93 by linzhengnd


									                                                                           Econ 311

04/27/11                                                                                    Prof. Ng

                                            Term Paper Part 1

        According to Sowell, the housing market is composed mainly of various key entities, some

private, others government run agencies, and even a hybrid of government created but privately owned

firms. Each of these players have their own separate rules of engagement, their particular business

models by which they function, as well as different supervising bodies dictating their governing

procedures and rules. Each entity has their own goals, their own bottom line, and models their business

practices according to the expectations of those they are accountable to. In the search for their own

success, each of these parties can cause varying negative effects on the housing market. These effects

can, like a domino effect, set off a chain of subsequent negative events and consequences in housing

market practices; they can directly impact the functionality of the other main players in the industry,

and even the market as a whole causing direct implications to the individual home buyer.

        Considering that the functionality and success of these various entities is so closely intertwined,

one would expect there would be some sort of rules or standards in place, requiring these players to

work together and coordinate their overall practices, keeping their communal end entire market benefit

in mind. Of course, if we would’ve had such measures in place, perhaps we could have addressed some

of the cautionary warning signs that flared up in the early build-up of the market pressures that would

eventually result in the bust. If we at least had one central supervising party governing all of the players

in the market, then maybe more attention could have been paid to those red flags, and preventative

action could have been put in place.

        Key responsibility is placed with The Federal Reserve System with regards to the levels of

interest rates. The FED indirectly sets the nationwide level of interest for mortgages, through the

interest it chooses to charge the lending institutions that are providing the mortgage loans to home
buyers. The lower interest rates lead to an increase in the demand for houses, given that prospective

buyers want to take advantage of the lower monthly payments made possible by the lower interest

rates. This increased demand pushes up the housing prices, and so one could argue that the FED

encouraged the rising home prices by maintaining the interest rates so low, for such a long period of


        In addition, the availability of low down payment financing, as well as creative financing

instruments created a surge in homes being purchased and acquired with little or no equity built in.

In the early stages of the housing boom, only 1/3 of the home buyers in California were first time buyers

who were coming into the financing with actual saved cash to put towards the down payment, and

hence their equity in the home. This means the remaining 2/3 of buyers were already homeowners,

who were counting on the equity built in their homes from the accelerated appreciation rate, and

putting that equity as the down payment in their next and larger home purchase.

        In addition, the 1/3 of first time homebuyers bringing cash down payments to closing, were

likely to engage in creative and risky endeavors, in efforts to make their monthly mortgage payments

affordable.For example, in 2005 interest only loans accounted for 45% of the mortgages that year.

Adjustable rate mortgages along with home equity lines of credit worsened the level of equity the

average homeowner had in their homes.

        While these lending rules may seem dangerous and irresponsible, they were enacted by

politicians seeking to create affordable housing for all Americans, specifically the low and middle income

households who were being blocked out of home ownership due to the stringent lending requirements.

The price of the land on which the home is built is the main driving factor as to why some areas like San

Francisco and Coastal California due to land use restrictions that were being imposed in these areas.

These restrictions were the result of special interest groups seeking to preserve a certain level of open

or wild natural land, thus preventing increasing amounts of land from being available for building and
housing. This re-classification of the land caused an artificial scarcity of land, which resulted in higher

and higher prices for the lands which remained suitable for housing. These scenarios occurred on a

localized level in various areas of the country like California, Las Vegas, and New York. These were also

the areas which, due to the government intervention causing scarcity of land for housing, would wind up

with sky rocketing housing prices and the corresponding market failure that ensued.

        According to Sowell, these trends of loose financing in the housing sector set the stage for the

housing market collapse, which would take down the entire US economy.On the contrary, the FCIC

report does not agree with Sowell’s extensive explanation of how the crisis unfolds. In fact, the report’s

position is that the low rates of interest and the politician’s crusades to “make housing affordable” had

little impact in the crisis that unfolded.The parties responsible for the crisis, according to the FCC report

are not quite in line with Sowell’s point of view. The villains are found to be a lack of government

regulation, Wall Street’s wild betting on risky securities, and inefficiencies in the running of lending

institutions. A fair amount of blame goes to the FED, particularly Alan Greenspan and Ben S Bernanke,

who served as Chairmen of the Federal Reserve. Alan Greenspan, who was Chairman of the Fed during

the time that the housing market was expanding, is found responsible for favoring deregulation which

the report sites as a major cause of the market failure. Bernanke, who succeeded Greenspan in this

same office, is faulted for his response to the crisis, the corrective actions and lack thereof which took

effect under his watch.

        Government responsibility is placed on both parties, however the Bush administration along

with the FED get particular attention as the report points out the inconsistent steps taken in the

management of the crisis, such as the decision to bail out Bear Sterns but allowing Lehman Brothers to

fail. The various regulators responsible for overseeing Wall Street and the lending institutions are

criticized, citing their lack of enacting actual regulatory measure over the entities they are to supervise.
It is proposed that given these two industries funnel funds towards political lobbying and politician’s

campaign donations they are in effect buying the alliance of those appointed to regulate them.

        Sowell points out those local housing markets, such as cities throughout coastal California, were

experiencing the high rocketing housing prices at a considerably higher rate compared to the rest of the

country. Discrepancies and contradictions were evident in the characteristics and trends of the housing

market at a nationwide scale, when compared to local housing markets. This contradicting information

made it confusing and difficult for government officials to implement corrective action in the way of

laws and industry standards. Therefore, the warning signs which were perhaps clear on a local level

were not address by the national agencies. Unfortunately, we came to find out that as these local

markets burst, it would have dire consequences which would expand well beyond its local market.

        The government played a key role in allowing the lower standards for borrowing to be

implemented. Sowell takes this idea further, arguing that there were government officials, from both

parties, who were lobbying for an easing of the restrictions put on borrowers, claiming that the resulting

higher rate of ownership would bring positive economic growth which would far outweigh any increased

lending risk. This government agenda may have been initially set into motion by the concerns of racial

discrimination which minorities seeking to finance the purchases of homes were supposedly being

subjected to. The goal was to make home affordable for all including minorities, and so pressures in the

way of laws were levied on the financial firms requiring them to meet certain target levels of loan

approvals to minorities who perhaps didn’t meet the lender’s qualifications.

        Once government officials were successful in executing this, the government intervention in the

lending market spread far beyond the concern of fair treatment to minorities, as the lowered standards

for mortgage approvals were extended to all borrowers across the board.Furthermore, government

imposed quotas with regards to the share of the bank’s loanable funds which were required to be

provided to low and moderate income households. This put pressure on lending institutions to conceive
creative, and more risky, financial instruments to make mortgages affordable for these target

households which banks were now being required to approve. Special financial programs offered by the

government were being restricted to only those financial institutions which had met the government

imposed quotas being dubbed as community reinvestment act. Therefore, banks had additional

incentives to extend mortgage loans to those who would not have been approved by normal

standards.Penalties were imposed on banks that did not conform to the government quotas, leading

banks to lower the down payment amounts and also lower the income requirements in order to gain a

larger pool of lower income buyers needed to meet the quotas.

        HUD can also be made responsible for magnifying the pressure on the market, as they required

Fannie Mae and Freddie Mac to have larger share of their mortgage purchases to be of low income to

moderate income buyers. In turn, additional demand is put on the banks that will need to make

increasing amounts of subprime and creative loans to fill the demand of Fannie Mae and Freddie Mac.

These loans were being made and then sold under repeating circumstances of asymmetric information.

Although banks had a plethora of pressure to relax lending qualifications, they were making loans with

the hopes that they would be repaid, and only the borrower knew the true riskiness of the transaction.

Then the banks bundled these loans they knew were somewhat questionable for Fannie Mae and

Freddie Mac to purchase, with these two entities having even less information on the borrower’s ability

for repayment. Ideal conditions were created for the principal agent problem to develop, as bank

executives had overwhelming incentives to make risky loans at higher interest rates, without regard to

the true credit worthiness of the borrower, since Fannie and Freddie were lining up to take such loans

out of their hands.

        HUD regulated Fannie and Freddie, who under HUD’s pressure were now accepting these risky

loans as good assets.These “good assets” were then packaged into mortgage backed securities and sold

to unsuspecting buyers on Wall Street, thereby entrenching the high risk factor of these loans deeper
into the US economy which would simultaneously become widely spread to the global economy. At this

stage of the game, the role of overseeing and regulating these products was now being passed on to

SEC, who wasn’t at all engaged in coordinating efforts of risk assessment with the housing and lending


        A trend emerged comprised of government imposing additional intervention on the housing

market, seeking to relax the lending standards so that more people could be approved for financing,

while simultaneously subsidizing such the costs of home purchases with various programs. The

government who was supposed to look out for the people’s best interest, set forth a system which

would allow and encourage the nation to purchase homes they couldn’t afford and engage in lending

contracts which they could not sustain. It was those politicians who under the claims of making housing

affordable for all, who in actuality set a trap to financial suicide for those very low income and minority

groups they pledged to be looking after.

        The bust of the housing bubble carried wide spread implications. Since housing is by and large,

the largest individual investment of the average American household. They were putting all of their

eggs in one basket, by funneling the bulk of the household investment resources into this one single

asset: their home. Given the trend of increasing appreciation which the average household expected to

continue, larger homes were being purchased with less than responsible family budgets, all working

under the assumption that housing values could only continue to climb. This may be reckless decision

making by home buyers, however there were just as reckless lending practices in place, which allowed

such buyers to obtain loans for amounts much larger than their repayment ability, and with variable

financing terms which would only intensify the financial strain on the household as the loan

matures.And so we find ourselves with an abundance of well-intentioned yet financially reckless

Americans, and a housing and lending system lacking checks and balances which enables these home

buyers to follow through on their overly aggressive home purchases. Since these less than qualified
buyers were being easily approved for mortgages, the rate of home ownership increased exponentially,

pushing up home prices even further and carrying up with it the over stated and unsubstantiated real

estate appreciation values. As the terms on the variable mortgages changed causing increasing financial

burden on already over extended home buyers, these home owners experienced increasing difficulty

with staying on time with their mortgage payments. This would eventually lead to large waves of

defaults and bank foreclosures across the nation. Not only are there how masses of people facing

foreclosure, they are also on a path to having no housing and no credit worthiness to be able to

purchase or rent a new home.

        Salvaging the home wasn’t an option for many buyers who had relatively little equity in the

homes either because they had been purchased with zero or very minimal down payment, or because of

overly confident owners opening up home equity lines of credit and using the presumed appreciation in

their homes to finance their lifestyle. Since the homes were being purchased at overstated prices, and

on average had insignificant equity being built in, the bank was now repossessing properties that were

valued at far less than the balances on their corresponding mortgages. Therefore, the peak of the

housing boom with its ever so favorable appreciation rates is followed by a fast and sudden plummeting

of home prices, which were fueled by the increasing numbers of repossessed properties which were

continuously feeding the inventory of homes for sale.

        This was coupled by a market with fewer and fewer buyers, as many of the would be first time

buyers and those seeking to upgrade had already engaged in purchases earlier in the cycle, and due to

defaults there were fewer qualified repeat buyers in the market. Unfortunately, as this chain of events

unfolded across the nation, it became a vicious cycle which continued to repeat, causing subsequent

defaults for home owners that given the sudden depreciation in prices; now found themselves upside-

down on their mortgages. These negative effects kept multiplying in frequency and therefore amplifying
the impact on the housing market, which would end up plunging into a collapse which by this time was


        In 1998, when the crusades for an increased need for affordable housing took off, the share of

their incomes that Americans were spending on housing was 17%. Given this figure was 30% years prior

in the 1980s, begs to question if there was truly a shortage of affordable housing. What empirical

evidence portrays is that there were specific pockets of local cities were housing was indeed a major

issue, requiring upwards of 50% of their income. Perhaps a plan targeting those troubled locations, as

opposed to making assumptions as to the need across the country, and undertaking crusades to correct

a housing shortage which didn’t even exist. The same politicians that set forth the conditions for the

housing bubble were now pointing fingers to the regulatory agencies for their negligence in regulating.

These were the same politicians who in the spirit of prosperity, voted down the regulating measures

that came before them. Politicians, regulators, and financial institutions alike all played an active role in

the make up for the housing bubble and burst.

        With regards to the lending institutions, the FCIC report acknowledges and documents careless

lending practices by these banks. The findings show that these financial power houses were severely

over extended, often having very little capital to offset the liabilities corresponding to the securities and

assets. The banks had leveraged their capital to such an extent, that a minimal percentage drop in the

assets they held would more than outweigh their capital, and hence send the firm into collapse.

It goes on to state that it was the Securities and Exchange Commission’s responsibility to hold these

large financial institutions accountable to a higher level of capital.

        While the report may point out shortcomings and reckless actions by the banks, it also provides

a certain level of immunity to the high powered executives that were running them. In essence, the

report openly accepts as truth these executive’s testimony of being unaware of the inherent high risk

factor of the loans being made by the banks they supervised. In the case of AIG for example, the
commission not only accepts but ratifies the AIG executive’s position that they were completely

unaware of AIG’s $79 billion dollars exposure in the way of questionable credit-default-swaps. I am

personally baffled by how the commission can allow these intelligent and successful business types to

take a position of ignorance, when their pedigree and expertize in the field would point to the contrary.

        Personally, I find great difficulty with trying to make an educated assessment on the situation.

Assuming all the research and testimony collected for this report is true; can we really expect the FCIC to

openly deliver their findings in an honest and unfiltered manner? Are they not politicians themselves,

with constituents, political allies, and supporting corporations who fund their election campaigns?

I personally believe the quest for an independent and unbiased assessment on the crisis is nearly

impossible given all the lobbying, special interest groups, politician’s dependency on campaign

donations, changing administrations that repeatedly undo the reforms the prior administration put in

place… These are at the core of how our system of democracy runs, and these practices are likely to

remain. Given the structure of our political system, I find the bare truth to be an unattainable illusion.

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