Time machine? Sadly, no.

The news reported recently that Fannie Mae and Freddie Mac plan to offer programs to allow young home buyers to buy a home with as little as 3% down to make it easier to buy a home.

Hmm…I thought for sure this was a headline from 1995, but no. It’s from December 2014.

Do they not remember how this ended last time?

Why not start a program that teaches financially responsible behavior young home buyers can use to save up a sizable down payment so they can truly be homeowners and not just renters with a deed.

I know why. That doesn’t sound as good.

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A step in the right direction?

I’m open for opposing opinions, but at first blush the plan Obama outlined to change Fannie Mae and Freddie Mac seems like a step in the right direction.

Private investors take more of risk. Agree.

Fannie and Freddie lose the implicit guarantee of government. Agree.

While home ownership is good, affordable rental housing is also acceptable. Agree. Renting makes sense for a lot of folks.

Owning does too. You should have to prove you are responsible before owning, though. When people have a tough time getting a loan from a private investor to buy a home, those people should be encouraged to demonstrate responsible behavior.

The only part I had trouble with, so far, was that government would be secondary guarantor. That sounds like an explicit guarantee. Maybe I don’t understand that part.

But, again, a step in the right direction, no?

Could Obamacare be next?

In his speech outlining the plan, Obama quips that this plan will sound confusing for those that call Obama a socialist. For the record, I never thought he was a socialist. I just thought his view on the role of government was on par with public school sophomores. It’s not so much socialism, but the belief that solving problems can be easily accomplished by having government do something about it.

The invisible hand is not the free market

Many people say that the housing bubble was caused by a failure of the invisible hand.

When I encounter such folks, I like to make sure they understand what the invisible hand is.  Many believe invisible hand is synonymous with free market.

It’s not.

The invisible hand is how a free market produces socially desirable outcomes.  It is not the free market itself.

So, what is the invisible hand?

It’s the incentives we face when we make the trade-off decisions that we encounter each day and how we respond to those incentives.

Some of the trade-off decisions might be: Do I go to work?  Do I buy a cup of coffee?  Do I refinance my house?  We face many invisible incentives around each of these decisions.  How much work do I have?  How much vacation have I banked?  What am I going to do with my time off?  Is the coffee good? Is it far out of my way?  Will there be a long line? Is the new mortgage rate worth the closing costs?

Others face trade-off decisions too.  Investors hire business managers to generate good returns on their investments.  Business managers, to stay employed, have to decide how to grow sales.  Do we try a new product or open locations in new markets?

The incentives that help guide our decisions is the invisible hand.  It’s invisible because we can’t physically see incentives, but they’re there.

Adam Smith claimed that the incentives in the invisible hand tended to produce socially desirable outcomes in a free market with little government regulation because in a free market we choose when and how to interact with each other.

That choice to interact or not is the key to producing socially desirable outcomes.

Consider the cup of coffee that you bought this morning.  Did you force the coffee shop to sell it to you? No. Did the coffee shop force you to buy it? No.

You and the coffee shop owner both chose to trade because you both felt like you came out ahead by doing so.  You valued the cup of coffee more than the $2 it cost you.  The coffee shop owner valued the $2 more than the cup of coffee he sold you.

That’s called a voluntary, mutually beneficial trade.  Value was created on both sides of the transaction — for you and the coffee shop owner (though most people forget about the value created for the customer, they only see the ‘profit’ for the coffee shop owner).

Smith’s famous quote illustrates the value creation engine of the invisible hand incentives nicely:

It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest.

We choose to interact with the butcher for the very reason he chooses to interact with us:  self interest.  We both benefit from the interaction, otherwise we would pass it up.

When things don’t appear to produce a desirable outcome, we are quick to blame the invisible hand.  We say it failed.

But, we shouldn’t rush to judgement.  What really happened is that the incentives changed somehow so some people traded even when they did not benefit from doing so.

We should look to identify where this occurred, because that will tell us what went wrong.

Alan Greenspan, for one, told Congress that he overestimated the self-regulation of the free market.  (That self-regulation being that two parties of a transaction prudently seek to come out ahead.)

He was specifically referring to trades where investors bought mortgage-backed securities from banks.  Investors bought these for what would turn out to be much more than they were truly worth.  In fact, these investors had an insatiable appetite for mortgage-backed securities.  So much so, that banks created as much as possible by lending to just about anyone no matter their credit history and ability to pay.

But, Alan Greenspan was wrong.

He didn’t understand why investors bought this stuff.  He thought they were incorrectly overvaluing mortgage-backed securities based solely on the expected payback.  If that’s all investors were buying, Greenspan would have been right.

I doubt any of these investors would have lent money directly to many of the folks who they lent money to through the mortgage-backed securities.

So why did they did they lend money to them through the mortgage-backed securities?

Because politicians in government changed the incentives by signing up taxpayers as unwilling, and unknowing, co-signers.  The taxpayers are the folks that traded in this house of cards when it did not benefit them from doing so. 

As Russ Roberts points out in his 2010 white paper, Gambling With Other People’s Money, mortgage-backed security investors weren’t only lending to folks unlikely to repay.  They were lending to these folks with U.S. taxpayers as co-signers.

Think of it this way, a friend with a bad credit history asks you for a loan.  The payment your friend would need to repay the loan would be more than half of his income.  Do you lend him the money?

Judging the transaction solely on its merits — that is, your chances of receiving the loan  back — you’re not likely to lend him the money.

But, what if your friend’s rich Uncle Sam co-signs the loan?  If your friend stops paying, Uncle Sam will pay what’s owed.  Will you make this loan now?

More likely.  But now, you’re not judging the loan purely on the merits of your friend.  You are factoring in the value of the co-signer.  Having the co-signer changed the incentives for you.

Russ Roberts makes a good case in his paper that’s exactly what investors in mortgage-backed securities did — and they turned out to be right.  And, this is the piece of the incentive structure of subprime mortgage-backed securities that Alan Greenspan missed.

Critics of this argument say that there was no explicit guarantee from U.S. taxpayers.  Roberts argues that the pattern had been established with previous government bailouts.  And, I’d argue that politicians from both sides of the aisle were in such a fervor to “expand the dream of home ownership” that they had been sending strong signals that they wouldn’t let these investors go under (though I think they hoped it wouldn’t come to this).

So, it wasn’t the invisible hand of the free market that failed.  What caused the failure was the introduction into the incentive structure a forced trade with U.S. taxpayers in co-signing the loans of people who would not have been able to get a loan 20 years ago.

Now, I do think there were other factors that contributed.  There was an overconfidence in the ability of statistical models to somehow group bad credit risks in a way that lowered risk.  There was also the fever of rising housing prices, which caused more people to want to buy homes just to be able to sell them a few months or a year later at a higher price.

But, even these things really had the implicit guarantee of the U.S. taxpayer underlying them.  Without this guarantee, the demand for housing would not have increased as rapidly, driving up prices.  Without this guarantee, we may have been more skeptical of those sophisticated risk models.

As Roberts has stated, “Capitalism is a profit and loss system.  Profit encourages risk-taking and losses encourages prudence.”  Having the U.S. taxpayer as co-signer reduced the chance of loss and reduced prudence in just about every decision in the chain.

The invisible hand of government

Peter Wallison in the Wall Street Journal makes a good case that government intervention in housing for the well-intended encouragement of expanding home ownership distorted the housing market and helped cause its bubble.

Beginning in 1992, the government required Fannie Mae and Freddie Mac to direct a substantial portion of their mortgage financing to borrowers who were at or below the median income in their communities. The original legislative quota was 30%. But the Department of Housing and Urban Development was given authority to adjust it, and through the Bill Clinton and George W. Bush administrations HUD raised the quota to 50% by 2000 and 55% by 2007.

It is certainly possible to find prime borrowers among people with incomes below the median. But when more than half of the mortgages Fannie and Freddie were required to buy were required to have that characteristic, these two government-sponsored enterprises had to significantly reduce their underwriting standards.

Research by Edward Pinto, a former chief credit officer of Fannie Mae (now a colleague of mine at the American Enterprise Institute) has shown that 27 million loans—half of all mortgages in the U.S.—were subprime or otherwise weak by 2008. That is, the loans were made to borrowers with blemished credit, or were loans with no or low down payments, no documentation, or required only interest payments.

Of these, over 70% were held or guaranteed by Fannie and Freddie or some other government agency or government-regulated institution. Thus it is clear where the demand for these deficient mortgages came from.

The huge government investment in subprime mortgages achieved its purpose. Home ownership in the U.S. increased to 69% from 65% (where it had been for 30 years). But it also led to the biggest housing bubble in American history. This bubble, which lasted from 1997 to 2007, also created a huge private market for mortgage-backed securities (MBS) based on pools of subprime loans.

I’m glad to see this expressed in the pages of the Wall Street Journal.  Few people see this.  Many seem to want to think the housing bubble was simply greed run amok….a failure of capitalism.  The free market didn’t work.

Capitalism without losses is not capitalism

Economist Russ Roberts put forth the idea that the financial crisis was caused, in part, by moral hazard resulting from a history of taxpayer financed bank bailouts and the implicit taxpayer guarantees on mortgages that were manifested in  Fannie Mae and Freddie Mac.

Roberts’ white paper Gambling With Other People’s’ Money: How Perverted Incentives Caused the Financial Crisis was released last April.  This is from the Executive Summary of the white paper:

Over the last three decades, government policy has coddled creditors, reducing the risk they face from financing bad investments. Not surprisingly, this encouraged risky investments financed by borrowed money. The increasing use of debt mixed with housing policy, monetary policy, and tax policy crippled the housing market and the financial sector. Wall Street is not blameless in this debacle. It lobbied for the policy decisions that created the mess.

Roberts goes on to say that gambling with other people’s money is wrongly mistaken with capitalism and capitalism was then incorrectly blamed for the crisis.

I agree with Roberts, but I haven’t seen many who have shown outright support for his hypothesis.  It seems others believe the moral hazard link is tenuous at best.  However, now the Administration might agree, according to this Wall Street Journal editorial.  From the editorial:

The Administration puts the case for federal withdrawal from the broader housing market in compelling terms: “The strength of this option is that it would minimize distortions in capital allocation across sectors, reduce moral hazard in mortgage lending and drastically reduce direct taxpayer exposure to private lenders’ losses.”

I believe Roberts said it best when he said:

Capitalism is a profit and loss system.  Profits encourage risk-taking.  Losses encourage prudence.

If you reduce or limit the losses because you believe that helps someone (home buyers), you also reduce the prudence of the lenders and increase the risk-taking.  And you no longer have capitalism.