Tuesday, January 27, 2015

The 20008 Housing Bubble and GSEs

The problem with those who propagate the dominant story about the 2008 housing bubble was their failure to identify the real source of the crisis. They mistakenly pointed the finger to free market capitalism. As in the past, the interventionist hand of the government escaped public notice.

In chapter 2 of Thomas Woods' book, Meltdown, he identified six culprits including the Federal Reserve. In this article, we will just deal with the first culprit, Fannie Mae and Freddie Mac. 

Before we describe how the US government caused the housing crisis through Fannie Mae and Freddie Mac, let us first give a brief background to the crisis. 

Thomas Woods narrates that from 1998 to 2006, there was a dramatic increase in housing prices. More houses were built and house flippers became a norm. In the third quarter of 2006, cracks in housing industry started to appear. Borrowers could no longer sell their houses for profit for price depreciation started. 

The eruption of this bubble rippled to the financial sector for many in the financial industry "invested heavily in mortgage-backed securities" (p.12). Before the crisis hits, homeowners were applying for mortgage at their local banks and paid their monthly obligation. But when bankers sold these mortgages in "the secondary mortgage market to institutions like Fannie Mae," the latter repackaged these mortgages and and sold them as "mortgaged-backed securities" (ibid.). Investors bought these products for credit agencies marked them with triple A rating, meaning, secured. But when homeowners started to default on their mortgages, foreclosures multiplied. And since increasing number of homeowners could no longer pay their mortgages, the value of "secured mortgage products" started to decline together with the companies that invested in them. Greedy lenders and foolish borrowers were blamed, but not the government.

The housing crisis that erupted in 2008 could be traced to the interventionist hand of the government. The crisis was the inescapable consequence of government intervention in the market. And let us see how the US government did it. 

Fannie Mae and Freddie Mac were "government sponsored enterprises" (p. 13). This meant that they enjoyed privileges that no private enterprises had. And besides, in case they would suffer trouble, the government was there to back them up by passing the financial burden to tax payers. 

When these GSEs bought the mortgages from local banks, with funds in their hands, bankers returned to mortgage market making it easier for people to own houses, and thereby boosted the housing market. The fund that caused this boom was not a product of capital accumulation, but derived from special privileges enjoyed by GSEs. Hence the boom was artificial, and it diverted capital from a more productive industry into the housing market. 

Fannie Mae and Freddie Mac could never cause the housing boom without the US government backing them up. Thomas Woods identifies the many privileges that these GSEs enjoy:

  • with special tax and regulatory privileges

  • traded on the NYSE

  • considered as "government securities"

  • considered low risk, and

  • with $ 2.25 billion line of credit

"Fannie was also deeply involved in the politically instigated move to lower lending requirements in the name of helping 'disadvantaged' groups" (p. 15). So the housing industry was a hot political issue that time. The call of Republicans to regulate Fannie and Freddie was considered by the Democrats as an "attack on 'affordable housing'" (ibid.). Critics of Democrats saw that the party's hesitation to regulate Fannie was due to the fact that the latter was a source of political fund. 

Ron Paul, the retired libertarian Congressman of Texas and two time US presidential candidate captured the precise role of interventionism in the housing crisis:

"The special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans. 
Despite the long-term damage to the economy inflicted by the government's interference in the housing market, the government's policy of diverting capitall to other uses creates a short-term boom in housing. Like all artificially created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged overinvestment in housing" (pp. 16-17).

Guide Questions:

1. What do you know about Fannie Mae and Freddie Mac?

2. Briefly explain how the financial industry was affected by the housing crisis.

3. Whoe were the two primary scapegoats for the housing crisis?

4. Briefly explain the two primary advantages of GSEs over private enterprises.

5. Why is the housing boom artificial?

6. Enumerate the privileges that GSEs enjoy.

7. In what way the housing industry was used as a political battlefield?

8. Summarize in your own words Ron Paul's description of the role of the government in the housing market. 

Source: Wood, T. E. Jr. (2009). Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington, DC: Regnery Publishing, Inc. 

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