Friday, June 21, 2013

Understanding the Financial Crisis of 2008

The Housing market – prices and lending behavior – went irrational in the first half of the first decade of the 2000’s, then crashed in 2008, sending seismic financial shock waves around the world which are still reverberating late in 2013, with stubbornly high unemployment and massive increases in public spending and debt which haven’t improved the situation at all.
Since housing was the spark that set off the fire, let’s take a closer look at that.
Not all housing markets (by geography) experienced the same wild gyrations. As a national average, the rise in purchase prices paid was only 38% from 1999 to 2005, and the ‘collapse’ only 10 percent from 2006 through 2008 (in other words, home prices were still higher in 2008 than in 1999 by 28% – hardly a crisis). But in certain local markets in Nevada, Florida, Arizona and coastal California and a few others, the rise and fall was much more amplified, with prices more than doubling in some places during the boom and falling almost as far or farther in the crash. Most of the rest of the country was not going nuts. In places like Houston and Dallas Texas, for example, there was hardly any extraordinary rise in prices and therefore no traumatic bust. Moreover, housing in general has been more affordable in those markets, taking a substantially smaller share of an owner’s or renter’s income to maintain than in the ‘hot’ markets.
In other words, the housing market surge and collapse was at its root a localized phenomenon, not a general or national one.
So why did prices rise so dramatically in these particular markets? It’s a question of Supply and Demand: mainly for land on the one hand, and for mortgage loans on the other.

The supply of loans (price/interest rate and availability/approval) is principally governed by the lender’s perception of the risk of getting paid back (or not) for the cash advanced to the borrower. In a free market, banks that lend to deadbeats will soon be bank-rupt, unable to recoup the money they’ve advanced (bankers consider that a bad thing). So traditionally these have been very conservative and prudent, wearing their bow ties and green eyeshades, scrutinizing and documenting every potential borrower’s credit history, good character and sources and amounts of income, as well as general economic conditions that may affect the continuance of the same. The higher the perceived risk of lending, the more constrained the supply of lendable funds and the higher the interest rate (credit price) charged. The calculation of risk and supply are made on the basis of general market conditions, the amount of cash that each bank has available, and case-by-case particulars centered around the individual borrower or co-borrowers.
In the 1970’s, the price of housing in Nevada, Florida, Arizona and coastal California were not that much different from the rest of the country, neither in absolute terms nor as a percentage of the owner’s/renter’s income required to maintain a home (which is to say, affordability).
Two contradictory and not fully thought-through political goals kicked off the long march to disaster:
• Wilderness Preservation
• Affordable Housing

Wilderness Preservation
Beginning in the 1970’s, the environmental movement and its political allies promoted increasingly extensive and rigorous land-use restriction laws. These policies were always promoted under the slogans of preserving wilderness, saving farmland, creating open space, ‘smart growth’, rescuing endangered species and/or habitat and other happy, desirable outcomes.
News Flash! Reducing the supply of a good puts upward pressure on its market price! In the markets and geographical regions where such laws were passed, real estate prices began to climb out of previously ‘normal’ ranges. The cost of real estate, and with it, housing, skyrocketed in relation to other regions where the legal environment favored full unfettered private property rights. Housing became less affordable.

Affordable Housing
"Neither by comparison with the recent past nor by comparison with other countries today is most housing in the United States unaffordable. The median-priced home in the United States as a whole is 3.6 times the median income of Americans. For Great Britain, the median-priced home is 5.5 times the median income and in Australia and New Zealand, the ratio of home prices to income is 6.3."
-Thomas Sowell, The Housing Boom and Bust

Nevertheless, the federal government and its appendages have been on a decades-long crusade to make housing in America more ‘affordable’.
The Community Reinvestment Act of 1977 gave the federal government an unprecedented foothold in micromanaging the business practices of lenders, telling them to whom they should lend, how much and on what terms. In the 1990’s the power of this act were amplified, with banks having to establish racial and ethnic quotas, both in their lending and in their hiring practices, and ask permission before merging or opening new branches (permission which might be denied on the political grounds of not having done enough ‘socially responsible’ work or lending in their communities). In 1993 the Department of Housing and Urban Development , or HUD, began suing banks over race-based statistical disparities.
The implicit assumptions seem to have been that a) bureaucrats in Washington (and community activists at ACORN) know better than bankers in Peoria what are the ‘correct’ lending criteria and practices for their local markets, what is the best and soundest ‘socially responsible’ policy for what to do with their depositor’s money, b) that lending is somehow doing someone a favor as opposed to being a mutually beneficial exchange, and c) that unless Washington keeps a close vigil on greedy, racist bankers, they would discriminate unfairly against racial minorities, denying them loans more often than White/European majority applicants.
Point a) is laughable on its face, yet its premise underlies most government economic policy today. Point b) seems to ignore the fact that lenders are in the business of lending and benefit from it, WANT to lend.
Point c) is easily refuted:
• Banker’s favorite color is not white or black, but green. Any banker offended by receiving a monthly loan payment from a brown or yellow person will soon find himself in the red. The natural mechanism of the market is for gaps in supply to be eagerly filled by entrepreneurs, however greedy or racist they may be. Customers missed by one supplier will be eagerly served by another.
• Statistical differences between racial groups are not proof of unfair discrimination against individuals. When controlled for credit ratings, wealth, income, employment history and other factors, no material discrepancies remain.
• Black-owned banks have been shown to turn down black applicants for loans at a higher rate than White-owned banks .
• Chinese and Japanese Americans have suffered discrimination and even internment in the past. But today, Asian applicants in the aggregate are turned down for loans less often than White/European Americans. This fact does not support a theory of white racism among bankers.
So banks were under increasing pressure to make loans to satisfy politicians rather than depositors and borrowers; to loosen lending standards, to NOT scrutinize and document the individual applicant’s creditworthiness, good character and sources and amounts of income but to focus their attention on rectifying the supposed evils of ‘redlining’ and ‘disparate impact’. Thus the non-traditional or ‘subprime’ market grew from 7 percent of all loans in 2001 to 19 percent in 2006.
But how could the banks do this (neglect their lending standards) without cutting their own throats?
The politicians who did the banker no favors by bullying them into making millions of loans that they might not have made, gave them a way out: Flip the loans, and with them the default risk – good, bad or ugly – to someone else.
Over the past 40 years, the privileges and obligations of two government-sponsored companies, Fannie Mae and Freddie Mac , have been significantly beefed up, again for the purpose of promoting ‘Affordable Housing’. These companies have CEOs, stockholders and profit-and-loss statements like private banks and other publicly-traded companies, but they were chartered by the federal government for the purpose of doing ‘good’ in their markets (as opposed to merely raking in obscene profits for their greedy shareholders and CEO’s like Franklin Raines and his $90 million compensation package), in exchange for which they enjoy preferential tax treatment and the implicit guarantee that if anything goes wrong, Uncle Sam (that’s you and me the taxpayer) will pick up the tab.
Since at least 1992, Fan and Fred have been under orders to buy up more and more ‘affordable housing’ mortgages from the originating lender banks. By 2007, Fan and Fred had purchased 40 percent of the sub-prime and/or non-traditional mortgages (a.ka. ‘Liar Loans’, loans made with minimal or no documentation, due diligence, credit checks, character references etc.) originated in the United States, or about one million million dollars worth . The total value of their debt outstanding as of 2010 was over 8 million million dollars; that’s two-thirds the magnitude of the national debt of the United States.
Fannie Mae and Freddie Mac have long enjoyed unwavering support from cheerleaders in positions of significant power in the federal government, among them Barney Frank, Christopher Dodd, Maxine Waters, Joe Baca, Nancy Pelosi, Charles Rangel and Kit Bond, among others.
In any event, the inevitable happened. In 2006, loan default rates, especially in the sub-prime market, reached record levels. In 2007 Countrywide Home Loan’s share price collapsed and it was acquired by Bank of America. BofA itself was one of several targets of the Troubled Asset Relief Program (TARP) to the tune of $45 billion, along with several other financial dominoes that were deemed ‘too big to fail’: Citigroup, $50 billion; AIG, $40 billion; Wells Fargo, $25 billion; J.P. Morgan Chase, $25 billion.
In spite of TARP and multiple rounds of economic ‘stimulus’ spending plans by the Bush and Obama administration (or perhaps because of them), the employment rate and general economic health of the country has sunk to lows not seen in at least 30 years, with hardly an exit in sight.
The natural economic forces of Supply and Demand were derailed in housing markets in America in the early years of the 21st century, leading first to the craze and then inevitably to the crisis. Like all crises of this magnitude, this one was one of government interference in the natural, self-correcting mechanisms of the free market, building one intervention on top of another until it collapsed of its own dead weight.