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Source link: http://archive.mises.org/10239/the-housing-boom-and-bust/

The Housing Boom and Bust

July 7, 2009 by

The epicenter of the current economic crisis has been the U.S. housing market. The collapse of the subprime mortgage market and the dramatic fall in home values have sent out shock waves of economic disruption around the world.

Many have interpreted these events as another example of the inherent instability of the free market. There have been loud calls for greater and more detailed government regulation of the mortgage business and financial markets in general.

But before hasty policy decisions are made it is always useful to step back and carefully look at the facts. How, actually, did this housing market horror story come about, and what government policies may have helped to set this disaster in motion?

The story is told with great persuasive clarity in The Housing Boom and Bust (Basic Book, $25) by economist Thomas Sowell, who is a long-time senior research fellow at the Hoover Institution on the campus of Stanford University.

Sowell explains that the Federal government began a huge regulatory push to create “affordable housing” in the 1990s, under the presumption that the cost of acquiring a home was out of reach for a growing number of American families.

However, he shows that in general average American incomes were keeping up with or even exceeding the cost of buying a home in most of the U.S. The only problem areas were in places like California, where regulations on land development and home building were making land scarcer and more costly to buy.

Prominent Democratic and Republican members of Congress and both President Clinton and President Bush put pressure on lending institutions to lower their credit rating standards; reduce the minimum down payment requirements (in a growing number of cases, to zero); and introduce short-term flexible monthly payment methods that would only increase later on.

Often under the intimation of bank and mortgage market regulators, financial institutions greatly increased their lending to targeted socio-economic groups that were less credit worthy due to fears that they might otherwise be hit with anti-discrimination law suits. As Sowell points out, the tragedy of forcing banks to make home loans to people really not financially able to bear the costs of a house once times turned even moderately bad, is that foreclosure rates are highest for this segment of the population.

Two major vehicles for the growth of this unsustainable housing bubble were the semi-governmental agencies, Fannie Mae and Freddie Mac. Congress and the White House pressured both agencies to extend loan guarantees or buy up the mortgages of these credits unworthy borrowers, until finally before the housing crash last year these two agencies held or guaranteed around fifty percent of all the home loans in America.

The irresponsibility of Fannie Mae and Freddie Mac, and those in Congress who pressured them to go out on this limb has been shown by their formal take over by the government and the huge sums of taxpayer’s money that it has cost to maintain their solvency.

What also fed this housing market frenzy, Sowell explains, was the monetary policy of the Federal Reserve. In 2003 and 2004, the central bank kept interest rates artificially at historically low levels. Indeed, when adjusted for inflation, for part of the time interest rates were zero or negative. Mortgage rates were pushed down to barely two or three percent in real terms.

If there is a lesson to be learned from the facts of the housing crisis, it is that its cause has been misguided and intrusive regulations and political pressures, and not any inherent weakness or instability in a market economy.

Richard Ebeling


Jake Le Master July 7, 2009 at 11:51 am

Is this the same Sowell who says the Fed played no major role?

Robbie Clark July 7, 2009 at 12:30 pm

If you are referring to the interview at reason.com that was previously mentioned in a comment on this blog, this is what Thomas Sowell said.

reason: How much weight do you place on the notion that Federal Reserve expansionary money and credit policies primed the bubble, and bust, in housing?

Sowell: I find it hard to accept. I’m sure if the interest rates had been at 8 percent the boom would not have gone as far and the bust would not have been as big. I’m not saying monetary policy had no effect. But I am struck by the fact that Federal Reserve policy is nationwide, and in places like Dallas the increase in housing prices was in single digits and the decrease has been in single digits. So while Fed policy undoubtedly aggravated circumstances, it can’t be the fundamental cause because the defaults were so heavily concentrated. 60 percent of all defaults nationwide were in five states, and I suspect if you broke down the data even more you’d find specific regions in those five states very heavily implicated in defaults.

His conclusion is exactly the opposite of what it should be as I see it. IE – because of the national policy of the Fed, bad policies being enacted in localities were allowed to explode into what we have now. I still wouldn’t discount the points made in the book however.

Rob Mandel July 7, 2009 at 1:26 pm

Saw this a few weeks back:


The greatest unseen destruction started in 2001 or thereabouts. The historic balance between non-residential and residential investment had been about 70/40 (non-res to res). Then for several years it closed to 60/40. This was the seed of the bust as residential, i.e. non-productive, investment replaced non-residential, i.e. productive, investment. And of course, true to the Austrian school analysis, once the Fed raised rates, the unsustainable investments busted.

And the real tragedy in all this, the real destruction, the real reason that the bust will be so long and severe, is that not only is the unsustainable investment in need of liquidation, but at that, it’s non-productive malinvestment. Even when purchased at reduced prices, it’s still, for all intent, useless as far as wealth generation is concerned.

Keith July 7, 2009 at 4:20 pm

Wouldn’t it actually make a great deal more sense for the more heavily regulated (in terms of housing markets) markets to be where most of these defaults would occur?

Let’s look at it this way. Supply and Demand play the main role in the price of goods. So what ends up happening when we add in a new infusion of credit. Creditors will want to put that money in places where it will produce the highest yield.

Because the supply of housing may be fixed or limited in a given geography (due to regulation and other reasons), a given shift in demand (in a fixed region) will drive up prices much more than in an area with much more useable land.

So given these two presumptions, it makes sense that creditors would overwhelmingly lend into these housing markets because over a given period of time the prices for homes would be much greater there than in a lower cost area. This also assumes that creditors believe their investment has no chance of its bottom falling out (which it seems most banks believe would be the case.)

This is simply a thought on my part and I do not believe it to be definitive; but given the situation it is quite logical.

Looking at factors like the factors that determine where bubble activity occurs would be a neat dissertation topic.

Don Lloyd July 7, 2009 at 4:24 pm

“Often under the intimation of bank and mortgage market regulators, financial institutions greatly increased their lending to targeted socio-economic groups…”

The word should be ‘intimidation’.

Regards, Don

Mike D. July 7, 2009 at 5:14 pm

I’m not sure this article is on the mark for the following reasons:
1) The initial meltdown occurred in the (California) jumbo loan market. Fannie and Freddie did not originate these loans.
2) Fannie and Freddie bought the AAA tranches of these packaged jumbo loans that had been originated by other non-agency lenders, such as Countrywide.
3) The money for these jumbo loans was provided by Wall Street through the “shadow banking system”.
4) This was a classic example of what Austrians term “malinvestment”. The Fed lowered interest rates to unrealistic levels, distorting the market for fixed income investments to the point that, after taxation and adjustments for inflation, most Government an AAA corporates were yielding negative returns. Investors were only too keen to invest in these AAA securities that paid a higher spread.
5) Moody’s and S&P based their ratings on historic default rates and growth in housing prices. They had never seen a scenario where adjustable rate mortgages had adjusted up (by 4 or 5%) and where housing prices had not risen by at least 5% annually, let alone dropped by 20%.
6) The problem has been incorrectly categorized as being caused by loans being given to borrowers with bad credit. This is categorically not true. While there were numerous NINJA loans (“no income, no job or assets”) few loans were given to people with low FICO scores – the credit scores only went down at a later date after they had defaulted on their loans. Bear in mind that credit scores do not consider, income, assets, job, race sex or age – their primary purpose is to be able to reject loan applications without being accused of discrimination.
7) The initial meltdown occurred with rental properties. The normal standard for these loans used to be 25% down and no cash-out refinancing. However, many of these loans were made with 0% down. When these loans resets, with payments in some case thousands of dollars higher, the rents collected were insufficient to meet the new payments. Having no equity in the house/appartment/condo, many landlords simply chose to walk away, causing a spate of foreclosures
8) When all is said and done, the failure of Fannie and Freddie was caused by overleverage – they were leveraged 50 to 1. Their GSE status allowed them to raise money at below market rates to by the AAA securites put together by Wall Street. When these securities started to tank they were cooked.

S Andrews July 7, 2009 at 5:19 pm

What Mike D said.

SailDog July 7, 2009 at 8:45 pm

This article talks about symptoms, not the real underlying issues.

As everyone on this site should be acutely aware money is meant to represent real things. Gold was a good substitute for a whole lot of reasons, but beyond that money is meant to represent real value.

Paper and digits on a hard drive are poor substitutes for gold, or even a currency backed by gold.

More and more things are now “money”. The alphabet soup of various derivatives and all the wondrous credit instruments outstanding, still more than 200 times global GDP, are just specious IOU’s written on the future. Most of it will have to unwind. We still have a savage de-leveraging to go.

The sub-prime mess was only one example. As it was visible, it got the blame. But the real problem was fiat money; and the irresponsibility and greed its lack of connection with real assets created. So this article misses the point.

jeffrey July 7, 2009 at 8:52 pm

Richard, can you offer an analysis of the relationship/compatibility between Sowell’s perspective and the Austrian view?

newson July 8, 2009 at 3:09 am

who killed cock robin? i’m with the others. sowell latches onto the accessories to the fact, not seeing the real aggressor.

monetary policy is the only way to explain why the contagion is global and synchronous; were it only due to us laws, it would be confined in scope.

Russ July 8, 2009 at 12:48 pm

newson wrote:
“monetary policy is the only way to explain why the contagion is global and synchronous; were it only due to us laws, it would be confined in scope.”

Come on, now. The rest of the world invests in the US, and the US invests in the rest of the world. Any shake-up in the US economy therefore is not going to remain isolated, whether the cause is monetary or not.

Besides, I’ve read the Sowell book, and he does criticize the Fed. For instance:

“During the early years of the 21st century, the interest rates that the Rederal Reserve System charged financial institutions were brought down to extremely low levels. Competition among financial institutions in turn brought down the interest rates they charged, including interest rates on mortgage loans. Mortgage interest rates fell to their lowest level in decades. Not surprisingly, housing prices rose to record high levels. This helped set the stage for the boom.”

Elsewhere he says:

“…a house of cards that was ready to collapse with a relatively small nudge. That nudge came as the Federal Reserve System, having lowered its own interest rates to an extremely low one percent, began slowly raising the interest rate back toward more natural levels in 2004.”

So he gives the Fed their fair share of blame for both blowing up the bubble, and for popping it.

Sowell just says that there is more to the problem than the Fed alone. There are also local laws artificially jacking up prices in certain areas, Fannie Mae and Freddie Mac, the Community Restructuring Act, etc.

Yeah, Fed bad. We get it. But there was more to the recession than just the Fed.

Russ July 8, 2009 at 12:53 pm

Oops. I meant Community Reinvestment Act. I always mix that up for some reason. Probably because “Restructuring” is more honest. *grin*

Nick Bradley July 8, 2009 at 2:39 pm

Great Point Kieth!

The way I see it, The Fed created the credit bubble and the regulatory apparatus directed it towards real estate. In the absence of pro-Real Estate regulation, the bubble would have occurred elsewhere, perhaps more evenly throughout the economy, perhaps in a concentrated sector.

There was an article in Harper’s Magazine about a hear and a half ago that postulated this very theory: easy credit from the fed is directed towards politically-approved sectors — often at the behest of corporate “insiders”. The Author, Eric Janzen, goes on to speculate that the next bubble will be in Alternative Energy and Infrastructure — with the groundwork already being laid.


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