What Caused the Bubble?

The primordial soup from which the Housing Bubble sprang to life may be directly traced to Congressional intervention in the housing market during the 1990s. Congress established the preconditions and distorted the personal economic incentives necessary to create, gestate and perpetuate the Housing Bubble. Without these government distortions, none of the excesses or abuses that followed would have been possible.

In 1992 congress began directing Fannie Mae and Freddie Mac to purchase huge sums of low income mortgages. By 1995 the GSEs were being given specific directives by HUD as to what percentages of their budgets were to be allocated towards purchasing subprime mortgages. The amount of government controlled money being directed to subprime grew annually, fulfilling congress’ overtly stated and well defined social agenda. The Community Reinvestment Act revision in 1995 furthered this process. Banks and lenders were directed to dramatically increase their subprime lending. Rules regarding the securitization of such debt were amended resulting in Bear Stearns completing the first such offering of subprime debt in 1998. This securitization mechanism facilitated the flow of massive amounts of capital into subprime mortgages.

Until the mid-1990s, lenders did not make loans to people with bad credit in large numbers because such borrowers were unlikely or unable to repay those loans. Why suddenly during the mid-90s did lenders begin to ramp up subprime mortgages in a large and growing capacity? The obvious answer is that Congress compelled lenders to engage in subprime activities. Legislation required that financial institutions lend to minorities, direct loans to inner-cities and give mortgages to people with bad credit. Fannie and Freddie, at the direction of legislators, exercised undue influence over lenders to further encourage subprime lending. Financial institutions were dependent upon these monopoly-like GSEs to facilitate their traditional mortgage businesses and treated such pressure as a cost of doing business. Fannie and Freddie were also directed to dedicate a large and growing portion of their resources to subprime activities. These expenditures represented an enticing opportunity for lenders.

As home prices began to rise during the mid-1990s, partially as the result of increased demand by the new pool of potential subprime borrowers, lenders observed an interesting phenomenon. In an environment of rising prices, subprime mortgages were actually profitable for the lender. If borrowers ran into trouble they could sell their properties for more than enough money to satisfy the requirement of the mortgage. Even better, the lenders could refinance such mortgages based on rising equity and generate a new source of profitable fees. Subprime lending, created by government edict and nurtured by Freddie and Fannie, transitioned from a cost of doing business for private lenders into a profitable, if unsustainable, business model.

At the same time Wall Street figured out a similar lesson. Investment bankers had already discovered how to make pools of assets functionally less risky and more valuable than the sum of their parts through the magic of securitizations. These financial rocket scientists observed that in a rising house price environment much of the value structure of the securitized subprime debt was of high credit quality.

The challenge was figuring out a way to lend to low income borrowers with poor credit and no assets. Such lending was required to meet government mandates and could be profitably mined while housing prices were rising. Capitalism when presented with an opportunity to generate profit is good at solving such problems and the innovation of affordability mortgages was created.

Given their extensive experience and resources, government officials and regulators should have recognized the dangers of low down payment asset purchases and introductory interest rates which distorted economic incentives. These mortgages encouraged the use of extreme leverage which was completely unsuitable for most home buyers. Teaser rates created an immediate but unsustainable economic incentive to buy houses. Both characteristics decoupled the prices of houses from the fundamentals of value. Combined with the expectation of rising prices, buyers were no longer sensitive to what price they paid for a house as they were not restrained by the need for a down payment or the necessity of cash flow to service traditional mortgage payments.

The Federal Government Is Complicit and Hypocritical

The federal government had been enjoying the “free lunch” of stable and rising housing prices
and high homeownership rates for decades. In fact Congress had actively engineered this phenomenon in part through the creation and manipulation of Fannie Mae, Freddie Mac, HUD and other federal organizations that distort the housing market. The deductibility of mortgage interest, the Community Housing Reinvestment Act of 1977 and its important revision in 1995, and the favorable capital gains treatment of primary residences are just a few more examples of government policies which distorted the supply, demand, credit availability, interest rates and tax treatment of housing.

In a fascinating and effective piece of political marketing government has consistently undertaken these efforts in an attempt to “make housing more affordable”. Yet in every case, with the exception of the recipients of direct welfare, each effort by the government to make housing more affordable through intervention has made housing less affordable.

For example, interest rates on mortgages are lower in the United States due to Fannie and Freddie’s abilities to borrow capital at preferential rates. The price of housing is partially dependent on interest rates. Lower mortgage rates mean higher prices. Buyers delude themselves into believing that they benefit from the lower, government sponsored mortgage rates but they in turn pay higher prices to purchase their homes.

The deductibility of mortgage interest is a popular tax break. Home buyers believe they are better able to afford houses because their effective cost of borrowing is lower. The lower cost of servicing a dollar of mortgage debt means that every buyer can afford to pay more for a house with the same level of cash flow. In reality the same pool of buyers are pursuing the same pool of houses but the buyers have a lower effective interest rate on their mortgages. Since house prices correlate to lower interest rates and higher effective incomes, house prices have risen accordingly.

Congress Pats Itself on the Back

The government’s initiatives designed to increase homeownership rates and provide mortgage access to subprime borrowers succeeded. As house prices rose steadily during the Housing Bubble to unsustainable levels, congress, policy makers and regulators cheered “financial innovation” for allowing subprime borrowers to access homeownership through affordability mortgages.

As Americans leveraged their houses to dangerous levels, congress, policy makers and regulators did nothing. In fact, they roundly applauded the benefit to homeownership rates of using such leverage.

When the wealth effects of rising home prices stoked unsustainable economic activity no government initiatives were proposed to limit the Housing Bubble’s impact or restrain rising prices. When Americans stopped saving and monetized their theoretical home equity gains the government did not cry foul, preach sanity or regulate this destructive behavior, they cheered and claimed credit for the roaring consumer based economy.

When capital was directed to building homes that no one needed, the Federal Reserve and Treasury did not act. In fact, Government leaders marveled at their abilities to create millions of home construction related jobs.

Now that the Ponzi scheme has failed the government is acutely interested in market driven housing prices. Policy makers are concerned about the leverage of homeowners entering foreclosure. Politicians are surprised that consumer spending is dropping as home prices revert towards sustainable levels. The Treasury and Federal Reserve have sprung into action over lost jobs, bankruptcies and credit disruptions.

Government mandates and legislation created the problem of overvalued house prices by distorting lending practices and increasing both the supply of and demand for subprime mortgages. Legislators directly benefited from an electorate fat and happy on paper wealth gains, falling unemployment, a surging economy and increased tax receipts. Now, in the name of political expediency, government wants to take action that can only have the effect of lengthening and deepening the extraordinary economic downturn it created.