The American Housing Boom and Bust

( Section of "An Austrian Theory of Business Cycles" in the Political Economy section of BENBEST.COM )

by Ben Best


Although the American housing market boom and bust of the first decade of the millennium was associated with an artificial credit expansion, the impact was not concentrated on capital goods and the central bank was not the only responsible agent, unlike the case for the classical Austrian business cycle scenario. The Federal Reserve was no less responsible than the Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac.

Fannie Mae (the Federal National Mortgage Association) is a government agency created in 1938 which monopolized the secondary mortgage market in the United States until 1970. In 1968 Fannie Mae was converted into a shareholder-owned "private corporation". In 1970 Freddie Mac (the Federal Home Loan Mortgage Corporation) was created, and in 1989 it was made a GSE modeled after Fannie Mae.

The purpose of both GSEs was to make borrowing for home ownership easier for Americans, especially those of limited financial means. Neither GSE issues mortgages directly. Instead they purchase mortgages from banks & other lenders and convert those loans into mortgage-backed securities which are sold like bonds. The GSEs guarantee that the principal & interest for all mortgages they purchase will be paid whether or not the homeowners default. The GSEs charge a fee for assuming all credit risk.

Although ostensibly private companies, there was a widespread (and ultimately vindicated) perception that the federal government would not allow the GSEs to fail. The GSEs were given monopoly privileges against which no true private enterprise could compete. Five Board members of both GSEs were appointed annually by the President of the United States. Both GSEs had a line of credit with the US Treasury Department, and both were exempt from state & local income tax on corporate earnings. Fannie Mae Discount Notes became the second-largest short-term notes issued — second only to T-Bills, and paying a yield that reflected implicit government backing. From the 1990s both GSEs held rather than sold most of their mortgage-backed securities — issuing debt below the yield of the securities and profiting from the spread. FDIC Bank Holding Company Act requirements that impose capital/asset ratio minimums of 3% on other financial institutions made no such requirement of the GSEs. Shareholders pressured the GSEs to take more risky loans so as to enhance profits. Those originating the loans became less wary of risks because they were able to transfer the risk to the GSEs.

Subprime loans are often considered to be loans made at high rates of interest to people with poor credit (a FICO credit score of less than 660). But at the peak of the subprime lending boom — 2005 & 2006 — most subprime loans were made to people with good credit, but who were borrowing more than their assets or income could justify. Many borrowers (both prime and subprime) obtained Adjustable-Rate Mortgages (ARMs) which were tied to federal interest rates, but gave lower initial interest as a sweetener. In 2005 43% of first-time buyers purchased their homes with no down payment, and the median down payment for a $150,000 home was 2%. This can be compared to an average down payment of 18% for first-time buyers in 1976. By 2006 20% of the entire mortgage market was subprime, and 81% of those loans were securitized.

There was political pressure to make home loans more accessible to more voters. The increased risk was justified as a social service. The Community Reinvestment Act (CRA) was an important instrument in implementing this policy, by requiring banks as well as GSEs to make subprime mortgage loans. The CRA empowered politically favored "community groups" to pressure local banks to make loans to people who were not credit-worthy.

Both GSEs increased subprime mortgage purchasing in the 1990s. The GSEs operated relatively free of congressional oversight and market discipline. When a congressman made public the outrageous compensation received by GSE executives they threatened to sue him. Near the end of the Clinton administration the Department of Housing and Urban Development (HUD) imposed "affordable housing" quotas on the GSEs. These quotas were later increased under the Bush administration — lowering mortgage requirements even further so more people could buy houses they couldn't afford. By 2007 HUD required that 55% of loans made by the GSEs be to borrowers at or below median income.

In 2003 — when the GSEs were the only two Fortune 500 corporations exempt from Securities and Exchange Commission (SEC) regulation — three Freddie Mac top executives were ousted for obstructing an accounting probe. Freddie Mac was fined $125 million by the Office of Federal Housing Enterprise Oversight (OFHEO) for understating earnings by $5 billion. In 2006 the OFHEO fined Fannie Mae $400 million for accounting fraud. In April 2006 Freddie Mac was fined $3.8 million by the Federal Election Commission (the largest fine in FEC history) because of illegal campaign contributions, much of which had benefited members of the House Financial Services Committee.

Fed Funds Rate
[Fed Funds Rate]

By 2008 the two GSEs owned or guaranteed about half of the $12 trillion worth of mortgages in the United States, including at least 70% of new mortgages being issued. Mortgage lending had become so politicized that the GSEs were required to have at least 56% of their mortgages with individuals having below average income, and at least 35% of the mortgages had to be in geographic areas deemed to be underserved by other companies.

The "housing bubble" began bursting in 2006. The Federal Reserve had played its role in the credit expansion and collapse that led to the liquidity crisis. The Federal Funds Rate was slashed from 6.5% in January 2001 to 1% by June 2003. After one year at 1% the Fed ratcheted rates back up to 5.25%. Conventional 30-year mortgage rates fell from about 8.5% in 2000 (10% in 1990) to below 6% in 2003, remaining mostly below 6% until late 2005, peaking to about 6.5% in the summer of 2008. One-year Adjustable Rate Mortgages (ARMs) dropped below 4% in 2003, but rose to about 6% in 2006. Because of lower mortgage rates, lax lending practices and ever-increasing housing prices, real estate loans more than doubled between 2001 and 2008. In 2005 & 2006 40% of home purchases were not primary residences. 28% of the homes purchased in 2005 were for investment and 12% were vacation homes.

Nationally, housing prices peaked in 2005, although regional differences were large. Between 2001 & 2006 Miami, Los Angeles and Phoenix saw 80% price appreciations, but prices appreciated less than 10% in Dallas, Detroit, Denver and Atlanta over the same period. The states with the highest subsequent foreclosure rates were California, Florida, Michigan and Ohio. The first two states had seen price appreciations above 80% in the 1998 to 2006 period, but the second two were among the states with the lowest price appreciations.

S&P/Case-Shiller US National Home Price Index
[S&P/Case-Shiller US National Home Price Index]

With Fannie and Freddie assuming the risk, by 2008 40% of subprime loans were generated by "automated underwriting". Between 1994 and 2003 subprime mortgage loans increased ten-fold. As interest rates began to rise, however, so did the mortgage default rate. In 2007 there were 1.3 million US homes subject to foreclosure, up about 80% from 2006. In March 2008 the delinquency rate on subprime loans having Adjustable Rate Mortgages was 25% — a five-fold increase from 2005. By August 2008 more than 9% of the entire $12 trillion US mortgage market was delinquent, and by September house prices had plummeted to the point where 18% of homeowners had negative equity (homes worth less than their mortgages).

In March 2007 Fannie Mae terminated its agreement to buy mortgage loans from New Century Financial Corporation, the second biggest subprime mortgage lender in the United States. New Century filed for bankruptcy the next month, and the bankruptcy examiner later charged that New Century's auditor had colluded in concealing financial problems. In July 2007 the investment bank Bear Stearns disclosed that two of its subprime hedge funds had lost nearly all of their value due to the meltdown of the subprime mortgage market. Shortly thereafter investors initiated legal action against the bank. By March 2008 the insolvency of Bear Stearns was prevented when the firm signed a merger agreement with JP Morgan Chase for a stock swap worth $2 per share of Bear Steans (down from $172 per share in January 2007) and a $29 billion non-recourse loan from the Federal Reserve to compensate Chase for the risk of assets the company was accepting.

The subprime mortgage crisis did not remain confined to the United States. Northern Rock, one of the top mortgage lenders in the United Kingdom, began subprime lending in 2006 with Lehman Brothers underwriting the risk. In September 2007 there was a run on the bank, resulting in two billion pounds being withdrawn before the British government announced that it would guarantee all Northern Rock deposits. In February 2008 Northern Rock was nationalized. The Basel Accords, which provides rules for international banking, mandated that banks have capital reserve of 8% for corporate loans, 4% for mortgages, but only 1.6% for mortgage-backed securities — creating an incentive for banks to hold mortgage-backed securites. Sovereign debt (government debt) is regarded as risk-free by the Basel Accords, and hence requires no capital reserve. The American Securities and Exchange Commission (SEC) mandated that the largest United States investment banks comply with the Basel Accords — further contributing to the financial meltdown in the USA.

On July 11, 2008 IndyMac — the seventh largest mortgage originator in the United States — was seized by the Federal_Deposit_Insurance_Corporation (FDIC) when the bank failed. On September 7, 2008 Fannie Mae and Freddie Mac were taken over by the federal government and placed under conservatorship of the Federal Housing Finance Agency (a virtual nationalization of the mortgage industry). Common stock of the GSEs, which had been trading at close to $80 per share for most of the decade, was soon below $1 per share (delisted from the New York Stock Exchange on July 16, 2010). Dividends on the preferred shares of the GSEs — held by many commercial banks — were suspended. The financial obligations of the two GSEs were estimated to be about $5 trillion, close to half the value of the federal national debt. The US Treasury Department pledged $100 billion to each GSE to maintain solvency.

On September 15, 2008 Lehman Brothers investment bank filed for the largest bankruptcy in United States history (IndyMac Bank had been the ninth largest). Lehman had closed its subprime lender, BNC Mortgage, a year earlier, but was still holding large positions in mortgage-backed securities which had huge losses in 2008. September 12 was the maturity date of more than $1.2 billion in unsecured loans that Lehman owed Freddie Mac. Also on September 15, rating agencies downgraded the credit ratings of the American International Group (AIG) insurance company forcing AIG — which had valued its subprime mortgage-backed securities at nearly twice the rates used by Lehman — to deliver $10 billion in collateral to creditors. Two days later the Federal Reserve confirmed that it had taken a 79.9% share in AIG in exchange for an $85 billion rescue package. AIG executives were under criminal investigation for misleading investors about how much the value of the company's credit-default swaps had declined. AIG had begun selling swaps that served as insurance against credit-default in 1998, and in 2004 expanded into swaps against defaults on Collateralized-Debt Obligations (CDOs) backed by securities such as mortgage bonds, auto loans and credit-card receivables. The computer models AIG had used to assess the risk of these Credit-Default Swaps (CDSs) did not account for potential write-downs or collateral payments. AIG had considered the risk of substantial payout to be small "even in severe recessionary market scenarios."

The credit crisis was worsened by the mark-to-market Financial Accounting Standard 157 (FAS 157, enacted in 2007) which requires businesses to price their assets at the lowest price for which similar assets have been sold. The SEC forced banks to value their mortgage-backed securities, credit default swaps (CDSs), and similar assets by FAS 157. Financial institutions feared buying mortgage assets strictly on the basis of future cash flows, anticipating future mark-to-market paper losses that could undermine their regulatory capital and credit ratings. Weak institutions forced to sell their CDOs and mortgage assets at "fire sale" prices weakened the financial position of more credit-worthy institutions which were forced to slash the value of mortgage backed securities below the price that would be justified by cash flows (mortgage payments). The stronger institutions were thereby weakened and forced to sell assets of their own to meet minimum capital (or collateral) requirements, creating a downward spiral of asset devaluations, credit downgrades, forced sales and bankruptcy.

Worsening the viscious-cycle, downward-spiral associated with mark-to-market accounting was the viscious-cycle, downward-spiral associated with ratings downgrade triggers. The credit ratings given by credit rating agencies (which assign credit ratings to various kinds of debt) affect interest rates and collateral required for debt obligations. The SEC-sanctioned rating agencies had been assigning triple-A ratings to junk mortgage paper, and SEC rules required money-market funds and stock brokerages to hold securities highly rated by the agencies. Credit rating downgrades can automatically trigger a requirement to post additional collateral for debt. A struggling company forced to sell assets at firesale prices to meet the additional collateral requirements can then be faced with another ratings downgrade — a "death spiral". AIG failed because of a ratings downgrade on its CDS contracts. The Lehman bankruptcy resulted in AIG being unable to find a market for the assets it had to sell to meet the increased collateral requirements.

On September 22, 2008 Goldman Sachs and Morgan Stanley, which had been the last surviving investment banks, transformed into commercial bank holding companies, similar to Citicorp and Bank of America. Lehman Brothers had gone bankrupt, Merrill Lynch had been bought by Bank of American, and Bear Sterns had been bought by J.P. Morgan Chase. With no more investment banks, most U.S. financial institutions were regulated by the Federal Reserve. (SEC bureaucrats lamented their loss of importance.) As commerical banks, Goldman Sachs and Morgan Stanley no longer were required to value their assets by mark-to-market, and would have acccess to funding by bank deposits rather than money market borrowing. Investment bank leveraging had soared in recent years (Merrill Lynch leverage ratio of assets to capital had gone from 15 in 2003 to 28 in 2007, and Morgan Stanley's had gone to 33), but as commercial banks leverage would need to be close to 10. Moreover, the banks would have access to short-term borrowing from the Fed. The Bank Act of 1933 (Glass-Steagall Act) had separated securities trading (investment banking) from lending (commercial banking) in the interest of protecting depositors. With no more investment banks left, it was an open question whether the Fed would also seek to regulate hedge funds.

The collapse of the credit market and stock market in the United States was followed by a stock market and credit market bloodbath worldwide — not surprising in light of the US debt and equity holdings of foreigners. The 2007 foreign holdings of US GSE debt was $1.3 trillion, 29% of which was held by China, 17.5% by Japan and 5.8% by Russia. Hong Kong investors who had purchased US$2.6 billion in risky Lehman Brothers products held protests.

On October 3, 2008 the US federal government enacted the Emergency Economic Stabilization Act of 2008 empowering the Treasury Department to purchase up to $700 billion in distressed bank assets, (especially mortgage-backed securities) through the Troubled Assets Relief Program (TARP). Although TARP was based on the supposition that removing "toxic assets" would restore the financial sector to health, there was considerable controversy & confusion in the government about the pricing of those assets. Use of mark-to-market pricing might not help the financial industry very much, but paying too much would leave politicians vulnerable to accusations of "welfare to the rich" at taxpayer's expense. The Treasury Department abandoned efforts to buy toxic assets. On October 14 the Treasury Secretary announced a decision to instead use TARP money to buy preferred shares of the nine largest American banks. In purchasing preferred shares of banks, the US Treasury subsidized those with bad credit practices as well as the more stable ones (who had no choice but to comply) — thereby rewarding and providing incentive for reckless & incompetent financial practices. The statutory limit on the national debt was increased from $10.6 trillion to $11.3 trillion. Interest rates were cut and proposals made to increase credit by other means. Many banks were able to repay TARP loans thanks to their ability to sell more than a trillion dollars worth of GSE-guaranteed MBS securities to the Federal Reserve.

Interest Paid by the Fed on Excess Reserves
Interest Paid by the FedExcess Reserves
[Interest by the Fed on Excess Reserves] [Excess Reserves]


In October 2008 the Federal Reserve took the unprecedented action of paying interest to the banks on the money they held that was in excess of their minimal reserve requirements. Banks had historically held a "relatively negligible" amount of excess reserves with the Fed, but the $2 billion held at the end of August 2008 had climbed to $1.5 trillion by the end of 2012. Banks historically loaned-out nearly all of their allowed reserves, but with the prospect of loan defaults in a weak economy, and with the 0.25% interest they were being paid by the Fed, banks found it more prudent to keep excess reserves. The Fed theoretically artificially lowers interest rates to encourage borrowing by consumers to stimulate the economy, but by paying interest to banks for not loaning money (to prevent inflation) the Fed is engaging in a contractory (and expensive) policy, in addition to the damage it does to credit markets by interest rate manipulation that discourages savings.

TARP was originally intended only to help banks that were relatively healthy. But Massachusetts congressman Barney Frank (head of the House Financial Services Committee, who had earlier told the New York Times that claims that the GSEs had financial problems were exaggerations) added a provision that would give special consideration for certain banks that had lost substantial equity due to large holdings of GSE stocks and bonds — as well as banks which served low-income families. Frank made no secret of the fact that he was particularly concerned about OneUnited Bank of Boston in his home state. In October, 2008 the FDIC and Massachusetts regulatory officials took enforcement action against OneUnited on grounds of poor lending practices and executive compensation abuses.

In September 2008 the Bank of America had agreed to buy Merrill Lynch. But by December, when Merrill's massive losses were showing no limit, Bank of America decided they had ample legal grounds to stop the deal. Federal Reserve officials warned that if the Bank of America was in future need of federal bailout money, the government would consider ousting executives and directors. Within a month a deal had been reached for the Bank of America to purchase Merrill with the aid of $20 billion in government money plus $118 billion in troubled asset loss protection. In 2008 the Bank of America had spent $4.1 million in lobbying, and Merrill Lynch had spent $4.7 million.

With the collapse of US credit markets the US Dollar strengthened significantly against most other currencies, a consequence of fractional-reserve banking that caught many by surprise. Then, in an effort to "combat deflation," the US Federal Reserve drove the fed funds rate nearly to zero. The Fed poured massive amounts of newly created money into the economy by buying commercial paper, mortgage-backed securities and bundled credit-card debt, among other things — increasing Fed reserves by more than an order of magnitude, weakening the US Dollar against other currencies.

Cause of the financial crisis
Poor lending practices27%
Lack of government oversight26%
Wall Street greed19%
Excessive consumer borrowing15%

The 2008 Presidential candidates blamed the financial crisis on "capitalist excesses", "predatory lending practices" and "excessive deregulation". Both parties promised to "clean up Wall Street" and impose stern regulation of the financial sector. Months after the election, public outrage was directed against AIG employees who had been pledged retention bonuses to stay with the troubled company — as if they had been the ones responsible for AIGs unhedged mortgage swaps. In a CONSUMER REPORTS poll, 26% of respondents blamed the financial crisis on lack of government oversight, and 78% of respondents wanted increased regulation of financial institutions [CONSUMER REPORTS; 74(1):24-27 (2009)]. This is ironic in that it was pressure from regulators and politicians which had been the driving force behind the subprime mortgage market and the securitization of that debt. Once again, disastrous regulatory policies (combined with government incompetence & corruption) that cause economic disaster leads to a public outcry for increased regulation.

The Financial Crisis Inquiry Commission appointed by the US government to determine the cause of the financial crisis concluded that lax regulation and faulty risk management by households and Wall Street were to blame. GSEs were held to be only marginally responsible.

The accusation that the years of the Bush Administration was characterized by deregulation is wildly at variance with reality. The politically ambitious hypocrite Eliot Spitzer elevated himself from New York Attorney General to Governor by his use of the 1921 Martin Act (an antifraud statute that relieves prosecutors from proving criminal intent) to extract costly settlements from Wall Street firms. As the "people's crusader against Wall Street" Spitzer drove the CEOs of AIG and other firms from office, with disastrous results for those firms and for the economy. The Sarbanes-Oxley Act of 2002 (enacted in reaction to the Enron, WorldCom and Tyco accounting scandals) imposed costly accounting regulations that were particularly onerous for small firms. The number of American companies deregistering from public stock exchanges nearly tripled after Sarbanes-Oxley became law, and there were few new foreign listings on the New York Stock Exchange. Even New York's liberal Democratic Senator Charles Schumer sought revisions to reduce the exodus of companies to overseas stock exchanges. The 2007 imposition of mark-to-market accounting by the SEC greatly amplified the crisis created by securitization of subprime mortgages. The two terms of the Bush Administration was associated with a 68% increase in spending on regulatory agencies — greater than the increase associated with the administrations of any of the six preceding Presidents.

In 2011 the Federal Reserve purchased 61% of U.S. Treasury securities, in contrast to negligible amounts purchased before the 2009 financial crisis — artifically depressing interest rates on Treasury bonds during a time of massive deficit spending financed by government borrowing. Foreign purchases of Treasury securities declined to 1.9% of GDP in 2011 compared to 6% of GDP in 2009, and U.S. private sector purchases declined to 0.9% of GDP in 2011 compared to 6% of GDP in 2009. In 2012 the Fed began expanding its "Operation Twist" to purchase bonds of longer maturity — a departure from its historical practice of operation at the short end of the yield curve — to drive down long-term interest rates. Fed holdings of bonds with maturities exceeding 5 years were increased by over $500 billion.

Massive Money Creation by the Federal Reserve
[Massive Money Creation by the Federal Reserve]

In December 2011 the SEC announced lawsuits against six top executives of the Fannie Mae and Freddie Mac. The SEC charged that the GSEs hid the size and riskiness of their subprime mortgage holders from investors, ratings agencies, and financial regulators.

It was the unregulated GSEs, their crony pseudo-capitalists, and their pork-barrel political allies who wrecked havoc on the financial system — with help from the misguided economic policies of Keynesians & Monetarists. Business people were responsible to the extent that they were bullied by politicians into making bad loans, or relieved of any responsibility for being concerned about risky loans because of implicit government guarantees. Loans were made to people who could not repay them rather than to businesses that could have used the money to increase production & employment. The naive belief that politicians & bureaucrats have the morality & competence to regulate businesspeople & the economy can only lead to waste, economic chaos and loss of freedom. This is not to say that no politician or bureaucrat has ability or good intentions, but they should not be regarded as divine beings and it is wrong to think that their judgments are superior to those that result from free competition subject to laws against fraud. Too many people think that the economy is too important to be left to the market, but it is instead the case that the economy is too important to be left to the politicians and bureaucrats.

The goals of the Obama Administration are to follow the example of Franklin Roosevelt during the Great Depression, by Keynesian spending programs intended to create jobs and "stimulate the economy". Government money can only come from taxing or borrowing money from people who would have otherwise invested the money more productively. The Bush Administration was an example of massive government spending increases that hampered economic growth.

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