How the Housing Market is Supposed to Work (absent government intervention)

How the Housing Market is Supposed to Work (absent government intervention)

Safe Borrowers Commercial Banks Safe Mortgage Risky Mortgage Risky Borrowers

Safe Borrowers Investment Banks (Lehmann Brothers) Commercial Banks Hedge Funds Safe Mortgage Risky Mortgage Risky Borrowers

Moody’s Standard & Poors Mortgage Backed Security Investment Banks (Lehmann Brothers) Commercial Banks Hedge Funds Safe Mortgage Reinsurance Companies (AIG) Risky Mortgage Pension Funds Other Large Savers

Investment Banks (Lehmann Brothers) Commercial Banks Mortgage Backed Security Hedge Funds Reinsurance Companies (AIG) Pension Funds Other Large Savers

Safe Borrowers Investment Banks (Lehmann Brothers) Commercial Banks Hedge Funds Safe Mortgage Reinsurance Companies (AIG) Risky Mortgage Pension Funds Risky Borrowers Other Large Savers

Safe Borrowers Commercial Banks Safe Mortgage Risky Mortgage Risky Borrowers

Safe Borrowers Mortgage Backed Security Investment Banks (Lehmann Brothers) Commercial Banks Hedge Funds Safe Mortgage Reinsurance Companies (AIG) Risky Mortgage Pension Funds Risky Borrowers Other Large Savers

Removing the intermediaries, we see that the end result is that entities with large amounts of savings loan to people who, in turn, buy houses.

Safe Borrowers Mortgage Backed Security Mortgage Backed Security Mortgage Backed Security Mortgage Backed Security Safe Mortgage Safe Mortgage Reinsurance Companies (AIG) Risky Mortgage Risky Mortgage Pension Funds Risky Borrowers Other Large Savers

How the Market Polices Itself (absent government intervention)

What if banks started making too many risky loans? Risky Borrowers Commercial Banks Risky Mortgage Risky Mortgage Risky Borrowers

Lenders would demand a higher interest rate to compensate for the greater risk. This would increase the cost of borrowing and so fewer people would borrow. Risky Borrowers Reinsurance Companies (AIG) Mortgage Backed Security Pension Funds Risky Borrowers Other Large Savers

With less borrowing, demand for houses would be reduced. With a reduced demand for housing, housing prices would not inflate and no price bubble would form. Risky Borrowers Reinsurance Companies (AIG) Mortgage Backed Security Pension Funds Risky Borrowers Other Large Savers

Summary: How the Market Polices Itself More risky borrowers means lenders demand higher interest rates. Higher interest rates limits the number of risky borrowers. Limited number of risky borrowers means stable demand for houses. Stable demand for houses means stable housing prices. Stable housing prices means no housing bubble forms.

How the Housing Market Did Work (behold government intervention)

Two government (or government-type) players enter the game. Lowers interest rates making borrowing less expensive. At the direction of Congress, buys mortgages with little regard for risk.

As the Fed lowers interest rates, more people seek loans. As Fannie and Freddie ignore borrowers’ riskiness, risky borrowers find it very easy to get loans. Safe Borrowers Safe Borrowers Safe Borrowers Safe Borrowers Commercial Banks Risky Borrowers Risky Borrowers Risky Borrowers Risky Borrowers Risky Borrowers Risky Borrowers Risky Borrowers Risky Borrowers

Summary: How the Government Short-Circuited the Market The Fed drove interest rates to low levels encouraging people to borrow. Fannie and Freddie bought high-risk loans from banks thereby encouraging the banks to make more high risk loans. The resulting surge in demand for housing drove housing prices up making housing appear to be a good investment. Encouraged by this apparent good investment, more people bought houses driving prices higher.

On average, every 1% increase in the size of the Federal government (relative to the economy) reduces per-capita GDP by $4,000 (in 2008 dollars). Data source: U.S. Census Bureau

Since 1969, the top income tax bracket has ranged from a high of 77% to a low of 28%. But, over that same period, Federal tax revenue has averaged a constant 18% of GDP (plus/minus 2.3%). Data source: Bureau of Labor Statistics, National Taxpayers Union

The total amount of money the U.S. government has either borrowed or owes retirees exceeds the size of the economy of planet Earth. Source: www.treasurydirect.com and CIA World Factbook

$100

$10,000 A stack of $100 bills, ½ inch high. Adapted from pagetutor.com

$1 million 100 packets of $10,000. Adapted from pagetutor.com

$100 million $100 million fits on a standard pallet. Adapted from pagetutor.com

$1 billion Adapted from pagetutor.com

$1 trillion About twice the amount of money the U.S. government spends on interest on the national debt in one year. Adapted from pagetutor.com

$12 trillion The value of all goods and services produced in the United States in one year. Also, the U.S. national debt (as of 2009). Adapted from pagetutor.com

$65 trillion Total debt and unfunded Social Security and Medicare obligations (as of 2009). Adapted from pagetutor.com

How the Housing Market is Supposed to Work (absent government intervention)