Linked below are a couple discussions between my favorite local opinion maker, Mike Rosen, and Donald Luskin, author of “I am John Galt.” Donald Luskin does not actually think he is anything approaching the heroes of Atlas Shrugged… but he talks about a few people who could be. He also mentions a few living analogues to Rand’s villains, like Paul Krug as Ellsworth Toohey (Fountainhead). A discussion of intellectual honesty follows. Other fun and surprising comparisons to Rand’s larger-than-life characters are made with Steve Jobs, Angelo Mozilo, Barney Frank, Alan Greenspan, Milton Friedman, and others.
I recently read The Housing Boom and Bust (revised edition) by Thomas Sowell. This book manages to organize a complex web of information into coherent explanations. A recurring theme of the book is that there is no “one single cause” of the housing boom and bust. But Sowell discusses a hierarchy of causes, many of which would not have had such a serious impact if not compounded by the other factors. He advances a handfull of key observations, and each one is treated with substantial development, complete with data, historical evidence, and corroborating analysis.
The book begins by introducing some economic factors of the housing boom, including land-use and housing finance, and explains how government policies have influenced these. Then Sowell introduces the role of the Federal Reserve, banking regulatory agencies, Wall St. firms, both major political parties, Fannie and Freddie, and government departments such as HUD, in the housing boom.
The book then explores political factors that fueled the boom, such as the Community Reinvestment Act (CRA) of 1977, and its heightened impact during the 1990s under the H.W. Bush and Clinton administrations. The CRA was intended to promote home ownership by influencing banks and savings associations to provide credit for home purchases, particularly for low- and moderate-income individuals and communities. The Department of Housing and Urban Development (HUD) set quotas on loans to individuals with poor credit, who were relatively unlikely to repay their loans. These quotas were achieved in part through regulatory pressures on banks and non-bank financial institutions. But a more insidious method of meeting these quotas was achieved by the government’s co-operation with Fannie and Freddie to purchase sub-prime mortgages from original lenders. The repurchase of mortgages by Fannie and Freddie gave lenders a large incentive to offer mortgages that would likely put their unqualified borrowers in financial straits. Ordinarily, lenders thoroughly check the financial soundness of potential borrowers, which serves to protect both the lender and borrower. However, because lenders knew they could quickly get cash for their mortgage by turning around and selling it to Fannie or Freddie, the initial lenders had very little incentive to check the creditworthiness of borrowers. It was in this environment that desktop loans, AKA “liar” loans began cropping up. These were loans granted to borrowers who did not have to substantiate their creditworthiness with much more than a wink and a nod. This environment also fostered the growth of the “creative” financing of mortgages, such as Adjustable Rate Mortgages (ARMs), zero downpayment loans, and others.
When government agencies introduced these incentives and private institutions acted on them, as one would expect, many more people sought to buy houses at these more lenient standards. This was one factor in the inflation of housing prices. Another significant factor was the historically low interest rates set by The Fed, which made borrowing cheaper.
With these conditions, more and more people sought housing, and the housing prices naturally began to increase. With home prices on a “dependable” rise, many speculators, family-home-buyers, and home equity borrowers began “banking” on ever-increasing housing prices.
What is amazing is that many sectors of the housing market made adjustments to these market distortions. The relatively unfettered markets of Dallas adjusted to these new “market” conditions. But the very restricted housing markets of coastal California, Fayette County Kentucky, Las Vegas Nevada, parts of Arizona, and Loudoun County Virgina, saw rapid increases in home prices. For example, during the housing boom, the largest one-year increase in home prices was seen in relatively-restrictive Arizona, at 35% increase, and the lowest was in relatively unencumbered Michigan, at only a 4% increase.
With rapidly increasing home prices, especially in particular localities, fueled by easy credit, creative financing, and government-backed subprime lending through Fannie and Freddie, many economists and a few people in government warned of the untenability of the scenario. But many special-interest groups stood to gain financially from the status quo. So there was concentrated political support for continued intervention in the housing market, especially from the National Association of Home Builders, the National Urban League, other special interests, and notably Fannie and Freddie specifically, who gave generous campaign contributions directly to Republicans and Democrats for their continued support.
As the admonitions of many economists, and some experts and some politicians were ignored, the boom eventually turned to bust. The precipitating factor appears to be a change in Federal Reserve policy. Amid fears that holding interest rates low for too long might cause inflation, The Fed began to raise interest rates from 1% in 2004 to 5.25% in 2006. By 2008, speculators who had once counted on rising home prices to mitigate their over-leveraging, and borrowers who utilized risky Adjustable Rate Mortgages to finance their home purchases, were now finding themselves unable to make monthly payments. What’s more, many people simply chose not to make the payments, as defaulting made more financial sense than making payments on a house that was suddenly worth far-less than what the borrower was committed to paying for.
Just as housing prices had spiked the most in very restrictive housing markets, prices also plummeted the most rapidly in these markets; by as much as 30% in one year. In the less restrictive markets, such as in Dallas, prices fell by only 3%.
The effects of plummeting prices were felt far away. This is because Wall St. repackaged many of the sub-prime loans into securities and sold them far away from the restrictive housing markets where the defaults began. The underlying value of these securities was simply people repaying their mortgages. Obviously, when people stopped making payments on their mortgages, the values of these securities tanked. Hence Bear Sterns, Lehman, and even companies overseas called for rescue.
The newness of these mortgage-backed securities meant that the ratings agencies had little historical data upon which to asses the risk of these securities. Further, due to the incentives which originated many of these loans, the lenders gathered very little information about the creditworthiness of the borrowers, and much of the information that was available was possibly made-up. This made it very difficult for the ratings agencies, such as Moody’s, Standard and Poor’s, and Fitch, to accurately assess the risk of such securities. What did not help this matter was the fact that the Securities and Exchange Commission only recognized these three agencies as credible ratings agencies. This effective “cartel” shielded these companies from natural forces, such as competition, which might have otherwise compelled them to produce sounder ratings for the mortgage-backed securities.
After the bust, the housing market made corrections in areas where it was free to do so. For example, “creative financing” offered to high-risk borrowers was mostly replaced with more-traditional 30 yr. fixed-rate mortgages which required a significant down-payment and reasonable credit history. However, the political rhetoric remained largely unchanged.
If you are like me, you have to ask where the drive to create such perverse incentives and behaviors in housing came from. Fortunately, Sowell is at his best in the last two chapters of The Housing Boom and Bust, explaining the past and present of a few of the ideologies and popular misconceptions which have lead us here. He also explains why some of the other popular myths of the housing debacle don’t pass muster.
It will be a long time before we understand everything about the housing boom and bust, but this book certainly provides a big piece of the puzzle. This is really a must-read for anyone looking for a nuanced understanding of the housing debacle. You won’t find easily-digestable platitudes with flimsy justification in this book. But you will find a handfull of well-developed concepts, which taken together, will help you begin to unravel the web of factors which led up to and through the boom and bust.