Possible Insight

Financial Crisis Act I: Government Meddling

with 9 comments

Let me start by saying that the financial crisis is a very complex situation.  I read several economics blogs every day and quite a few academic papers every month.  My semi-professional opinion is that no economist even comes close to fully understanding the financial system, let alone the complete macroeconomy.  Luckily, I haven’t seen any of them delusional enough to assert that they do in a professional forum. So when you hear a talking head spouting off about the crisis, take what he says with a grain of salt (this includes me, of course). At best, he only sort of knows what he’s talking about.

Because of the complexity, I think we should be very careful to take baby steps.  Going off half-cocked is much more likely to make things worse than better.  I think we need to do three things.  First, we need to understand the underlying causes of the mortgage meltdown that kicked off the cascade (not because I think fixing the cause will solve the problem, but because it will help us avoid making things worse).  Second, we need to examine how the cascade was magnified so we can hopefully install some breaks going forward. Third, we need to agree on the outcomes we most want to prevent as a society (as individuals, I’m sure we all want to keep our houses, jobs, and savings).

One of my hot buttons is the narrative that the mortgage meltdown was caused by capitalism run amok. This… is… just… plain… wrong.  The root cause of the problem is the government f***ing around with the housing and mortgage markets.  This intervention caused a potential energy gradient on which capitalists at the aggressive end of the curve could feed. Don’t lay all the blame on the sharks when you go swimming off the Great Barrier Reef after slashing your arms and legs with a razor blade. The feeding frenzy was magnified by the risk structure of the resulting market, a structure that made it easy for some people to fool themselves and their overseers.  Not everyone, mind you, but selection pressure caused the organizations these people ran to grow larger than those lead by wiser heads. But we’ll get to the sharks in the next installment.

The government intervenes in the housing market per se in a number of ways.  The most obvious is that mortgage interest and property taxes are both deductible on your federal and most state returns.  As a homeowner, I obviously like this.  As a wannabe economist, I know this is a wealth transfer to homeowners and therefore artificially inflates the demand for home ownership. But the feds aren’t the only ones with a finger on the scales here.  State governments do their part.  For example, California has a whole department dedicated to planning for housing. In general, these types of planning restrictions actually reduce the supply of housing.  Moreover, we also have Proposition 13, which penalizes people for selling their houses because their property taxes then increase dramatically.

The net result is that, on average, the federal government stimulates demand and the state government restricts supply.  As everyone knows from basic econ, this drives up prices.  Then we have all the knock on wealth effects.  With rising prices, homes become an artificially attractive form of investment so people that would otherwise rent, choose home ownership and those that would already buy, choose larger homes.  As a result, the original distortions become magnified.  With population growth, demand and supply gradually get more and more out of whack, causing housing prices to spiral.

Of course, this upwards spiral can’t go on forever.  Eventually, home prices increase so much more than wages that fewer and fewer people can afford homes using the traditional 20% down 30-year fixed rate mortage. But don’t worry, the federal government already has a huge bureaucracy in place to support the mortgage market.  Just pull some levers and twist some dials.  Hallelujah!  Now people have accesss to more “affordable” mortgages.

The federal initiatives surrounding mortgages are truly staggering.  Fannie Mae and Freddie Mac guarantee half of the $12T mortgages in the US. But those guarantees aren’t (or weren’t) full government guarantees. So don’t forget Ginnie Mae, which specifically promotes affordable housing with a full government guarantee. Since it’s inception in 1968, it has guaranteed the mortgage backed securities (MBS) for over $2.6T of loans to low and moderate income borrowers. In fact, I would argue that Ginnie was the seed around which the market for MBSs crystallized. Without someone offloading the risk from the least attractive mortgages, trading in MBSs would have been much less attractive. Then there’s the FHA, which insures 4.8M single family mortgages. Together, legislation and regulation aimed at these institutions effectively controls the requirements to obtain a mortgage in the US. Yes, individual banks can loan on different terms, but if they do, they’ll never be able to sell those mortgages to anyone else.  So they mostly fall in line.

Now we reach the climax of Act I. As home prices escalated, fewer people could afford homes. They saw this as a loss of status and became restive. The political response is covered quite well in this Washington Post article, but I will sum up. The politicians started to pull levers and twist dials. First, just a little adjustment. In 1995, the Department of Housing and Urban Development (HUD), gave Fannie and Freddie affordable housing tax credits for buying subprime MBSs. The combination of tax advantages and high fees proved irresistible.  They increased their purchase of subprime MBSs tenfold from 1995 to 2004. But that wasn’t enough. Bush had an election coming up so he increased the HUD’s affordable housing goal from 50% to 56%. HUD relaxed its oversight of Fannie and Freddie and they got tax credits for loans that would have been deemed “contrary to good lending practices.”

From a complex systems standpoint, we’d really like there to be either negative feedback or redundancy to blunt the impact of this initial problem. As we’ll see in the next episode, we unfortunately had positive feedback. But there’s already a question you can answer for yourself. Do you think any legislation package aimed at addressing the crisis should increase or decrease the government’s involvement in housing and mortage markets?


Written by Kevin

October 1, 2008 at 5:23 pm

9 Responses

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  1. I am curious as to why mortgage backed securities are a good thing in the first place. Or any type of derivative on illiquid assets, especially ones that individuals are not prepared to treat as pure investments such as their homes. Yes derivatives grease the wheels of the market and provide ersatz liquidity where there may be none, however they increase volatility and create lever points for cascades like the current situation. Perhaps we should be asking whether leverage on family homes is something that society can do without, and what stability benefits might result from such a “backwards” move.


    October 2, 2008 at 5:24 pm

  2. BTW, Michael Shermer was part of an interesting debate that is somewhat relevant here:


    While I normally think Shermer’s stuff is right on, I found myself agreeing with his opponent on just about everything and thought that Shermer was showing himself to be an ideologue in a way that I’ve never seen from him before. His application of evolutionary and sociological theory and studies seem like long, trite stretches of logic and unsophisticated. I guess some people are better at detecting BS than slinging their own 🙂


    October 2, 2008 at 5:33 pm

  3. Re MBSs in general, Arnold Kling thinks you’re on to something:


    The problem is that derivatives on illiquid assets tend to make risks opaque, which is bad. So you need to couple them with well guaranteed insurance. This is what the FHA does for low-income borrowers–where the marginal decrease in interest rate from improved liquidity does the most “good”.

    As Taleb notes, in areas of high uncertainty, you want redundancy. So I would say that, except for FHA insured mortgages, we should have high down payments, limit trading in MBSs, and have high capital requirements for the trading we allow.


    October 2, 2008 at 6:19 pm

  4. […] Act I, we saw how government meddling overheated the housing and mortgage markets. Now we’ll see […]

  5. […] 15, 2008 by kevindick As we saw in Act I and Act II, the current financial crisis was enabled by government interference in the housing and […]

  6. […] 31, 2008 by kevindick If you’ve been following my posts on the financial crisis (here, here, and here) and Singularity Summit (there, there, and there), you might wonder, “Uh, but […]

  7. […] Act I, we saw how government meddling overheated the housing and mortgage markets. Now we’ll see […]

  8. […] we saw in Act I and Act II, the current financial crisis was enabled by government interference in the housing and […]

  9. […] 05/08/2009: see here] If you’ve been following my posts on the financial crisis (here, here, and here) and Singularity Summit (there, there, and there), you might wonder, “Uh, but […]

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