What Caused the Housing Boom and Bust? A Timeline of Events
With the end of the latest version of the homebuyer tax credits and the rise in interest rates (stemming from the Federal Reserve’s cessation of purchasing mortgaged-backed securities), many in the real estate industry are in wait-and-see mode when it comes to the future health of the U.S. housing market. All are hoping that the decline in housing values has reached its end and that a “double dip” in values (meaning that values would again decline after a slight increase over the past year) does not occur.
Regardless of the immediate results, eventually the housing market will be on the rise again. If we want to avoid a downturn similar to what started in late 2006, it is necessary to examine the root causes of the crash in order to avoid repeating those same mistakes again.
To that end, I highly recommend The Housing Boom and Bust by Dr. Thomas Sowell . I’ve long been an admirer of Dr. Thomas Sowell, an economist and senior fellow of the Hoover Institution at Stanford University and one of this country’s best free market thinkers.
A politically popular theory says that “greed” caused the boom and bust in the housing market. To exemplify this “greed”, advocates of this theory point to the reckless lowering of lending standards by U.S. banks and mortgage brokers and the rampant speculation in the housing market. Dr. Sowell carefully points out that these factors were symptoms of the disease.
In truth, the very government that has been actively engaged in fixing the housing crisis was the most responsible party for creating the environment that led to the crisis. Moreover, the housing bubble and its subsequent bursting was set in motion at least thirty years prior to the crash with laws passed to encourage the growth of “affordable housing”.
Here’s a brief timeline of events leading to the boom and bust in the housing market:
Under the auspices of encouraging “affordable housing”, the Federal Government enacted the Community Reinvestment Act of 1977, which directed “each appropriate Federal financial supervisory agency to use its authority when examining financial institutions, to encourage such institutions to help meet the credit needs of the local communities in which the are chartered consistent with the safe and sound operation of such institutions.”
Starting in late 1989 with the George H.W. Bush administration, and continuing more aggressively with the Clinton administration, the U.S. Department of Justice (“DOJ”) began investigating financial institutions over alleged racial discrimination in mortgage lending practices.
In 1993, the U.S. Department of Housing and Urban Development (“HUD”) began commencing legal actions against some financial institutions who turned down a higher percentage of minority applicants than white applicants for mortgage loans. In addition, DOJ would use its power to block several bank mergers if either of the banks involved engaged in what DOJ believed were discriminatory lending practices. Community activist groups such as ACORN seized on this second course of action, pressuring banks to make riskier loans to quell potential objections to an intended merger.
With DOJ and community activist groups bearing down on them, lenders loosened their lending practices to approve more low-income borrowers.
At the same time, HUD imposed quotas upon Fannie Mae and Freddie Mac to purchase mortgages made to people in the “underserved population.”
In the late 1990s and early 2000s, the Federal Reserve System lowered its interest rates to historically low levels and kept them there for many years. These low rates, combined with the push on lenders from DOJ and HUD to approve more low-income borrowers, led to the creation of the mortgage products often highlighted as the root cause of the housing bubble; namely, the interest-only mortgages, the adjustable rate mortgages (ARMs) and the option-ARMs which allowed borrowers to skip a monthly payment if they so desired, along with other products classified under the “subprime” banner.
The three financial ratings agencies recognized by the Securities and Exchange Commission (“SEC”) – out of the hundreds of similar agencies which exist – Moody’s, Standard & Poor’s and Fitch, having little incentive to develop new and better ways to assess risk because of their government-granted monopoly, overvalued the securities backed by these riskier mortgage products.
When the Federal Reserve began to raise rates in 2006 to curb fears over inflation, it toppled the house of cards which our housing market had become. The higher rates choked off what had been a steady stream of new homebuyers, leaving those with the risky loans unable to pay back the mortgages they had received; banks then foreclosed and, not being in the business of owning real estate, sold these homes at greatly reduced rates. This drove prices even lower and forced other borrowers into default (since they could no longer refinance out of their less favorable mortgage loan nor could they find a willing buyer at a price necessary to satisfy all indebtedness against the home). And the race to the bottom was on.
With housing prices falling and defaults rising, the holders of these mortgages (Fannie Mae and Freddie Mac) as well as the holders of the securities backed by these mortgages (Bear Stearns and the like) tanked, triggering the economic recession and leading to the now infamous bailouts (TARP in 2008 and the stimulus bill in 2009).
What’s notable about this timeline is how small a role the usual suspects, i.e., “greedy Wall Street bankers”, “banks and their risky lending practices”, “speculators”, even more abstract villains such as “deregulation” and “the market”, were not at the forefront of causing this current crisis. Rather, a litany of government agencies – DOJ, HUD, the Federal Reserve, the SEC and government-backed private institutions such as Fannie Mae and Freddie Mac, all acting in furtherance of the Community Reinvestment Act of 1977 and the noble goal of creating more “affordable housing” (whatever that means) – set the events in motion that ultimately led to the crumbling of the U.S. housing market.
The most salient point of Dr. Sowell’s book is his analysis of the government attempts to revive the housing market. In fact, he writes, “the market has already responded quickly to the housing crisis, with a drastic reduction in interest-only loans, no-down-payment loans, and other such ‘creative’ financing.” Everything else – the homebuyer tax credits, the loan modification programs, TARP and stimulus bills – are simply more of the same: a government solution to a government-created problem, and likely will result in a similar set of unintended consequences as the last round of fixes.
So, you ask, what is the solution to this larger problem; i.e., the nonstop government intervention into the free market? You’ll have to read the book to find out.