Monday, November 23, 2009

A Case Study of Government Interference in the Housing Market

Congress, the Fed, and both the Bush and Obama administrations all blamed the housing bubble and accompanying financial meltdown on failings in the free market and have called for more regulations and expanded lending facilities for the Fed to control the money supply. Is there any truth to the claim that it was a failing of capitalism? Was the mispricing of real estate really a free market caught in a frenzy, like the dot com bubble or the original tulip mania? The facts don't support that claim.
After the dot com bubble burst, money managers were sitting on loads of cash, looking for returns. Meanwhile, the Greenspan Fed kept interest rates artificially low for an extended period. With the low cost of capital, investments were made that would not have been if rates were higher. That's what happens when money is cheap. When it's market priced, investments compete with each other for capital. The winners get funding. In commercial real estate it worked this way. 1)Fund eyes property, say a downtown mixed use skyscraper, calculates expected returns based on projected rents and compares with cost of capital. The deal looks good. 2)They obtain financing from, say, J.P. Morgan. JPM makes money on the transaction... and wants to do it again and again so 3) they arrange to sell the debt obligation, freeing them to lend the same money again. 4) Rinse and repeat. They're allowed to do this because they've convinced regulators that if the loan is sold, it should not adversely affect capital requirements. Of course the buyer of the debt obligation only puts a fraction down with JPM financing the rest... for a fee, of course. As more money poored into commercial r.e., prices increased significantly relative to rents. That's inflation. This poor government regulation and monetary policy was going to lead to a bubble but at least it's damage would be contained to professionals. NOT. The private housing sector had another blender in the bowl to really whip up prices. The quasi governmental entity FNMA (Fannie) became the number 1 purchaser of mortgages in the secondary market. Lenders like Countrywide and WaMu were able to write many more mortgages than they would have without government interference in the market. They made bad mortgages and sold them to Fannie. The government also lowered loan requirements and forced banks to make loans in poorer neighborhoods. Housing prices shot up. Economically responsible people were either priced out of the market or compromised their principles and joined the game. The point is, these well intentioned progressive programs were essential to the bubble and did tremendous damage to the American poor and middle class in the long run. It wasn't Dems or Reps alone that did this. Neither one has made any effort to constrain the federal government's growth and influence in markets. When the federal government subsidizes an industry or behavior, capital flows into that industry leading to bad investments and inflation. The solution to the ensuing disaster is more government interference, currently socialism for the rich bankers at the expense of the rest of the country. If market forces had been allowed to determine the price of money (interest rates) instead of by Fed fiat, we would not have had the housing bubble and we would not be in recession.