The housing crisis explained: It’s a failure of the free market
UPDATE (Oct. 1st): I’ve provided an even more detailed explanation, and updated my information, here.
I’ve been having a tiff with David Strom of the MN Free Market Institute over his incendiary comments about the current housing crisis. On Friday, MnPublius and I complained about Strom’s comments that anti-redlining laws were responsible for the state of our housing market. After Zack and I complained, Strom tried to clarify:
What I said was that anti-redlining laws had created a situation that forced banks to PROVE that they weren’t redlining….Perhaps, just perhaps those risky loans were made to ensure that the lender wouldn’t face penalties for “redlining” an area that was actually filled with risky loan applicants who might not be able to make the payments on those loans? Or is it just a coincidence? (longer quote after the break)
Sorry, David, but you’re way off the mark. It’s ironic to me that someone who’s dedicated his career to defending free markets is so misinformed about how the market works. So I thought I’d explain. The housing crisis is basically a combination of two factors — the selling of mortgages to third-party investors combined with the normal cyclical nature of the housing market. The two of these combined to create a housing bubble; they also combined to make the collapse of the bubble particularly painful.
Ultimately, the housing crisis is a failure of the free market. Market failures are a common occurrence; you’ll find a discussion about market failures in any introductory microeconomics course. The free market is great when it works properly, but market failures are one of the reasons why we need government regulation — something which Strom has railed against for years.
[After the break: a detailed explanation of the housing crisis, and why Strom's arguments are completely backwards.]
The housing market, like the stock market or most any other type of market, is cyclical in nature. It has its ups and downs, but over the long run, there is almost always growth. About a year ago, the red-hot housing market hit its peak. Prices reached the point where nobody wanted to buy anymore; as usual, when that happens, there is soon an oversupply of housing, and home prices begin to decrease. This is pretty normal, and it can be painful for those who bought at the peak, but it is typically not catastrophic.
So why was this downturn in the housing market such a problem? This time, Wall Street found a way to make a lot of money off of mortgages. An insatiable appetite for greater and greater returns led to riskier and riskier loans, until eventually the entire system collapsed. Here’s an overview of what happened, and how the coincidence with the market downturn created the “perfect storm” that plunged us into a recession.
In a process called securitization, mortgages were bundled together into Mortgage-Backed Securities (MBS). Essentially, banks sold the mortgages they held to third parties, and the resulting bundles of mortgages formed something resembling a mutual fund or bond. MBS earned an interest rate that was tied to the rates of the mortgages in the security. The fact that each security was a bundle of thousands of loans reduced the risk of the occasional foreclosure. (For more on securitization, see this short explanation from the Chicago Fed) (PDF link)
Early in the decade, a record percentage of Americans were homeowners, but it looked like we were reaching a peak in the number of people who could comfortably own. Around the same time, the demand for MBS was growing rapidly, and the market was looking for methods of gaining greater returns from these securities. The “answer” to both of these problems was the subprime loan. Subprime loans made it easier for those with low incomes and/or bad credit to own a home. In exchange for the greater risk, they carried higher interest rates. Many were adjustable-rate mortgages or interest-only loans instead of fixed-rate mortgages. It seemed like a win-win situation: we’d have more homeowners, and Wall Street would see higher returns on mortgage-backed securities.
For a while, it worked great. The rise of MBS coincided with a period of appreciation for housing. Everybody was winning: both lower-income families and upper-income owners of MBS were building wealth hand over foot. And that is exactly the point at which the cyclical nature of the housing market ruined the party. The continuing success of subprime loans relied on constant appreciation of housing values; this allowed even subprime lenders to build equity, flip their houses, and/or refinance their loans into more affordable fixed-rate loans. But as we all know, the market is cyclical. Appreciation couldn’t go on forever, and it didn’t.
So what happened once housing values went down? Well, things fell apart. Without continued appreciation, subprime loan holders could no longer refinance into fixed rate loans; soon, their rates started adjusting upwards, and their mortgage rates soared beyond what they could afford. Foreclosures started increasing at a rapid pace, which in turn drove down housing prices throughout the country as the supply of housing increased. With subprime loans foreclosing at such a rapid rate, the rates of return on mortgage-backed securities also plummeted.
That brings us up to today, and back to Strom. Now that we understand how the housing crisis, we can evaluate his defense of his comments. On his blog, Strom attempted to explain his comment that anti-redlining laws were responsible for the housing crisis:
What I said was that anti-redlining laws had created a situation that forced banks to PROVE that they weren’t redlining, meaning that they would have to make risky loans in neighborhoods like mine that they otherwise wouldn’t on purely economic grounds. Talk to any banker and she will tell you that they lived in fear of accusations of redlining and made loans that they otherwise would not have to avoid that charge.
…
Perhaps, just perhaps those risky loans were made to ensure that the lender wouldn’t face penalties for “redlining” an area that was actually filled with risky loan applicants who might not be able to make the payments on those loans? Or is it just a coincidence?
Gosh, those darn liberals. They forced the banks to issue subprime loans! The banks were just so scared… they felt terrible about the tremendous profits they made off of mortgage-backed securities, but they didn’t have any other choice! Of course, subprime loans didn’t really take off until about 30 years after the Fair Housing Act of 1968, but I guess the banks are just slow on the uptake.
Strom’s argument just doesn’t match the reality of the situation. Subprime loans were a vehicle for Wall Street to increase the return of mortgage-backed securities, and for a few years, they were among the hottest investments available. That doesn’t sound like the behavior of a market under seige by government regulators. In fact, the opposite was the case: a lack of government regulation allowed giddy brokers to continue extending subprime loans to riskier and riskier candidates.
What does this mean for Strom’s argument? Well, it’s possible that he’s not a bigot, just misinformed. The fact remains, though, that anti-redlining laws were good for our country and for our economy. Redlining was rarely based on sound economics; rather, it was based on the racist concept that black homeowners would bring down property values. Indeed, black applicants who were less financially risky often were turned down for loans that poor whites could be approved for. Anti-redlining laws simultaneously criminalized housing discrimination while expanding the number of potential homeowners in the US. They didn’t force banks to lend to risky borrowers — the banks thought of that idea all on their own.
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Policy | 
Jeff Rosenberg | August 11, 2008
By David Strom, August 11, 2008 @ 6:23 pm
Surprisingly, much of your explanation is actually pretty good.
There is no question that an element of the current crisis is a market failure. There certainly was a housing bubble, but you completely ignore a major element of that bubble: GSE’s.
GSE’s helped fuel the market bubble by creating the illusion that mortgage backed securities were unusually safe. You may or may not have noticed that Fannie Mae and Freddie Mac are going hat in hand to the government to bail them out.
GSEs were created not by advocates of the free market, but in fact by liberals who wanted to push home ownership rates far higher than market conditions would support.
Your conveniently ignoring the key role of GSEs, which by the way are FAR more leveraged than other non-government backed financial institutions, lets you put the failure completely on market conditions. Market conditions were artificially altered by MASSIVE government intervention through regulation and the existence and practices of GSEs.
Sorry to burst your bubble, but come on. Could you possibly have missed the whole Fannie Mae/Freddie Mac debacle? Or do you seriously claim that they are part of the free market?
By David Strom, August 11, 2008 @ 6:40 pm
One last thing: again, I want to reiterate a comment I made at the beginning of my response: much of your explanation is actually very good and spot on.
BUT your response to the failures of the market assumes a fact that not only is not in evidence, but is in fact debunked: that governments are better equipped than markets to prevent undesirable things from happening.
Let me give you an example, and one that should appeal to both of our moral sense: segregation and racial discrimination.
The preponderance of the harm done during the Jim Crow era to minorities was done by and through government. Not prevented by it. Not ignored by it.
Caused by it. Review the history. The Jim Crow era was characterized by Jim Crow LAWS, which were obviously imposed by governments.
Racial discrimination, which obviously pervaded all aspects of American society, was institutionalized through law. Whites who would otherwise have chosen to associate with or do regular business with blacks were prevented from doing so through laws.
The worst of racial discrimination was perpetrated through the interference with the free market, not because of it.
There are manifold examples of GOVERNMENT FAILURE which far exceed in consequence most of the failures of the free market.
It boggles my mind that somebody as obviously intelligent as you are could completely ignore the evidence throughout history that however often the market fails, the government almost always fails on a more massive scale and with worse consequences.
By Jeff Rosenberg, August 11, 2008 @ 10:33 pm
David,
Thanks for your comments. I don’t know enough about the housing market to write in detail about Fannie Mae or Freddie Mac. I do agree that GSEs (government-sponsored enterprises) are part of the problem, not part of the solution. I don’t believe that government should try to act like corporations, or vice versa. They each have their own place. Our government should limit its commercial enterprises, and corporations should not fulfill critical governmental roles such as defense. You’re not going to find me arguing for government for government’s sake.
As far as your examples of how the government always fails worse than the market, we could go tit-for-tat on these examples for months. Once again, I’m fully willing to admit that government has been complicit in some terrible things. Do you deny that the market has been as well?
By Herb, August 22, 2008 @ 6:03 pm
I’m coming into this in the middle, but are my eyes lying to me? Do I see a free market fundamentalist actually admitting that there’s such a thing as market failures?
Wow…
I used to argue with a libertarian extremist dude that I knew and we never got past the “free markets rule and you suck” phase.
I’m still a little confused why market forces are so celebrated in “free market” circles when government forces are vilified.
In the government, there’s at least the semblance of some kind of accountability to the interests of its people.
With market forces, the main motivating force is self-interest and there is little to no accountability at all.
That doesn’t sound like a very efficient way of doing things….
By Oisin, October 1, 2008 @ 8:13 am
Irish government guarantees all bank deposits
http://uk.reuters.com/article/hotStocksNews/idUKWLA044420080930