Swept under the rug

Risk is an unavoidable part of our economy. Without risk-taking, none of the conveniences of the modern world would have come to market. The problem is that government encourages some risks and discourages others based on political factors unrelated to inherent riskiness, and one risk that the government has consistently encouraged is lending to a homebuyer. This encouragement obviously causes companies to act differently than they would have otherwise, but is the government-induced mortgage lending good or bad for the economy?

To encourage home ownership, the government passed regulations mandating that banks make loans that look bad on paper. Incentives were put in place to lower the banks’ risk if someone defaulted on the mortgage (an indirect way of subsidizing the mortgage), but this just shuffled the risk around rather than actually lowering it. Attempts at hiding these risks caused the government to set up more and more elaborate mechanisms to grease the mortgage market, and financial intermediaries responded to these incentives by treating risky mortgages as if they were far less risky than they really were. The bankers didn’t know where the risk went, but it wasn’t with their bank.

On the surface, the risk of lending to homebuyers appears low. Homeowners will do whatever they can to avoid getting thrown out of their homes, so there really isn’t as much risk in a mortgage as there would be in a similar-scale commercial investment. The problem is that the banks already knew this and had been treating people accordingly, but the government wanted more mortgages written. The rails were greased, and a derailment became inevitable.

While home prices were rising, the risks being swept under the rug didn’t matter very much. Once a bubble started to form, more homes were being purchased by speculators and landlords than people who actually intended to live in them. Speculators and landlords do not have the same aversion to foreclosure, so banks required 20% down payments and other assurances that the loans would be repaid. This assurance was always some variation on “prices are going up, so even if I default you can seize the house and sell it at a profit.” As long as speculators and landlords were a relatively small fraction of homebuyers, these assurances were sufficient.

Meanwhile as the bubble inflated, homeowners cashed out their equity to improve their lifestyles. When people they ran out of equity, they stopped spending. This decrease in consumer spending set off ripples through the economy, and it turned out that just about everyone who lost a job as a result of the slowdown happened to own a house. A shock to the real estate system causes house prices to stop rising. In fact, the amount that people were willing to pay dropped below where owners were willing to sell.

This inability to agree on a price has happened in the past, and the usual result is for home sales to freeze until inflation causes home values to catch up with the prices that sellers demand. This time, however, the fraction of speculators in the market wasn’t so small. Speculators didn’t want to have houses, they wanted to sell houses. A clearance sale ensued, lowering prices and making millions of legitimate homeowners upside-down on their mortgages. Suddenly a vast number of homes had zero or negative equity, consumer spending skidded to a halt, and the real estate market got even worse.

All of that risk that had been swept under the rug came out at once.

Shifting risk around the economy is just as important as shifting money around the economy, but risk is harder to understand and easier to ignore. The government moves money around the economy all the time. It’s a very inefficient process, but people at least understand the principles involved. When the government moves risk around the economy, it does just as inefficient a job but voters tend not to notice. When a spending project like the Bridge to Nowhere is discovered, people get outraged at the politicians (rather than, say, the construction workers). When a risk-sharing project like Freddie or HAMP blows up, politicians take advantage of the confusion and lay blame on the people who specialize in taking calculated risks. Sure, the incentive schemes of bankers are imperfect. These imperfections led to some of the problems of their companies, but the severe distortions of the mortgage market induced by the government are much more directly linked to the problem and responsible for far more of the risk that ended up knocking the economy to its knees.

No amount of punishing banks for doing what the government told them to do is going to fix the underlying problems, because the government is still telling the banks to do precisely the same things that led to the current housing crisis. As a consequence of the government’s risk-shifting, money is being shifted from responsible people (renters and prudent homeowners) to rescue irresponsible homebuyers. The current loan modification program is comically inefficient; it would actually be cheaper for the federal government to buy the distressed home outright and give it to the homebuyer. This isn’t working, so the government will need to try something else. Either the government is going to unwind its subsidies on home buying and cause a lot of short-term pain, or the government is going to come up with an even more elaborate shell game to sweep the risks under another rug.

The government’s fixation on increasing home ownership has led to increasingly complex and risky schemes to get banks to play along. It was inevitable that greasing the rails for so long would lead to a derailment. It is clear that this particular case of risk-shifting has damaged the economy, and it will continue to cause occasional disasters until the government gives up on this obsession.