In my ignorance as a young MS Finance candidate, I destroyed an otherwise good April 2008 presentation to my Corporate Risk Management class on the mortgage and housing crisis with one small bullet point. After an analysis of the technical causes of the mortgage crunch, I offered my take on policy moving forward, with the offending point highlighted on the following slide:
The real issue here is that legislation is not a suitable tool for fixing bad broker behavior; in fact, legislation is THE CAUSE of this behavior. This statement seems counterintuitive at first, but we see it is almost undeniably true as we get to the root of the mortgage lending industry and related government policies. The best place to start is the group of organizations that together issue 70% of new mortgages and in recent years controlled 90% of secondary mortgages in the United States: Fannie Mae and Freddie Mac. (1)(2)
Known as GSEs or Government Sponsored Enterprises, Fannie and Freddie are supported in financial and regulatory form by the federal government in return for their acquiescence with mortgage-related laws created by the U.S. Congress. Between the 1990s and the mortgage crisis, Congress has been pushing Fannie and Freddie to cheapen mortgage rates so that more hardworking Americans could realize the American Dream and own their own homes (3). This was simple enough for the GSEs which, with the downside protection of the American taxpayer, could simply drop lending standards and set interest rates wherever Congress deemed "fair." This is price fixing; interest rates are simply prices expressed as annual percentages.
Since the GSEs control such a large portion of the market, their activities quickly forced their privately controlled competitors to either follow suit or die. Business would be lost to the GSEs if brokers did not change policies, and as any organization concerned with staying profitable would, the private lenders matched their government-sponsored counterparts by assuming much higher risk than the market would have otherwise dictated was acceptable. Brokers opened up no-doc, 100% financing loans to everyone at low rates, and in the process of trying to stay competitive had to compensate themselves for the increased risk by altering loan terms in their favor. This completely rational reaction to the changing regulatory environment was the creation of the Adjustable Rate Mortgage you've undoubtedly heard about recently, a product that achieved the dual role of offering competitive rates to borrowers and compensating the company, via massively ballooning interest rates down the line, for the higher risk they had to take to stay competitive.
When Judgement Day arrived in 2007, two very predictable outcomes arose from this interventionist policy in the mortgage lending market. One, the government bailed out the GSEs, creating a moral hazard problem by encouraging poor risk management practices and indicating to investors that a certain class of companies would not be allowed to fail. Two, the private lenders who were desperate to keep up with the government-backed mortgage giants collapsed as a result of the lending policies they had to adopt. Interventionism killed the biggest private players in the mortgage market. We can continue to manipulate the market since all people "deserve" to own their own homes, and for significant periods we will see homeownership rise, but it will always come crashing down when the market finally recognizes and attempts to correct the misallocation of capital. This will happen in increasingly dramatic ways.
A final note. Anyone who argues that the cause of our housing crisis was corporate greed has not considered closely enough the foundation of our capitalist economic system. Capitalism was chosen for our nation specifically because of the unavoidable greed that many individuals are angry about; this greed allows for the correct pricing of goods and services, a function that is thrown off by artificial pricing enforcement. We know that corporations will seek to maximize profits, and with that in mind, Countrywide et al did exactly what we would expect them to do in their situation. Had they not adopted more competitive rates and policies, these private organizations would have gone out of business as the GSEs soaked up more and more of the mortgage market. So, taking on enormous amounts of risk and hedging this risk with "innovations" like the ARM was a survival tool, just as a company facing near-imminent bankruptcy will take negative NPV, higher-risk projects as a survival tool. This is the inevitable unintended consequence of interventionism, agency cost paid for by the American taxpayer.
For those interested in the financial background of our mortgage crisis, I invite you to view my entire presentation.
(1) http://www.nytimes.com/2008/09/06/business/06fannie.html
(2) http://hnn.us/articles/1849.html
(3) http://www.cato.org/pubs/pas/pa528.pdf
Good to see you're using Movable Type--I think it's the most attractive platform out there right now; for the past two blogs we've started, we've used TypePad (an affiliate), and the support and on-going development has been gratifying. I originally chose TypePad because it had the nicest templates and lent itself to collaborative blogging.
Our first time out in the blogosphere was with WordPress, on Gloria's blog, because George Nemeth used it and recommended it. Then, I did a spate of new things with Google/Blogger, started another on RealNEO using the Drupal platform, and finally lit on TypePad. I think we started all this in May of 2005.
I think it's a good idea not to moderate comments. It takes away the "open source, open space" feel of things. If they're awful, you can always zap them as being beyond the pale.
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Kyle
Although I agree with your analysis of the situation, I disagree with the cause being more than corporation and investor greed. I do not blame capitalism. Capitalism has worked great in other industries with high profit, complicated risk situations.
I currently work for a large medical device company and had have worked in others in the past. The medical and drug market now is very lucrative and profitable for investors and there is a lot of chance for companies to put risky inventions to market for potentially large profit. I would compare this to the potential to give risky loans.
The reason companies do not all jump off a cliff and sell every invention that gets past the FDA is the knowledge that if the risk goes bad, they will "loose" and a competitor will be waiting to gobble them up. Sometimes all it takes is one manufacturing error and one sick person. No government bailout will be waiting for a drug company that goes under when it's new drug cures everyone (gives then a home) and then makes them sick again a few years later (ballooning interest rates and foreclosure).
The medical industry has taken a zero tolerance to risk stance. Anything that reduces risk is done. That is not saying there isn't any. There is always an unforeseen variable or chance something can go wrong.
In home loans I would equate this to giving loans to people with good credit. Sure, some will default no matter what, but we won't be stuck with NINJA (no income no job no assets) loans failing is huge numbers.
The loans companies should be diversified enough that when one company takes more then it's normal market share of home loans to risky people, they can weather the storm until that bank fails and things go back up for grabs.
I think we see that in the banks that are left and buying up their troubled brethren.
I have no economics background, this is just my 2 cent observation.
James, I absolutely agree with you regarding the diversification of the mortgage companies. The problem with the current situation is that an entity with implicit government sponsorship will never fail, so the process you mentioned of better positioned companies eliminating the less efficient ones never gets to happen. Instead, private competitors need to find increasingly creative ways to keep up, and they end up doing something stupid like this which leads to a much more violent correction than would have occurred in a well functioning market.
Another followup article, very short, very applicable, and dated 1997:
http://www.cato.org/pub_display.php?pub_id=6047
Well, Kyle, I admit you got balls--you might be the last man in America willing to stand-up for free market totality. I mean, even Greenspan's apparently bailed that ship. One note though: Capitalism wasn't exactly "chosen" for this country, anymore than Christianity was. I'll admit that the founding fathers were sympathetic to capitalism and engaged in capitalist pursuits, but they kinda sorta seemed to lack an awareness of other possible economic systems (they also lacked the awareness that black people were equal to whites--not making any kind of juvenile comparison there...but just saying). And the commerce clause, in fact, seems to give regulatory powers over to the federal government, as if to say, "Yeah, we're all for trade and stuff, but we, the Congress, want to set the rules for that."
There have been endless and unfruitful debates about what the founding fathers would have thought about free trade in light of the industrial revolution wherein we found a major stabilization of wealth in the hands of a few and the basic exploitation of those at the bottom. Many of the founders loved the idea of capitalism and Adam Smith because it appeared to promise social equality, which just hasn't proven true. Now, those same founders (Jefferson comes immediately to mind) also had slaves, which is arguably worse than workers (although, and this is a kinda weak argument but contains a germ of truth, slave owners for the most part didn't want their slaves to die [a loss of investment, if nothing else] but industrialist could give two shits if their workers died because there was no investment there and the workers were easily replaced), which seems to betray their all capitalism-equals-equality arguments. But nonetheless, we've been shown again and again that capitalism doesn't breed equality, the wealth spreads to the wealthy's progeny and we wind up with a kind of de facto aristocracy that the spirit of our country has tried to move away from. Alright, I'm done now. Word.