Fed also indirectly influences interest rates, some more directly than others. (There are many different interest rates, of course, e.g. for car loans, student loans, mortgage loans, business loans, long-term loans, short-term loans, or loan sharks’ loans.) The interest rate the Fed controls most directly is called the fed funds rate, the interest rate in the market where banks borrow reserves from one another for short periods. By buying and selling U.S. Treasury securities, the Fed intentionally changes the supply of reserves (cash on hand) available for banks to borrow and lend to each other. The supply of cash reserves that banks hold directly affects the fed funds rate. The Fed intentionally targets this fed funds rate—it chooses a level at which it means to keep this rate and it keeps it there (or close) by buying or selling U.S. Treasury securities as necessary to do so.

  As shown in Figure 11.1, during the period when the housing boom was at its most intense, roughly 2001 to 2006, the fed funds rate was well below its historical range. Indeed, as shown by the dashed line in Figure 11.1, from 2002 through 2004 (shaded in gray) the Fed’s target interest rate was 2 percent or lower. Adjusting for inflation, the fed funds rate was near zero from 2002 to 2005, as shown by the solid line in Figure 11.1. That is, when banks borrowed money at the fed funds rate in that period, what they repaid in principal and interest had no more buying power than what they had borrowed; it was like paying no interest at all. Think what having to pay almost no interest does to people’s incentive to borrow money and invest it.

  Figure 11.1 The Federal Funds Rate, Nominal and Inflation-Adjusted

  What was the consequence for mortgage interest rates of the Fed’s creating so much new money that it kept the fed funds rate near zero? Mortgage interest rates fell below their historical range, as illustrated in Figure 11.2. The gray shading shows the period when the Fed’s target for the fed funds rate was two percent or lower, as in Figure 11.1.

  With new money flowing from the Fed into the economy, banks and other mortgage originators competed to lend the new money in the booming housing market by offering it at increasingly low mortgage rates. Attracted by these low rates (and the large profits being made in housingas prices rose), more and more people chose to enter the market for a new house, a bigger house, or another house. By doing so, they helped bid up the price of housing and reinforce the boom’s illusion that “housing prices always go up.”

  Figure 11.2 Mortgage Interest Rate

  Additionally, the very low short-term interest rates led lenders to offer a lot of adjustable-rate mortgages (ARMs). Lenders who believed that interest rates were unlikely to stay so low for thirty years wanted to be able to adjust upward the interest rate they were receiving if rates overall rose. These ARMs with very low initial rates attracted many borrowers who assumed that they would later be able to refinance their (then more valuable) houses, or to sell them at a profit, before the interest rate reset. As housing prices stopped rising and started falling, however, many people found themselves with less valuable houses when their interest rates reset to levels higher than they could afford. For this reason, adjustable rate mortgages make up a disproportionate share of mortgages in default.

  The Fed’s reckless creation of new money helped cause and worsen the housing boom. Without the fuel of new money, the fire could not have burned so brightly. On this point there is widespread consensus among scholars in economics: the Fed created too much money too fast in the early 2000s, especially from 200
1 to 2004, when the Fed held the fed funds rate below 2 percent.

  At this point I expect some readers to wonder, “Where is the intervention? All I see is a mistake: the Fed created too much money.” The answer is that the Fed itself is an important—maybe the most important—government intervention in our economy.

  The Fed is a government-created central bank. The fundamental interventions that it represents, and that underlie its over-issuance of money in the early 2000s, are 1) its legal monopoly on issuing paper money, and 2) the irredeemability of the Fed’s money in any underlying commodity such as gold or silver. These two legislated privileges, starkly at odds with freedom of exchange, exempt the Fed from market discipline. Lacking market-based feedback, the Fed always faces a bad case of the knowledge problem: In a free economy, profit-and-loss would guide banks to discover pretty nearly the correct money supply—how this works is to me one of the most fascinating instances of spontaneous order; we’ll discuss it shortly. With the right money supply (we’ll discuss what the “right” levels are shortly also), the competitive interactions of saver/lenders and borrower/spenders would generate pretty nearly the right interest rates (those crucial “prices of time”). Free-market interest rates would give us the benefit of price coordination across time, coordinating the actions of billions pursuing their myriad goals that involve borrowing and lending.