Tag: Housing

Five Lessons from Ireland

The news is going from bad to worse for Ireland. The Irish Independent is reporting that the Swiss Central Bank no longer will accept Irish government bonds as collateral. The story also notes that one of the world’s largest bond firms, PIMCO, is no longer purchasing debt issued by the Irish government.

And this is happening even though (or perhaps because?) Ireland received a big bailout from the European Union and the International Monetary Fund (and the IMF’s involvement means American taxpayers are picking up part of the tab).

I’ve already commented on Ireland’s woes, and opined about similar problems afflicting the rest of Europe, but the continuing deterioration of the Emerald Isle deserves further analysis so that American policy makers hopefully grasp the right lessons. Here are five things we should learn from the mess in Ireland.

1. Bailouts Don’t Work – When Ireland’s government rescued depositors by bailing out the nation’s three big banks, they made a big mistake by also bailing out creditors such as bondholders. This dramatically increased the cost of the bank bailout and exacerbated moral hazard since investors are more willing to make inefficient and risky choices if they think governments will cover their losses. And because it required the government to incur a lot of additional debt, it also had the effect of destabilizing the nation’s finances, which then resulted in a second mistake – the bailout of Ireland by the European Union and IMF (a classic case of Mitchell’s Law, which occurs when one bad government policy leads to another bad government policy).

American policy makers already have implemented one of the two mistakes mentioned above. The TARP bailout went way beyond protecting depositors and instead gave unnecessary handouts to wealthy and sophisticated companies, executives, and investors. But something good may happen if we learn from the second mistake. Greedy politicians from states such as California and Illinois would welcome a bailout from Uncle Sam, but this would be just as misguided as the EU/IMF bailout of Ireland. The Obama Administration already provided an indirect short-run bailout as part of the so-called stimulus legislation, and this encouraged states to dig themselves deeper in a fiscal hole. Uncle Sam shouldn’t be subsidizing bad policy at the state level, and the mess in Europe is a powerful argument that this counter-productive approach should be stopped as soon as possible.

By the way, it’s worth noting that politicians and international bureaucracies behave as if government defaults would have catastrophic consequences, but Kevin Hassett of the American Enterprise Institute explains that there have been more than 200 sovereign defaults in the past 200 years and we somehow avoided Armageddon.

2. Excessive Government Spending Is a Path to Fiscal Ruin – The bailout of the banks obviously played a big role in causing Ireland’s fiscal collapse, but the government probably could have weathered that storm if politicians in Dublin hadn’t engaged in a 20-year spending spree.

The red line in the chart shows the explosive growth of government spending. Irish politicians got away with this behavior for a long time. Indeed, government spending as a share of GDP (the blue line) actually fell during the 1990s because the private sector was growing even faster than the public sector. This bit of good news (at least relatively speaking) stopped about 10 years ago. Politicians began to increase government spending at roughly the same rate as the private sector was expanding. While this was misguided, tax revenues were booming (in part because of genuine growth and in part because of the bubble) and it seemed like bigger government was a free lunch.

Eventually, however, the house of cards collapsed. Revenues dried up and the banks failed, but because the politicians had spent so much during the good times, there was no reserve during the bad times.

American politicians are repeating these mistakes. Spending has skyrocketed during the Bush-Obama year. We also had our version of a financial system bailout, though fortunately not as large as Ireland’s when measured as a share of economic output, so our crisis is likely to occur when the baby boom generation has retired and the time comes to make good on the empty promises to fund Social Security, Medicare, and Medicaid.

3. Low Corporate Tax Rates Are Good, but They Don’t Guarantee Economic Success if other Policies Are Bad – Ireland used to be a success story. They went from being the “Sick Man of Europe” in the early 1980s to being the “Celtic Tiger” earlier this century in large part because policy makers dramatically reformed fiscal policy. Government spending was capped in the late 1980 and tax rates were reduced during the 1990s. The reform of the corporate income tax was especially dramatic. Irish lawmakers reduced the tax rate from 50 percent all the way down to 12.5 percent.

This policy was enormously successful in attracting new investment, and Ireland’s government actually wound up collecting more corporate tax revenue at the lower rate. This was remarkable since it is only in very rare cases that the Laffer Curve means a tax cut generates more revenue for government (in the vast majority of cases, the Laffer Curve simply means that changes in taxable income will have revenue effects that offset only a portion of the revenue effects caused by the change in tax rates).

Unfortunately, good corporate tax policy does not guarantee good economic performance if the government is making a lot of mistakes in other areas. This is an apt description of what happened to Ireland. The silver lining to this sad story is that Irish politicians have resisted pressure from France and Germany and are keeping the corporate tax rate at 12.5 percent. The lesson for American policy makers, of course, is that low corporate tax rates are a very good idea, but don’t assume they protect the economy from other policy mistakes.

4. Artificially Low Interest Rates Encourage Bubbles – No discussion of Ireland’s economic problems would be complete without looking at the decision to join the common European currency. Adopting the euro had some advantages, such as not having to worry about changing money when traveling to many other European nations. But being part of Europe’s monetary union also meant that Ireland did not have flexible interest rates.

Normally, an economic boom drives up interest rates because the plethora of profitable opportunities leads investors demand more credit. But Ireland’s interest rates, for all intents and purposes, were governed by what was happening elsewhere in Europe, where growth was generally anemic. The resulting artificially low interest rates in Ireland helped cause a bubble, much as artificially low interest rates in America last decade led to a bubble.

But if America already had a bubble, what lesson can we learn from Ireland? The simple answer is that we should learn to avoid making the same mistake over and over again. Easy money is a recipe for inflation and/or bubbles. Simply stated, excess money has to go someplace and the long-run results are never pleasant. Yet Ben Bernanke and the Federal Reserve have launched QE2, a policy explicitly designed to lower interest rates in hopes of artificially juicing the economy.

5. Housing Subsidies Reduce Prosperity – Last but not least, Ireland’s bubble was worsened in part because politicians created an extensive system of preferences that tilted the playing field in the direction of real estate. The combination of these subsidies and the artificially low interest rates caused widespread malinvestment and Ireland is paying the price today.

Since we just endured a financial crisis caused in large part by a corrupt system of housing subsidies for Fannie Mae and Freddie Mac, American policy makers should have learned this lesson already. But as Thomas Sowell sagely observes, politicians are still fixated on somehow re-inflating the housing bubble. The lesson they should have learned is that markets should determine value, not politics.

Reflections on a Mortgage Summit

Yesterday the Treasury and HUD hosted a “Conference on the Future of Mortgage Finance.”  It was an invite-only of Washington insiders.  Somehow I found myself on the invite list, which was almost enough to make me believe that the Administration was finally serious about reforming Fannie and Freddie.

After getting over the nausea of being in a room full of people who I personally knew bore some responsibility for the mess we are in, I was then shocked that, compared to the rest of the room, Treasury Secretary Geithner came across as the radical.  On one hand Geithner was very clear that the Administration was going to push for some sort of government guarantee, but also that the current structure, particularly Fannie and Freddie, were broken.  He also went as far as admitting that Fannie and Freddie were a cause of the crisis.

Such statements only became radical in contrast to the rest of the room.  Maybe about 80 percent of the attendees were blindly and violently attached to the status quo.  Most offensive to those us who fight for free markets was that the industry representatives were the most vocal advocates for the status quo.  To even suggest that lenders should bear the risk of loans they make was crazy to this group.  It was a clear reminder that being pro-market and pro-business are generally two very different things.   In fairness, not all lenders were busy plotting to find ways to profit while dumping their risk onto the taxpayer; some, such as Wells Fargo, were far more supportive of the private sector actually bearing the risk.

Most of those who were not industry insiders were housing and community advocates.  While this group did seem a little less self-interested, they appear to have learned little about the risks of over-expanding homeownership.  Repeatedly, access to homeownership, as if it could solve every social ill, was pushed as the primary goal.  A few dissenters reminded us that rental is a viable option too, although they were mainly looking to continue/expand Fannie and Freddie’s support of the multifamily rental market.

If the Administration was hoping that this group was going to come up with answers, then they must have been sorely disappointed.  If Obama is serious about taking the taxpayer off the hook for risk in the mortgage market, then he is going to have to take on the special interests.  My fear is that the event was just the beginning of how health care reform played out:  cut a deal with the industry, pay off the Democratic base, and screw the taxpayer.  Let’s hope we actually see some change on this one.

Two Cheers for the U.S. Economy

Two articles in today’s Wall Street Journal deal with the housing sector.  They complement each other. Journal reporters note that “Industry Speeds Recovery, And Housing Slows It Down.”  The story notes that that “ground-breaking for new homes and applications for building permits both plunged last month.”  Meanwhile, U.S. industrial output showed strong growth in May.

Bravo for both numbers, which are inter-related.  The headline (over which reporters have no control) reflects conceptual confusion.  U.S. industrial production is strong at least in part because construction of new homes is weak.   The bloated home sector is no longer absorbing a disproportionate share of economic resources.  The new homeowners tax credit has mercifully expired, ending that bit of misguided stimulus.

David Wessel’s article, “Rethinking Home Ownership,” further clarifies the reallocation of resources taking place in the U.S. economy.  Beginning in the 1990s, the federal government adopted a number of policies to stimulate home ownership.  As Wessel makes clear, it was a bipartisan effort.  Home ownership rates rose from around 65% to a peak of 69.4% in 2004.  It was an unsustainable policy, a true asset bubble.

Home ownership rates have now fallen back to where they began, or even below.  The experience of the 1990s and early 2000s in housing demonstrates why government stimulus is not a permanent source of demand, nor the path to sustainable economic growth. Lest we forget, the folly of these programs is measured not just in housing numbers, but in shattered dreams and hopes and ruined lives. And the terrible financial crisis to which these programs contributed

Cisneros Rewriting HUD History

In a recent speech to real estate interests, former Clinton HUD secretary Henry Cisneros preposterously claimed that the recent housing meltdown “occurred not out of a governmental push, but out of a hijacking of the homeownership process by some unscrupulous interests.”

The only criticisms Cisneros could muster for the government’s housing policies over the past 20 years were that regulations weren’t tough enough and it should have focused more on rental subsidies.

The reality is that Cisneros-era HUD regulations and policies directly contributed to the housing bubble and subsequent burst as a Cato essay on HUD scandals illustrates:

  • Cisneros’s HUD pursued legal action against mortgage lenders who supposedly declined higher percentages of loans for minorities than whites. As a result of such political pressure, lenders begin lowering their lending standards.
  • On Cisneros’s watch, the Community Reinvestment Act was used to pressure lenders into making more loans to moderate-income borrowers by allowing regulators to deny merger approvals for banks with low CRA ratings. The result was that banks began issuing more loans to otherwise uncreditworthy borrowers, while purchasing more CRA mortgage-backed securities. More importantly, these lax standards quickly spread to prime and subprime mortgage markets.
  • The Clinton administration’s National Homeownership Strategy, prepared under Cisneros’s direction, advocated “financing strategies, fueled by creativity and resources of the public and private sectors, to help homebuyers that lack cash to buy a home or income to make the payments.” In other words, his policies encouraged the behavior that he now calls “unscrupulous.”
  • Cisneros’s HUD also put Fannie Mae and Freddie Mac under constant pressure to facilitate more lending to “underserved” markets. It was under Cisneros’s direction that HUD agreed to allow Fannie and Freddie credit toward its “affordable housing” targets by buying subprime mortgages. Fannie and Freddie are now under government conservatorship and will cost taxpayers hundreds of billions of dollars.

Cisneros now serves as the executive chairman of an institutional investment company focused on urban real estate. Might that explain why Cisneros is now a fan of subsidizing rental housing?

“Unscrupulous” would be a good word to describe the millions of dollars Cisneros has made in the real estate industry following his exit from government.

From the Cato essay:

In 2001, Cisneros joined the board of Fannie Mae’s biggest client: the now notorious Countrywide Financial, the company that was center stage in the subprime lending scandals of recent years. When the housing bubble was inflating, Countrywide and KB took full advantage of the liberalized lending standards fueled by Cisneros’s HUD. In addition to the money he received as a KB director, Cisneros’s company, in which he held a 65 percent stake, received $1.24 million in consulting fees from KB in 2002.

When Cisneros stepped down from Countrywide’s board in 2007, he called it a “well-managed company” and said that he had “enormous confidence” in its leadership. Clearly, those statements were baloney—Cisneros was trying to escape before the crash. Just days before his resignation, Countrywide announced a $1.2 billion loss, and reported that a third of its borrowers were late on mortgage payments. According to SEC records, Cisneros’s position at Countrywide had earned him a $360,000 salary in 2006 and $5 million in stock sales since 2001.

Congress Begins Conference on Financial Regulation

Today begins the televised political theatre that Barney Frank has been waiting months for:  the first public meeting of the House and Senate conferees on the two financial regulation bills.  While there are a handful of important differences between the House and Senate bills, these differences are overshadowed by what the bills have in common.  The most important, and tragic, commonality is that both bills ignore the real causes of the financial crisis and focus on convenient political targets.

As our financial system was brought to its knees by an exploding housing bubble, fueled by government mandates and distortions, one would think, just maybe, that Congress would roll back these distortions.  Despite their role in contributing to the crisis and the size of their bailout, however, neither bill barely mentions Fannie Mae and Freddie Mac.   Except, of course, to continue their favored and privileged status, such as their exemption from a proposed new “consumer protection” agency.  What we really need is a new “taxpayer protection” agency.

Nor will either bill change the government’s meddling in what is probably the most important price in the economy:  the interest rate.  Given the overwhelming evidence that loose monetary policy was a direct cause of the housing bubble, one might expect Congress to spend time and effort preventing the Fed from creating another bubble.  Not only does Congress ignore the issue, the Senate won’t even allow GAO to look at the Fed’s conduct of monetary policy.

Instead of spending the next few weeks gazing into the camera, Congress should stop and gaze into the mirror.  This was a crisis conceived and born in Washington DC.  The Rayburn building serving as the proverbial back-seat of the housing bubble.

Guess Who’s Behind the New Fire-Sprinkler Mandates

California just adopted effective next year a requirement that all new one- and two-family dwellings include indoor sprinkler systems. Other states are debating similar mandates, spurred by changes to national building code standards. Earlier legal mandates have required the inclusion of smoke alarms and carbon monoxide alarms, but the cost of those devices is relatively minor, whereas full-blown sprinkler systems add measurably to the cost of a new home, as well as posing challenges in such areas as maintenance, aesthetics, and risk of property damage through accidental activation.

It will surprise not a single reader of these columns, I suspect, to learn that the fire sprinkler industry has been a major force in pushing the new mandate. As for the opposition, home builders have managed to mount a bit of resistance – New Jersey, for example, saw the current depressed state of the residential construction business as reason to postpone its mandate for a year. But the builders are pretty much on their own in the fight, since future buyers of new homes are a group with no organized political presence whatsoever.

Real estate blogger Christopher Fountain writes that he’s “never heard of a home buyer voluntarily ordering this equipment when building a house, so it sounds to me like one more instance of people who know better dictating to those who don’t.” Exactly. A South Carolina paper quotes a state official as saying if buyers feel priced out of the new home market by the cost of the mandate, they have other ways to save money “such as choosing less expensive flooring or countertops, or not installing yard sprinklers”. Easy to make someone else’s budget decisions for them, isn’t it? And shouldn’t the “affordable housing” community be taking more of an interest?

Obama’s Fannie and Freddie Amnesia

Peter Wallison calls attention to President Obama’s amnesia regarding events that precipitated Fannie Mae and Freddie Mac’s collapse. Writing in the Wall Street Journal, Wallison points out that in 2005 then-Senator Obama joined with his Democratic colleagues in stopping legislation that would have helped rein in the government-sponsored housing duo’s risky behavior:

The bill would have established a new regulator for Fannie and Freddie and given it authority to ensure that they maintained adequate capital, properly managed their interest rate risk, had adequate liquidity and reserves, and controlled their asset and investment portfolio growth.

These authorities were necessary to control the GSEs’ risk-taking, but opposition by Fannie and Freddie—then the most politically powerful firms in the country—had consistently prevented reform.

The date of the Senate Banking Committee’s action is important. It was in 2005 that the GSEs—which had been acquiring increasing numbers of subprime and Alt-A loans for many years in order to meet their HUD-imposed affordable housing requirements—accelerated the purchases that led to their 2008 insolvency. If legislation along the lines of the Senate committee’s bill had been enacted in that year, many if not all the losses that Fannie and Freddie have suffered, and will suffer in the future, might have been avoided.

The president’s complicity in the housing collapse hasn’t stopped him from pinning the blame on Republicans, “special interests,” and Wall Street “fat cats.” As he does with other problems, the president blames everyone except himself and his party.

As I recounted in a Cato Policy Analysis, Fannie and Freddie epitomized the tawdry relationship between businesses that receive special federal breaks and policymakers. Democrats, including Obama’s chief of staff Rahm Emanuel, played a key role in facilitating Fannie and Freddie’s destructive activities. Emanuel, a then recent senior adviser to President Clinton, was appointed by Clinton to Freddie Mac’s board of directors, where he earned $320,000 in compensation and sold company stock worth more than $100,000.

Then there’s the current Office of Management and Budget director, Peter Orszag. In 2002, Fannie Mae commissioned a paper authored by Nobel Laureate Joseph Stiglitz, Jonathan Orszag, and Peter Orszag, who was then at the Brookings Institution. The study concluded that “the probability of default by the GSEs is extremely small.” Oops.

Given the company Obama keeps, it’s not surprising that the administration still hasn’t come up for a plan on what to do with Fannie and Freddie.

The administration has intentionally not incorporated Fannie and Freddie into the federal budget in order to hide the cost to taxpayers. And on Christmas Eve the administration quietly announced that the government would cover all of Fannie and Freddie’s losses beyond the original $400 billion limit through 2012. The Congressional Budget Office estimates that the final cost to taxpayers for bailing out Fannie and Freddie will approach that figure, although Wallison calls that projection “optimistic.”

See this essay for more on the problems the federal government causes in the housing market.