 Welcome to Free Thoughts from Libertarianism.org and the Cato Institute. I'm Aaron Ross Powell, editor of Libertarianism.org and a research fellow here at the Cato Institute. And I'm Trevor Burrus, a research fellow at the Cato Institute Center for Constitutional Studies. Our guest today is Mark Calabria, Director of Financial Regulation Studies at the Cato Institute. Today we're going to be talking about government housing policy, how it created the financial crisis, helped create the financial crisis, and how it generally distorts the market. First, because it's generally the case with these when you're on mark, Aaron and I know very little about this. So we're going to be asking a bunch of possibly dumb questions. So the first question I think is this 30-year fixed mortgage. I think historically too it's important too. We hear about this all the time. Your 30-year fixed mortgage, like it's this, it has to be the case. It's the only way you could possibly buy a house. Why is this such a huge part of the American marketplace? You know, there really is an obsession with the 30-year fixed mortgage. Let's actually back out, I guess even on a smaller level. The reason is 30 years is because that's obviously the amount of time that the mortgage is outstanding. A fixed rate obviously means that the rate does not vary over the term of the mortgage as opposed to adjustable rate mortgages. Worth keeping in mind, most of the rest of the world uses adjustable rate mortgages far heavier. There are some distinguishing differences. I mean, you can get a 20-25-year fixed in Germany at a rate that parallels which you can get a 30-year fixed in America today. And so some of the thinking of course is that, well, you have certainty in your payments. I'll set aside that the typical life of a 30-year mortgage, and of course I'm giving you a median. So of course there are some people who stay in that house for 30 years. The median is closer to seven or eight years in terms of how long someone stays in a house. One of the policy rationales, and it's really important to keep in mind, the seeds of the 30-year mortgage came out of the creation of the Federal Housing Administration, FHA, in the 30s, which started out with a 20-year mortgage when it was created in the 30s, which is really revolutionary, both in good and bad way. And so up until the Great Depression, the typical mortgage was five or 10 years. Sometimes a balloon payment, which meant that you would pay interest for a number of years and then all of a sudden you'd have a very big payment at the end. It's certainly important to keep in mind they were almost always refinanced. They usually were rolled over. One way to think about it for those who follow commercial real estate is the typical residential mortgage pre the Great Depression looked like the typical office loan today. Obviously it's a lot smaller, but a lot of the features that are common in the office market were common in the residential market. Such as what? So there could be interest only. It could be balloon. It could be for a short time, such as a five-year loan or a 10-year loan. It could be floating for part of that. And of course some of the features we've saw during the crisis and pre-crisis, I should certainly say a lot of the things that we saw in the crisis were actually developed in the 70s and 80s to react to the very high rates of inflation we had. So the fixed-rate mortgage works wonderful up until the 70s and 80s when interest rates went up and all the savings and loan industry had these fixed-rate mortgages on their books. So the first question, this might be the last question in some way or two, but why is the government setting the terms, the durations of mortgages? It seems like that market would absolutely have you get a 20-year one, you get a 17-year one, you get a 60-year one. If you really like going long, it seems like that would have all those different availabilities. So the initial reason for extending the duration, it's another example of crisis hits, government intervenes to try to moderate the effects of the crisis, and then that intervention doesn't go away. And so one of the reasons that 30-year mortgages are thought as attractive is that because you've stretched out the time that it amortizes, the monthly payments can be lower for the same house price. So if you're in the middle of the Great Depression and everybody has 10-year mortgages and they've got a, at the time, would have been a $5,000 house or something, and they're paying a 10-year mortgage, then to lower the monthly payments, you refinance them into this 30-year mortgage. Suddenly they've got the same size mortgage, they've got the same size house, but now their monthly payment's a lot less. So it really was a reaction by the government to say, let's kind of keep people in their homes by reducing their monthly payments. We'll do a wink and a nod with the banks by, we won't actually forgive the loans, still same loan amount. And again, you have that extra duration and it also allows borrowers over the course of cycles to actually bid for higher house prices. So one of the reasons that the real estate industry loves the 30-year mortgages, it allows you and I to bid more for a house. What did the banks think of this? So it's certainly important to keep in mind that most of the banks up until the 20s, so national banks weren't even allowed to actually do mortgages until the 20s. And for the most part, the real estate concerned about the fixed rate component of it. So let's think about there are at least two risks inherent to the mortgage. There's the credit risk, which is, you know, I give Trevor a mortgage, I give money, he's a deadbeat, doesn't pay me back. That risk is to you, is the lender? That risk is to me as a lender. The other risk of me as a lender is the interest rate risk. And of course, this is the same for a borrower or for a lender, is that the interest rates change dramatically over the time of the mortgage. Why would that occur? So it could incur for inflationary reasons. It could incur for business cycle reasons. So for instance, the setting aside the actions of a central bank, which tend to reinforce this in recessions, interest rates tend to fall because investment demand tends to fall. In expansions, interest rates tend to go up because of investment demand that tends to expand. And so if you have a adjustable rate mortgage, you know, when the flip side would be in a recession, your mortgage payment should fall, which would be a consumption boost right when you want it. And of course, during expansion, it would moderate your consumption. So adjustable rate mortgages actually are pretty good at moderating the business cycle. It's fair to say that what we have today, commonly in America, is kind of a one-way adjustable. So you might see this in commercial mortgages. You see this in the subprime market as prepayment penalties. But in the prime market, it's commonly understood that borrowers will refinance pretty heavily into a lower rate when rates fall. So we have it actually, the fixed rate is kind of misnomer. It is a adjustable one-way down in some ways, as long as you're not underwater and can actually qualify for a new mortgage. Well, let's take a step back so we can get the big picture here. Obviously, the interest rate, it's a price like anything else. It goes up and down based on whether or not there's a lot of – mostly demand for lending and whether or not there's a lot of supply of money to lend out. Is that pretty much what creates interest? Yeah. So there's demand and supply for livable funds. And of course, there is inherently, in all of that, our discounted value of time. So it's important to keep in mind that most of what the federal government has done, whether it's FHA, whether it's Fannie or Freddie, whether it's rural housing service, there are a number of mortgage programs, actually just guarantee the credit risk. So this is one of the confusing elements of the debates you hear about Fannie and Freddie and the 30-year mortgage, which is – what's interesting about a 30-year mortgage is the interest rate risk. But Fannie and Freddie don't actually cover that. They just cover the credit risk, which is the fact that somebody will repay. We need to definitely clarify this. So the interest rate risk is the risk that the interest rate will go – the normal interest rate will go below what you're paying. Or above. Or above. So therefore, your fixed rate is no longer going to be accounting for the interest rate. But the credit risk is the risk that – The person just doesn't repay. It doesn't pay at all. Or what about burns down the house? Is that also a credit risk? That's a credit risk as well. The underlying collateral risk. So let's keep in a quick example would be what did in the savings and loan industry was. Savings and loans entered the 70s and 80s with 30-year mortgages on their books. And so if you've got a 5% mortgage on your books, but all of a sudden the cost of your funds becomes 10%, you're losing money real quick. And so because deposits, which are mostly how savings and loans and banks are funded, even on Wall Street, they might tend to be more shorter-type funding. Since your shorter-term funding goes up and down pretty quickly, banks would ultimately prefer to have the cost of mortgages match the cost of their funds and that way it reduces that risk. Now we've made a broad public policy decision to say that homeowners should basically not really be able to get to choose. They do get to choose, but we should put our thumb heavily in the scale in the way of having financial institutions bear that interest rate risk rather than households. Let me ask what may be a very dumb question about the variability in the variable rate and where that comes from and how that's influenced by things outside of the relationship between, say, me, the borrower, and you, the specific lender. So interest rates are often – I mean, they come from a very basic level. Like if I want to borrow $100 from you, I have to pay you for not just – I have to pay you because you now don't have that $100. Exactly. So I'm giving you some percent over time to compensate you for not having the $100 until presumably when I get to the end of the payoff period. So some of that would be you're paying me to defer my consumption. Right. Now so that's kind of the time value element of it. So you could think about one of this is the time value element of it. Because that I don't see how like the variability – that's something we agree upon when we enter into it. And so the outside conditions, I don't see how those might impact that level of – So built into the time value of money would be the value of money going forward. So the inflation rate. So for instance, one of the reasons that – and you've seen this a number of empirical studies have looked at this. The reason, for instance, that America has a higher share of fixed rate mortgages than, say, Italy is because we have actually, despite – I'll be the first on the Federal Reserve, but I'd also be willing to say that the record of the Federal Reserve post-World War II has been better than the record of the Bank of Italy pre-Europe. And so countries with very high rates of inflation and very variable, unpredictable rates of inflation just don't have long-term financing. And so part of it is, again, you are for me – you're paying me to defer my consumption, but I need to make sure that my consumption in the future when you pay me back is protected against inflation. Okay. Yeah. If you were in Weimar, Germany, it would be very hard to be like, I'll lend you a billion rex. I'm sorry. I'm sorry. It's a billion Deutschmarks now, but next week it's going to be worth nothing. So I would emphasize, the biggest driver of whether a country uses predominantly fixed financing for its mortgage market is really its monetary policy and history of such and the inflation rate. Yeah. That drives more than anything. But what about – see, the other part of the story, though, which I think is the really interesting part of the story is that there's a thing about – there's a political side to this. Oh, yeah. There's a thing about houses in America, which is – I mean, I'm not the same in Europe. I mean, people want to own houses in Europe, but it's not this constituent element. It's not baiting the American greed. Exactly. You're a white-picked fence in your Donna Reed show if – It's surreal. It's a very good question of why is there obsession about it in the U.S.? Certainly, it should start – we'll say among developed countries, we're only 17th or 18th in terms of home ownership rates. So let's keep in mind places like Canada, Switzerland have higher home ownership rates. It does seem to be that countries that have more of an attachment to private property rights tend to have higher rates of home ownership. And you do tend to see that. Now, of course, it's also a function of the affordability relative to incomes, the ability to own land and property in general. But there is something uniquely American about obsessing about home ownership in a way that you generally just don't see around the rest of the world. Do we know – so there's – we can compare actual home ownership rates, but is there – can we compare expected home ownership rates? Like, are Americans more likely to think that at some point in my life I'm going to own a home than people in other countries are? So they are, and there have been studies. So for instance, it might be a shocker. Someone who's 25 is much less likely to own a home than someone who's 35. In somebody who lives in a rural community is much more likely to own a home than someone who lives in an urban area. So a number of studies have looked at this and said, let's hold demographics constant statistically across countries and see if there's a big difference. And you certainly see most of the difference between the U.S. and other countries goes away, but some of it still remains. So there's still so – yes, the biggest differences are for a wealthy country in which we have an older population. Countries that also have older populations tend to have high home ownership rates. But again, I would emphasize there is an unexplained residual in those regressions that certainly suggests that there's something an attachment in America to home ownership that's not at the same level. Right. Well, that's what I was asking about, I guess, is not expected in the sense of like, will people actually at some point in the future? You'll see those polls of high school kids where you'll ask them how much do you think you'll be making when you're 40 and they enormously overestimate how much they think they're going to make. And so that's what I'm getting at. It's like Americans – there are a lot of Americans who think like, I'm going to own a home someday and then never will. And is that number – whereas you might say ask Canadians, do you think you're going to own a home someday and they might be more realistic about it? That's a good question. And I haven't seen surveys that actually ask this question. I will say there are number of surveys that ask people in America what they think house price appreciation is going to be. And so on average, people tend to way overestimate how much they're actually going to see an appreciation. And of course, there's confusion between real and nominal values in that as well. I think for the most part, if you consider that we've got a home ownership rate just over 64%, there have been certainly a number of studies that have tried to estimate the home ownership rate. And it is quickly accountable for a number of factors that make sense like age, household structure. If there's – I don't think there's an exaggeration that a lot of people think they're going to be homeowners and not. It's a question of when. I'll also say – because I know we're going to get to the conversation sort of about the financial crisis and the politics of it. One of the things I think we have not unique but different here is so much of our mortgage finance policy is influenced by racial politics. And of course, as we all know, there are racial politics everywhere in the world. But they are certainly impact mortgage finance policy in a unique and dangerous way in America. So, yeah, to return to the story, as you said, the story so far, the 30-year fixed rate, the Federal Housing Administration, which is created in the 30s during the New Deal. Now, you've mentioned Fannie Mae – so we're going to build up the constituent elements of federal housing policy up to the crisis. You mentioned Fannie Mae and Freddie Mac. When did they come in about? So, Fannie Mae was initially created about a year after FHA. It was created to be part of a government agency. So, if you hear the term Genie Mae today, Genie Mae today is what Fannie Mae started out as. A wholly-owned government agency that could only buy initially FHA loans. And where did it get the silly name? Because it's an acronym. It's a Federal National Mortgage Association. So, I mean, and Freddie's got a similar name. So, Fannie Mae was created, I believe in 34, 35 or so, created after FHA in order to buy and create a market for FHA loans. So, there was a sense of we created FHA. Lenders did not follow over themselves to participate. So, how do we create a way to get people to participate? It's one of those things where first government and intervention is not all that successful. So, how do you have another government intervention to put a patch on the previous government intervention that wasn't all that successful? And success here was home ownership rates? Success was really trying to move the mortgage market because for the first decade of both FHA and Fannie's existence, home ownership rates fell. Which is great to present. Exactly. So, of course, you know, Paul Krugman was here. He'd say, well, it would have been worse. So, of course, we have no counterfactual. We don't really know. But it's certainly fair to say that home ownership rates did not move much during this time. In fact, home ownership rates didn't move until after World War II. And of course, there are a lot of arguments for that in court in the VA loan program. Expansion managers said, highways and such. So, Fannie was created in the 30s. Fannie initially only bought mortgages. That's also something to keep in mind. Fannie and Freddie do not buy mortgages. They buy more, rather directly from the consumer. They buy mortgages from the banks. So, the bank gives you a $300,000 mortgage. So, Bank of America makes you the mortgage. They have the deed on the house. You're paying the, and then they can sell it to Fannie. They sell the mortgage to Fannie. And then when your payments go, do they go to Fannie? Fannie and Freddie, though they are serviced by the lender. So, again, keep in mind, Fannie and Freddie are not set up in a way they're supposed to interact directly with the consumer. And so, initially, Fannie was set up to only buy from banks. Freddie was initially part of the savings and loan system and was set up in the late 60s to buy from the savings and loans, so that you had something parallel. And of course, after the savings and loan crisis, they were, quote-unquote, privatized. And they were, charters were changed so that they could directly compete. So, it wasn't until the beginning 70s that Fannie and Freddie could compete with each other. They had very different market niches before then and very different business models. Also, we're saying, pre-the savings and loan crisis, their market shares were in low single digits. So, the truth was, Fannie and Freddie were largely irrelevant before 1980, despite Fannie being around since the 30s. Even though there's a government-sponsored enterprise, it seems like it would be a more secure institution. So, let's keep in mind too that – so, Fannie initially in the 30s, if you go back and look at the authorized legislation, it was not meant to be unique. So, what the Roosevelt administration had proposed was a number of bank-owned associations, essentially cooperatives. And when Fannie was initially created, it was owned by its bank members. And so, it was thought to be that this would be multiples. It wasn't thought that there'd be a government guarantee. In fact, that's quite the opposite. It was thought to be, again, that this would – I guess I should add, one of the factors you have to understand in terms of development of our mortgage finance system is most of American history had a very fragmented banking system. And we've talked about this before. But the reason for that is that you've created Fannie and Freddie, FHA, and many of these things to try to bring diversification benefits as an offset to the restrictions on branch banking that you had. And these are the diversification we talked about in a previous episode that if you only have two banks and they're both based on the corn economy, then when the corn goes, then both banks go. It's even more so the case in the mortgage market because you think about if you're a bank that's located in one town and all of your mortgages are from that one town, you've got a whole lot of risk concentrated there. And, of course, that would still make it risk-free on an agricultural product because there are payments. So the point here being that the lack of branching policies or the prohibition on branching and diversification meant that the government thought that there were too few mortgages being backed up and given. And so Fannie came in to make up this problem. You're trying to essentially try to diversify the risk. So one of the reasons, if not the primary reason, you don't see Fannie and Freddie institutions around the rest of the world is because we are unique in how bad our branch banking restrictions were and the sort of financial protectionism we had for so long. And so you didn't need that, again, Fannie and Freddie were in interventions that offset the ill effects of previous interventions that were largely created at the state level. Interesting. So all of this was all these kind of wheels within wheels were set up in order to goose home ownership. I mean, we decide like home ownership is a good thing. We want to improve these numbers. Construction jobs is a big part of it too. Okay. But I guess what I want to ask is so whether or not these particular policies are good or bad in the sense of they can script the market. They can lead to financial crises. They can lead to other sorts of problems. The underlying motivation of it's good for people to own their homes is that true? Is it good for lots of people to own homes as opposed to renting? It's a very good question. There are lots of empirical studies that have tried to answer this. And of course, you have also problems of causality. So there are a couple issues here. So what does the research say that I think you can suggestively that is very strong findings? So very strong findings are there are a whole lot of positive attributes that are correlated with home ownership. We know that homeowners are more likely to vote. We know that homeowners are more politically active. We know that homeowners are more likely to maintain their homes. There are kids to college. So there's a whole lot of positive social outcomes that are associated with home ownership. Now, of course, it's something that we should all repeat to ourselves at least once a day. Correlation is not causing. And so there's a couple of things to pick out of that. And the way I sort of characterize it sometimes is does home ownership make people responsible? Or is it likely that more responsible people are more likely to become just this chicken and egg? I think there's a bit of a feedback myself. But it's also important to keep in mind most of the studies look at the average homeowner, not the marginal homeowner. So the average homeowner could be a very different person in terms of financial stability and the responsibility characteristics than the person just on the margin who would have not but for the intervention become a homeowner. So I would say I'm quite skeptical for another reason in that the vast majority of the so-called benefits associated with home ownership accrue to the individual. So think about it this way. If I'm Trevor's neighbor, I care that he doesn't leave junk in his yard and doesn't have his car up on center blocks. If I don't live in Trevor's neighbor, I care a lot less about that. So most of the quote-unquote positive externalities are negative externalities highly, highly localized. So you could say, I mean, if you want to use that you could argue these are justifications for zoning and such but they're not justifications for, you know, federal home ownership policies. Also say it's an important side particularly in this economic cycle which just came through which is there are also negative downsides of home ownership and the most obvious one is you're tied to your home. So for instance a gentleman and a professor in the UK, Oswald I cannot remember his first name but there's something developed that's called the Oswald hypothesis which has been supported across empirical states U.S. states as well which is the higher your home ownership rate the higher your structural unemployment rate. That makes sense because mobility. And so, you know, you think about it again, you know, and I think one of the problems in this crisis which one of the difference in this crisis previous recessions, the mobility rate of home owners increased. In this last recession the mobility rate of home owners declined for a variety of reasons that we locked them into place and so one of the downsides of home ownership is, you know, if you're that carpenter in Tampa who gets laid off who really ultimately for your own good and for society's good probably should move to Dallas and get a job, you're more likely to stay in Tampa and rate it out in these circumstances. So there are negative consequences I would probably say as much as a percentage point of excess unemployment rate this time around came from because of our high level of ownership going to the crisis. So by the 50s of course we have this big housing boom that occurs with some of the things we mentioned, veterans loans and things like this and Fannie is diversifying the market. Freddie said it comes about in the 60s for the savings and loan market which it actually cover listeners and for me too actually can you explain the exact difference between a regular bank and a savings and loan? Well today there's almost no difference. I mean they have eroded, you know, so this is something that has developed, you know, over a hundred plus years. So banks' initiatives I mentioned national banks couldn't even do mortgages at all until the 1920s. This was Hoover's great invention as Commerce Secretary was let's get banks into home ownership. So between the Civil War and the 1920s national banks could not do real estate loans at all. They were very limited to commercial short-term loans. So they were very different cycle and then the savings and loans which were up and at that point exclusively state chartered institutions that almost exclusively did mortgages. And so you've seen a convergence over time in these charters to where today they don't make a whole lot of difference. You know, there are still some regulatory definitions that require savings and loans or thrifts, however you want to call them to be more involved in real estate but again that is eroded over time. They used to have their own insurance funds. They used to have some different treatment in this but again more and savings and loans like up until I think the 70s also were not taxed like credit unions are today. So again there were some differences but those have eroded over time. So what was the next if we're at the 60s in the 70s that the inflation caused some of the problems but what was the next mistake in this line if we're moving up a big investment act or things like that? So let's keep in mind that we went into World War II with a national home ownership rate somewhere in the mid 40s by the time we got to the 60s. So the really big increase in home ownership rate was the late 40s and 50s. So we entered the 60s with the home ownership rate around 64% which is about where it is today. And so most again there's a lot of studies that debate these issues whether it was FHA, VA, interstate highway system you know and of course interstate highway system expanded the supply of housing and brought down its supply and of course there was a lot of forced savings if you will during World War II. A lot of money and ability to make down payments coming out of that and of course materials that were taken from war use and put in the housing. So bang, we're at the 60s we've hit the home ownership rate we are today you really entered the 60s and entered the 70s with a lot of social unrest because we all know was not a happy time in America for a variety of reasons. And you saw at that point the reaction and this first came in FHA, you know CRA was something later in the 77 where there was a sense of let's deal with urban problems by trying to increase ownership and of course to some extent the simplistic thinking of it was somebody's not going to burn down their own neighbor in their own house somebody's not going to break the window on there so some of this was how do you predecessor to Bush's ownership society of the 2000s you had an ownership society mentality in the 60s and 70s that tried to expand home ownership you say that the home ownership in the 60s was about the same as it is now but was it demographically the same like are there groups that didn't own homes then that do more now or does the picture look more or less identical? Proversially enough it looks worse for some of the groups in which you actually want to try to help today it does. So let's start with to me what I think is very shocking observation which is we have census data back for some time. In 1910 the ownership gap between African-Americans and Caucasians was about 23 percentage points so that meant that the home ownership rate for Caucasian households is 23% which is higher than that for African-Americans today that gap is 22 percentage points so in a hundred years we have reduced the percentage gap one point now that might sound bad enough if it wasn't a straight line because that percentage gap actually had steadily but slowly declined until about 1980 so 1980 actually was the low point in gap and again it was about 19 percentage points which was before really the growth of securitization so we made some very modest gains mostly post-World War II mostly sixties all of those gains were essentially reversed to where we're almost back where we were the progressive era pre-new deal in terms of home ownership rates by race of course I should say he's an aside and there's a lot of debate how much of this is driven by racism and of course for a very long time very extensive ugly racism in our residential housing market there's no debate about that very well documented there's certainly debates about how extensive that is today versus then but there are a number of studies that have looked at and said within the United States home ownership rates determined by demographics family structure income in these things and you see almost the entire difference in gap go away when you look at factors like like income family structure then you can of course regress that to say well of course those income differences and those family structure differences and all those wealth differences are all other factors and of course that's one of the bigger sort of knots within federal mortgage policy is the use of federal mortgage policy to try to fix all those other factors and the community reinvested act was related to trying to fix some of these gaps it was a little bit but let's keep in mind okay so what the community investment in my act has been sort of characterized I think mischaracterized by both its proponents and opponents so let's go back to what we talked about in previous conversations about local banks had monopolies for a very long time in America what is a monopoly do monopoly restrict supply raises price so accordingly with the very short and again the original community investment act is only a few pages long it's not that long less than 10 pages what it essentially says is you know you shall make credit available in your community so there was a real concern that banks were essentially gathering deposits in their communities following them off to higher value uses elsewhere are that because they were engaged in the local monopolies that they were restricting credit so in a sense I look at the initial CRA is an attempt again to offset previous government and inventions that restricted entry and created local monopolies so it essentially it was an initial attempt to try to nudge the monopolist to increase production a little bit and in this case that's loans it did not become a sort of quota system until the Clinton era in 1995 so the initial CRA was very process driven didn't really have much teeth at the beginning either because it only mattered when you were trying to merge so it's not only the 1995 regulatory changes it's also the 1994 Regal Neal Act which removed restrictions on branch banking which set off the merger wave so this is also an aside in the banking context the big growth and consolidation of banking was not the repeal of Class Deagle because by 1999 it was really between 1994 and 1999 the big growth and consolidation happened so you had and you also had a number of other things the home mortgage disclosure act was passed in the 70s you fair credit acts were passed in the 70s so you really had this sense of trying to open up access to credit markets and again I don't think there's any debate evidence and anecdotal evidence as well as empirical academic evidence our housing markets certainly up until the 70s and early 80s were certainly characterized by discriminatory behavior when do we get the legendary subprime mortgage that's a good question because people throw the term around a lot so subprime can either mean the borrower or the loan now in the borrower the usual cutoff is most of us have credit scores the leading credit score provider is Fair Isaac which produces the FICO score there are other credit score providers out there but the usual cutoff in the housing market or in credit marketing I guess I should say FICO was initially developed for credit card lending but is used widely in mortgage lending is anything under a 660 or a 620 tends to be the cutoff for subprime let me emphasize this data is incredibly strongly predictive somebody with a 620 FICO or a 580 FICO I believe the bottom is maybe 350 get some 350 about it so somebody in the 600s and the 500s has a very high probability of not paying you back and again that's just a fact now there are debates about how much we could extend this now the other type of subprime is often considered the product so a lot of products that were risk layered so you could think about pick a payment or option arm which would mean you increased the length of your principal so a number of loans were thought of as high risk regardless of whether if they were given to high credit borrowers and for the most part these high risk loan characteristics were almost exclusively given solely to people with high credit scores so you do see this breakdown what kind of risks would be there that aren't a factor of the borrowers credit score for instance a negative amortization loan where you build principal or an interest only loan so if you have a situation where the house becomes increasingly under water for instance one of the empirical findings and this should not be surprising when you think about it higher credit higher income borrowers are more likely to walk away if the mortgage is under water they're more ruthless as the way the literature puts it and again they have a better sense of what their financial situation is they understand that in most places like California a mortgage is non-recourse which means a lender can only go after you for the house and so you actually see this more ruthless behavior if you will on the higher end income and so that's an offset and so you often will see a bigger requirement to have more equity in those markets but again the point is that by and large subprime talks about first the borrower credit history second some characteristics of the loan that might actually be a higher risk like for instance during the bubble and you're starting to see this come back you might have seen loans with over 100% loan to value like 110 even 120% loan to value loan explain exactly what that means so loan to value the size of the loan divided by the value of the house so 100 would be not the house value the mortgage are equal that's already high risk given that you're going to have to pay 5 or 6% to get out of the house to sell it transaction cost when you start to get above 90% and 95% and certainly above 100% the risk of the loan start to skyrocket even for good credit borrowers and of course that's because it's looked at as you're out of the money, it's a risk stick it to the lender and walk away and we started to see this sort of strategic default behavior become more of an issue so estimates were that back in the late 80's 6% of defaults were which means you can't pay but you don't want to and that's only it the estimates this time around are that strategic defaults were somewhere between 25-40% of the foreclosures in the 2008 era you mentioned the non-recourse it seems to be the case if they can only recover the house itself does that even include any depreciation on the house so one of the problems we've seen increasingly over time you could think about it being borrow or friendly but of course lenders aren't stupid they take offsets where it's increasingly easy to get out of paying a mortgage so for instance the height of the crisis the median time to a foreclosure in Chicago was something like a thousand days so you could literally be in your house and make no payments for over three years before they got you out that seems to raise the price this is something my dad complains about and of course the ton of empirical studies that find that this shockingly increases foreclosure rates my dad does housing banking stuff and this is a thing that there are actually organizations that will tell you online how to get out of your mortgage how to stay the longest though too send this letter in and then don't sign it or send it later during the new deal so we set up something in the homeowners loan corporation which worked with FHA loans are actually by law recourse but government doesn't exercise that during the thirties they were aggressive if you got a mortgage refinanced by the federal government under the rosa administration and you didn't pay it they came out they garnished your wages they made you move they were quite aggressive and of course there is this moral hazard aspect now of course I'll say I don't think what that should make us forget that the number one reason why somebody doesn't pay their mortgage is because they've lost their job it's almost predominantly labor market driven and the subprime stuff did it just spring into existence in the nineties or something basically these sound like these are idiotic loans so why all of a sudden there's a couple of different issues going on this most recent was not the first boom and bust in the subprime mortgage market we had a boom and bust in the nineties but during the nineties most subprime mortgage lending was done by state chartered finance companies so there were no insured deposits no Fannie and Freddie hired money lenders who put their own money in or they funded themselves short term on Wall Street during the maybe we should say the first because it's probably not going to be the last russia default in the nineties interest rate skyrocketed about 30 these guys went out of business and it was no financial prices the difference was in the nineties if you were going to get a subprime loan and you were a 620 fight go you were going to put 30% down and so we got over time and I very much remember I was on Capitol Hill at the time bank and committee staff were in the early 2000s I certainly had a chain of community activists coming through my door lobbying me saying you know we really need to get Fannie and Freddie into subprime to clean up that business and of course there is this sense in Washington that somehow your credit score something that happens to you rather than something that you might have something to do with and so there's long been a push we saw in the Clinton administration we saw in the Bush administration to try to close this racial home ownership gap I talked about and so the only ways for you really to do that were to either either are lower the age profile of homeowners and lower the credit profile because unsurprisingly somebody who is 25 on average has a lower fight go score than somebody who's 35 because of course you need time to build your credit and such so a lot of the expansion in the 2000s we literally for households under 25 came close to doubling their home ownership rate in the last decade under 25 we went from something like 13% to 20 some percent I should not have owned a house under 25 I don't think I've met a 25 year old you're also living with their parents well you know unfortunately we have not learned what I think should be an obvious lesson which is if you try to have a federal policy geared at let's get a lot of 22 year olds in the home ownership it's probably not going to work out well the depreciation by loan is going to be a problem I know it's going to punch through the walls and that's on top of the student debt they now so we double whammy for that generation but again the very large difference in age profiles between minorities in Caucasians was one of the drivers here and so for you to close that gap you had to deal with the sub-prime issue you had to deal with an age issue and the way it would trust was lowering underwriting standards and so I now will say as I mean Peter Wallison at AEI has a new book out now where he's documented and to me some of the documentation he's brought up really reminds me of some of those conversations you know 10-12 years ago where there really was a push and I guess I should certainly say this is another example of really good intentions going bad you know I worked at the Nastras and Realtors before I worked on the Hill and one of the things I worked on was their outreach to African-American communities on wealth-building home ownership and you'd have these conversations with very earnest people about well you know that 20-some percentage point gap is clearly racism and we can eliminate without taking additional risk of course that was absolutely false so I think there are a lot of good intentions who felt like we could just really expand home ownership risk-free and cheaply and of course that did not turn out that way and turned out to be very costly for the government, for the economy and most importantly for the families themselves that were involved and it leaked into the market I think the important thing too here is that it wasn't just people losing their homes because they had been turned into securities which we mentioned but I think we need to redefine what a security is and then linked into the market and therefore polluted everything correct so actually we need to redefine security I think we did that in our last episode but it's a worthwhile thing to watch and say oh it's been 5-6 years we're going to have another boom bus we every 10-15-20 years have booms and busts in the housing market in the US the last one was historically the largest but we certainly had booms in the 50s in the 70s we had a boom and busts in the beginning of the 80s and the late 80s so housing markets are volatile so first of all for those of you thinking about a home if somebody tells you that home prices only go up you should slap them there's one thing you remember from this episode housing prices are out can and do go down I'll say interestingly as an aside Bob Schiller who recently won the Nobel who's at Yale assembled a house price series back to 1890 and a lot of the earlier decades you can question the quality of it but one of the interesting findings of his data a lot of volatility but basically in real terms if you bought a house in 1890 you had no appreciation for the next 100 years real after inflation terms 100 years I mean I'm not going to say flat because again a lot of volatility but even if you held on to it you basically made what you paid after inflation so there's a question of how great of an investment housing is and many of my advocacy friends who are big home advocates will first say well it's the only investment that poor people can get into on a highly leveraged basis and of course I repeat that through them and say that's actually what you want to achieve is to get people highly leveraged and that's both ways magnifies the losses as well as the gains now I guess if your assumption is that the taxpayer is going to eat the losses then maybe you don't care so back to the securitization question this was really the first housing crisis that was securitization driven and so again you know we had the savings and loan crisis was very ugly we paid $150 billion in the bailout the savings loan industry it arguably might have cost the first George Bush's reelection it caused a global financial crisis in the same way and the reason was up until starting late 80s or early 90s the typical way a mortgage was done was the person you sat across the table from originated from held that mortgage it was what was called an originate to hold model we moved with the growth of Fannie and Freddie and later the private label market to an originate to sell a securitized model so you had growth of mortgage brokers which really were mostly the sales guys who were involved in the SNLs at first so you'd sit across the table from somebody who's got no money at all whose job really is just to close a loan and then quickly sell it quote-unquote table fund it to Fannie and Freddie who would wrap it into security and sell it to the securities markets and so the attempt really was to sort of connect and the security is now just a tradable package of mortgage the idea is just to aggregate the risk some of them might be good, some of them might be bad that was exactly the thinking you would diversify the risk by putting the mortgages the thinking was that pool of 100 or 1000 mortgages was going to be riskier than any one of the individual mortgages it was also thought to be more liquid mortgages traditionally have not been a very liquid asset meaning you couldn't as a lender sell them very quickly without taking much of a loss so the thinking was if you put them in a mortgage back security you have a liquid security that the market understands so that if you need to raise money you can do that pretty quickly so and this was all pre this was all a growth of the 90s for the most part again pre savings and loan crisis the securitized mortgage market was released around an era again up until almost 1990 and so you saw the growth of the securitization market that spread the securities throughout the financial system banks held them about a third of their collado on their overnight repurchase repurchase market and the repo market so mutual funds and hedge funds and investment banks often by themselves a third of that collateral was Fannie and Freddie securities you know another fourth was private label mortgage back securities so what we did of particular danger in this because I'll certainly say this on the side if you map out prices in office properties or retail properties or shopping centers they displayed the same pattern as we saw on the housing market this past time around and of course that should not be surprising you know the interest rate sensitive assets and all the land use controls and restrictions hit those types of assets as well but the difference was when the office market went boom and bust it did not cause a financial crisis because we hadn't spread the risk in the same way in the same amount of leverage in it so for instance even for Fannie and Freddie so Fannie and Freddie also buy loans on office buildings apartment buildings but the typical apartment loan that Fannie and Freddie would buy would have 50% equity 50% debt whereas the typical mortgage they would buy would be 95% debt you know 5% equity so there was a lot more leverage in the single family side than there was in the apartment side even though of course apartment dwellers tend to be younger less attachment to labor force so there's certainly a risk there but again more prudent underwriting more equity by the on the part of the originator and the owner and so because we spread this mortgage risk into the financial system that really was one of the things if not the most crucial thing that sort of let the fire behind the system and as I mentioned you know Peter Wallace earlier has written about the housing goals Fannie and Freddie and we really did see Fannie, Freddie and other market participants greatly lower their credit quality and so maybe to put things you know in perspective so you know I often use 1960s kind of a turning point in the housing market a big way partly because that's where we hit the trend rate we have now for ownership also important to keep in mind up until 1960 the majority of homeowners own their homes free and clear the majority the majority the majority had no mortgage at all wow now of course to me that is home ownership it's real home ownership so it's important to keep in mind that we in today even today about you know a third of homeowners own their homes free and clear so there are people who actually do pay their mortgages and you know rather than just pull equity out the entire time and so you saw this erosion over time where we increase the amount of leverage behind ownership so my back of the envelope was first on the institutional side so the banks and Fannie and Freddie and all those who held the mortgage market at the height of the crisis were leveraged about 60 to one now explain exactly what that means so that means that you've got $60 of debt for every $1 of equity you have which means does not give you much room to go wrong and so for instance Fannie and Freddie do a number of things one of the things they do when they package mortgage back securities and seldom is they wrap a credit guarantee around it and they charge a guarantee fee their guarantee business which is about half their business was by statute leveraged over 200 to one so it meant that all they needed to do was take half a percentage point of loss on that business before that business is wiped out so just to clarify that which means the depreciation the loss of it in some way just needs to be a half a percent then the guarantee business is a loser yeah because it's 1 to 200 so it really is I mean so you know Peter the leveraging puts you at risk I guess the big problem here because I'm not a finance guy but the high leveraging puts you at higher risk to unknown things that might happen in the world that change that relationship it puts so whether it's leveraged on the part of the borrower or in the part of the investor lender it puts you at a greater risk of insolvency bankruptcy so you think about if you're a homeowner and you don't have much equity in your house then the prices go down you could define yourself underwater now let's be clear because some of the if you read the papers you somehow think that being underwater triggers foreclosure it does not the lender actually doesn't want your home if it's underwater but it changes the incentive for people to walk away it also changes the incentive in that often what triggers foreclosure is you know kind of what kind of so-called double trigger you lose your job but if you lose your job and you have a lot of equity you can borrow against it and you've got a reason to stay and you can weather that if you lose your job or you have you know the Elizabeth Warren favorite of you've got unexplained medical costs that throw you into bankruptcy well you know if you've got home equity to tap you can make it through that way if you don't have home equity then you cannot or it makes it much more difficult to get to survive the first trigger and of course it also and changes the incentives for people to walk away and strategic to fall so a we've reduced the cushion for bad things to happen on the homeowner side we also reduce the cushion for bad things to happen on the financial side part of this was of course the capital treatments I mean you know example I like to give is it wasn't atypical for Bank of America to take a thousand mortgages south to Fannie Mae buy back the mortgage back securities holding those thousand mortgages back on the Bank of America's balance sheet it kept the intro yeah you're looking like well that is that that makes no sense in Ron style because it is um so what it was really done was because it was a capital arbitrage so if Bank of America did that and bought back the very same mortgages but wrapped as mortgage back security can cut the level of capital it held in half which also means the flip side is we've doubled the leverage in the system we've doubled the vulnerability of the system so we've had a lot of rules gained into the mortgage system that greatly increased leverage in the system you know because housing is often relatively fixed in supply even at the top of the bubble 2006 we were building about 2 million units keep in mind we've got about 120 million units so at the at the most heated crazy as part of the bubble we are expanding by less than 2% this seems to be directly tied to government let me see how this this so we've got this whole story now the members understanding it we we attempted to increase home ownership and as a result of all these policy interventions and institutions we set up we have increased the number of people who have poor credit who are risky who are have mortgages we have increased the amount that those people are leveraged or that people in general are leveraged which means that the the lenders are more leveraged we've increased we've then taken these things bundled them up sold them all over the place which has spread all of this throughout the system but then how do we get from that to the financial crisis sure and so the way to think about it is a lot of what we've done on the mortgage side for the homeowner is trying to ultimately increase the demand for housing and so you can think about it like for instance you know the down payment is a good suggestion you know if the down payment is 5% and you've got $5,000 and you get $100,000 house if the down payment is two and a half percent that you could buy a $200,000 house and so you allow people to bid at a higher rate and of course if you buy down the interest rate so Fannie and Freddie were widely believed to lower interest rates somewhere between 7 and 20 basis points is that because of their because the perception that they were government backed they could borrow it near treasury rates and so some amount of this and there's a large debate about how much but to set aside the quantitative the qualitatively rates were lowered by a small amount by Fannie and so not enough to increase home ownership rates you really have to get rate reductions of near two percentage points which are 200 basis points to see any real movement of home ownership rates so largely what was done was the rates were lowered slightly and that allowed people within the same monthly payment to bid more for the house price so these often quote-unquote interventions in the housing market just allowed borrowers to bid more for the house without actually changing the home ownership rate although the home ownership rate did increase during the bubble so we got we got people in we got them in by via more debt let's also keep in mind during this time for a variety of reasons which are outside of the scope of this conversation you saw fairly stagnant income growth during that time so the housing bubble was not driven by you and I and everybody else making a whole lot more money in real terms it was driven by credit and so that pushed up house prices and because in many price places housing supplies in elastic you just pushed up prices without actually increasing construction much and then because those mortgages were packaged into mortgage backed securities spread throughout the system you know they all seem like very low risk you know everybody was making a lot of money and increasing housing prices can cover up you know a lot of problems is I guess it's Warren Buffett's one of his favorite saying is that you don't know who's swimming naked until the tide comes in and that's the same thing you don't really know who's highly leveraging who's risky until prices turn but at some point you ultimately hit how many people you could have so there's something in finance that's occasionally called the greater fool theory in the thinking is that you know a lot of people were essentially buy an asset on the belief that somebody else will be there to buy it from them at a higher price and of course that can't go on forever it's like musical chairs eventually you know there's not enough chairs eventually you are the greatest fool and there's nobody else left to take that off your table and so that's what we did we eventually hit that wall in about 2006 where we had gotten everybody who wanted to be a homeowner who was still breathing in and then the demand slowed down and then you started to see construction slow down you know you started to see construction jobs lost and so it's also important to keep in mind there's a couple hundred factors here and so one of the things that always bears reminding is we were in a recession for a year at a minimum before the financial crisis hit we had already lost two million jobs before September 2008 a lot of those were construction jobs and so there is a degree to which the economy drives finance as well as finance driving the economy and so what there really was I think and starting actually in August of 2007 but more so in the fall of 2008 are really a wake up to wow all these housing investments were really safe because they've been paying off really well for a number of years and let's keep in mind you know we had the housing market hit bottom in 1994 and kept going you know into 2006 so a 12 year stretch is almost unheard of and of course part of us was the Federal Reserve just flooding liquidity into the system after the dot-com bubble and after 9-11 but so you saw this spreading of risk where market participants suddenly looked at this and said wow you know the buyers aren't coming I'm the greater fool and so that's also why a lot of Wall Street banks got stuck with holding a lot of mortgages and mortgage backed securities because again they thought they could continue to turn them out and so some of this again was a re-pricing of risk in the mortgage market I actually think some of the interventions that sparked this was in 2006 something called the ABX index was created which is an index based on the value of subprime mortgage backed securities up until about 2006 there was no way for you to short the housing market in a sustained way but you could try to short home-builder stocks and that shorting is betting on something going down exactly and so you didn't have any way to bring pessimism in the balance of the market and you know for those of you who ever read the big short it's a great narrative of how a couple of guys tried to short the market and how they made a lot of money doing it you didn't really really was very difficult to do that before 2006 and then you also had around 2006 Case and Schiller as I mentioned Bob Schiller put together a house price index which is traded on the Chicago the CME now so you could hedge your house price risk and on the flip side but you could also bet on house prices so it was the net result of this that they started looking at the downside of the market there were now institutional things starting in about 2006 but building to 2008 you had what I would call an information shock suddenly you know the stream of never-ending borrowers dried up suddenly the expectation that housing prices would continue increasing covering up problems really started to hit home that wasn't sustainable and then you saw the market adjust and prices start to fall and of course housing prices started to fall that resulted in foreclosures going up delinquencies going up which resulted in the value of the mortgage securities going down none of this was really a mystery the broad characteristics of it were well understood it's just that the model we had made it a system that was so much more highly leveraged than the previous system which itself was highly leveraged it's not like the savings loan industry was not leveraged so it seems that we created a system that we put a lot of incentives in there via government to do some very bad things but have we learned our lesson are we still have we created a situation where there's going to be a boom and bust cycle again we I don't know if the housing crisis and the financial crisis was just some sort of black strong event that will never happen again or have we learned our lesson are we still promoting housing in an irresponsible way we have the video thing double down great so let's start with Randy O'Toole who's written about the supply aspect of this the thing is we really did have a perfect storm of bad behavior it's just most of those bad behavior we're still here so starting in the 90s with the expansion of zoning and growth controls and stuff we went in ten years from Orlando being an easy place to build to have a growth boundary so we increased the inelasticity of supply and housing so which means that housing prices will going forward all else it will be more volatile that's still in place if anything it's worse than it was we've increased the government guarantee so the moral hazard that's there market discipline and the mortgage market still there we've actually made it easier now for borrowers I mean there's going to come a day in the future where lenders will look nostalgically back on only a thousand days to foreclose those were the good old days it will be harder to foreclose next time around why should we even charge them prices for housing well we are at the risk of some slight amount of exaggeration we're going down the path where mortgages are becoming unsecured loans that are just a little better than credit cards and now you've seen some offset in that and so of course by a little better than credit cards the ability to collect back from the collateral so you've seen lenders of course react to that by saying well I'm not going to make loans to people who aren't going to pay me back and of course that has you tell a lender you can't get the house back they're suddenly like well I'm not going to give it to people I'm not going to get the house back from but of course the political process is not going to live with that because home ownership is great and good and great wealth making overnight gamble machine for everybody that we need everybody into and the politicians love it so you've seen unfortunately the president recently has gone down this path as his HUD secretary so we had a few years it's amazing to me in my lifetime to hear democrat president say if Annie and freddy should go away I can't say I expected that to happen so we had a few years where there was a rebalancing of the conversation those years are behind us we didn't expect any day now that people start telling me again that housing prices only go up so we've really lost a lot of the memory the political cycle has turned back to believing that home ownership is great and good and we must do it and get people in with very little equity regardless of their credit score so the one favorable thing is right now housing prices are not at the elevated levels they were before but they will be at some point we will see housing price will turn again we still have a lot of subprime credit in the market today mostly in the form of FHA but fanny and freddy still have a lot but it's less than they had before and so there is some market awareness of this what I would say the one silver lining is that a lot of market participants who did get burned and had some of their own money on the line are a little more jaded but all of the bad public policies that contribute to the moral hazard and distortions in our mortgage market are worse today than they were before the crisis we are listening to free thoughts if you have any questions or comments about today's show you can find us on twitter at free thoughts pod that's free thoughts pod free thoughts is a project of libertarianism.org and the Cato Institute and is produced by Evan Banks to learn more about libertarianism visit us on the web at www.libertarianism.org