The Government's Role in the Housing Bubble
(Note: I realized after writing this that it came off like a grand theory of everything. My argument is not that the government, all by its little lonesome, caused the housing bubble; it's that these things, along with many decisions in the private sector, helped create it. Bubbles are a feature of asset markets, and I don't think that getting rid of either government or free markets could cure us of them.)
I never would have guessed that years in, we'd still be debating the role of the government in the housing bubble. Conservatives are still pinning most of the blame on the Community Reinvestment Act, while liberals are saying that there's no evidence that government played any significant role--unless, perhaps, it was all the fault of Alan Greenspan.
As it happens, I think that the government did play a role. A big role. But I think it's rather subtler, and thus, rather more problematic, than most people on either side are discussing.
To me, the unsung villain of the mortgage crisis is the 30-year fixed rate self-amortizing mortgage with no prepayment penalty. This hothouse creature is beloved of liberals, who like any product that gives the consumer the power to shaft banks whenever it is to their advantage. And it is beloved of conservatives because it smacks of sober citizens taking on modest, stable obligations they can meet.
But this product is about as stable as a nitroglycerine shot with a TNT chaser. The 30 year fixed rate mortgage was ultimately at the heart of the Savings and Loan crisis. Yes, yes, deregulation set the stage for the ultimate denouement--but the Savings and Loans were deregulated in such a haphazard fashion in part because they were being slowly driven into bankruptcy by their huge collection of low-interest, long-term real estate loans, in an environment where Paul Volcker had briefly driven short-term interest rates up to 20%. While fraud and abuse were certainly rampant, the enormous scope of the problem was not due to S&L officers suddenly becoming more thievish, or regulators more tolerant of thievery, but because everyone in the industry was flopping as wildly a a beached sturgeon in an attempt to keep their banks solvent atop large portfolios of low-interest loans. Meanwhile, whenever interest rates dropped, people would refinance, meaning that even the high-interest loans they did make didn't help much.
The answer to this, as you may recall, was . . . the creation of the massive private market in mortgage bonds. In an environment with a floating currency and considerable worrries about inflation, the only thing that can neutralize the risks of the 30-year mortgage is laying them off to as large a pool as possible. MIchael Lewis chronicles what happened next in the still-terrifyingly-relevant Liar's Poker.
Moreover, this product exists, as far as I can tell, only because of massive government intervention into the markets, a point that Reihan Salam and Chris Papagianis made in their recent, excellent piece. Until the Great Depression, the mortgage was a very, very different product. There was no amortization, and down-payments were often massive--half or more of a home's value. They lasted perhaps 3 or 5 years, and were rolled over if borrowers could not meet the balloon payment. The default crisis of the 1930s resulted from the inability to roll those loans, and so the government stepped in, causing the fifteen year self-amortizing loan to proliferate. This process was especially accelerated by the VA loans that were offered to returning veterans. Eventually, the payment terms stretched out to allow more and more people to buy homes.
This had some curious effects. As aforementioned, it was ultimately not good for banks that were restricted to the kind of boring business many commentators would like to see banks return to: loaning money to consumers and small businesses, and taking deposits. The mismatch between their short-term obligations and their long-term assets too easily becomes catastrophic.
It also--at least according to economists I've interviewed--contributed to the long, broad run-up in housing prices that took place in the latter half of the twentieth century. People price their homes by their monthly payment, and what the bank will lend them. As banks lent more, and longer terms lowered the monthly payment for a given loan amount, people bid up the price of housing. This created the expectation of steadily appreciating home values--something that had not been historically true. Over time, people began pricing expected appreciation into their purchase price as well, a phenomenon that again, tended to accelerate over time.
Most subtly, and most perniciously of all, it created generations of buyers who thought of all mortgages as thirty-year fixed rate loans. People in other countries understand that their mortgage rate resets when interest rates go up. Even the people who theoretically understood that they were taking on an adjustable rate mortgage didn't have any cultural context for them--no unhappy childhood memories, no newspaper stories, no parents or friends to warn them about what would happen when the loan rate reset. And of course, many very naive people simply assumed that their floating-rate mortgage was fixed--and were rooked by unscrupulous mortgage brokers.
As I see it, this decades long intervention in the housing market took a terrible toll. And whenever this product went bad, rather than reconsidering its support, the government staged another intervention to keep this type of loan alive. It gave an implicit guarantee to Fannie and Freddie, deregulated the savings and loans (and then bailed them out), had its regulators and lawmakers help create the market in mortgage securities, and so forth. All the while, it gave a giant tax subsidy to mortgage interest that convinced people they were fools not to buy.
As of this writing, are we rethinking any of it? Will the new head of the CFPA crack down on mortgages that offer prepayment options? Will lawmakers finally break up Fannie and Freddie and cut off the flow of cheap capital they glean from the implicit government guarantee? Will it get the FHA out of the business of propping up the conventional loan market?
Of course not. There is no constituency for such a thing except for a few crazy libertarians.