Note: Updated in response to Monday’s news and opinion columns.
Last week’s excitement seemed to take many by surprise, yet it was in fact predicted by many. Start with Charles Morris, who began writing his 2007 book, The Trillion-Dollar Meltdown, in 2005.
“The whole world economy is at risk,” said The Economist, also in 2005. “It is not going to be pretty.” In 2004, the magazine-that-calls-itself-a-newspaper estimated that two-thirds of the world’s housing (by economic value) was “a potential housing bubble.” By 2005, it was calling it “the biggest bubble in history.” And, as it noted in 2003, “soon or later,” bubbles always burst.
We read about derivatives and credit default swaps putting investment banks and insurance companies into bankruptcy. But it all comes down to the housing bubble. Without the housing bubble, none of this mess would have happened.
The big political debate is whether the meltdown means we need more or less government intervention in the free market. Thomas Friedman says, “If it werenÃ¢â‚¬â„¢t for the government bailing out Fannie Mae, Freddie Mac and A.I.G., and rescuing people from Hurricane Ike and pumping tons of liquidity into the banking system, our economy would be a shambles.” But what if the government created the problem in the first place, just as it created Fannie Mae and Freddie Mac? Maybe we need a little more of some kinds of intervention, and a lot less of others.
The first government intervention dates back to 1938, when Congress created Fannie Mae as part of the New Deal. The goal of Fannie Mae was to help the housing market recover by keeping mortgage interest rates low.
That may have seemed worthwhile during the 1930s, but by the 1950s the housing market was booming. By then, Fannie Mae had created the secondary mortgage market, buying mortgages from banks and repackaging them as mortgage-backed securities and selling them to investors. While this certainly promoted homeownership, it did not absolutely require government support in the form of exemptions from state and local taxes, exemptions from Securities & Exchange Commission (SEC) oversight, and access to the federal government’s line of credit.
In 1968, President Johnson semi-privatized Fannie Mae, mainly to get its budget off the federal books. As a semi-private corporation, Fannie Mae had stockholders and highly paid executives but was still implicitly backed by the faith and credit of the federal government. By comparison, Congress fully privatized Sallie Mae, the student-loan version of Fannie Mae.
As a corporation obligated to earn profits for its stockholders, Fannie Mae was selective about the mortgages it purchased. Its creation of the secondary mortgage market made housing more affordable for middle-class families, but that didn’t mean it would take on risky loans. Still, the implicit backing of the federal government created a moral hazard, that is, an incentive to take risks knowing the taxpayers would back it up.
To avert this risk, in 1992 Congress gave the Department of Housing and Urban Development (HUD) regulatory oversight over Fannie Mae and Freddie Mac (which had been created in 1970 to help Fannie Mae expand the secondary mortgage market).
Due to land-use regulation, housing prices started ballooning in 1995. Congress put pressure on HUD to keep housing not only affordable but to increase homeownership among low-income families. HUD responded by using its regulatory authority to direct Fannie and Freddie to increase the percentage of loans they bought that had been made to low-income families, eventually to 56 percent.
Fannie and Freddie responded by heavily increasing their purchases of subprime loans. This, in effect, legitimized the subprime market among banks and led to a wave of both primary and secondary subprime loans.
To safeguard themselves against defaults, banks and other investors used a form of insurance called the credit default swap. A bank buying high-risk securities would also buy insurance from someone else, often another bank. If the security defaulted, the insurer would have to pay the bank. Otherwise, the insurer made huge profits.
Insuring loans, however, is not like insuring cars or homes. A car getting in an accident or a house burning down is an isolated event. But when a housing bubble bursts, defaulting mortgages can cascade into more defaults, putting the insurers on the hook for billions or trillions in losses. Most banks both bought and sold credit default swaps, so their net liability was low, but AIG only insured them, leaving it exposed to close to $80 billion in defaults.
A major worry among central bankers is that instability in the market could lead to runs on banks. Banks accept deposits from some customers and loan them to other customers. They are required to keep a reserve on hand for withdrawals, but this would not be enough to take care of a run. The Federal Deposit Insurance Corporation insures deposits to make runs less likely.
Similarly, the Securities and Exchange Commission requires investment banks — banks that don’t accept deposits — to keep a minimum of assets on hand. But this minimum was greatly reduced in 2004, thus leaving the banks more vulnerable to declines in the value of their assets such as secondary mortgages.
So some regulatory changes are needed. Fannie Mae and Freddie Mac should have been — and still should be — completely privatized and subject to SEC oversight. The SEC should increase the asset requirements of any investment banks that manage to survive this meltdown (update: none did). But the most important change is to deregulate the land and property market so we don’t have any more housing bubbles.
Housing prices can decline without bubbles. As the above map (borrowed from the Economist) shows, the big housing price declines were in bubble states like Arizona, California, Florida, Maryland, and Nevada. Michigan and Ohio, however, didn’t have bubbles, but saw prices decline due to the closure of auto factories and the highest unemployment rates in the nation.
The loss of jobs in one industry, however, is not likely to cause an international financial meltdown. The deflation of the biggest housing bubble in history has done just that. And one thing about housing bubbles: when they deflate, prices may come down, but they never come down as far as they went up. Which means that each successive bubble is worse than the last. If this is compounded by more bubbles due to more land-use regulation in more states, then the next bubble will be even worse.