Unexpectedly Intriguing!
28 March 2013

It's easy to forget that it takes three components to make a fire: fuel, oxidizer and a spark. Typically, you only see two of the fire-making components coming together: fuel and the spark. But that's only because the oxidizer is already there, in the form of the invisible oxygen molecules that are in the air. Without it, you're not going to succeed in making a fire. But with it, not only can you make a fire, you can make a huge fire.

In this third installment of our series, we'll explore how oxidizer, in the form of the "environmental" factors of financial and governmental policies, contributed to the fire that was the first U.S. housing bubble.

The Impotent Fed

After consistently throwing fuel on the fire that was the first U.S. housing bubble during the first years of its existence, the Federal Reserve became increasingly concerned that the U.S. economy was becoming too overheated by June 2004, a year after it had lowered its benchmark Federal Funds Rate to what was then an all-time record low level.

The Fed's Open Market Committee then used every opportunity provided by its regular meeting schedule to jack up interest rates by quarter-point intervals over the next two years, with mortgage interest rates following suit.

But the rise in home prices that defined the inflation phase of the first U.S. housing bubble continued on unabated. Prices rose at the same rate they did before the June 2004 interest rate hike all the way through September 2005 before shifting to a slower upward trajectory.

U.S. Median New Home Sale Prices vs Median Household Income, 1999-2013, through February 2013

But the forces behind the bubble's upward inflation continued, until the bubble finally peaked in March 2007, as it plateaued near that level for the next several months before finally entering its deflation phase after November 2007, as the U.S. economy entered into recession.

But why was the Fed's policy of increasing interest rates to halt the inflation of the bubble economy so impotent? With homebuyers worldwide traditionally very sensitive to changes in mortgage interest rates, how could the bubble in U.S. home prices have continued for so long after the Fed began acting to correct the situation?

The answer to these questions may be found in the reaction of financial institutions and government policy makers to the prospect of slowing economic growth, who responded to the Fed's efforts by fanning its flames in opposition to the Fed's actions - feeding oxygen to what might otherwise have been a fading fire and making it burn more brightly instead.

Fanning the Flames

Recalling that the first U.S. housing bubble was initially sparked by investors looking for something to do with the money they took out from the stocks they sold during the deflation phase of the Dot Com Stock Market Bubble, we should note that a lot of that money entered the housing markets of the U.S. in the form of large cash down payments.

Not coincidentally, the kinds of mortgages that were taken out to fund home purchases in the initial phase of the housing bubble were conventional mortgages, which really benefited from the Fed's low interest rate policy.

But as time progressed and interest rates began to rise again in 2004, those mortgages became more expensive. Along with the increase in home values that were taking place, the combination of rising rates and rising prices should have cooled the market.

But financial institutions, both private (PLS) and government-supported enterprises (GSE), enjoying the outsize profits they were making on their real estate loans fought back against the Fed's actions by funneling home buyers into adjustable rate mortgages (ARM) instead of fixed rate mortgages (FRM), which offered lower introductory interest rates, and which lowered the initial costs of buying a home.

FHFA Composition of Mortgages

Soon, even that change wasn't enough to continue the flow of profits, and more aggressive financial institutions began degrading their mortgage underwriting standards to fan the flames of the bubble. Subprime loans were increasingly pushed to bring individuals who would not otherwise qualify for a mortgage into homes they couldn't otherwise afford. Ultimately, outright fraud became a common practice in the form of "liar loans" and the "robosigning" of mortgage documents.

But how did that come to happen? And where was the government in all this?

As it turns out, many of these actions were actually enabled years earlier by seemingly well-intentioned government policies, and pushed by seemingly well-meaning politicians and regulators.

Enabled in Washington D.C.

What happens when powerful politicians use the power of their offices to sway regulators to push policies that promote home ownership, no matter the cost?

It's a tenet of economics to observe that people respond to incentives. And if those incentives come in the form of political and regulatory pressure to comply with a well-meaning politician's goal, or the goals of their major campaign contributors, then something is going to happen, especially if it puts money in certain people's pockets.

Unfortunately, we often only find out that particular dynamic after charges have been filed. Often years after the fact:

Washington, D.C., Dec. 16, 2011 — The Securities and Exchange Commission today charged six former top executives of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) with securities fraud, alleging they knew and approved of misleading statements claiming the companies had minimal holdings of higher-risk mortgage loans, including subprime loans.

Russ Roberts offers a perspective of the government's role in the years leading up to and through the inflation phase of the first U.S. housing bubble:

The SEC suit against former execs of Fannie and Freddie appears to vindicate the Pinto/Wallison view that government housing policy pushed Fannie and Freddie into unsafe loans and caused the financial crisis.

I think Pinto and Wallison are half right. Fannie and Freddie did help cause the financial crisis. But not in the way Pinto and Wallison claim and not without a lot of help from the investment banks. Fannie and Freddie helped push up the demand for housing between 1995 and 2003. During that time, they expanded their activities, particularly among low-income borrowers. They started making loans with low down payments. This was not a secret by the way. Fannie Mae’s CEO, Franklin Raines bragged about it in 2000. Josh Rosner wrote about it in 2001. All of that activity drove up housing prices. That in turn, made it imaginable to lend to people who normally would not qualify for a mortgage and to lend them money without very much or any down payment. That in turn made the financial alchemy of AAA-rated mortgage-backed securities (MBS) possible. So yes, Fannie and Freddie had something to do with the crisis.

This aspect of the government's involvement in enabling the housing bubble helps explain why so many minority and low-income earning individuals found themselves badly burned when the housing bubble finally entered into its deflation phase after November 2007 - they were the intended beneficiaries of the policies the government had established in the 1990s to help them become home owners. As things played out, they became the hardest hit victims of the degradation of underwriting standards championed for them by U.S. politicians, as many were financially incapable of sustaining the payments on the houses they bought when the economy turned downward.

But that's not the full scope of the damage. Roberts goes on to identify the "too-big-to-fail" moral hazard aspect of the government's involvement in backing the risks being taken by the U.S. investment banks and Government Supported Enterprises (GSEs) like Fannie Mae and Freddie Mac and how that directly led to the financial crisis in 2008:

To really explain the housing boom and bust followed by the financial crisis, you need an explanation of why Fannie and Freddie AND the investment banks were so reckless. The Pinto/Wallison explanation is that Fannie and Freddie were reckless because the government made them do it. The left’s explanation is that the investment banks were reckless because the govnernment let them do it. Both left and right ignore the role of the other part of the market. But more importantly, both the left and the right leave unexplained how the reckless risktakers–the GSE’s and the investment banks–were able to do it–how they all were able to borrow money at relatively low rates despite ridiculous levels of leverage. How were they able to borrow all that money at so low rates when leverage meant high risk for the lenders?

My answer is that they were all GSE’s, all government sponsored enterprises–Fannie and Freddie and Bear and Citi and Goldman and Lehman and on and on. They all had an implicit guarantee from the government that allowed them to borrow at low rates (often from each other), rates that were well below market because of the implicit guarantee. And they were able to borrow at low rates even though they were highly leveraged which made them vulnerable to defaulting on their debt. Despite that vulnerability, they were still able to borrow at low rates. When things fell apart, almost all the creditors, lenders, and bondholders got all their money back, 100 cents on the dollar. The only exception was Lehman. The rest were all taken care of despite funding really bad bets.

For institutions like these, it must be nice to have Uncle Sam either backing or directing your every ill-advised move.

From Bubble to Bonfire

We find then that the steady degradation of underwriting standards, often prompted by legislation or by political pressure placed upon financial institutions during the late 1990s and early 2000s, that enabled the first U.S. housing bubble to become as large as it did by supplying the oxygen that fanned the flames of the bubble when it might otherwise have died out. We can see this in the growing number of sub-prime loans, as well as outright "liar loans" made increasingly throughout the bubble's inflation phase. That Fannie, Freddie, Bear, Citi, Goldmann, Lehman, etc. were all behaving as if they could reliably expect a bailout from the taxpayers no matter what only contributed to that environment.

The fuel for the U.S. housing bubble was the interest rate policies of the Federal Reserve, which held interest rates well below where the market would have otherwise set them, and especially so in 2003 and 2004, following the terrorist attacks of September 11, 2001 and subsequent recession. The inflation phase of the housing bubble didn't begin to decelerate until the Fed began pushing up U.S. interest rates to where they should have been all along in 2005 and 2006, as defined by the Taylor Rule.

But the spark that ignited the fire was the bursting of the Dot-Com stock market bubble, which began after August 2000, as the outflow of funds from that event provided a good portion of the money that helped push up real estate prices at a time the U.S. was entering into recession, breaking the established relationship between housing prices and household incomes. That factor, combined with the development and expansion of low-and-no money down mortgage products, as well as relaxed underwriting standards, was sufficient to counteract what typically happens in a recession, when housing prices fall in lockstep with falling household incomes and to cause it to grow beyond anyone's imagination.

And thus the bonfire that became the first U.S. housing bubble was formed. All it took was fuel, oxidizer and a spark.


Sharp-eyed readers will note that we've modified our chart detailing the relationship between median U.S. new home sale prices and median household incomes since we debuted this series two days ago!

Incorporating just released data for February 2013 into it, we can make a pretty good, but only preliminary argument that the recent run-up in home prices since July 2012 only inflated at rates consistent with the inflation of the first U.S. housing bubble through December 2012. We'll be able to confirm if that's indeed the case with just two to three more months of data. (We don't cite Keynes often, but we find this alleged quote applies.)

If that is the case, what we saw from July 2012 through December 2012 is more consistent with the shift in home prices that occurred following the enactment of the Tax Reform Act of 1986. Here though, we suspect we'll find the fingerprints of the reaction to the risk of higher taxes related to the fiscal cliff crisis at the end of December 2012, which we'll take on in upcoming posts.

Previously on Political Calculations

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