Sunday, November 20, 2011

Cause of the Housing Bubble

I learned about this by reading "13 Bankers," a great book about the housing crisis that I'd highly recommend.

After the Great Depression, laws were put in place to keep the financial system sound. The FDIC was created to guarantee bank deposits and prevent runs on banks (a bank run is when depositors cause a bank to fail by withdrawing their money at the same time). Because the government was guaranteeing the deposited money, it also required banks to only invest that money in safe investments: specifically in housing loans. The housing loan could only provide 80% of the appraised value of the house, ensuring that the bank would not lose money on the loan. This is called the era of “boring banking” in 13 Bankers. From the close of the Great Depression until the 80s, these regulations kept the financial system boring, stable and sound. Economic growth was steady and the financial system did not cause any recessions (the major recession of the 70s was caused by skyrocketing oil prices).

Ronald Reagan believed that stronger economic growth could be achieved by deregulating the financial system. I will quickly quote from “The Evolution of the Subprime Mortgage Market” about how financial deregulation lead to the growth of the subprime mortgage market:

“Many factors have contributed to the growth of subprime lending. Most fundamentally, it became legal. The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was adopted in 1980, preempting state interest rate caps. The Alternative Mortgage Transaction Parity Act (AMTPA) in 1982 permitted the use of variable interest rates and balloon payments. These laws opened the door for the development of a subprime market, but subprime lending would not become a viable large-scale lending alternative until the Tax Reform Act of 1986 (TRA). The TRA increased the demand for mortgage debt because it prohibited the deduction of interest on consumer loans, yet allowed interest deductions on mortgages for a primary residence as well as one additional home. This made even high-cost mortgage debt cheaper than consumer debt for many homeowners. In environments of low and declining interest rates, such as the late 1990s and early 2000s, cash-out refinancing becomes a popular mechanism for homeowners to access the value of their homes. In fact, slightly over half of subprime loan originations have been for cash-out refinancing.”1

Although it took a fair bit of time for the housing bubble to build, I think it is clear that it either would never have existed, or would not have done serious damage to the financial system if these regulations had not been repealed. If subprime borrowing was illegal, borrowers that couldn’t afford to pay for their homes would never have gotten loans in the first place. I would also agree that some other things contributed to the problem, such as the “global savings glut,” Alan Greenspan continuing to hold interest rates down in spite of evidence that a housing bubble existed and additional deregulation that took place under Bush and Clinton (such as repeal of Glass-Steagall and allowing banks to leverage themselves too much).

Now I want to quickly dispel a conservative myth: that the Community Reinvestment Act (CRA), passed under Bill Clinton, caused the housing bubble. The CRA required large banks to make loans in low-income areas as well as high-income areas. I feel confident that the CRA did not cause the housing bubble because the CRA only governed some of the largest organizations that could originate a loan, and 75% of of subprime loans were issued by institutions not covered by CRA.2 I’m not saying I agree with the CRA, I’m just saying it didn’t cause the housing bubble.

So there you have it: the housing bubble and and this recession was ultimately caused by financial deregulation.




daveloper said...

I think it a bit simplistic to say one thing caused the housing bubble. Certainly a number of things 'crashed' as a result of the housing bubble which means that these institutions, practices, and were all unfit to weather the collapse.

The crash of the construction industry was not the direct result of regulation but rather the direct result of the reduction of demand for new housing. Sure lax regulation help in that regard but industry itself had itself invested heavily in fulfilling the previous demand. This was a bad investment on their part in hindsight.

I agree that the repeal of Glass Steegal was a bad, bad thing. Unfortunately Dodd Frank was not a re-instatement of Glass-Steegal but rather different and separate regulations all together. The effect of which is similar to HIPAA and SOx in that they cause mega-organizations to perform more efficiently relative to their smaller, less funded, counterparts and competition.

The CRA, while small, was very, very poisonous. By creating a new and more treacherous sector of sub-prime lending and then forcing the banks to cover the loans was market interventionism and price fixing at its finest. The reason why these banks didn't naturally accept these loans without the CRA is because they are not worth the risk at those forced low rates. Quite simply, the market doesn't bear that kind of deal. This is an unnatural force moving through the market place and it proved to sour the financial milk as it were by making risk, riskier. 25% is a lot of the the subprime market and that 25% was far and above more risky than the other 75%. Couple that with houses that were overpriced because of easy credit and too much demand and you have a recipe for disaster. Sometimes the one ingredient is all that is missing to turn regular old saltpeter into gunpowder (in this case charcoal...20%).

The whole situation was made worse because the Fed kept rates too low. Had rates been higher, aggregate demand for housing would have been lower shrunk. So the bubble would have still burst, but it would have been a lot less treacherous because there would have been less investment, not more.

Bennion said...

So because there were declines in many (if not all) sectors, you think they were "all unfit to weather the collapse." I contend that those declines are the intentional, rational responses to a recession. A company doesn't want to overproduce, so if the economic forecast is bad, they cut production and fire workers, which hurts the economy further. It's not that the industry was weak before, or mal-investing, it's that it is rationally responding to a recession.

I have mixed feelings about Dodd-Frank because I don't really understand it, and the experts have given mixed reviews. But I'll take it over Republican's ideas of "let the banks regulate themselves" anytime. I just wish it actually broke up the big banks...

The CRA didn't create subprime lending, that was created years before it, like I said above. Most of the bad deals were simply made by the market, without being forced by regulation or anything. There's no reason to think that the 25% of subprime loans made by CRA-governed banks were any worse than the other 75%, and the FDIC Chair Sheila Bair said "Most of the riskiest subprime and nontraditional loans were made by entities that were not subject to CRA," so it sounds like the 25% were actually better than the 75%.

Of course low rates were a contributor too, but that wouldn't have been a problem if decent regulation had been in place. And low rates do help to make housing affordable, which is good.

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