Any decent explanation of the financial crisis of 2006-9 needs to include the implicit backing of mortgages with taxpayer dollars. In the U.S., most mortgages are backed by GSE’s. Backing means that if those real estate purchases went well, the mortgagee/buyer keeps the gains, but if they do badly and the mortgagee/buyer walks away or declares bankruptcy, the holder of the mortgage covers the loss.
Note that I do not say mortgager. Most mortgages are offered/written and/or contracted by local financial institutions. The money to make those loans often comes from GSE’s. And the mortgages, once written, are often bought by GSE’s; they then receive the payments as their income to finance their operations, including making new loans.
And what’s a GSE? That’s short for Government Sponsored Enterprise. Basically, there is no private entity doing some thing (usually because it is a dumb idea that won’t make money). So the government creates/sponsors one. These then operate sorta’ like private corporations. Except: 1) they’re located in D.C. and report primarily to politicians and bureaucrats, and 2) if they go bankrupt it’s seen as something that must be prevented at all costs, so those politicians pony up tax revenues to keep them running. There are lots of GSE’s in the U.S., and in other countries too.
In the U.S., the big GSE’s involved in housing are the FHA (Federal Housing Administration, this one is actually part of the government), Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corporation), and Ginnie Mae (Government National Mortgage Association).
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N.B.
It is an urban myth that real estate is always good investment. That’s why they needed to create GSE’s: they wanted to jump start a type of investment that markets deemed unwise for most people.
The sense in which contemporary real estate purchases are a “good investment” is that you are allowed to make the purchase mostly with borrowed money, and the protections for the buyer if the investment goes bad are stronger than with other investments.
Basically, it’s heads you win, tails someone else loses … set up with an investment that is mediocre. That creates a moral hazard.
Financially, it also makes home purchases like buying a call option, with the attendant agency problems.
Here’s the thing (or two things). Our mythology of America is that the Great Depression was caused, in part, by people buying stocks with borrowed money. So Congress’ solution to that was to make that hard to do, but make it easy for people to buy houses the same way. Duh! And, most people are told to shy away from buying options, and yet they’re encouraged to buy homes as options without telling them that they now have an option. Double-duh!
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D.C. likes to tell us that reforms instituted after 2008 (including Dodd-Frank) cleaned up this mess.
Most economists do not find this credible. While Dodd-Frank did many things, it did not address the fundamental problem: there’s moral hazard involved in borrowing someone else’s money to buy a home. Further, homes are probably the last asset you’d like people to buy with borrowed money: they’re not very liquid, and you can’t shop them around to different locations in the hopes of finding buyers willing to pay more for them.
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All of this is a lead up to an informative blog post by Kevin Villani at Chicago Boyz. It turns out that Villani has way more expertise on this than most people. Here’s his bio:
Kevin Villani, chief economist of HUD during the Carter and Reagan Administrations and Freddie Mac from 1982 to 1985, is the author of Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.
Here’s the history of these GSE’s, in a nutshell:
U.S. secondary markets evolved entirely in response to anachronistic political forces. FHA was created in 1936 to stimulate new construction jobs [not a bad idea during the Great Depression] subsequent to a huge housing construction boom [it worked]. Fannie Mae was created two years later to prop up flagging demand for FHA mortgages [investors didn’t have money for mortgages before, and they didn’t still when FHA marketed more of them]. Ginnie Mae was created in 1968 to liquidate Fannie Mae after prior privatization attempts failed … Rather than liquidate, the privatized Fannie turned to funding conventional mortgages for their mortgage banker clients. To protect their turf, portfolio lending savings and loans [S&L’s were a different type of bank, also created by legislation during the Great Depression, which have largely ceased to exist, except in name, when many of them crashed in the financial crisis of the late 1980’s] then demanded their own secondary market facility, Freddie Mac. It later privatized mainly to provide management incentives comparable to Fannie, particularly stock options.
They then morphed into massive public directed credit institutions, with profits from government subsidies privatized but otherwise lacking the benefits of market efficiency and discipline. About half of F&F subsidies were captured by shareholders, managers and politicians (my estimates) … [Bracketed comments are from me. Parenthetical comments are the authors].
Many presidential candidates, and much of Congress is interested in further reforms. Villani points out what we’ve learned so far:
- Private markets operate on one set of incentives and accountability, government on an entirely different set. Each has its problems and imperfect solutions.
- Private markets may inappropriately discriminate against qualified borrowers, for example, whereas public programs may fail to adequately discriminate.
- Public enterprises created to jump-start or complement private markets often miss the mark, with unintended consequences.
- Politicians much prefer to deliver subsidies through taxes (in this case tax exempt debt substituting for taxable equity) rather than expenditures – especially since the Budget Control Act of 1974 – and implicit off-budget credit guarantees that delay the reckoning.
- In spite of good intentions and design to get the best of both, privatized hybrid public-private systems inevitably embody the worst: public risk for private profit. Lacking both market and public discipline, they cause systemic failure that “nobody could have seen coming.”
- Political reform reflexively blames private market failure, doubling down on unaccountable and ineffective bureaucratic methods while providing opaque bailouts through greater tax and credit subsidies.
- Political reform starts with what is, not what should be, repeating the cycle.
Read the whole thing. Highly recommended.
Anyway, d’ya think mortgage finance is a big enough issue to be covered in macroeconomics classes? Yep.
And, it’s common for people to make the claim “no one told us this could happen”, but I can attest that the moral hazards of GSE’s in the housing market has been part of my macro classes for 30ish years.
Oh … and … student loans are financed the same way (through, you guessed it, Sallie Mae). Just sayin’ …
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