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 weren’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.
Let’s review what happened. Most analyses start with “the bursting of the housing bubble.” But let’s go a little further back — okay, a lot further.
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.
There are a number of medications like Kamagra that can help you in treating erectile dysfunction. viagra generika http://frankkrauseautomotive.com/cars-for-sale/page/4/?order_by=_price_value&order_by_dir=asc Nursing mothers also need the medical advice is must to ensure your safety as little ignorance and a unsafe dosage may sildenafil tablets without prescription cause you to suffer from impotence. At the age of 35 she decided to start generic cheap viagra Chiropractor proper care. This is why it will be necessary to take cheap sildenafil the pill three or four times before it works for a majority of the people who try it — about half stem further loss of hair, while the other half experience new growth. 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.
Fannie and Freedie are “PART” of the problem, not the root. A-hole predatory lenders overtly screwing po’ folks have to take some of the blame here (you can also blame the borrowers themselves for letting themselves get screwed). So, do you think that if Fannie and Freddie were privatized completely by Johnson this bubble wouldn’t have burst and our financial markets would not be tumbling. SEC oversight has not been good enough. Our John McCain, American version of free market capitalism wants government out of corporate business (at least that’s the philosophy in non-election years). The Neo Robber Barons look like they’re going to get off scott free. So yeah, lets privatize Fannie and Freddie that way the ENRON prototypes an come in take over, keep screwing normal folks, because we so support the “freedom” of the market that we can’t let government control anything, because that aint “free.”
I still say that the root cause of this problem is the lack of government planning in the financial market.
We don’t have anything resembling a free market in housing finance or any other market I can think of. Opponents of the free market are quick to claim a failure of a tightly regulated market – driven by political forces – is somehow a failure of the free market. Those interested in learning about capitalism might read “Capitalism the Unknown Ideal”, “Free to Chose”, or any of dozens of other books that shed some light on market capitalism. The book, “Knowledge and Decisions” is the best explaination that I know of describing how politically made decisions (like the decision to loan money to borrowers who cannot pay it back) versus how an individual or a corporation would make a decision on creditworthyness. The moral hazard created by having a implicitly backed governemt entity buy subprime loads is likely an important factor in the current market difficulties. The unintended consequence of this practice was entirely foreseeable, as we saw investors such as Warren Buffet completely sell his holdings in Fannie Mae a number of years ago, while warning of the lack of transparency and the risk of derrivitive securities.
“The book, “Knowledge and Decisions†is the best explaination that I know of describing how politically made decisions (like the decision to loan money to borrowers who cannot pay it back) versus how an individual or a corporation would make a decision on creditworthyness.”
I’ll have to check this book out, because it was my understanding that most of these lenders made the predatory loans, not for political reasons, but because of greed.
Please.
This was just another bubble that was allowed to happen to move money upwards to the few. There is a long history of such things. In addition, banks were allowed to – by revocation of Glass-Stigall – get into other ventures. Greed took over and the rest is history.
There is a reason why central banks intervene to prevent bubbles. It is greed.
The neocon-neolib experiment is over. It failed. We and our children will pay for it.
DS
This is by far one of the best explanations I have read. This is no failure of the free market but a failure of government. Why can’t the media get it right?
This is no failure of the free market but a failure of government.
I agree.
Why didn’t the gummint stop the plunder? Why did the gummint allow these private corporations to make risky loans, hide the risk, and the CEOs keep their salaries?
Why is the gummint bailing out these crooks with our money and allowing the capitalists to keep their gains? Why must we pay for this?
Why is the gummint rushing this thing without debate, analysis, or input from us, and why are they going on recess after they vote?
Why is Paulson getting all kinds of power with no review? Why can’t I say which private corporation my children’s college money is getting p*ssed away to?
Massive failure on a criminal scale. Talk about wealth transfer. I need to sharpen my pitchfork and oil the torch.
DS
The government failures was not merely in terms of oversight. The social engineers in government throughout the last quarter century (give or take a decade) pushing for upwards of 60-70% homeownership rates and legislating to make it happen encouraged those the market would not naturally qualify for home loans, etc, to be eligible. There is no right or entitlement to home ownership, nor is there to upward social mobility; there is only a freedom to be completely responsible for your station in life, and that is where the government oversight and mandates overstepped their bounds.
“This is no failure of the free market but a failure of government.”
I guess I’m confused on how the governments unwillingness to oversee and properly regulate and failing market driven by greed, is solely the governments fault and is not a market failure. The financial market is failing no? Yes the government deserves their share of the blame, (as I understand it the Glass-Stigall repeal was bipartisan) but what about the other players, mainly the dudes walking away with millions in compensation just to have their (former) companies walk into Washington begging for 700 million of middle and working class dollars. Talk about a boondoggle. These are the same people that say there isn’t enough money to socialize healthcare? I bet $700 million would get us close.
Correction $700 BILLION. Sometimes it’s hard to think about a number that big.
The money p!ssed away in Iraq, bennett, would get us real close too, unless we continue to let more money-hungry jackals chew on the carcass. Maybe Halliburton and KBR will float us a loan, seeing as how they’re newly flush with our cash.
At any rate, this is indeed partially a market failure. The Experiment failed and the architects of the experiment are trying to get us to pay for the obvious result. The experiment would have gone better for us had we more information, but alas this is another obvious part of the problem with free markets, as there is incentive to lie, cheat, and hide information.
DS
That’s a lot of questions Dan. The most important answer to why it’s the government’s fault goes back to pushing sub prime loans. The antiplanner did a good job explaining that. Even when it became obvious something needed to be done congress failed to act. I should note it was the working man’s party of Democrats that blocked needed reforms.
Without a doubt it all goes back to Fannie and Freddie. Government created, government controlled.
Next time I hear the phrase public-private partnership I will think of Fannie Mae and how well mixing the two turned out.
N.Y. Times op-ed columnist Paul Krugman has written some interesting and relevant things on this subject:
08-Aug-2005: That Hissing Sound: http://www.nytimes.com/2005/08/08/opinion/08krugman.html
Some relevant words (emphasis added):
Then there are the numbers. Many bubble deniers point to
average prices for the country as a whole, which look worrisome
but not totally crazy. When it comes to housing, however, the
United States is really two countries, Flatland and the Zoned
Zone.
In Flatland, which occupies the middle of the country, it’s easy
to build houses. When the demand for houses rises,
Flatland metropolitan areas, which don’t really have
traditional downtowns, just sprawl some more. As a result,
housing prices are basically determined by the cost of
construction. In Flatland, a housing bubble can’t even get
started.
But in the Zoned Zone, which lies along the coasts, a combination
of high population density and land-use restrictions – hence
“zoned” – makes it hard to build new houses. So when people
become willing to spend more on houses, say because of a fall
in mortgage rates, some houses get built, but the prices of
existing houses also go up. And if people think that prices
will continue to rise, they become willing to spend even more,
driving prices still higher, and so on. In other words, the
Zoned Zone is prone to housing bubbles.
21-Dec-2007: Blindly Into the Bubble: http://www.nytimes.com/2007/12/21/opinion/21krugman.html
Quotes:
That’s quite an understatement. In fact, the explosion of “innovative”
home lending that took place in the middle years of this decade was
an unmitigated disaster.
But maybe Mr. Bernanke was afraid to be blunt about just how badly
things went wrong. After all, straight talk would have amounted to a
direct rebuke of his predecessor, Alan Greenspan, who ignored pleas
to lock the barn door while the horse was still inside  that is, to
regulate lending while it was booming, rather than after it had
already collapsed.
I use the words “unmitigated disaster” advisedly.
Apologists for the mortgage industry claim, as Mr. Greenspan does in his
new book, that “the benefits of broadened home ownership” justified the
risks of unregulated lending.
But homeownership didn’t broaden. The great bulk of dubious subprime
lending took place from 2004 to 2006  yet homeownership rates are
already back down to mid-2003 levels. With millions more foreclosures
likely, it’s a good bet that homeownership will be lower at the Bush
administration’s end than it was at the start.
The Antiplanner wrote:
> 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.
IMO, at least some parts of Virginia (e.g. Northern Virginia) are worthy of desigation as a “bubble” state:
22-Sep-2008: A Sense of Resentment Amid the ‘For Sale’ Signs: http://www.washingtonpost.com/wp-dyn/content/article/2008/09/21/AR2008092102534.html
The bailout doesn’t smell right to the people of Manassas Park, where the foreclosure signs are as common as azaleas. They know all about bad debt here. This is a terrain of oversize dreams, misjudgment, financial calamity — and empty houses. “Foreclosure. Foreclosure. Foreclosure,” said Ed Merkle, 58, as he pointed to the “for sale” signs lining his street.
This may be a Main Street bailout backlash in the making. The details of the financial crisis are still hard for most people to follow — what with talk of exotic “derivatives” known as “credit-default swaps” and so on — but the central fact of the matter hasn’t been lost on anyone in this Northern Virginia community: The taxpayers are on the hook for the bad judgment of others.
Prince William County is one of many ground zeros in the subprime mortgage crisis. Pick up a pamphlet on home sales in the county, and you will come across an ad saying “Foreclosures R Us!” Pictured are dozens of homes being sold for what seem like bargain-basement prices, some under $200,000. But there aren’t many buyers — because no one knows what anything is really worth, or whether the market is anywhere near bottom.
See also the Krugman column from yesterday:
22-Sep-2008: Cash for Trash http://www.nytimes.com/2008/09/22/opinion/22krugman.html
Some skeptics are calling Henry Paulson’s $700 billion rescue plan
for the U.S. financial system “cash for trash.” Others are calling
the proposed legislation the Authorization for Use of Financial
Force, after the Authorization for Use of Military Force, the
infamous bill that gave the Bush administration the green light
to invade Iraq.
There’s justice in the gibes. Everyone agrees that something
major must be done. But Mr. Paulson is demanding extraordinary
power for himself  and for his successor  to deploy taxpayers’
money on behalf of a plan that, as far as I can see, doesn’t
make sense.
Some are saying that we should simply trust Mr. Paulson, because
he’s a smart guy who knows what he’s doing. But that’s only half
true: he is a smart guy, but what, exactly, in the experience of
the past year and a half  a period during which Mr. Paulson
repeatedly declared the financial crisis “contained,” and then
offered a series of unsuccessful fixes  justifies the belief
that he knows what he’s doing? He’s making it up as he goes
along, just like the rest of us.