Was the crisis "actually imposed by the government?"
I was going to do an original post tonight, but the questions and comments are too much of a temptation, so I'll start right in.
Aodhan, you ask, "how significant was the government's inadvertent 'role' here in precipitating the crisis by pursuing the political goal of fostering home ownership?" Thomas Sowell, in The Housing Boom and Bust, has concluded that complex financial bets "went bad" only because "the government had exerted pressure over time on many lenders to make loans to the uncreditworthy" so that they could buy houses ( as you paraphrase Sowell). Financial instruments like credit-default swaps, of course, depended on those loans' performance, so they failed and brought down the financial system.
Thanks for the question.
Sowell is right -- to a point. American politicians' blind support of universal home ownership helped transform housing into the most destructive bubble we've seen in our times.
We learned from the 1920s that government should control borrowing for speculation. Before the 1929 stock-market crash, people could borrow nearly 100 percent of the money they needed to purchase stocks. The stock exchange and lenders thought this practice was perfectly safe (you'll read some unintentionally funny quotes illustrating this point early in my book!). After all, lenders could seize and sell stock instantly if a customer stopped paying.
Problem is, though, that you can sell stock instantly at the price you want until you can't, just as you can sell a house within a week at the price you want until you can't.
We learned the first lesson back then. To this day, thanks to Depression-era rules, the Fed and SEC forbid people from borrowing more than 50 percent against their stock portfolios. That rule is not to protect the stock purchasers. They can still lose all of their money; they can even lose some borrowed money if stocks fall fast enough.
The rule is to protect their lenders, and, more important, the financial system. Without such protection, lenders would curtail credit after a stock bust in order to cover their own heavy loan losses, exacerbating a recession.
In housing, down payments work like these limits on borrowing work in the stock market. Requiring a purchaser to put 10 or 20 percent down on a home doesn't eliminate the risk of prices going up or down. But it limits such price moves so that the economy can absorb them.
Requiring buyers to maintain 20 percent down payments -- or even 10 percent -- over the past 15 years would have averted many problems. It's true that many poor people would not have been able to buy houses. But, by the same token, many poor people who had already saved up to purchase their homes would not have found themselves victimized by mortgage brokers who pressured them into taking all of the equity out of their homes; they would have had to leave a cushion there of non-borrowed money to protect against any downturn. Many middle-class people would not have been able to afford McMansions, and many rich people would not have been able to afford two or three or five houses.
House prices could not have risen to the extent that they did, because as they rose, fewer and fewer people would have been able to come up with the down payment, dampening demand. When a (smaller) bubble burst, fewer people would have had a reason to walk away from their homes; they would have still had some equity, even if that equity had fallen far from 20 percent.
Down payments would have alleviated the fraud problem, too. If you don't have to put any money down, you'll say anything on a mortgage application. You are less likely to risk your own money behind your lie.
Why did down-payment requirements begin to disappear in the Nineties, when they were all that tethered house prices to reality? Politicians and regulators should have seen that people were borrowing to speculate with the value of the roof over their head.
Politicians failed to act, but not just because they wanted poor people to be able to buy houses. Rather, rising home prices solved middle-class problems. People could pull money out of their homes and buy lots of stuff. They didn't have to worry so much about their kids' education or their retirements.
Washington studiously ignored the housing bubble's potent dangers not to "help" the poor, but to "help" two-income families who loved seeing their paper wealth rise with every home sale on their block.
As for government impositions like the Community Reinvestment Act, which Cas mentions here -- yes, the CRA and other home-lending mandates were and are problems. But the government continually expanded "affordable-housing" requirements only because both Democrats and Republicans thought that "markets" were solving social problems with only the gentlest of nudges -- magic! Affordable housing was politically popular because nobody had to pay for it.
And what about those complex financial instruments? The only thing complex about them is that bankers and traders devised them, too, to escape old-fashioned limits on borrowing.
If you want to make a bet on the direction of oil prices on a regulated exchange, you've got to put some cash down. This requirement works the same way a down payment does. But if you were AIG in 2005, and you wanted to bet, through a "complex" derivative, that housing prices would never fall, you could do so -- and commit to potentially tens of billions of dollars in payouts if you were wrong -- with no cash down upfront.
What if AIG had to wire $10 billion in cash to an exchange for every $100 or even $200 billion that it made in bets? Its executives would have felt the risk that the money wouldn't come back, rather than consider it as an abstract notion, and they would have asked real questions.
If AIG had made the bad bets and failed, anyway, it could have gone bankrupt. Markets would have known that the rules had required AIG to put some cash down to cover at least some of the losses. The rule would have muted the panic.
The lack of "down payments" in financial markets, in fact, magnified the original problem multi-fold. Through synthetic derivatives, financial actors could take one $300,000 mortgage and spin $1 million worth of risk out of it, creating financial products whose value depended on the value of that one mortgage. There was no room for error.
If we had applied old rules to new markets -- in housing as well as derivatives -- we would be talking about something else tonight!
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Feb '10
Re: Was the crisis "actually imposed by the government?"
John Xenakis talks a lot about this on his Generational Dynamics website. (I highly recommend his free online book, Generational Dynamics for Historians.)
While Democrats blame it on Republican deregulation, and Republicans blame it on the Democrats' misplaced desire to get everyone into a home whether they could afford it or not, the truth is that a whole generation behaved irresponsibly, and we are now reaping the consequences.
When the people who lived through the last major crisis (the Great Depression) all retired or died, the rules they put in place to prevent such a thing from happening again were gradually relaxed, removed or ignored. A new generation thought such rules were for old fuddy-duddies, or that we were more sophisticated this time around. Turns out we were too sophisticated for our own good, and some good old-fashioned simple rules would have served us in good stead.
We'll suffer the consequences (much more still to come) and be so traumatized we'll eventually put back more rules. If we are able to solve other structural problems, we may yet return to prosperity, only to have our grandchildren commit the same errors again after we're all dead.
Feb '10
Re: Was the crisis "actually imposed by the government?"
For more on Generational Dynamics, see:
Also see John Xenakis' List of major Generational Dynamics predictions.
May '10
Re: Was the crisis "actually imposed by the government?"
Nicole Gelinas: We learned the first lesson back then. To this day, thanks to Depression-era rules, the Fed and SEC forbid people from borrowing more than 50 percent against their stock portfolios...
The rule is to protect their lenders, and, more important, the financial system. Without such protection, lenders would curtail credit after a stock bust in order to cover their own heavy loan losses, exacerbating a recession.
The assumption here is that a decline in the supply of credit would be economically harmful. I think that during a recession, firms running the risk of a collapse (due to failure to satisfy demand) should either be denied credit by lenders or lent credit at interest rates augmented by default risk premiums reflecting the default risk of the ailing borrowers. A credit crunch is a necessary thing during recessions; my contention is that recessions are made necessary by an abundance of bad credit.
May '10
Re: Was the crisis "actually imposed by the government?"
What frustrates me to no end is that the Krugmans of the world, when troubled to acknowledge the CRA and related policies at all, shrug off their impact. I doubt that many people believe government was completely responsible for the housing bubble, but it's clear government policies influenced the market in catastrophic ways.
Conservatives seem to have little trouble admitting that markets involve humans, who are greedy and often make mistakes. It'd be great if leftists were as realistic about the (presumed) humans involved in the creation and enforcement of government regulations! Unfortunately, it's easier to whack at the strawman of total deregulation and insist that bureaucrats should manage every nook and cranny.
Nov '10
Re: Was the crisis "actually imposed by the government?"
Two other items that require focus.
1. There was/is no such thing as a 30 year fixed mortgage. A borrower can refi whenever s/he wanted with no repercussion and no cancellation fee for the previous mortgage. Therefore, all money was short money and rates were artificially low. Ergo many more borrowers clamored for cheap credit driving up illusory valuations.
2. The mortgage obligation does not extend beyond the real property financed. Therefore, if a borrower walks from a home whose value has dropped below the loan value, there are little or often no repercussions. This implied "put" option has tremendous value and could only be supported by higher home prices. It is also a moral hazard as it tempts borrowers to take the easy way out by reneging on an obligation.
So, what has happened? People say that the banks are not lending. Not true. They are lending to borrowers who truly can afford to repay the loans and with LTVs that are greater than 20%.
Edited on January 15, 2011 at 6:56amJan '11
Re: Was the crisis "actually imposed by the government?"
My brief understanding is that in the early half of the 20th century, America was a great innovator and manufacturer. Towards the end of the century, it became expedient to outsource much of the manufacturing, but still rely on innovation and invention. As we entered the 21st century, there was one last great American combined innovation and manufacturing project - money - by transforming financial institutions into "banks", which became highly leveraged at 40:1. All that money had to go somewhere. . . . .
Re: Was the crisis "actually imposed by the government?"
Nicole, something that really strikes me, on reading the case you've compiled, is how blindingly obvious it should have been, at every stage. Hindsight is always 20/20 and all that, but in this case, it's really one of those great puzzles of history--how could the danger we were running not have been apparent? In trying to answer that to my own satisfaction, I wonder to what extent policy makers were so focused upon, scarred by, and intellectually involved with the problem of inflation--particularly in the 1970s--that it caused a kind of collective tunnel vision, a willingness to say, "OK, no runaway inflation--we're good! No problem!" Does that ring true to you?
Oct '10
Re: Was the crisis "actually imposed by the government?"
Claire, they did know. The Fed minutes from 2004/2005 clearly show this. But they were afraid of pricking the bubble themselves. Interest rates are a terrible tool to prick a bubble (once it's already formed) and no one knew what else to do. Nor did they want to shoulder the blame. So nothing got done.
Oct '10
Re: Was the crisis "actually imposed by the government?"
And of course, global capital flows made monetary policy ineffective. Long-term interest rates continued to fall, long after the Fed started tightening short-term rates. Between the Latin American financial crisis in the mid-90s, the Asian crisis in 1997, and the 2008 crisis, I think its obvious unrestricted capital flows are a bad thing.
Jul '10
Re: Was the crisis "actually imposed by the government?"
Great piece, Nicole.
Claire, I was working for a mortgage company at the time when Fannie started offering mortgages with a down payment of only 3 percent. I remember thinking about how impossible it would be for the financial institutions to secure these loans when it was barely possible with a 10% down payment.
We know what happened since: The exact opposite of what should have taken place. I could not have been the only person who realized what was going to happen. Money must blind everyone.
May '10
Re: Was the crisis "actually imposed by the government?"
All this time I had no idea you were a guy, Nicole. Nice trilby.
Are there non-synthetic derivatives? They're windhandeln, as the Dutch tulip-traders would say. But no more evil than insurance contracts and/or wagers. Always bugs me when people who can't even do basic math say sagely "it's those derivatives."
Sadly, both parties were culpable in this real estate inflation fraud. Somehow the American Dream means owning your house and having mom over for some apple pie while watching the ball game. I've long advocated having a rent deduction to match the mortgage deduction. Sure, it double counts, but as a renter, I'm cool with that. And it might just drive home the idea that hey, renting is every bit as honorable as owning.
Sep '10
Re: Was the crisis "actually imposed by the government?"
The point has been repeatedly made that the Depression taught society the lesson that needed to be learned. I think significant financial failure is the only way this lesson is taught. MS Shales recent book pointed out that the idea that the government put humpty back together again is more or less a fallacy. I assume most have read this also. Some of the regulations enacted at that time may well have been good, but some precipitated the crisis we are talking about. It is not so much that people did not see the risk as they FELT the government could prevent humpty from cracking apart or at the least put him back together. The more the government is involved in the system (ie regulation) the more this FEELING will persist. This is a non-logical process. I do not mean by this that reason does not play a role, but that many decisions are prompted by emotion not reason. Think love and sex rather than balancing your checkbook. The market is not a machine; it is millions of people making millions of decisions every day. When it is tinkered with the outcome is far from certain.
Re: Was the crisis "actually imposed by the government?"
We should also consider the powerful speculative incentive created by high marginal tax rates on ordinary income. Consider that in California the top combined federal/state tax rate on W-2 income is nearly 50%. Capital gains in corporate stock compounds tax free and is taxed at 25% (combined) when finally realized. Borrowed money against, say, increasing home equity, is completely tax free. Under the Clinton-era tax law changes, the first $500,000 in profit on a residence is tax free for a couple, and this exemption resets every two years. And most home mortgage interest (subject to phase-outs) is tax deductible.
Who wouldn't sign up to earn a seemingly guaranteed $250,000 each year tax free ($500K every other year), borrowing as needed ahead of realizing the gain in order to fund a nice lifestyle?
Sep '10
Re: Was the crisis "actually imposed by the government?"
George Savage: We should also consider the powerful speculative incentive created by high marginal tax rates on ordinary income. Consider that in California the top combined federal/state tax rate on W-2 income is nearly 50%. Capital gains in corporate stock compounds tax free and is taxed at 25% (combined) when finally realized. Borrowed money against, say, increasing home equity, is completely tax free. Under the Clinton-era tax law changes, the first $500,000 in profit on a residence is tax free for a couple, and this exemption resets every two years. And most home mortgage interest (subject to phase-outs) is tax deductible.
Who wouldn't sign up to earn a seemingly guaranteed $250,000 each year tax free ($500K every other year), borrowing as needed ahead of realizing the gain in order to fund a nice lifestyle? · Jan 15 at 6:46am
In her book Nicole mentions that FDR enacted regulations that encouraged homeownership. These evolved over time to what you mentioned. I believe most think they were one of the good regulations. What could be wrong with the government encouraging home ownership? See what can happen when government decides to tinker with the market.
Sep '10
Re: Was the crisis "actually imposed by the government?"
Nicole; Though I disagree with some of your observations and conclusions I think you did a superb job of laying out the legal frame work that you think markets could operate in today. You gave a good, concise history that gives people insight into the problems we are facing; but most importantly you did it in a manner that entices them to read it. Congratulations.
Sep '10
Re: Was the crisis "actually imposed by the government?"
Nicole I have a question that may be too arcane. There has been work, mainly in the field of mathematics, that hypothesizes that risk, at least in markets, cannot be mitigated. Most of the work is over my head but I think I am correct that the conclusion reached was that often what is happening when derivatives, deposit insurance, etc. is being used is that a risk that is recognized and generally well understood is being exchanged for a risk that is either not recognized or not properly understood. Sometimes the new risk is recognized and understood and is being, I would argue fraudulently, shifted onto someone else who does not understand the risk. If the work is correct it places these instruments in a different light. What do you think?
Re: Was the crisis "actually imposed by the government?"
I'm curious about this too. (I'm unfamiliar with this work, but the idea sounds interesting.)
Re: Was the crisis "actually imposed by the government?"
LJ, I commend Nassim Nicholas Taleb's work to you, particularly The Black Swan. Taleb presents the mathematical issues you describe in an unusually accessible way. One of his core theses is that we inappropriately use the normal probability distribution where it does not apply; partly because we have particularly good quantitative techniques to model this distribution and also because "normality" fits most of the physical world around us. Assuming normality allows one to neglect the impact of extreme outliers on the mean--we can confidently assume that no 100 foot tall individuals will come along to appreciably shift the mean height of a group of men--making for tidy mathematical predictions. But human-designed systems are not necessarily normal--the financial equivalent of the 100 foot tall person just happened, for example--and so we are fooling ourselves by employing precise-seeming mathematical tools inadequate to the purpose.
Edited on January 15, 2011 at 5:29pmSep '10
Re: Was the crisis "actually imposed by the government?"
Go to page 186 of Roger Lowenstein's When Genius Failed Chapter 10 At The Fed and then 42 year old Peter Fisher (a familiar name from the later Bush Administration) and you will see the same thing.
There are well known cognitive psychological traps that repeat themselves in these situations covered well in Michael Roberto's Know What You Don't Know
Jun '10
Re: Was the crisis "actually imposed by the government?"
Moral hazards aren't just hazards--they're usually the script of the play. If you don't account for basic human nature, the urge to gamble on a rosy future, you're asking for trouble. With all amateur investing, people need protection from themselves too.