Garrison on Housing Policy and ABCT

In ABCT and the Community Reinvestment Act (CRA), Peter Klein makes readers aware of new evidence, contra Krugman, that Federal housing policy, and especially the CRA, significantly contributed to the financial crisis.

Peter concludes, “Raghu Rajan [author of the new NBER paper Klein is highlighting] puts it in a very Austrian-sounding way” and then argues, “I’d reverse the order of emphasis — credit expansion first, housing policy second — but Rajan is right that government intervention gets the blame all around.” Klein is correct to reverse the emphasis.

Roger W. Garrison in Alchemy Leveraged: The Federal Reserve and Modern Finance  (pp. 445-446) as he often does, very clearly lays out this Austrian argument concerning the relationship between the interaction of central banking policy and housing policy in creating this most policy driven bubble/boom/bust cycle and crisis.

Putting housing policy in the right perspective, Garrison writes:

Unsound as these policies were, they were not the principal cause of the financial crisis. Again, Dowd and Hutchinson are right in identifying the expansion-prone Federal Reserve as the principal institutional cause. Had the Fed provided no fuel for the boom, federal housing policy, though perverse, would not have been unsustainable [emphasis mine]. The mortgage market would have had to compete with all other markets for the funds that savers provided. There would have been a continuing bias in favor of the mortgage market, and the ongoing rate of foreclosures would have been higher. House prices would have been higher (because houses and mortgage loans are complements), but they would not have been high and rising. Practitioners of modern finance would have paid due attention to the higher VaR, which would have reflected the expectation of an ongoing higher foreclosure rate.

Thus given Fed policy but without the housing policy there would still have been a boom and a bust with a bubble in some other interest rate sensitive sector.

In Garrison’s words:

… had the federal government not enacted legislation and created institutions that rigged mortgage markets so as to increase home ownership, credit expansion by the Fed would nonetheless have created an artificial boom, which inevitably would have ended in a bust.

In conclusion, Garrison adds:

The housing crisis in 2008 occurred because a credit expansion took place during a time when the federal government was pushing hard for increased home ownership for low-income families. We understandably identify these different cyclical episodes (the dot-com crisis, the housing crisis) with “what was going on at the time.” The common denominator, however, is the Fed’s propensity to expand credit.

Business cycles are complex but a critical factor in almost all cyclic, rather than shock driven macroeconomic crisis, is the Fed (or any central bank) feeding (turbo charging or piggy-backing on) whatever is going on elsewhere in the economy. Without the created credit and the associated lower (relative to the natural rate) interest rate accompanied by less risk adverse credit environment generated by monetary policy, distortions in the economy are more easily discovered and corrected before they can become unsustainable with economy wide repercussions.


  1. Housing Bubble / Financial Crisis Timeline:

    Pre-2001: CRA, mortgage interest deduction, government guarantees and other support for the housing sector has long been in place. Both major political parties desire to promote home ownership.

    Developing countries’ and their citizens’ savings are invested in long-term Treasurys, bringing down long-term rates including traditional mortgage rates.

    These factors support housing values from the mid-1990s onward, even after the bursting of the bubble.

    Post 9/11, Americans culturally become focused on their own homes rather than travel or external recreation – improvements such as granite countertops, additions, home entertainment centers, become sought-after.

    Lending standards typically include credit (primarily, repayment history) check, income and debt service coverage check, and loan-to-value (loan amount versus value of the home being financed). This has not changed in years.

    The way you go about buying a home is to first become pre-qualified for a mortgage up to $X. This is based primarily on your ability to cover the loan payments. The lower the rates, the higher your pre-qualification, and vice versa. You’ll be approved for that amount subject to loan-to-value limit on the home you are purchasing – but generally the purchase price is the deemed value. This assumes that nobody wants to overpay and assumes a slow and steady increase in values with population growth.

    Low delinquency and default rates on mortgages have been the norm for decades. For decades, historical delinquency and default rates were effective ways to predict future delinquency and default rates . Most people fix for a long period of time, and when rates spike, fewer people take out mortgages and not many mortgages “re-set” at the higher rates. Short rates have never plummeted and then sprung back up, leaving a relatively flat yield curve, thus there has been no incentive to finance with short-term money. ARMs and HELOCs exist but are not as popular, as the curve has been relatively flat and there has not been a period characterized by a massive, sudden creation of new home equity out of thin air.

    Because of the historically low delinquency and default rates, and government guarantees, and because a pool of loans diversifies risk, CDOs look like a rational way for banks to go a little further out on the risk-return curve to get a little more yield. The pressure to do this increases as bond yields fall, due to the increase in foreign savings.

    Refinance-with-cash-out and HELOCs are approved based on the above factors and an appraisal, which generally is based on comparable sales. The same comps can be used to appraise an unlimited number of homes. If you have a 100-home development built in the 1950s in a stable neighborhood with limited turnover, you might have three homes that were bought in the 1990s and sold between 2000-2002. Because to-date, values have not changed for the better in any rapid fashion, this has not yet been a recipe for disaster.

    Banks finance these builders with interest-carry at floating rates – thus if short-term rates were to plummet, the same rates that fuel the repayment source also lower the debt service. But this has not happened yet. Subdivision-development loans to most private developers of 10-100 unit sub-divisions, are based on a project-finance model, with cash draw to build 1-2 speculative homes and 1-2 pre-sold homes at a time. They are reviewed annually. Again, in a stable market which has never seen a massive temporary influx of credit, this is not a bad model, the only model possible unless you want all builders to also maintain apartment complexes with income streams.

    Mortgage closing attorneys, home sales closing attorneys, real estate agents and mortgage brokers are paid per transaction, thus have no incentive other than possibly reputation to think of the transaction beyond immediate terms. But-for bubble periods, this is not a significant risk – the risk of rapid changes in value is lower than the risk that the home will turn out to have termites, etc…

    The internet makes all markets including real estate much faster-paced – you can take a virtual tour of a home, search listings in a neighborhood, etc…

    In Sum, the government provides important supports to the housing market and housing and credit systems assume some small amount of monetary accommodation but are not built to deal with dramatic shifts in monetary policy. The market for real estate and mortgages has evolved, but not in a necessarily bad fashion, as long as values and rates remain stable. “The system” has worked very well for decades and are built for the environment that has slowly evolved over those decades. The secondary market for mortgages has grown, and is seen as relatively safe, precisely because the system has worked so well. There is unforeseen exposure to volatility in short-term rates, particularly on the down-side – but short-term rates are set by fiat and have not previously been volatile, at least not on the downside.

    2001: In response to the collapse of the bubble and the 9/11 shock, the Fed cuts the discount rate (and as a result, short term Treasury yields) to record lows, where they stay for almost three years. Some economists cheer this on – whether tongue in cheek or not – precisely as a way to inject cash into the economy through increasing home values. There is no other specific stated reason for the policy other than generally to “support” the economy.

    2001-2003: More people buy new homes with ARMs. The payments are incredibly low. The low pricing results in lower debt service for the same debt – meaning the borrowers can qualify for higher debt levels. The expanded credit soon translates into higher amounts paid for the same homes.

    2002-2004: People notice the values going up. Would-be renters start to scramble to buy “before we’re priced out of our dream of one day owning a home.” Would-be laborers in non-housing-related fields enter construction, and over the next few years make six-figure incomes, not through the value-add of the houses they build but through the appreciation in value of the land between their purchase of the lot and their sale of the finished home. Would-be professionals in non-housing-related fields become real estate closing attorneys, agents, appraisers.

    2002-2004: A refinancing boom begins. The 3-4 homes sold in the subdivision for $100M-$200M more than their purchase price 4-5 years earlier translates into a $100M-$200M increase in appraised values for the other 96-97 homes in the subdivision. People refinance with ARMs, with cash out, increasing their mortgages by $150M, and the payments actually decrease. People take on HELOCs – second position, floating rate mortgages. The money is then spent, temporarily boosting the local and broader retail economy. Banks and other institutions invest in huge mortgage-lending infrastructure to meet the demand for housing credit.

    2003-2004: Values really start to shoot up. Some banks, seeing a decrease in loan-to-value, believe that this will enable them to take on higher risk in other factors of the transaction. Lenders understand that rates will one day increase, but the focus in underwriting is on the transaction, and assumes the rest of the environment will remain. “This borrower might have trouble making the payments if rates go up by 300 bps before the ARM re-prices, but by that time the home will be worth another $150M and he can easily sell or refinance.” Mortgage lenders also consider that they will be selling the loan long before it re-prices. Nobody is thinking that the macro picture is just the aggregate of all of the similar transactions.

    2002-2005: Retirees who have some savings built up see second homes in the Sun Belt as a win-win – - buy that second home for recreation purposes but also hold it as an investment, thus not having to choose between spending and investment. A building boom occurs in Florida, Nevada and California. People who get in early enough finance a new home in 2002 and then refi or take out a HELOC in 2004.

    McMansions become the norm (and in the exurbs and Midwest, ranches), because people can afford them. Home Depot, Tractor Supply Company, Lowe’s, are the chief retailers, because people have to maintain their McMansions.

    2001-2004: With rates continually low, delinquency and default rates stay low. If you lower the bar, it makes it easier to clear the bar, thus fewer people will trip on the bar. Institutions continue to use historical delinquency and default rates to predict future delinquency and default rates because their predictive capacity appears to have, if anything, increased. There has never been a period in which millions of people could get 3/1 ARMS in the low 3s and had them re-price in the high 6s, because the rates had never gone that low – so the inability of predictive models to pick this up has never previously been a problem.

    2001-2005: With rates remaining so low, the savings rate goes negative. 0% credit cards proliferate. Many people take them on and max them out. There is no incentive to save and every incentive to borrow – if you can get what you want now, with negative real financing cost, why would you save?

    2004: The Fed starts to slowly raise rates. There is even more of a frenzy as the former renters who were already thinking “I’d better buy before I am priced out” also think “I’d better buy now while I can still afford the payments, before the rates go up.” Few take the analysis to the next step: “if the rates go up, the values will stop going up.” The “mania” is a follow-on – it is a characteristic of a bubble in the mid-late throes, but it is not the cause.

    2005: The short rates are not low enough for HELOCs and ARMs to function as conduits to build up the values and inject new-found cash into homeowners’ pockets. Values peak. Refinancing and HELOC volume slows.

    2005-2006: Mortgage lenders, principally those that do not hold on to the mortgages, have spent the last 3 years building out their infrastructure. They need to maintain volume. To do so, with values no longer rising, they need to lower credit standards. This is when the proliferation of no-doc loans, 0% down loans, etc…, occurs.

    2007: Those subdivision builders with floating rate loans see their payments going up, and see a slack in demand for the homes they are building. The loans come up for review and the banks stop financing new speculative homes, and pressure the builders to sell faster, even at a discount, to stop the bleeding (interest accruing at the new higher rate). Values start to come down. When a new house sells for $50M less than the same model did a year earlier, this has an effect on comps/appraisals for HELOCs and ARMs – as well as people attempting to refinance their HELOCs and ARMs at fixed rates – that is opposite of the effect of the rising prices 4-5 years earlier.

    2001-2007: Prices of non-housing margined assets rise and then plummet as well, in inverse proportion to interest rates. When rates are again cut, commodity prices rise again. Such assets include oil and gold. Oil-rich states such as Texas and Alaska do not suffer the same housing bubble – the values go up but do not come down, as the oil-related revenue continues to fuel a local boom. Gasoline and heating oil prices shoot up, eating up more of the budget of people who bought the McMansions.

    2007: HELOCs and ARMs originally priced in the 3s re-price in the 6s, 7s and even 8s, and the payments increase by 50-60%. They cannot all continue to make the payments, particularly with energy and food prices so high. Delinquency and default rates start to spike up. Homeowners with short-term financing are no longer maintaining their consumption levels, and they are not being replaced with new cash-out consumption, and so local and retail spending falls, affecting the economy as a whole. People with non-housing jobs and fixed-rate mortgages lose their jobs and fall behind on the payments.

    Most of the second-home mortgages are non-recourse. Because of rising fuel prices, it also costs a lot more money to fly to Florida, Nevada and California. If you’re 70 and under-water on a non-recourse mortgage on a vacation home that costs more to visit, your best bet is to mail the keys to the bank, and that is precisely what happens.

    2008: With the sudden spike in delinquency and default rates, the CDO market collapses. The construction workers, the mortgage lenders, the real estate brokers, are all laid off. Unemployment also increases among the ranks of those who marketed, distributed and sold the items that these people used to buy. The bubble in margined-commodities temporarily crashes as well, at the same time, but recovers when the Fed cuts the rates again, thus preventing price deflation which could have provided some relief to the newly out-of-work.

    2008-Present: Fed’s response is to cut rates even lower and flood the economy with money. Federal government’s response is bailouts and “stimulus” spending. Fed ends up buying 60% of the Treasurys at auction in 2011. China, Japan, banks and other institutions buy up much of the remainder. Banks got burned with housing and won’t lend there, but commodities are right back up. Prices are not coming down despite the recessionary conditions, because of the new money. Fuel and food prices do not factor into CPI, thus reported inflation is lower than people’s actual experience. Large businesses have locked-in and used the low rates to de-leverage. They deposit the cash in banks, which is mistaken for “cash on the sidelines” – banks use it to by Treasurys, since the federal regulators do not make them reserve against sovereign debt but make them reserve up to 11% against private debt. With meager individual savings, a result of the previously-discussed prior decade of spend-spend-spend, there is little left over to invest. The cycle generally starts with emerging firms raising equity from these savings, and cyclical firms getting bank loans to finance equipment production to meet demand from these emerging firms – demand was pulled forward in the 2000s at the expense of savings, and so now this cannot happen. 0% rates do not help. This is the classic Hayekian Triangle.

    Conclusion: The but-for cause, the first domino, the factor without which most of the other factors would not have occurred and NONE of them would have resulted in a boom-crash cycle, was the Fed’s rate policy from 2001-2005.

    Alternative Theories:

    “Mania” – as discussed above, while this was part of the vicious cycle, it was a follow-on event, and would not have happened but for the initial boom, which resulted from the rates.

    “Exotic mortgage products” – what was exotic about them? The exposure to volatile short-term rates, which previously had not been volatile.

    “Risk” – risk of what? Risk that the ARMs and HELOCs originated at low rates would re-price at high rates. Risk that the rise in values that resulted from this influx of credit would stop when the influx of credit ended. No-doc and low-doc? Yes, bad risk policies – but again this was a follow-on event – but-for the initial boom, there would have been no massive increase in overhead in the mortgage and housing industry, and the decision “do we lay these people off or do we get more creative about how to maintain volume” would not exist – there would be no infrastructure and no volume to maintain, and these people would have done what they have to do now, which is find work outside of housing and mortgages.

    And again, most of the damage was done not via this late-cycle detour from historical lending practices but via the fact that the historical lending practices did not account for such a volatile shift in rates. Predicting default rates for a portfolio based on historical rates works as long as the environment does not shift; predicting default rates for an individual loan based on debt service coverage and loan-to-value is rational assuming stable rates thus stable loan payments.

    “Decline in aggregate demand / not everyone laid off was in construction or mortgage lending” – as noted above, people stopped saving and spent beyond their real means, because the immediate, credit-infused means were suddenly available. This was by-definition unsustainable, which meant that the jobs temporarily created by virtue of that credit-infused demand had to go away when the credit went away.

    “Savings glut” – the increase in foreign savings did not reverse itself; the low short-term rates did, and that is when the housing market shifted and the bubble burst.

    “CRA” – amplified the bubble and directed some of the new credit into places like Detroit, but cannot explain the Sun Belt or anywhere else. Bad policies but not the policies that caused the bubble.

    “Big banks marketing high-risk CDOs as low-risk CDOs” – bad actions, primarily in 2007-2008. When the bubble was bursting, those who saw it first took advantage. That wasn’t the cause of the bubble. You really can’t put the CDOs sold in 2004-2006 on which a higher than expected proportion of the underlying mortgages would go into default three years later into the same category as the last handful of CDOs that they got out the door just before it all fell apart, which means that the malpractices that people like Elizabeth Warren complain about are genuinely bad acts that should be punished, they are not, and should not be confused as being, the cause of the housing bubble and bust, or the prolonged recession that has ensued, any more than the boiler-room stock brokers in the late 1990s caused the bubble-bust. The smart money might ride the bubble and jumps off in time, sometimes illegally and/or immorally – but it doesn’t create the bubble.

    This was a credit-bubble, plain and simple.

  2. The article, and the book that was reviewed, also devote much time/space to the Gini coefficient and income distribution. This is a red herring. My neighbor makes more money than I do. If my neighbor wins the lottery and I get a $20K raise, the “gap” grows, and my “share of the building’s income” falls – if I get a $5K raise and my neighbor not only does not win the lottery but her firm cuts her bonus, the “gap” shrinks and my “share of the building’s income” increases. Clearly I am better off, however, in the former scenario. And that is the difference between America and Scandinavia, and between America post-1980 and America in Krugman’s beloved 1950s.

    Another difference is that, we’re comparing households and average household size shrank during this period. Yet another is that the former influx of middle-income workers from Europe was replaced with an influx of lower-income workers from Mexico, the Caribbean and South America.

    Bottom line, “income distribution” is a red herring, and I think it is one that is deliberately placed. One re-states the numbers in the relative because the numbers in the absolute don’t support their point.

  3. I work in banking – commercial but the banks for which I have worked have done both commercial and residential, both of which are affected by CRA. It’s difficult to quantify the effect of CRA on banking – - basically the banks are graded on their support of the community in which they operate, and those grades are considered when deciding whether the bank can acquire a new bank, or do anything else that requires regulatory approval.

    The idea behind CRA – that banks taking deposits from poor neighborhoods should have to meet poor neighborhoods’ credit needs – is a bit absurd (poor people tend not to have much in the way of deposits, and many of them don’t use banks at all because their deposit accounts never have the minimum balance required to not be charged a maintenance fee to compensate for the fact that the bank can’t lend $25 out at a margin and thereby make up the cost of maintaining a checking account). The end result of CRA – steering credit into less-profitable investments – is obviously inefficient and bad for the economy, if by “good” for the economy you mean maximizing consumer benefit from the resources that exist.

    But that does not mean that CRA played a causal role in the housing meltdown.

    It was the rates, it was the rates, it was the rates.

    The Fed cuts rate so far so fast that people and banks started going short, and more real estate lending took the form of ARMs and HELOCs. This steered a ton of credit into real estate, which in turn bid the values up. This happened quickly because it always happens quickly: loans are approved based on debt-service-coverage (the lower the rate, the more leverage the same borrower can take on); loans also must meet a loan-to-value test, but the value is determined based on an appraisal. Three homes in a 1950s-era development that sold for $225K in 1991 sell for $350K in 2001, EVERY home of a similar size in the same development is now deemed to be worth $350K, and the ones on the corner or with an addition are worth $395K.

    THEN the frenzy begins. Renters think “I’d better buy now before houses are out of reach.” Lenders think “I can approve a tight deal because the values have to go up like this for only 1-2 more years, and then if THIS borrower gets into trouble, he can sell and repay the loan.” Nobody’s thinking any more about what caused the boom, and that a reversal of this cause would cause a crash.

    THEN the nice neighborhoods get priced up and lenders think it’s time to focus on neighborhoods where the values haven’t shot up yet, thinking that these still have upward potential. People get priced out of Newton and Brookline and start buying in Needham, then in West Roxbury, JP, Dedham, bidding the values up there, and so on and so on. People who get priced out of Wellesley and Wayland start buying in Natick. And again, it takes only 2-3 sales in a development to re-price the rest of the development for purposes of getting a HELOC or refinancing with an ARM – - and because the rates are STILL low, the mortgages cash flow.

    In short, the standards by which banks approved loans did not change during the 2001-2004 period. The low rates had the effect of pumping up the values and making it temporarily easier for a borrower with a given income to make the payments.

    Meanwhile the ratings agencies did not change the way they rated the mortgages – - because home mortgages had historically enjoyed very low delinquency and default rates, and increasing values were seen as a new mitigant to default risk. The previous low delinquency and default rates resulted primarily from the fact that there had not previously been this kind of sudden swing in mortgage pricing, certainly not in the era of ARMs and HELOCs.

    THEN some banks lowered their standards – because the initial injection of credit had fueled a boom in values, which the banks thought meant the borrower could easily sell to repay the loan. AND because the ratings agencies did not change their methodology.

    THEN some banks invested in overhead – employees, systems, advertisements – to build out their mortgage businesses. THEN when the rates started going back up again, the banks that had made these investments started to change their underwriting standards to maintain volume – aided in part by the fact that the ratings agencies continued to operate using the same methodology.

    THEN fewer and fewer people qualified for ARMs and HELOCs because they could not make the payments at the higher rates, and with less credit being pumped into real estate, values stopped increasing.

    THEN the ARMs and HELOCs from 2001-2003 re-priced, and with a suddenly less liquid market, the owners couldn’t just put the place on the market to pay the debt off, and delinquency and default rates soared. Moreover, with fewer buyers and higher borrowing rates, developers slowed down and started laying workers off. Moreover, with people not being able to borrow against new-found home equity to pay for improvements, and contractors laid off staff and had less money to spend. The homeowners themselves could no longer leverage new-found home equity to buy more stuff. As a result, contractors and non-contractors alike were buying less stuff. The economy slowed, unemployment increased, and more people were unable to make the payments even on fixed rate loans.

    But we cannot confuse the order of the dominoes here. The first domino was the ARMs and HELOCs re-pricing.

    And we cannot miss the but-for cause of all of this – the rates. Even without government support for home mortgages and home ownership, even without the mortgage interest tax deduction, even without CRA, the same thing would have happened. These factors merely amplified the boom-bust.

    There is no other cause. And there are really no other arguments. People talk of “exotic lending products” – what was exotic about them was the short-term RATES. People talk of “risk” but what “risk” is that? Interest rate risk. People talk of leverage but as discussed above, the leverage ratios increased because the lower the rate, the more debt a borrower can service – as long as the rate stays low. So “exotic products” and “risk” are not different arguments from rates.

    You could blame the banks for not foreseeing that the low rates were unsustainable – but banks and bankers, like most firms and people, forecast only 12-24 months. And the few banks who did foresee it – like Goldman – get creamed in the press for hedging their position on mortgages once the rates had gone up, which is the prudent thing to do. And what exactly is it that the banks should have foreseen? The reversal that, to avoid 1970s-style inflation, HAD to happen in Fed policy? Banks and bankers should know better, and after-the-fact some of them do – but if the problem with the banks is that they did not foresee the result of unprecedented and unnecessary swings in Fed policy, clearly the greater blame should be assigned to the Fed itself.

    Clearly the Fed policy was the but-for cause of the boom-bust. All other factors were factors only in that they increased the market’s exposure TO this factor or resulted in turn FROM this factor. If after 9/11 the Fed cuts rates only to 2.5% and only for one year, then ratchets back up to 4% and stays put, this never happens, this can’t happen.

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