What Caused the Crisis?
Last night National Government Radio promoted a documentary on National Government TV about the financial crisis of 2008, which concludes that the problem was . . . not enough government.
If the “Frontline” episode mentioned any of the ways that government created the crisis — cheap money from the central bank, tax laws that encourage debt over equity, government regulation that pressured lenders to issue mortgages to borrowers who wouldn’t be able to pay them back — NPR didn’t mention it.
For information on those causes, take a look at this paper by Lawrence H. White or get the new book Financial Fiasco by Johan Norberg, which Amity Shlaes called “a masterwork in miniature.” Available in hardcover or immediately as an e-book. Or on Kindle!
And for a warning about the dangers lurking in Fannie Mae and Freddie Mac, see this 2004 paper by Lawrence J. White.
Filed under: Cato Publications; Finance, Banking & Monetary Policy
Regulation and Competition among Mortgage Brokers
With the House Financial Services Committee moving forward with a bill to increase the regulation of our consumer credit markets, particularly our mortgage market, it is worth asking the question: what’s the best protection for consumers, regulation or competition?
Let’s take the example of mortgage brokers. They’ve often been targeted as one of the causes of the crisis. The story goes that they just made the loans and passed it along to the lenders and/or Wall Street and so, didn’t care about the quality of the loan.
The response of government, first at the state then the federal level, has been to subject mortgage brokers to increased oversight and licensing, with the intent to keep the “bad actors” out of the marketplace. How well did this all work out?
According to Professor Morris Kleiner and Minn Fed Economist Richard Todd, not exactly the way you’d want. What the economists found was that tighter regulation on who can become a mortgage broker is actually associated ”with higher broker earnings, fewer brokers, fewer subprime mortgages, higher foreclosure rates, and a greater percentage of high-interest-rate mortgages.”
It seems the barrier to entry created by these licensing requirements reduced competition in a manner that caused far more harm to consumer than any protections provided by increasing the “quality” of mortgage brokers.
Perpetuating Bad Housing Policy
Perhaps the worst feature of the bailouts and the stimulus has been that, whatever their merits as short terms fixes, they have done nothing to improve economic policy over the long haul; indeed, they compound past mistakes.
Here is a good example:
For months, troubled homeowners seeking to lower their mortgage payments under a federal plan have complained about bureaucratic bungling, ceaseless frustration and confusion. On Thursday, the Obama administration declared that the $75 billion program is finally providing broad relief after it pressured mortgage companies to move faster to modify more loans.
Five hundred thousand troubled homeowners have had their loan payments lowered on a trial basis under the Making Home Affordable Program.
The crucial words in the story are “$75 billion” and “pressured.”
No one should object if a lender, without subsidy and without pressure, renegotiates a mortgage loan. That can make sense for both lender and borrower because the foreclosure process is costly.
But Treasury’s attempt to subsidize and coerce loan modifications is fundamentally misguided. It means many homeowners will stay in homes, for now, that they cannot really afford, merely postponing the day of reckoning.
Treasury’s policy is also misguided because it presumes that everyone who owned a house before the meltdown should remain a homeowner. Likewise, Treasury’s view assumes that all the housing construction over the past decade made good economic sense.
Both presumptions are wrong. U.S. policy exerted enormous pressure for increased mortgage lending in the years leading up to the crisis, thereby generating too much housing construction, too much home ownership and inflated housing prices.
The right policy for the U.S. economy is to stop preventing foreclosures, to stop subsidizing mortgages, and to let the housing market adjust on its own. Otherwise, we will soon see a repeat of the fall of 2008.
Housing Bailouts: Lessons Not Learned
The housing boom and bust that occurred earlier in this decade resulted from efforts by Fannie Mae and Freddie Mac — the government sponsored enterprises with implicit backing from taxpayers — to extend mortgage credit to high-risk borrowers. This lending did not impose appropriate conditions on borrower income and assets, and it included loans with minimal down payments. We know how that turned out.
Did U.S. policymakers learn their lessons from this debacle and stop subsidizing mortgage lending to risky borrowers? NO. Instead, the Federal Housing Authority lept into the breach:
The FHA insures private lenders against defaults on certain home mortgages, an inducement to make such loans. Insurance from the New Deal-era agency has enabled lending to buyers who can’t make a big down payment or who want to refinance but have little equity. Most private lenders have sharply curtailed credit to those borrowers.
In the past two years, the number of loans insured by the FHA has soared and its market share reached 23% in the second quarter, up from 2.7% in 2006, according to Inside Mortgage Finance. FHA-backed loans outstanding totaled $429 billion in fiscal 2008, a number projected to hit $627 billion this year.
And what is the result of this surge in FHA insurance?
The Federal Housing Administration, hit by increasing mortgage-related losses, is in danger of seeing its reserves fall below the level demanded by Congress, according to government officials, in a development that could raise concerns about whether the agency needs a taxpayer bailout.
This is madness. Repeat after me: TANSTAAFL (There ain’t no such thing as a free lunch).
C/P Libertarianism, from A to Z
HUD Helps to Set the Ground for Next Round of Mortgage Fraud
Just when you were thinking it was safe to go back into the mortgage market, today’s Wall Street Journal is highlighting the next source of mortgage fraud, the Federal Housing Administration’s (FHA) reserve mortgage program. In a typical reverse mortgage, the bank sends the borrower a monthly check (or a lump sum payment at the beginning of the loan).
It seems that some creative individuals have figured they could deed a run-down house to an elderly individual, and then get a reserve mortgage on that property; leaving them with the cash and the government with the run-down worthless property. Of course, this requires getting an appraiser to go along with the value of the home, but since the Clinton HUD decided to do away with FHA control of appraisers and let the lender pick the appraiser, that sadly hasn’t been much of an obstacle.
The great thing for lenders is that if the loan goes bad, or the value of the house falls below the mortgage amount, FHA – backed by the taxpayer – picks up the tab. Of course, the borrower is required to pay an insurance premium to cover any potential shortfalls. But just like in any other federal insurance program, when these’s a shortfall beyond funds collected via premiums, we taxpayers are left on the hook. I could go on about what a great job Washington does running insurance programs; suffice to say, Washington does a pretty poor job.
If Washington were serious about cracking down on predatory lending and mortgage fraud, Congress should end the practice of allowing lenders to put 100% of their losses to the taxpayer. Maybe that would provide the correct incentives for the lender to actually make sound loans.
FTC to Protect Us from Multi-Colored Beer Cans
Recently Anheuser-Busch hit upon the marketing idea of selling Bud Light beer in cans decorated with the college-team colors. As the Federal Trade Commission (FTC) doesn’t have much else to do - it’s not like there’s been say fraud going on in the mortgage market – it quickly turned its attention to the issue, expressing “grave concern” that these team-colored cans would encourage underage and binge drinking.
As quoted in the Wall Street Journal, FTC attorney Janet Evans said “this does not appear to be responsible activity.” What’s not responsible is the FTC wasting taxpayer resources wondering what color beer cans we are drinking out of. When I was an underage drinker, the last thing on my mind was the color of the can. The ultimate purpose of the marketing campaign is to shift demand away from boring, non-team color beer cans toward team color cans. If beer drinkers (or can collectors) get some pleasure out of a certain colored can, where’s the fraud or deception in that?
The real purpose of FTC’s interest is revealed in the comments of the Licensing Resource Group, which represents the colleges in protecting their logos. Almost all the colleges that have asked Anheuser-Busch to stop selling the cans have cited trademark concerns. Yet none of the cans have any team logos. While no one would dispute the right of a college to control the use of its team logo, is it really reasonable to conclude that the colleges also own the rights to the use of certain colors?
Mortgage Mods: Congressman Prefers Coercion over Cooperation
The recent focus in Washington on mortgage modifications once again illustrates one of the most fundamental flaws in current political debate: the notion of using government to threaten or force the “voluntary” transfer of wealth from one group of citizens to another.
Just this week Rep. Barney Frank warned the banking industry if they don’t “voluntarily” do more to reduce foreclosures, Congress will step in and make them do so, by allowing bankruptcy judges to re-write mortgage contracts. This proposal is really nothing more an ex poste transfer of wealth from investors in mortgage backed assets to borrowers.
Of course, Rep. Frank and others respond that they are only trying to “bring lenders to the table” in order to keep negotiations going. In the words of many “consumer” advocates, this is just a “stick” to the motivate the lenders. I could think of few things more offensive to a free society. In a government truly constituted on the notion of the common good or general welfare, it would be no more appropriate to use the stick of the state on lenders than it would be on borrowers. Government quite simply should not take sides in purely private disputes.
One would think that if anyone could understand the principle that government should not interfere in the private, voluntarily entered relationships of consenting adults, it should be Mr. Frank.
Why Mortgage Modifications Aren’t Working
As covered in both today’s Wall Street Journal and Washington Post, the Obama administration has called 25 of the largest mortgage servicing companies to Washington to try to figure out why the Obama efforts to stem foreclosures has been a failure.
The reason such efforts, as well as those of the Bush Administration and the FDIC, have been a failure is that such efforts have grossly misdiagnosed the causes of mortgage defaults. An implicit assumption behind former Treasury Secretary Paulson’s HOPE NOW, FDIC Chair Sheila Bair’s IndyMac model, and the Obama Administration’s current foreclosure efforts is that the current wave of foreclosures is almost exclusively the result of predatory lending practices and “exploding” adjustable rate mortgages, where large payment shocks upon the rate re-set cause mortgage payment to become “unaffordable.”
The simple truth is that the vast majority of mortgage defaults are being driven by the same factors that have always driven mortgage defaults: generally a negative equity position on the part of the homeowner coupled with a life event that results in a substantial shock to their income, most often a job loss or reduction in earnings. Until both of these components, negative equity and a negative income shock are addressed, foreclosures will remain at highly elevated levels.
Sadly the Obama Administration is likely to use today’s meeting as simply an excuse to deflect blame from themselves onto “greedy” lenders. Instead the Administration should be focusing on avenues for increasing employment and getting our economy growing again. Then of course, this Administration has from the start been more focused on re-distributing wealth rather than creating it, which explains why it views mortgage modifications as simply a game of taking from lenders (in reality investors – like pension funds) and giving to delinquent homeowners.
Does the Left Know We Had a Housing Bubble?
Over the last week, speaking at a variety of events, I heard three different representatives of the Left; first a Democrat US Senator, then a senior member of the Obama Administration, and finally a “consumer” advocate, all repeat the same narrative: all was fine in the housing market until predatory lenders forced hard-working honest families into foreclosure, which reduced house prices, bringing the economy to a crash. That’s correct, apparently the Left believes we all would still be seeing double-digit home price appreciation if it wasn’t for those evil lenders.
Undoubtedly foreclosures, especially those that result in houses that remain vacant for a considerable amount of time, have an adverse impact on surrounding property values. Many constitute a serious eye-sore and provide a haven for criminal activity. But did foreclosures really drive down prices, or were foreclosures first driven by price declines resulting from a bursting housing bubble? While causality is always difficult to establish with certainty, we do know that the rate of house price appreciation peaked and started declining about 18 months before the dramatic up-turn in mortgage delinquencies. If one prefers a more rigorous test, economists at the Boston Fed have directly tested if prices first drove foreclosures or whether foreclosures drove prices. Their results conclude that its was declining prices that matter, and that the price effect of foreclosures is minimal.
Why does any of this ultimately matter? Because if we craft policies to avoid the adverse impacts of the next property bubble based upon a narrative of “consumer protection” — as is being pushed by the Obama Administration, we will do little to avoid the creation of the next housing bubble and its damaging aftermath. Instead we should be focusing attention on those policies that contributed to the creation of the housing bubble: expansionary monetary policy and the Federal government’s blind pursuit of ever-expanding home-ownership rates at any cost.
Administration Reform Plan Misses the Mark
The Obama Administration is presenting a misguided, ill-informed remake of our financial regulatory system that will likely increase the frequency and severity of future financial crises. While our financial system, particularly our mortgage finance system, is broken, the Obama plan ignores the real flaws in our current structure, instead focusing on convenient targets.
Shockingly, the Obama plan makes no mention of those institutions at the very heart of the mortgage market meltdown – Fannie Mae and Freddie Mac. These two entities were the single largest source of liquidity for the subprime market during its height. In all likelihood, their ultimate cost to the taxpayer will exceed that of TARP, once TARP repayments have begun. Any reform plan that leaves out Fannie and Freddie does not merit being taken seriously.
Instead of addressing our destructive federal policies aimed at extending homeownership to households that cannot sustain it, the Obama plan calls for increased “consumer protections” in the mortgage industry. Sadly, the Administration misses the basic fact that the most important mortgage characteristic that is determinate of mortgage default is the borrower’s equity. However, such recognition would also require admitting that the government’s own programs, such as the Federal Housing Administration, have been at the forefront of pushing unsustainable mortgage lending.
While the Administration plan recognizes the failure of the credit rating agencies, it appears to misunderstand the source of that failure: the rating agencies’ government-created monopoly. Additional disclosure will not solve that problem. What is needed is an end to the exclusive government privileges that have been granted to the rating agencies. In addition, financial regulators should end the outsourcing of their own due diligence to the rating agencies.
The Administration’s inability to admit the failures of government regulation will only guarantee that the next failures will be even bigger than the current ones.
Congress “Helps” Credit Card Customers
One of the best laugh lines always has been “I’m from the government and I’m here to help you.” Certainly that’s true when it comes to consumer protection.
In the name of saving customers from the evil, rapacious credit card companies Congress plans on limiting access to credit. It also is working to hike costs for people with good credit.
Now Congress is moving to limit the penalties on riskier borrowers, who have become a prime source of billions of dollars in fee revenue for the industry. And to make up for lost income, the card companies are going after those people with sterling credit.
Banks are expected to look at reviving annual fees, curtailing cash-back and other rewards programs and charging interest immediately on a purchase instead of allowing a grace period of weeks, according to bank officials and trade groups.
“It will be a different business,” said Edward L. Yingling, the chief executive of the American Bankers Association, which has been lobbying Congress for more lenient legislation on behalf of the nation’s biggest banks. “Those that manage their credit well will in some degree subsidize those that have credit problems.”
This makes a lot of sense. We’re worried about bad debt, bad mortgages, and bad loans. So Congress is going to penalize people with good credit who carefully manage their financial affairs. Of course!
It has long been evident that Congress has the reverse Midas touch. Everything congressmen touch turns to, well, this is a family-oriented blog. You can fill in the blank.
If Congress wants to help consumers, the best thing it could do is take an extended recess.
Filed under: Finance, Banking & Monetary Policy; Government and Politics
Obama’s Broken Toaster
Recently on Leno, President Obama compared some financial products to an exploding toaster. His words:
When you buy a toaster, if it explodes in your face there’s a law that says your toasters need to be safe. But when you get a credit card, or you get a mortgage, there’s no law on the books that says if that explodes in your face financially, somehow you’re going to be protected.
So this is — the need for getting back to some common sense regulations — there’s nothing wrong with innovation in the financial markets. We want people to be successful; we want people to be able to make a profit. Banks are critical to our economy and we want credit to flow again. But we just want to make sure that there’s enough regulatory common sense in place that ordinary Americans aren’t taken advantage of, and taxpayers, after the fact, aren’t taken advantage of.
While I think we would all like to get to “common sense” regulation – arriving at such is unlikely if one’s understanding of the very problem is flawed, as seems to be the president’s.
Unlike broken toasters, mortgages and credit cards do not fail to pay themselves – borrowers fail to pay, almost always for a reason that has little to do with the characteristics of the loan itself. There is a wealth of empirical data documenting the causes of bankruptcy, mortgage and credit card default – much of which has been assembled by those on the left (take a look at any of Professor Elizabeth Warren’s work on bankruptcy). The fact is that the number one cause of all of these events is job loss. If the president has a plan for a mortgage that protects you from losing your job, I would love to see how that’s going to work. After job loss, comes unexpected health bills and divorce.
My hope had been that Obama’s talk about broken toasters was just a little pandering and could be safely ignored. However, judging from the structure of his foreclosure relief plan, he appears to believe that if we just lower the borrower’s rate, all would be saved. The sad truth is that his foreclosure plan does nothing for those really in need – who have lost their job for instance – they are simply out of luck. But then helping people who have lost their job would undermine the argument that it is all the fault of the product.
Shocking News: Fannie Mae Is Losing More Money
Yes, I know. It’s hard to believe. Fannie Mae continues to lose money and, even more surprisingly, isn’t likely to ever pay taxpayers back for all of the billions that it already has squandered. Rather, it says it will need more bail-out funds — probably another $110 billion this year alone.
Fannie Mae reported yesterday that it lost $23.2 billion in the first three months of the year as mortgage defaults increasingly spread from risky loans to the far-larger portfolio of loans to borrowers who have been considered safe.
The massive loss prompts a $19 billion investment from the government to keep the firm solvent, on top of a $15 billion investment of taxpayer money earlier this year.
The sobering earnings report was a reminder of the far-reaching implications of the government’s takeover in September of Fannie Mae and the smaller Freddie Mac. Losses have proved unrelenting; the firms’ appetite for tens of billions of dollars in taxpayer aid hasn’t subsided; and taxpayer money invested in the companies, analysts said, is probably lost forever because the prospects for repayment are slim.
But the government remains committed to keeping the companies afloat, because it is relying on them to help reverse the continuing slide in the housing market and keep mortgage rates low.
Even as the government bailout of banks appears to be leveling off, the federal rescue of Fannie and Freddie is rapidly growing more expensive. Fannie Mae said that the losses will continue through at least much of the year and that it “therefore will be required to obtain additional funding from the Treasury.” Analysts are estimating that the company could need at least $110 billion.
Freddie Mac, which has been in worse financial shape than Fannie Mae and has obtained $45 billion in taxpayer funding, will report earnings in coming days.
The response of policymakers in the administration and Congress to this fiscal debacle? Silence. No surprise there, since many of them helped create the very programs that continue to bleed taxpayers dry.
Alas, this isn’t the first time that the federal government has promoted a housing boom and bust. Instead, writes Steven Malanga in Investor’s Business Daily:
This cycle goes back nearly 100 years. In 1922, Commerce Secretary Herbert Hoover launched the “Own Your Own Home” campaign, hailed as unique in the nation’s history.
Responding to a small dip in homeownership rates, Hoover urged “the great lending institutions, the construction industry, the great real estate men … to counteract the growing menace” of tenancy.
He pressed builders to turn to residential construction. He called for new rules that would let nationally chartered banks devote a greater share of their lending to residential properties.
Congress responded in 1927, and the freed-up banks dived into the market, despite signs that it was overheating.
The great national effort seemed to pay off. From mid-1927 to mid-1929, national banks’ mortgage lending increased 45%. The country was becoming “a nation of homeowners,” the Times exulted.
But as homeownership grew, so did the rate of foreclosures, from just 2% of commercial bank mortgages in 1922 to 11% in 1927.
This happened just as the stock market bubble of the late ’20s was inflating dangerously. Soon after the October 1929 Wall Street crash, the housing market began to collapse. Defaults exploded; by 1933, some 1,000 homes were foreclosing every day.
The “Own Your Own Home” campaign had trapped many Americans in mortgages beyond their reach.
Financial institutions were exposed as well. Their mortgage loans outstanding more than doubled from the early 1920s to 1930 — $9.2 billion to $22.6 billion — one reason that about 750 financial institutions failed in 1930 alone.
The only serious option is to close down all of the money-wasting federal programs and laws designed to subsidize home ownership. A stake through the hearts of Fannie Mae, Freddie Mac, Federal Housing Administration, and Community Reinvestment Act, to start. Otherwise the cycle is bound to be repeated, again to great cost for the ever-suffering taxpayers.
Filed under: Finance, Banking & Monetary Policy; Government and Politics; Tax and Budget Policy
Mortgage ‘Safe Harbor’ Anything But Safe
After the Senate’s rejection last week of allowing bankruptcy judges to re-write mortgage contracts, the so called “cramdown” provisions, it was starting to look as if the Senate cared about respecting private contracts. Sadly, such concern has been short-lived.
Tucked away in the mortgage bill is a provision that gives servicers of mortgages, that is, the entities that collect payments and perform modifications on behalf of the actual investors in mortgages, a “safe harbor” from any litigation by investors if the servicer chooses to follow the interests of the borrower or the government, rather than fulfilling their fiduciary duty to the investors.
Supporters of the safe harbor claim that too many foreclosures have taken place due to contractual restrictions on the ability of servicers to modify mortgages in a manner that would allow borrowers to stay in their homes. Most pooling and servicing agreements allow mortgage modifications without the investors’ approval if the modification increases the net present value of the mortgage. However, if the mortgage modification resulted in a loss to the investor, over what they would recover in a foreclosure, then they are not allowed under current contracts. The safe harbor intends to fix this “problem” by allowing the servicer to impose additional losses on investors, as long as that servicer follows President Obama’s foreclosure plan.
Allowing parties to a contract to ignore their contractual obligations as long as they sign-on to presidential initiatives is a dangerous precedent, and one that will ultimately raise the cost of entering into and enforcing contracts.
As these costs will have to be borne by someone, it is likely in the future that these efforts at undermining contracts in our credit markets will result in higher interest rates for all borrowers.
With ‘Cramdown’ Rejection, Is Senate Ready to Respect Marketplace Contracts Again?
After rejecting the proposed ‘cramdown’ changes to the bankruptcy code, the Senate may be slowly waking up to the need to respect contracts. One cannot rebuild trust and confidence in our markets, while at the same type trying to destroy the trust that underlies contractual relations. Were the cramdown legislation approved, the message to investors, or any market participants, would be that the enforceability and terms of your private agreements will be subject to the direction of the political winds.
Proponents of cramdown claimed that the bankruptcy code favored one’s vacation home or yacht over one’s primary residence, as the mortgages on these assets could be reduced to reflect their current value. Such a claim is at best misleading, if not outright false. One’s primary residence is already the most favored asset in bankruptcy — due to the very simple fact that one generally gets to keep their home, while one usually has to give up their boat or vacation home in order to satisfy one’s debts. There simply is no ‘yacht-stead’ exemption. In fact, under Chapter 13, primary residences whose equity values are greater than the homestead exemption are crammed-down, and the home is transferred to the lender.
Our economy will only turn around once families, investors, entrepreneurs and other market participants believe the rules of the game will be fair and certain, and not constantly subject to political manipulation. Voluntary consensual agreements are one of the basic pillars of our society, and should be respected as such. They should not be written solely as a means of taking from one groups of citizens and giving to another.
Solve the Financial Crisis (and Make Some Serious Money)
Peter Van Doren and I have been puzzling over this very interesting NYT op-ed on home foreclosures by Yale economist John Geanakoplos and Boston University law professor Susan Koniak. If G&K’s story is right, then shouldn’t there be an opportunity for some clever financiers to help struggling homeowners keep their houses, help banks and other investors repair their balance sheets — and the financiers could help themselves to piles of cash in the process?
G&K argue that all three parties to a home mortgage — the homeowner, the lender, and the loan servicer who works as a go-between — currently face grim financial prospects:
- Many homeowners are “underwater” — that is, they owe more on their mortgages than their homes are now worth. According to First American Core Logic, some 20% of mortgages were underwater as of December 2008. The percentage varies greatly from state to state, with 55% of mortgages underwater in Nevada, but only 7% in New York. The homeowners who are underwater include not just those who purchased with little down payment, but also many people who put down the traditional 20 percent when they bought in 2005 or 2006, at the peak of the real estate bubble. According to Case-Shiller index data, house prices nationwide have fallen 27% (as of December) from their May 2006 peak. Some local markets have experienced more dramatic declines, highlighted by Phoenix’s 46% slide. Rental prices are now far below many homeowners’ monthly mortgage payments, and lots of underwater homeowners will have to make payments for years before they have some equity stake in their homes. Many of those homeowners would rather default and risk foreclosure. G&K’s op-ed includes this figure showing that defaults increase dramatically as homeowners sink further and further underwater. Given their current options, default is rational.
- The mortgage lender faces heavy losses if the home enters foreclosure. According to G&K, ”the subprime bond market now trades as if it expects only 25 percent back on a loan when there is a foreclosure.”
- The servicer also is at risk. According to G&K, the servicer is obligated to continue paying the lender its monthly payment even if the borrower is in default. That obligation only lifts at foreclosure.
Because of the servicer’s obligation, the servicer has strong incentive to push for quick foreclosure. However, the homeowner and the mortgage lender would likely benefit from a loan modification — even a significant write-down of principal — because that would keep the homeowner in his house and it would deliver a better return to the lender than the 75% loss from foreclosure. G&K thus argue that government, instead of continuing to bail out the banking industry and struggling homeowners (and putting taxpayers on the hook for hundreds of billions of dollars), should simply require that the lenders write down the mortgage principal.
But is government action needed? Couldn’t some private actors accomplish the same thing — and make some serious scratch in the process?
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