A Brief History…

Now that we have explained the bailout, how did we get here ? Milton Friedman might have said this.

This is an elegant piece on the moral hazard problem and where it came from. Richard Epstein points out how social engineering led us here.

Disasters like this latest financial meltdown don’t just happen. Mistakes this huge require an impoverished political philosophy to grease the skids. Fannie and Freddie didn’t design their horrific lending policies by chance. No, behind this lending fiasco lay the strong collective preference for the “patterned principles” of justice that Robert Nozick attacked so powerfully in his 1974 masterpiece, Anarchy, State, and Utopia.

I have ordered the Nozick book as it looks like that rare philosophy work that I can get through.

Anyway,

The key function of the legal system is to minimize the transactional barriers and increase the velocity of voluntary exchanges, all of which generate mutual gains for the parties. So long as one is sure that the given distribution of resources is obtained by legal moves from the original position, don’t worry about the relative positions of one person vis-à-vis the others. Don’t, in other words, use state coercion to create a distinctive pattern of rights deemed ever so desirable in the eye of some political beholder.

This is what we call the “market” and that market is the enemy of Barack Obama and his allies. They are concerned with ends, as well as means, and will tilt the scale to attain those ends. Was the market at fault? Russell Roberts says partly but not totally.

Many believe that wild greed and market failure led us into this sorry mess. According to that narrative, investors in search of higher yields bought novel securities that bundled loans made to high-risk borrowers. Banks issued these loans because they could sell them to hungry investors. It was a giant Ponzi scheme that only worked as long as housing prices were on the rise. But housing prices were the result of a speculative mania. Once the bubble burst, too many borrowers had negative equity, and the system collapsed.

Part of this story is true

But that is not the whole story.

Beginning in 1992, Congress pushed Fannie Mae and Freddie Mac to increase their purchases of mortgages going to low and moderate income borrowers. For 1996, the Department of Housing and Urban Development (HUD) gave Fannie and Freddie an explicit target — 42% of their mortgage financing had to go to borrowers with income below the median in their area. The target increased to 50% in 2000 and 52% in 2005.

For 1996, HUD required that 12% of all mortgage purchases by Fannie and Freddie be “special affordable” loans, typically to borrowers with income less than 60% of their area’s median income. That number was increased to 20% in 2000 and 22% in 2005. The 2008 goal was to be 28%. Between 2000 and 2005, Fannie and Freddie met those goals every year, funding hundreds of billions of dollars worth of loans, many of them subprime and adjustable-rate loans, and made to borrowers who bought houses with less than 10% down.

This was a Ponzi scheme alright but who was Ponzi ?

The Community Reinvestment Act (CRA) did the same thing with traditional banks. It encouraged banks to serve two masters — their bottom line and the so-called common good. First passed in 1977, the CRA was “strengthened” in 1995, causing an increase of 80% in the number of bank loans going to low- and moderate-income families.

Fannie and Freddie were part of the CRA story, too. In 1997, Bear Stearns did the first securitization of CRA loans, a $384 million offering guaranteed by Freddie Mac. Over the next 10 months, Bear Stearns issued $1.9 billion of CRA mortgages backed by Fannie or Freddie. Between 2000 and 2002 Fannie Mae securitized $394 billion in CRA loans with $20 billion going to securitized mortgages.

This money is all lost and will have to be repaid by taxpayers. Here is more about the CRA effect with examples.

Did the Bush Administration play a role in the fiasco ?

The Fed did its part, too. In 2003, the federal-funds rate hit 40-year lows of 1.25%. That pushed the rates on adjustable loans to historic lows as well, helping to fuel the housing boom.

The Taxpayer Relief Act of 1997 [which raised the capital gains exemption on houses-Ed]and low interest rates — along with the regulatory push for more low-income homeowners — dramatically increased the demand for housing. Between 1997 and 2005, the average price of a house in the U.S. more than doubled. It wasn’t simply a speculative bubble. Much of the rise in housing prices was the result of public policies that increased the demand for housing. Without the surge in housing prices, the subprime market would have never taken off.

I have a theory that the 9/11 attacks contributed to this bubble. There is also a theory that the Panic of 1907 was caused by the 1906 San Francisco Earthquake because of the enormous insurance losses. Most of the worst property damage in San Francisco was caused by fire producing a gigantic insurance loss since fire was covered when earthquake was usually not. The 9/11 attacks caused an enormous capital loss, both due to the property damage in New York and by the effect on airlines and oil prices that followed. The Bush Administration fought deflation with low interest rates and by telling people to “shop” as a contribution to national security. This has been widely quoted and attacked but it is misunderstood, like most of Bush’s policies. He has been almost criminally inept in explaining them.

The low interest rates were continued too long and contributed to the bubble. Had Bush and the Fed raised rates two or three years ago, the bubble would have popped with much less damage as the speculation might have stopped before the worst of the excesses had occurred. Here is someone who was warning about this years ago. He got nowhere.

Anyway,

Once Congress set in place a destructive lending policy, we could count on private parties to issue bad loans from which they profited, knowing that dear old Fannie and Freddie would happily pay face value for paper that everyone knew was worth a whole lot less.

But Congress lived in a dream world. It forgot that the quality of the paper would deteriorate as its ambitious social objectives let its underwriting go south. So, too late in the game, we learn from yet another case where Congress should have done good by doing nothing at all. Let people rent or buy in unsubsidized markets and then watch with supreme indifference what residential patterns emerge.

This does not explain how to recover but it does point out how unlikely it is that Congress will be helpful in the next phase of this crisis. Obama, in particular, has all the helpful instincts of Herbert Hoover. He is opposed to free trade. He is an interventionist. And he is stubborn and unwilling to acknowledge that raising taxes is the worst thing a government can do in this situation.

God help us all.

Tags: Congress, Fannie Mae, home mortgages, markets, Obama

This entry was posted on Wednesday, October 8th, 2008 at 5:31 pm and is filed under financial, politics. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.