Tag: housing bubble

Thursday Links

  • Prepare to pay more: Today, an average insurance policy can cost about $2,985 for an individual or $6,328 for a family.  Under the Senate bill, those premiums will increase to $5,800 for an individual worker and $15,200 for a family plan by 2016.

Tuesday Links

  • All eyes on India: Party crashers aside, Indian Prime Minister Manmohan Singh’s visit to the U.S. was an important event.

New Paper: Would a Stricter Fed Policy and Financial Regulation Have Averted the Financial Crisis?

Many commentators have argued that if the Federal Reserve had followed a stricter monetary policy earlier this decade when the housing bubble was forming, and if Congress had not deregulated banking but had imposed tighter financial standards, the housing boom and bust—and the subsequent financial crisis and recession—would have been averted.

In a new study, Cato scholars Jagadeesh Gokhale and Peter Van Doren investigate those claims and dispute them.

Weekend Links

Fixing Fannie Is Essential

This past week witnessed continued debate in congressional committees over changes to our financial regulatory system.  Perhaps catching the most attention was Fed Chairman Ben Bernanke’s appearance before House Financial Services. 

Sadly missing from all the noise this week was any discussion over reforming those entities at the center of the housing bubble and mortgage meltdown:  Fannie Mae and Freddie Mac.

While many, including Bernanke, have identified the “global savings glut” as a prime force behind the historically low interest rates that drove the housing bubble, often missed in this analysis is the critical role played by Fannie and Freddie as channels of that savings glut.  After all, the Chinese Central Bank was not plowing its reserves into Countrywide stock; it was putting hundreds of billions of its dollar reserves into Fannie and Freddie debt.  Fannie and Freddie were the vehicle that carried excess world savings into the United States.

Had this massive flow of global capital been invested in productive activities, or even just prime mortgages, it is unlikely tha we would have seen such a large housing bubble.  Instead, what did Fannie and Freddie do with its Chinese funds?  It invested those funds in the subprime mortgage market.  At the height of the bubble, Fannie and Freddie purchased over 40 percent of private-label subprime mortgage-backed securities.  Fannie and Freddie also used those funds to lower the underwriting standards of the “prime” whole mortgages it purchased, turning much of the Alt-A and subprime market into what looked to the world like prime mortgages.

Given the massive leverage (at one point Freddie was leveraged 200 to 1) and shoddy credit quality of mortgages on their books, why were the Chinese and other investors so willing to trust their money to Fannie and Freddie?  Because they were continually told by U.S. officials that their losses would be covered.  At the end of the day, Fannie and Freddie were not bailed out in order to save our housing market; they were bailed out in order to protect the Chinese Central Bank from taking any losses on its Fannie/Freddie investments.  Adding insult to injury is the fact that the Chinese accumulated these large dollar holdings in order to suppress the value of their currency, enabling Chinese products to be more competitive with American-made products.

While foreign investors have been willing to put considerable money into Wall Street, without the implied guarantees of Fannie and Freddie, trillions of dollars of global capital flows would not have been funneled into the U.S. subprime mortgage market.  As Washington seems intent on continuing to mortgage America’s future to the Chinese, that at minimum it seems that fixing Fannie and Freddie might help insure that something more productive is done with that borrowing.

Republicans Just as Guilty of Flawed Keynesian Thinking

The core of Keynesian economic policy is that the government must come in and replace reductions in private sector demand with public sector demand, therefore bringing overall demand back to its previous level.  One of the many flaws in this thinking is in assuming that the previous level of demand was “correct” and getting us back to that level is the appropriate policy response.

Take the example of the housing market and the government response.  The primary response of Republicans in Washington has been to offer tax credits and other incentives to replace the drop in demand for housing.  Witness Senator Johnny Isakson’s  recent comments on why we need to extend the $8,000 homebuyer tax credit: “If you take that kind of business out of what’s already a very weak housing market, you do nothing but protract and extend the recession.”

This analysis could not be more wrong.  The tax credit largely acts to keep housing prices from falling further.  However, that is how markets are supposed to clear in an environment of excess supply.  If there’s too much housing, the way to address that is to allow housing prices to fall, which attracts buyers back into the market.

We should also recognize that the tax credit does not help the buyer, it helps the seller, by allowing the seller to charge that much more for the price of the home.

Perhaps the worst impact of the policy is that it encourages the continued building of homes, only adding to the over-supply, which itself will “protract and extend the recession.”  Witness the recent news that housing starts in the US just hit a nine month high.  While these levels are still low in historic terms, and housing inventories are declining, we still have an excess of housing.  The damage done by creating a false floor to housing prices is that builders don’t respond to inventory, they respond to prices, and as long as there is a positive gap between prices and construction costs, builders will build.  The tax credit only serves to widen that gap between prices and construction costs.

Back to Keynes: the central flaw in the thinking behind the tax credit proposal is its assumption that we need to re-inflate the housing bubble.  The previous level of housing demand, from say 2003 to 2006, was not driven by fundamentals; we had a bubble.  There will be a correction in the housing market.  Our choices are to either take that correction quickly and move on, or to prolong that correction, maybe even make it worse, by trying to create a false floor to the market.

Reform Needed, but Obama Plan Would Result in More Financial Crises, not Less

Today President Obama took his financial reform plan to the airwaves.  While there is no doubt our financial system is in need of financial reform, the President’s plan would make bailouts a permanent feature of the regulatory landscape.  Rather than ending “too big to fail” – the President wants us to believe that with additional discretion and power, the same Federal Reserve that missed the boat last time will save us next time.

The truth is that the President’s plan will result in a small number of companies being viewed by debtholders as “too big to fail”.  These companies would see their funding costs decline, allowing them to gain market-share at the expense of their rivals, making these firms even larger.  Greater concentration in our financial services industry is the last thing we need, yet the Obama plan all but guarantees it.

Obama also chooses myth’s over facts.  The President claims that de-regulation and competition among regulators caused the crisis.  The facts could not be more different.  Those institutions at the center of the crisis – Fannie Mae, Freddie Mac, Bear Stearns, Lehman –could not choose their regulator.

The President’s plan chooses convenient targets and protects entrenched interests, rather than address the true underlying causes of the crisis.  At no time have we heard the President discuss the expansionary monetary policies that helped fuel the bubble.  Nor has the President talked about the global imbalances – the global savings glut that poured surplus savings from the rest of the world into the US.  But then the President appears to hope that loose monetary policy and continued American consumption funded by China will get him out of his own political problems with the economy.  It is especially striking that the President makes little mention of the housing bubble, as if it was only the bust that was the problem.

The President continues to say he inherited this crisis.  While true, he did not inherit the same individuals – Tim Geithner and Ben Bernanke – who were at the center of creating the crisis.  All Obama needs to do is find a position for Hank Paulson and he will have completely re-assembled the Bush financial team.

Without real reform – fixing Fannie and Freddie, scaling back the massive subsidies for leverage in our tax code, loose monetary policy – it will only be a matter of time before the next crisis hits.  If we implement the President’s plan, we will, however, guarantee that the next crisis will be even larger and severe than the current one.