Government Responds to Economic Woes by Making More Bad Mortgage LoansRobert Higgs • Sunday November 22, 2009 7:42 PM PDT •
Since the summer of 2008, the U.S. Treasury and the Fed have initiated a welter of new spending, lending, and subsidizing programs ostensibly aimed at stemming the recession that began early in that year and deepened quickly in its last quarter and in the first quarter of 2009. Among the most notable of these programs have been attempts to prop up the real estate market and the residential construction industry, where the Fed’s easy-money policies in the first half of the present decade induced lenders to make millions of mortgage loans to home buyers who would not have qualified for such loans if traditional underwriting standards had been applied.
During the housing bubble, however, with congressional backers goading Fannie Mae, Freddie Mac, and other lenders, caution was thrown to the wind, and loans were extended to home buyers who had little more than a pulse as a qualification. People who believed that real estate prices would never fall did not worry much about the great volume of dicy credit being extended to house buyers – for the moment everybody seemed to be getting rich effortlessly with little or no risk. However, people who believed that real estate prices would never fall were fools, and when the Fed began to back away from its easy-money policy and interest rates began to rise, real estate prices began to fall, mortgage delinquencies and foreclosures began to rise, and before long the entire house of cards began to collapse: house prices dropped drastically, as did the pyramid of financial derivatives built atop the mountain of mortgage loans, and in quick succession some of the world’s largest banks and other financial-services companies went belly up. Some, including Fannie, Freddie, and AIG, were taken over by the government or the Fed; hundreds of others were bailed out, at least for the time being.
A sensible person, surveying all of this wreakage and pondering how such a debacle might be avoided in the future, certainly would have concluded that the government should cease and desist from artificially spurring the real estate market by subverting traditional underwriting standards for mortgage loans. Those standards include, for example, a substantial down payment, usually 20 percent, and well-documented sources of income sufficient to permit the buyer to service the loan, usually a steady job or substantial assets.
During the crisis since mid-2008, however, the government has not done what a sensible person would have concluded it should do. Indeed, it has done the opposite. Rather than terminating the government policies that had encouraged the foolish behavior of real estate buyers, sellers, and lenders – foolishness that lay at the heart of the artificial boom that went bust during the past two years – the government has undertaken to continue and even to compound the selfsame policies that in large part caused our present economic troubles. For example, Fannie and Freddie, now effectively government owned and operated firms, continue to extend loans as if promising borrowers were superabundant.
Moreover, the Federal Housing Administration, a government agency created in 1934 to insure conventional mortgage loans, has greatly expanded the volume of its business, and according to a recent report in the New York Times, the FHA “is underwriting loans at quadruple the rate of three years ago even as its reserves to cover defaults are dwindling.” The Mortgage Bankers Association affirmed on November 19 that “more than one in six F.H.A. borrowers was behind on payments.” The FHA has backed 37 percent of all residential mortage loans made in 2009. Reporter Patrice Hill observes that “these loans are exposing taxpayers to the same kinds of soaring default rates and losses that brought down Fannie Mae and Freddie Mac as well as destroyed many banks and the private market for mortgage loans.”
The government is not resting content, however, with taking over the mortgage-loan business and making a multitude of rotten loans. Hill reports:
The FHA’s predominance was enhanced further this year when Congress lifted the ceiling to more than $729,000 for major urban areas and passed an $8,000 tax credit for first-time homebuyers that can be accelerated for borrowers to use as a down payment on FHA loans and avoid any cash commitment to their home purchases.
While these changes were intended to be temporary and expire by the end of the year, given the fragility of the housing and mortgage markets, Congress is considered likely to extend them this fall.
The significant expansion and liberalization of FHA’s loan programs is enabling Americans to go back to many of the same bad credit practices that analysts say were at the root of the housing crisis, likely feeding further waves of default and foreclosure. But this time it is the taxpayer—not the banks—who could end up holding the bag.
Whitney Tilson, manager of investment firm T2 Partners LLC and author of “More Mortgage Meltdown: 6 Ways to Profit in These Bad Times,” called “cataclysmic” the surging default rates of more than 30 percent on loans insured since 2006 by the FHA. That is not far below the 40 percent rate of default and foreclosure on the notorious subprime loans that ignited the credit crisis.
“The FHA’s portfolio is exploding and the taxpayer is now on the hook for 100 percent of the losses,” he said.
“I find it hard to distinguish between the actions of FHA and the self-denominated subprime lenders,” said Edward Pinto, a former chief credit officer at Fannie Mae who recently testified before a House panel on FHA’s growing default problems. “The results are the same—unsustainable loans that prolong and perpetuate our nightmare of foreclosures.”
Mr. Pinto estimates that 20 percent of the FHA’s entire portfolio of $725 billion mortgages will end up in foreclosure—a rate recently borne out by estimates FHA provided to Congress. He predicts that the agency will require a taxpayer bailout within two to three years.
One reason defaults are soaring is that the agency is attracting nearly all of the business of homebuyers who haven’t saved enough to make down payments, he said. Loans with little or no down payments have high rates of default because the borrowers have little financial stake in losing their homes to foreclosure.
The agency requires a minimal 3.5 percent down payment—far below the 20 percent now required by private lenders. That’s very little “skin in the game,” especially in today’s market where the buyer’s equity can be quickly wiped out, Mr. Pinto said. Home prices have fallen an average of 30 percent nationwide.
Many borrowers have been able to avoid even that minimal level of personal investment in their homes. The government is enabling these buyers to put up no cash at all by allowing them to get advanced payments of the $8,000 homebuyers tax credit through arrangements with nonprofit housing groups and state housing agencies. The tax credit can be used the same way to pay closing costs.
Beyond the loosened standards on down payments, the FHA remains willing to make loans to people with low credit ratings, even those with histories of default, foreclosure or bankruptcy. Those with histories of default are far more likely to default again.
Naturally, anything this horrendous in housing-finance policy has a high probability of being backed by Representative Barney Frank and his congressional partners in crime, who continue to conspire with the”affordable housing” coalition as if the present debacle had not plainly revealed the destructive consequences of such policies. At present, 14.4 percent of residential mortgages are delinquent or in foreclosure – an all-time high – and the percentage continues to rise, notwithstanding the government’s commitment of some $50 billion in TARP funds for its Housing Affordability Stability Plan, which seeks to modify and refinance home loans. In this area, as in the labor market, things will probably get much worse before they begin to get better.
To listen to our glorious leaders discuss such matters is to realize that they have no real understanding of what they are dealing with. They see the collapse of an artificially stimulated house-construction industry, and they conclude: the government must subsidize more house construction. They see the collapse of real estate prices, and they conclude: the government must stimulate demand for real estate in order to raise its price. Thus, they demonstrate that they have no comprehension of the structural logic of economic activity. By this expression I mean that, contrary to the way of thinking advocated and formalized in modern macroeconomics, in which an addition to GDP is an addition to GDP, and all such additions are equally apt and good, the sound economist understands that the nation’s economic activity consists of millions of distinct inputs and outputs, and these elements must assume a particular configuration, or structure, if the whole process is to achieve generally beneficial results for its participants.
No one knows (and no one can know) precisely what this structure should be at any particular time, but if people are left alone to exchange their private property rights as they think best, they will make bids and offers that establish market prices for inputs and outputs, and these prices (and the profits and losses associated with them) will set in motion the reallocations of inputs and the alterations of outputs that allow demanders and suppliers to coordinate the changes in their actions that must be made if they are to pursue their objectives successfully. If policy makers ignore or work against this vastly complex, dynamic process of constantly changing prices, input uses, and output production, the result will be a mass of malinvestments and distortions in input use and output production—a veritable economic monstrosity.
When this twisted creation proves incapable of living and breathing and breaks down in agonizing spasms of business losses, bankruptcies, and unemployed labor, the preeminent need is for a restructuring of the economic process: industries and locations mistakenly stimulated by bad policies must shrink; and industries and locations previously starved for inputs must receive them, as investors and workers abandon the enterprises now revealed as losers and seek opportunities elsewhere for more profitable employment of their resources. Cutting short this process of liquidation and redirection by implementing more of the same distortive policies that created the mess in the first place only insures that the restructuring will take longer and be more painful.
To be more specific about the case at hand, the government’s bad monetary policy and bad housing-finance policies earlier in this decade created house prices that were too high and securities based on the returns to mortgage loans (and their derivatives) that were overvalued. To repair this situation, house prices, security valuations, and corporate share prices driven skyward in the government-stimulated frenzy need to come down, in many cases down so far that bankruptcies, unemployment, and substantially reduced wages will occur in the process. Simply piling on more and more of the same distortive policies that generated the crisis in the first place can, at best, only delay the day of reckoning while magnifying the adjustments that ultimately will have to occur. For Fannie, Freddie, and the FHA to pile more bad real estate loans atop the mountain of such bad loans extended between 2002 and 2006 is the height of folly, a virtual apotheosis of a policy of living for today at the expense of our future prosperity.
To repeat unsolicited advice I have given since the beginning of this crisis, I maintain that the best thing the government can do now is to get out of the way: abandon the bad monetary and housing-finance policies conducted in recent years and let the economic process sort itself out through market processes. The claim that without the government’s vast interventions the economy will sink into oblivion is nothing but another fallacy that no sound economist will countenance. This economy and others, when markets were allowed to function without government interference, worked splendidly for a long time before John Maynard Keynes ever achieved his ill-deserved status as the über-architect of macroeconomic salvation. It can work well again if the politicians will stand down – and the people will recognize the wisdom of this laissez-faire course and cease their clamor for salvation via Washington at someone else’s expense.
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