Free Our Markets

by Howard Baetjer Jr

  But what if interest rates are high, say, 6.5 percent? That would mean that investable resources are significantly less abundant relative to borrower/spenders’ desire for funds. Perhaps saver/lenders have not been willing to save as much, or perhaps available funds are being bid away for projects that promise to generate a return of over 6.5 percent. Either way, the higher interest rate signals that there are insufficient investable resources with which to complete all three projects. In that case, you would offer a loan only to the restaurateur, and only she would be willing to accept it, because only the refurbishment of the pizzeria is expected to create enough value (for its patrons, in this case) to cover the $6,500 annual interest on the loan. The house purchase and the tractor purchase, which would create less value, are screened out by the higher interest rate. Interest rates provide the price signals used in the profit-and-loss calculations made by you and your would-be borrowers. With those calculations, you and they discover where your loanable funds should go.

  And so it is in all the lending and borrowing that occur in a free economy. In the manner illustrated here, repeated countless times daily all around the world, in an immense, uncontrollable, imperfect, but marvelous and indispensable process, the people of society continually discover what quantity of investable resources is available at any point and what projects deserve to get some of those resources. The order that spontaneously emerges is well-coordinated over time. Saver/lenders, intermediaries, and borrower/spenders alike all frequently make mistakes, of course—in an uncertain world it is never clear ahead of time which projects will succeed or which intermediaries will identify the winners most of the time. But losses persuade us to give up on the mistakes, and profits and interest earned encourage us to pursue the successes. Borrower/spenders go bust when their projects ultimately do not create enough new customer value to cover their costs. Saver/lenders and intermediaries who make bad loans make losses on them, and go bust if they make too many for too long. Interest rates and profit-and-loss feedback keep us mostly on the right track.

  This completes our simple sketch of how house buying is financed, including just the major private-sector elements consistent with a free market and leaving out the government interventions we’ll describe below. To summarize, saver/lenders lend to house-buyers through intermediaries, mainly commercial banks, that turn their depositors’ money into mortgage loans. The mortgages are often sold to non-depository financial institutions such as investment banks. The investment banks can retain ownership of the mortgages, paying for them with money they have received from large institutional investors to whom they have sold bonds. Alternatively, the investment banks can pool large numbers of the mortgages into mortgage-backed securities (MBSs) and sell shares of those MBSs to the large institutional investors. To the extent that there is a ready market for mortgages to be bundled into MBSs, mortgage originators arise that originate mortgages and immediately sell them to investment banks and others that create and sell MBSs. A huge variety of possible projects compete with housing for investable resources, and market interest rates allocate those resources to whatever projects are expected to serve people’s well-being best by creating the most value for them.

  Now a very important point for understanding the housing boom and bust: In this process in a free market, how many mortgages are made, of what kinds, and at what interest rates, would be determined as part of a much larger process that determines how many of all different kinds of investments are made. Housing would receive no special treatment. Banks don’t care whether they lend a given amount to a house buyer, farmer, or restaurateur; they care about getting paid back with interest. Big institutional investors similarly don’t care whether they lend for housing, hospitals, or runways; they care that the bonds they buy (mortgage-backed or otherwise) pay off. In a free market, therefore, all the different projects in all the different sectors of the economy would compete for loans on an equal basis; again, housing would receive no special treatment.

  Likewise, in a free market, no bank would be granted a special monopoly on some aspect of banking. And all banks would be free to decide what kinds and sizes of loans to make in each category.

  Also in a free market, saver/lenders would receive no special protections of their investments, whether deposits or bond purchases.

  As we will see in the chapters to follow, in our actual, only partly-free market, housing did receive special treatment of various kinds; one bank did have a crucial monopoly over one part of banking; all other banks were restricted in the kinds of loans they could make; and certain saver/lenders did receive special protection of their investments.

  What were the consequences of these interventions, which interfered with price coordination, blocked profit-and-loss feedback, and distorted incentives? They were not pretty, as we shall see next.

  Chapter Nine

  Boom, Bust, and Turmoil

  An unsustainable housing boom started around 1997. The ruinous housing bust that followed it in 2007 set off the wrenching financial turmoil of 2008 and began the Great Recession. Before we investigate why it all happened, here is an overview of what happened.

  The Housing Boom and Bust

  The housing boom began around 1997, when house prices began a remarkable rise. People increasingly, if foolishly, came to believe that housing prices would always rise. For a whole decade they did rise, and much faster than consumer prices in general. The run-up in housing prices—as in previous bubbles in tulips, tech stocks, and real estate—fed itself. Many people who otherwise would have been content to rent sought to buy a house instead. Speculators, seeing the above-normal increases in prices and profits, got into the action. People with little or no experience in buying and selling real estate got flipping fever. Johan Norberg captures the fever for flipping houses in his very useful book, Financial Fiasco:

  On June 23, 2005, the TLC television network first aired a reality series called Property Ladder, where viewers get to follow a person or group who has the idea of buying a home, fixing it up, and then trying to sell it for more. Three weeks later, the Discovery Home Channel launched Flip That House, which is about someone who has just bought a house, often in southern California, and does what it takes to sell it quickly at a good profit. And 10 days after that, on July 24, 2005, the A&E Network premiered a new TV series with a not entirely dissimilar name, Flip This House, whose subject is a company based in Charleston, South Carolina, that is in the business of buying, fixing, and selling.

  As more of these new investors sought to buy houses in the expectation that housing prices would increase, they bid up the prices of housing further and thereby fulfilled their own prophecy. As shown in Figure 9.1, for a quarter century leading up to 1997, housing prices had risen at about the same rate as overall inflation; the price of a home had been about three and a half times the household income of the home owner. Not so between 1997 and 2007. Throughout that decade (shaded in Figure 9.1) housing prices consistently rose faster than inflation on a consistent basis. They climbed far above their normal range of about three and a half times average household income; by 2007, on average, the price of a house was over five times the household income of the home owner.

  Figure 9.1 Housing Prices Rose Faster than Consumer Prices

  But then, in 2007, prices leveled out and began to fall, and the whole process of price changes and expectations went into reverse. That was the bust; as of this writing in 2013 the housing market has still not recovered.

  As home prices increased between 1997 and 2007, the rate of home ownership also rose, to higher levels than ever before. Indeed, such increases were the goal of government policies; and as we’ll see below, those policies were fueling the boom. From the 1960s to 1998, the rate of homeownership in the U.S. had fluctuated between 63 and 66 percent. But in 2000, it rose above 66 percent for the first time, on its way to 69 percent in 2007. The bust erased that increase; by April of 2012, the homeownership rate was back down to 65.4 percent, where it had stood in t
he spring of 1997.

  Helping to finance all this new housing was a great deal of mortgage lending and a dramatic increase in the number of loans that did not meet traditional standards of soundness. Figure 9.2 illustrates the trends. The proportion of risky loans originated increased from 14% in 2001 to 50% in 2006.

  In 2006, more money—more than an additional trillion dollars—was loaned in overtly shaky subprime and Alt-A mortgages than in sound, conventional prime mortgages. In 2008, after the bust, far fewer home loans were made and lenders returned to traditional standards of soundness.

  During the boom, one of the most important ways in which traditional standards were eroded was by allowing house buyers to take out a loan without making a substantial down payment. While twenty percent down used to be the standard, loans were made to borrowers who put only ten percent, or three percent, or even zero percent down. The result for such loans was a high loan-to-value ratio; home buyers had little “skin in the game”—little actual ownership of the houses they bought. In hard times such borrowers, owning little, have an unhealthy incentive to “walk away”—default on their obligation to pay and let the bank take the house.

  Figure 9.2 Sound and Shaky Mortgages Originated in the Boom and Bust

  Along with making low to no down payments, many borrowers had taken out adjustable rate mortgages (ARMs) at low introductory rates, hoping to refinance later when the prices of the houses had risen. But as house prices began to fall in 2007 and to fall even faster in 2008 and 2009, they were unable to refinance. And when their adjustable interest rates reset to a higher level, many were simply unable to pay what they owed. Many were “under water”—they owed more on their loans than their houses were worth. Defaults on mortgage payments consequentially surged to levels never seen in America before, resulting, as shown in Figure 9.3, in an alarming increase in the rate of foreclosures.

  As more and more homeowners defaulted on their mortgages, the holders of mortgage-backed securities containing those mortgages saw their income streams and the value of their investments shrink rapidly. And this takes us to the financial crisis because, strangely, a very large portion of those mortgage-backed securities were owned by banks.

  Figure 9.3 Foreclosure Rates on Sound and Shaky Mortgages

  The Spillover from Housing to Financial Institutions

  The housing bust was not confined to housing. A crucial aspect of the financial troubles of 2008 and thereafter is that the big problems in the housing sector of the economy got transmitted to the financial sector and from there to the rest of the economy. That did not have to be. After the bursting of the dot-com stock bubble in 2000, a bust that wiped out trillions of dollars’ worth of stock value, there was no financial turmoil; banks and banking continued unruffled.

  This time, however, for reasons we’ll investigate, many banks and other financial institutions had invested a tremendous amount in mortgage-backed securities (MBSs), so that when people came to suspect that those securities were worth much less than had been believed, the banks’ financial security and ability to lend was badly hurt. Furthermore, because of the complexity of the MBSs and other securities derived from them, it was difficult to tell who owned a lot of “toxic” mortgage-backed securities that contained the failing mortgages. For this reason, too, financial institutions

  hesitated to lend to one another, worrying that if they did, they might not get paid back.

  Losses in the financial sector were gigantic. Many banks around the country failed. The famous Wall Street firm Lehman Brothers failed entirely. Bear Stearns and Merrill Lynch survived by marrying themselves off hurriedly to others. As shown in Figure 9.4, bank stocks plummeted, losing on average 83 percent of their value between May, 2007, and February, 2009 (shaded area in Figure 9.4).

  Figure 9.4 Average Bank Stock Value

  Surviving banks grew cautious, hoarded cash and cut lending, so the normal flows of credit in the economy dried up. Companies that had never missed a loan payment found they could not get financing for shipments of materials or for upgrading their equipment; shops couldn’t finance routine renovations; start-ups couldn’t get seed money. So orders for materials and equipment dropped off; renovators were idled; new businesses did not open up; hiring sputtered; unemployment turned upward toward heights not seen in decades, as shown in Figure 9.5. Thus the problems in the financial services industry spilled over into the rest of the economy. The Financial Crisis and the Great Recession of 2008 had begun.

  Figure 9.5 Unemployment Rate in the U.S.

  What Was Really Lost in the Housing Boom and Bust

  Before we look in detail at the causes of the whole mess, let us focus a moment on what, fundamentally, went wrong in the home mortgage boom and bust. What is the core problem reflected in all the gory statistics of prices soaring and plunging, foreclosures, delinquencies, bankruptcies, and the rest? What is the problem society got into?

  The problem is that scarce, precious resources were not flowing to the different parts of the economy in appropriate proportions. The signaling system of market prices and profit-and-loss feedback that society needs to maintain good coordination got fouled up. Too many resources went into producing two-by-fours, PVC pipe, siding, wiring, and insulation for housing. Too much human talent went into architecture, carpentry, plumbing, roofing, and bricklaying for housing. Too much of the time of bankers, mortgage brokers, and investment bankers went into financing for housing.

  Scarce resources were wasted there. They would have created far more value for people in other types of projects, in other pursuits.

  What caused this massive discoordination? As the chapters to follow will explain, all those resources were misdirected because the market process was not permitted to guide them aright. Government intervention into the economy, well-intentioned perhaps, but wrong-headed for sure, fouled up prices—housing prices and interest rates especially—and distorted the profit-and-loss feedback that would have produced well-balanced, sustainable investments across the economy. There were market prices on all these resources, of course, but they were not free market prices; they were hampered market prices distorted by special tax treatment, subsidies, money creation, government guarantees, and banking regulations. Therefore the profit-and-loss calculations and feedback based on these prices could not tell entrepreneurs which projects promised to create the most value.

  We turn now to seven main interventions by government that combined to cause the housing boom and bust and trigger the financial crisis that followed.

  Chapter Ten

  Why Housing Boomed

  What caused the housing boom? There was a lot of money in the economy to be invested (for reasons we’ll examine in the next chapter). But why did that money go into housing, rather than tech stocks, or commodities, or tulips? Three main government interventions into the economy provide the answer: special tax treatment of housing, government guarantees of the debts of the “government-sponsored enterprises” (GSEs) Fannie Mae and Freddie Mac, and the so-called “affordable housing” policies, which both Republicans and Democrats in Washington, D.C., supported.

  Intervention #1 - Special Tax Treatment for Housing

  The first culprit we’ll consider, though probably not one of the main causes of the housing boom and bust, may well have started the boom. The Taxpayer Relief Act of 1997 excludes from taxation capital gains on a personal residence, up to $250,000 for an individual or $500,000 for a couple, while leaving in place the twenty percent capital gains tax on all other investments. The measure diverts the flow of resources in the economy from higher value uses to lower value uses by fouling up profit-and-loss feedback to investors. It does so by artificially increasing the after-tax profitability of investments in housing relative to investments in everything else.

  In criticizing this special treatment of housing, I do not mean to oppose tax reductions as such! In a free society, taxes should be no greater than necessary to protect lives and property and to enforce contracts. The
capital gains tax should probably be eliminated altogether. Accordingly, exempting up to $250,000 or $500,000 in capital gains on any and all kinds of investment would be a step in the right direction. But the special treatment of gains on housing alone distorts markets badly.

  To understand why, consider a thought experiment: Suppose you, the reader, have a choice between two investment opportunities. The first is a pizzeria; you can buy it for $300,000, and you believe that if you invest another $100,000 in improvements, you’ll be able to resell for $600,000 and net a profit of $200,000. This profit would come in the form of a gain in the capital value of the business, a “capital gain.” The second opportunity is a house; you can buy it for the same $300,000, and you believe that if you invest the same $100,000 in improvements, you’ll be able to resell the house (“flip” it!) for $580,000, for a net profit (via capital gain) of $180,000. In the absence of any tax, which would you choose?

  Investment Opportunities

  Pizzeria

  House

  Expected future sale price

  $600,000

  $580,000

  Less purchase price + renovations

  $400,000

  $400,000

  Profit = Capital gain

  $200,000

  $180,000

  Certainly you would choose to invest in the pizzeria, because doing so would yield you $200,000 in profit (capital gain) as opposed to only $180,000 for the house. Significantly, this decision would be best for other people, too, if your projections are correct. That is because the $400,000 invested in the pizzeria would create at least $200,000 in new value for others, as judged by the $600,000 price you expect the purchaser to pay for it. But the same $400,000 invested in the house would create only $180,000 in new value for others, as judged by the best price you expect a house purchaser to be willing to pay. Here is a simple instance of the Profit-and-Loss Guidance Principle at work.