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Crisis of a House Inflated

Friday, July 24, 2009

Nick Schulz interviews Thomas Sowell about the housing boom and bust—and who deserves the blame.

Thomas Sowell is the Rose and Milton Friedman Senior Fellow on Public Policy at the Hoover Institution at Stanford University. He writes frequently on economics, history, social policy, ethnicity, and the history of ideas. He is the author of several acclaimed books, including A Conflict of Visions: Ideological Origins of Political Struggles. editor Nick Schulz interviewed Sowell about his latest book, The Housing Boom and Bust, in which Sowell examines some of the underappreciated aspects of the housing bubble and its aftermath.

Nick Schulz: What role did land use restrictions play in the housing boom?

Thomas Sowell: Severe land-use restrictions in particular localities around the country—coastal California being the largest and one of the most extreme—created an artificial shortage of housing that led to skyrocketing housing prices which, in a number of places, took half of a family’s income to make monthly mortgage payments or to pay rent for an apartment. These places provided the extreme examples which allowed politicians and the media to depict a national housing “crisis” requiring a national program by the federal government. In reality, however, housing in most of the country took a smaller share of family income than it had before the “affordable housing” campaign got under way. Housing prices in the atypical enclaves with severe building restrictions were some multiple of the national average, even when the houses themselves were smaller than the national average and were often on smaller lots as well, especially in San Francisco. In short, the federal government set out to “solve” a national problem which did not exist and in the end created a national and even international financial problem whose existence is as undeniable as it is painful.
NS: You write: "Government officials were in fact the driving force behind the loosening of mortgage loan requirements." How so?

The biggest popular misconception about the housing boom and bust is that it was due to a lack of regulation.

TS: Because banks are regulated by various federal agencies, and need permission from federal regulators to make business decisions that other businesses make without requiring the federal government’s permission, federal regulators have been able to force banks to change the mixture of people to whom they make mortgage loans, to conform to the government’s conception of which part of the population is “underserved,” such as low-income people, ethnic minorities, or residents of neighborhoods where lenders have been reluctant to make real estate loans because of conditions in the surrounding community. The Community Reinvestment Act of 1977 provided the underlying rationale for such government intervention but it was not a major force until the 1990s, when highly publicized statistical differences between black and white mortgage loan approval rates created demands for more active interventions, which quickly spread from issues of race to broader issues of “underserved” groups in general and mandatory statistical reports on the makeup of those approved for mortgage loans. Only banks receiving a satisfactory rating on their responsibilities under the Community Reinvestment Act were now allowed to engage in the new and wider range of banking operations that competing banks were engaging in. In addition, the purchases of mortgages from banks and other lenders by Fannie Mae and Freddie Mac now had to include a specified quota of mortgages made to the “underserved” population. The combination of these regulatory policies led banks to lower their standards for making mortgage loans and for Fannie Mae and Freddie Mac to lower their standards for purchasing these mortgages from banks and other lenders. The net result was that lenders had less reason to maintain traditional standards of creditworthiness, since they were under pressure to make loans and could then sell these mortgages to Fannie Mae and Freddie Mac, who were under pressure to buy them. Moreover, since riskier mortgage loans, like other riskier loans, charged higher interest rates, both the banks and Fannie Mae and Freddie Mac stood to profit more from such loans if the borrowers made the payment—and to pass on the risks if the borrowers did not. The banks could pass the risks to Fannie Mae and Freddie Mac, while these two government-sponsored enterprises could count on ultimately passing the risks on to the taxpayers because of a general expectation that the federal government would not let these enterprises fail.

NS: There is much debate about the role Fed policy under Alan Greenspan played in the boom and subsequent bust. Where do you come down on that and why?

What most surprised me about this episode has been the utter gullibility of the media in accepting Washington politicians’ attempt to put blame on everybody except themselves.

TS: The extremely low interest rates set by the Federal Reserve system in the early years of the 21st century facilitated home purchases by making the monthly mortgage payments lower than they would have been otherwise. Among the “creative” ways of arranging financing to take maximum advantage of these low interest rates were adjustable-rate mortgages with payment only for interest during the first two years. This made the initial payments much lower than on a conventional 30-year loan. But it also meant that the payment would rise over time—first if the interest rate rose from its unusually low levels and secondly when time came to begin repaying the principal on the loan. Because many such mortgages were made to lower-income people with no previous experience in buying a house, and often with less education, it is by no means clear whether they understood that their initial mortgage payments could rise very substantially. The Federal Reserve’s low interest rates were intended to deal with conditions in the economy as a whole, but it had a disproportionate effect in the housing market. Moreover, although Federal Reserve chairman Alan Greenspan warned Congress of the dangers of having Fannie Mae and Freddie Mac buying so many risky mortgages, by his own later admission he did not foresee the full magnitude of the dangers in the housing markets as a whole until very late.

NS: As I read the book, a combination of state actions contributed significantly to the boom (and bust): land and zoning restrictions in the name of protecting the environment pushed up the price of housing in many parts of the country. Meanwhile, a zeal to engineer “affordable housing,” particularly for minorities, led to government pressure to relax lending standards (with catastrophic results). Is it fair to say this is the first economic crisis created by political correctness?

TS: I am not sure whether this was the first economic crisis brought on by political correctness, though it is clear that the heedless and open-ended pursuit of “open space” laws created the skyrocketing local housing costs and the equally heedless pursuit of higher “affordable housing” statistics were driving forces behind the housing boom and bust. However, there were similar government efforts to increase home ownership artificially under Republicans in the 1920s, under the Democrats in the 1930, and under both parties in the post-World War II era. This, however has led to a bigger debacle than those—and of course we have no way of knowing how much longer and how much further the negative repercussions will go.

NS: What is the greatest popular misconception about the boom and subsequent bust?

TS: The biggest popular misconception about the housing boom and bust is that it was due to a lack of regulation. In reality, it was precisely the intervention of federal regulators that caused traditional mortgage lending standards to be reduced, leading to sales of homes to many people who either could not or would not pay for them.

NS: Are there any new government regulations you would propose in the wake of the bust?

I would get rid of Fannie Mae and Freddie Mac entirely. As long as these hybrid private and government enterprises exist, they will be a standing invitation to politically motivated decisions.

TS: In the wake of the current debacle, I would severely restrict regulators to enforcing clear-cut rules known in advance, and strip them of the power to impose arbitrary quotas. I would also get rid of overlapping jurisdictions of different regulatory agencies, so that someone could be clearly held accountable. If at all possible, I would prefer to have the regulators insulated from political pressures by having staggered terms, like the members of the Federal Reserve Board. I would get rid of Fannie Mae and Freddie Mac entirely. As long as these hybrid private and government enterprises exist, they will be a standing invitation to politically motivated decisions.

NS: What if anything has surprised you about this whole episode?

TS: What most surprised me about this episode has been the utter gullibility of the media in accepting Washington politicians’ attempt to put blame on everybody except themselves.

NS: Who should we feel most sorry for in the wake of the bust?

TS: The people I feel most sorry for in this whole episode are the people few express any concern about—the taxpayers, present and future, who will be forced to pay the price for decisions they had nothing to do with. Moreover, the thrust of the “affordable housing” crusade was not to reduce or eliminate the impediments that raised the cost of housing but to force banks and other lenders to finance home purchases at existing prices but on less stringent terms. The net result was a variety of “creative” financing schemes to lower monthly mortgage payments, if only temporarily—such as during the first two years of a 30-year mortgage—and to lend to people whose income and down payments did not meet the standards of conventional mortgage lending.


Image by Darren Wamboldt/Bergman Group.

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