No More of the Same!!

No, I’m not referring to the presidential election. I am referring to Congress’ financial bailout plan. Though it’s too late to stop the bailout now, it is still crucial to understand why the current proposal will not fix the problem: it doesn't address the policies which brought us to this point in the first place. Unless the real cause and effect of those policies are properly understood, no real or lasting solution is possible.

So how did we get here? What policies not only allowed but encouraged the poor financial decisions for which we are now paying the price? Here is my attempt to understand it all. Comments and corrections are welcome.

A full understanding has to go back to debunking the myths which permeate explanations of the 1929 stock market crash and the Great depression. The standard interpretation is that both were caused by the free market and ended by government intervention. Lest this article become unwieldy, I refer you here and here for arguments which address those myths, and effectively demonstrate how government meddling both caused the crash and delayed the recovery. (For a brief summary, check here.)

However, several legacies of the New Deal are playing key roles in our present situation. One of those is the Federal National Mortgage Association. More affectionately know as Fannie Mae, this government agency was initially established in 1938 with the express purpose of increasing home ownership by stimulating the mortgage market. This was accomplished through government enhancement of the secondary market for mortgages.

A secondary market is not in and of itself a problem. The trouble is caused when government interference distorts free market signals so that lenders and borrowers invest and take risks in ways not justified by the true state of the economy. Free market prices connect us to reality. Government manipulations in the market place distort those price signals, disconnecting everyone from economic reality.

But what actually is a secondary market? A secondary market is simply the resale of an item. Here it involves “repackaging” mortgages into bundles based on risk, and then selling and buying small portions of the loan packages as securities. (That's the infamous "securitization" we keep hearing about.) This makes sense because lenders make loans to make money. Mortgage-backed securities are a way for investors to make money on the loan business, just like investors buy stock in Wal-Mart or Microsoft with the hope of participating in the financial successes of those businesses.

Fannie Mae purchases loans from banks, pools them by risk level, and subsequently offers them for sale as securities. In this manner, shares can be purchased in large or small amounts, in varying degree of risk, depending on the resources available to the investor. The idea is for risk to be spread out among multiple investors (a.k.a. risk-takers) lowering the amount of risk assumed by any one investor. Lower risk makes it possible to charge less interest. (In a free market, risk and interest are directly related. That’s why you’re getting less than 1% on your federally-insured bank savings account, and you have potentially much higher return –or loss- on stocks.) Lower interest rates on the mortgages means more people can afford the loans. Again, not necessarily a bad thing, unless the lower interest rates are not based on the presence of real value.

Fannie Mae was created to buy mortgages from primary lenders. By selling to Fannie Mae, initial lenders are able to use the money received to make even more loans. For 30 years, Fannie Mae had a virtual monopoly on the secondary mortgage market. Why? Because of its association with the government, at first directly, as an actual government agency, and after 1968 implicitly, as a GSE (Government-Sponsored Entity.) Perceived as more financially secure due to government backing, Fannie was able to borrow funds at lower rates and sell at higher rates compared to companies without that government association. The savings Fannie experienced could be passed down the line to home buyers via lower interest rates, making houses relatively “more affordable.” It also let them out-compete their private competitors in the secondary mortgage market.

Freddie Mac (Federal Housing Finance Agency), another GSE, was created in 1970 to expand the secondary market even further, and purportedly to provide “competition” for Fannie. This increased secondary-market for mortgages directed even more investment into housing. Securitization –the way Fannie and Freddie offered the pooled mortgages for sale-- in and of itself is not a cause but rather simply the means by which the expansion occurred.

(There is much more complexity to the Fannie/Freddie story, including dubious ties to politicians along with questionable accounting schemes and business practices. More information can be found here and here. )

In 1977, Congress instituted the Community Reinvestment Act. The CRA was enacted for the express purpose of increasing access to mortgages under the guise of fair and affordable housing. Justified by the erroneous perception of racial discrimination in lending practices*, the CRA holds the banking industry hostage through its regulatory power to deny permission for expansion, new branches, and mergers. The ransom? Banks must provide a certain amount of mortgage money to borrowers who without government pressure would not otherwise qualify for loans. Why wouldn’t they qualify? Poor credit history, insufficient income and even lack of employment, lack of down payment. In other words, people who are at high risk for default.

The regulatory powers of the CRA were strengthened and the push to lend to subprime borrowers was significantly increased in 1995 under the Clinton administration. Advocacy groups like ACORN and NACA gained influence and leverage, further politicized the mortgage business, and placed even more pressure on banks to make unsound loans. An excellent analysis of the effects of the CRA came be found in Howard Hussock’s City Journal article, “The Trillion-Dollar Shakedown That Bodes Ill for Cities.” More information can be found here, here, and here.

To summarize the set-up: In response to the bankruptcies and loss of homes which occurred following the 1929 stock market crash and subsequent Great Depression, FDR created Fannie Mae to make borrowing to buy a home easier. The key question to ask is this: easier than what? Easier than what was supported by actual economic circumstances. Freddie Mac expanded this assistance, further increasing the artificial stimulus to home purchases. Freddie and Fannie made it easier for everyone to obtain mortgages, but the CRA, required banks to lend to the marginally-solvent, precisely because they were not creditworthy, all under the admirable-sounding euphemism of “affordable housing.”

Then, along came the dot-com boom and crash. Euphoria in the success of new markets via the Internet fueled investment beyond actual value. We know it now as the Dot-Com Bubble. Eventually, enough of the companies with poor management or inadequately marketable ideas – failed. Stock prices adjusted to more accurately reflect real existing value. First the euphoria and then market confidence in general dissipated. Add in a contraction of the money supply by the Fed in 1999 and early 2000, and voila! The crash.

With the dot-coms no longer a “sure bet,” savings and investment money needed a new outlet. Burned by the ephemeral ether of the Internet, people looked for something tangible, solid and real in which to invest. (They don’t call it real estate for nothing!)

Compound this new flow of money into housing, facilitated by the expanded mortgage market through Fannie and Freddie, with an intentional “easy money” policy by the Federal Reserve (which hoped to lift the economy out of first the dot-com, and then the 9/11 market down-turns,) all accompanied by the effects of the CRA –and you have the recipe for the Housing Boom, Bubble and Bust.

I’ve explained Fannie, Freddie and the CRA, but what is “easy money” and how does that contribute? Easy money means it’s easier to get (borrow) money. Through a series of financial transactions, the Fed increases the supply of money available to banks. This increased supply leads to a fall in interest rates. (Interest is the price of money and when supply goes up, price comes down.) The rising and falling of interest rates is not the problem though---it's that fact that the cost of our money is being intentionally manipulated. Artificially-created lower interest rates makes borrowing more affordable than it otherwise would be. Debt is encouraged. In this case, the debt was heavily in the form of mortgages. The secondary-mortgage market greased the spending/lending further. Increased housing debt means increased demand for houses which leads to increased housing prices. Rising prices encourage building, investment and speculation. A new bubble begins to form.

As long as housing prices were going up, then marginally-solvent borrowers could refinance when they got into trouble. But, the building spree resulted in increased supply of houses, and…prices fell. Unable to sell or refinance when adjustable rates increased, more and more people defaulted. The magnitude of the problem was enhanced by highly leveraged speculation, both in houses and in the mortgaged-backed securities of the secondary market, so sweetly enlarged by Fannie and Freddie. Lower housing prices and defaulting loans brought into question the value of the complex financial instruments which were based on them, so the credit market froze. Trapped between illiquid assets of uncertain value and a built-in system requiring short term cash flow, banks began to fail.

Eventually reality caught up. The inflated housing prices were not real and there for not sustainable. The end result is the crash (a.k.a. a correction) we are experiencing now. Unless the manipulation of the money supply, lending regulations which violate free trade and property rights, and the use of economic policy for political purposes are recognized as significant causes of dangerous distortions in the market,all those destructive policies will continue. Solutions which include those flawed policies will be ineffective, and any benefits will be temporary.





*Day, Theodore and Liebowitz, "Mortgage Lending to Minorities: Where's the Bias?" Economic Inquiry 36:1:1998 referenced here.


Recommended Reading

CRA

Husock, Howard “The Trillion-Dollar Shakedown That Bodes Ill for Cities” City Journal Winter 2000 http://www.city-journal.org/html/10_1_the_trillion_dollar.html as of 10-03-08
An 8 page in-depth review of the history the CRA, ACORN and NACA and their effects on lending practices.

DiLorenzo, Thomas “Government-Created Subprime Mortgage Meltdown” http://www.lewrockwell.com/dilorenzo/dilorenzo125.html as of 10-03-08

Liebowicz, Stan “The Real Scandal: How the Feds Invited the Mortgage Mess” New York Post 02-05-08 http://tinyurl.com/RealScandal

Charen, Mona, “ACORN, Obama and the Mortgage Mess” RealClearPolitics 9-30-08 http://tinyurl.com/CharenMona

Pethokoukis, James, "Why McCain Goes Easy on Fannie and the CRA" US News 10-30-08 http://tinyurl.com/3lf8xa

Fannie and Freddie

Hassett, Kevin, “How the Democrats Created the Financial Crisis” Bloomberg.com News 09-22-08 http://tinyurl.com/HassettKevin

Burnham, Bill “Fannie Mae’s Golden Goose: A Lesson in Moral Hazard”on Burnham's Beat 07-11-08 http://billburnham.blogs.com/burnhamsbeat/2008/07/fannie-maes-gol.html
If you only have time for one article on this topic, start here.

Wallison, Peter and Calomiris, Charles “Blame Fannie and Congress for the Credit Mess” Wall Street Journal 9-23-08 http://www.aei.org/publications/filter.all,pubID.28664/pub_detail.asp

Duhigg, Charles, “At Freddie Mac, Chief Discard Warning Signs” New York Times 08-05-08 http://tinyurl.com/DuhiggCharles

General Analysis

Lott, John “Financial Markets Are In A Mess” FoxNews.com 03-17-08 http://www.foxnews.com/story/0,2933,338629,00.html

Editor, Wall Street Journal “A Mortgage Fable” WSJ 09-22-08 http://online.wsj.com/article/SB122204078161261183.html
Provides a nice summary of the contributions the Fed, Fannie/Freddie, CRA, bank regulations and credit-rating to the curent crisis. It's no surpirze that politian's are blaming Wall Street and fail to see how thier policies and laws created the set-up in the first place.

Coats, Warren “The ABC’s of the Housing “Crisis” Warren Coats’ Facebook, Sunday, April 6, 2008 http://tinyurl.com/CoatsABCs
If my article is an introduction or summary, Coat's articles provides Crisis 101. This article is linked to in the "DEF" article below. I had to join Facebook to access it. If you want a copy and can't access it here, email me and I will send you one.
Coats Warren, “The D E Fs of the Financial Markets Crisis” Cato.org 09-26-08 http://www.cato.org/pub_display.php?pub_id=9667

Coats, Warren, “The US Mortgage Market – The Good, the bad and the Ugly” delivered to the Association of Banks in Jordan, June 22, 2008 http://tinyurl.com/goodbaduglu

Leonhardt, David, “Can’t Grasp the Credit Crisis? Join the club" New York Times 3-13-08 http://tinyurl.com/LeonhardtDavid

Studies on Lending Discrimination

Zuckoff, Mitchell, “Mortgage Gap Still Exists for Minorities” Globe.com 09-27-1992 http://tinyurl.com/mortgagegap

Resulting Manual:
Closing the Gap: A Guide to Equal Opportunity Lending http://www.bos.frb.org/commdev/commaff/closingt.pdf

Day, Theodore and Stan Liebowitz, “Mortgage Lending to Minorities: Where's the Bias?” Economic Inquiry, 1998, vol. 36, issue 1, pages 3-28

Malanga, Steven “The Long Road to Slack Lending Standards” RealClearMarkets 10-01-08 http://tinyurl.com/SlackStandards

Federal Reserve/Monetary Policy

Calhoun, Joseph, "In Times of Crisis, Trust Capitalism" RealClearMarkets 9-29-08
http://tinyurl.com/TrustCapitalism
This article discusses how the Fed has contributed to the credit crunch and describes how a free market would handle the problem better.

O’Driscoll, Gerald “Asset Bubbles and Their Consequences” Cato Institute Briefing Paper No. 103 May 20, 2008 http://www.cato.org/pubs/bp/bp103.pdf

Shelton, Judy “Loose Money and the Roots of the Crisis” Wall Street Journal 9-30-08 http://online.wsj.com/article/SB122273029076687929.html

Great Depression

Powell, Jim, FDR's Folly: How Roosevelt and His New Deal Prolonged the Great Depression
Read a review here: http://www.amazon.com/review/R54S4FGIWH20O/ref=cm_cr_rdp_perm