Fault Lines: How Hidden Fractures Still Threaten the World Economy (8 page)

The greater expansion in mortgage lending to subprime ZIP codes is associated with higher house-price growth in those ZIP codes. Indeed, over the period 2002–2005 and across ZIP codes, house-price growth was higher in areas that had lower income growth (because this is where the lending was focused). Unfortunately, therefore, all this lending was driving house prices further away from the fundamental ability of household income to support repayment. The consequence of all this lending was more default. Subprime ZIP codes experienced an increase in default rates after 2006 that was three times that of prime ZIP codes, and much larger than the default rates these areas had experienced in the past.

Could the increased borrowing by low-income households have been driven by need? After all, I have argued that their incomes were stagnating or even falling. It is hard, though, to imagine that strapped households would go out and borrow to buy houses. The borrowing was not driven by a surge in demand: instead it came from a greater willingness to supply credit to low-income households, the impetus for which came in significant measure from the government.

Not all the frenzied lending in the run-up to the recent crisis was related to low-income housing: many unviable loans were made to large corporate buyouts also. Nevertheless, subprime lending and the associated subprime mortgage-backed securities were central to this crisis. Without any intent of absolving the brokers and the banks who originated the bad loans or the borrowers who lied about their incomes, we should acknowledge the evidence suggesting that government actions, however well intended, contributed significantly to the crisis. And the agencies did not escape the fallout. With the losses on the agencies’ mortgage portfolios growing and hints that investors in agency debt were getting worried, on Sunday, September 7, 2008, Henry J. Paulson, secretary of the treasury, announced what the market had always assumed: the government would take control of Fannie and Freddie and effectively stand behind their debt. Conservative estimates of the costs to the taxpayer of bailing out the agencies amount to hundreds of billions of dollars. Moreover, having taken over the agencies, the government fully owned the housing problem. Even as I write, the government-controlled agencies are increasing their exposure to the housing market, attempting to prop up prices at unrealistic levels, which will mean higher costs to the taxpayer down the line.

The agencies are not the only government-related organizations to have problems. As the crisis worsened in 2007 and 2008, the FHA also continued to guarantee loans to low-income borrowers. Delinquency rates on those mortgages exceed 20 percent today.
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It is perhaps understandable (though not necessarily wise) that government departments will attempt to support lending in bad times, as they play a countercyclical role. As Peter Wallison of the American Enterprise Institute has pointed out, it is less understandable why the FHA added to the subprime frenzy in 2005 and 2006, thus exacerbating the boom and the eventual fall.
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Delinquencies on guaranteed loans offered then also exceed 20 percent. The FHA will likely need taxpayer assistance. The overall cost to the taxpayer of government attempts to increase low-income lending continue to mount and perhaps will never be fully tallied up.

As house prices rose between 1999 and 2007, households borrowed against the home equity they had built up. The extent of such borrowing was so great that the distribution of loan-to-value ratios of existing mortgages in the United States barely budged over this period, despite double-digit increases in house prices.
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House-price appreciation also enabled low-income households to obtain other forms of nonmortgage credit. For instance, according to the Survey of Consumer Finances conducted by the Federal Reserve Board, between 1989 and 2004 the fraction of low-income families (families in the bottom quartile of income distribution) that had mortgages outstanding doubled, while those that had credit card debt outstanding grew by 75 percent.
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By contrast, the fraction of high-income families (families in the top quartile of income distribution) that had mortgages or credit card debt outstanding fell slightly over this period, suggesting that the rapid spread of indebtedness was concentrated in poorer segments of the population.

Indeed, although housing booms took place around the world, driven by low interest rates, the boom in the United States was especially pronounced among borrowers who had not had prior easy access to credit, the subprime and Alt-A segments of the market. Detailed studies indicate that this housing boom was different because house prices for the low-income segment of the population rose by more and fell by more than they did for the high-income segments. By contrast, in previous U.S. housing booms, house prices for the high-income segment were always more volatile than for the low-income segment.
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Relative to other industrial countries like Ireland, Spain, and the United Kingdom, all of which had house-price booms that turned to busts, U.S. house prices overall were nowhere as high relative to fundamentals.
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But the boom was concentrated in those least able to afford the bust. The U.S. boom was different, at least in its details.

Some progressive economists dispute whether the recent crisis was at all related to government intervention in low-income housing credit.
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This certainly was not the only factor at play, and to argue that it was is misleading. But it is equally misleading to say it played no part. The private financial sector did not suddenly take up low-income housing loans in the early 2000s out of the goodness of its heart, or because financial innovation permitted it to do so—after all, securitization has been around for a long time. To ignore the role played by politicians, the government, and the quasi-government agencies is to ignore the elephant in the room.

I have argued that an important political response to inequality was populist credit expansion, which allowed people the consumption possibilities that their stagnant incomes otherwise could not support. There were clearly special circumstances in the United States that made this response more likely—in particular, the many controls the government had over housing finance and the difficulty, given the increasing polarization of U.S. politics, of enacting direct income redistribution. Moreover, the objective of expanding home ownership drew on the politically persuasive historical symbolism of small entrepreneurs and farmers in the United States, all owning their property and having a stake in society and progress. These specific circumstances would not necessarily apply in other industrial countries.

That said, there are a number of parallels, both in U.S. history and in the contemporary experience of emerging markets, for the use of credit as a populist palliative. A previous episode of high income inequality in the United States came toward the end of the nineteenth century and the beginning of the twentieth century. As small and medium-sized farmers perceived that they were falling behind, their grievances about the lack of access to credit and the need for banking reforms were articulated by the Populist Party. Pressure from such quarters helped accelerate the deregulation of banking and the explosion of banks in the early part of the twentieth century. Indeed, in North Dakota, after a Populist candidate won the 1916 gubernatorial race with the support of small farmers, the Populist Party created the United States’ first state-owned bank, the Bank of North Dakota.
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The explosion in rural bank credit was followed in the 1920s by a steady decline in the prices of agricultural produce, widespread farmer distress, and the failure of a large number of small rural banks. As in the recent crisis, populist credit expansion went too far.

The tradition of using government-linked financial institutions to expand credit to politically important constituencies of moderate creditworthiness is also well established in emerging markets. For example, Shawn Cole, a professor at Harvard Business School, finds that Indian state-owned banks increase their lending to the politically important but relatively poor constituency of farmers by about 5 to 10 percentage points in election years.
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The effect is most pronounced in districts with close elections. The consequences of the lending are greater loan defaults and no measurable increase in agricultural output, which suggest that it really serves as a costly form of income redistribution. Most recently, the coalition United Progressive Alliance (UPA) government waived the repayment of loans made to small and medium-sized farmers just before the 2009 elections, an act that some commentators believed helped the coalition get reelected. Populism and credit are familiar bedfellows around the world.

Growing income inequality in the United States stemming from unequal access to quality education led to political pressure for more housing credit. This pressure created a serious fault line that distorted lending in the financial sector. Broadening access to housing loans and home ownership was an easy, popular, and quick way to address perceptions of inequality. Politicians set about achieving it through the agencies and departments they had set up to deal with the housing-debt disasters during the Great Depression. Ironically, the same organizations may have helped precipitate the ongoing housing catastrophe.

This is not to fault their intent. Both the Clinton administration’s attempt to make housing affordable to the less well-off and the Bush administration’s attempt to expand home ownership were laudable. They were also politically astute in that they focused on alleviating the concerns of those being left behind while buying time for more direct policies to work. But the gap between government intent and outcomes can be very wide indeed, especially when action is mediated through the private sector. More always seems better to the impatient politician. But any instrument of government policy has its limitations, and what works in small doses can become a nightmare when scaled up, especially when scaled up quickly. Some support to low-income housing might have had benefits and prompted little private-sector reaction. But support at a scale that distorted housing prices and private-sector incentives was too much. Furthermore, the private sector’s objectives are not the government’s objectives, and all too often policies are set without taking this disparity into account. Serious unintended consequences can result.

Successive governments pushed Fannie and Freddie to support low-income lending. Given their historical focus on prime mortgages, these agencies had no direct way of originating or buying subprime loans in the quantities that were being prescribed. So in the years of the greatest excess, they bought subprime mortgage-backed securities, but without adjusting for the significantly higher risks that were involved. And the early rewards from taking these risks were higher profits. That there also were very few defaults initially emboldened the agencies to plunge further, and their weak and politically influenced regulator did little to restrain them. At the same time, as brokers came to know that someone out there was willing to buy subprime mortgage-backed securities without asking too many questions, they rushed to originate loans without checking the borrowers’ creditworthiness, and credit quality deteriorated. But for a while, the problems were hidden by growing house prices and low defaults—easy credit masked the problems caused by easy credit—until house prices stopped rising and the flood of defaults burst forth.

On net, easy credit, as is typically the case, proved an extremely costly way to redistribute. Too many poor families who should never have been lured into buying a house have been evicted after losing their meager savings and are now homeless; too many houses have been built that will not be lived in; and too many financial institutions have incurred enormous losses that the taxpayer will have to absorb for years to come. Although home ownership rates did go up—from 64.2 percent of households in 1994 to 69.2 percent in 2004—too many households that could not afford to borrow were induced to do so, and since 2004, even home ownership has declined steadily (to 67.2 percent as of the fourth quarter of 2009), with the rate likely to fall further as many households face foreclosure.
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This is a lesson that needs to be more widely absorbed. Few “solutions” hold more support and promise up front, and lead to more recrimination after the fact, than opening the spigot of lending. For poor countries there is a strong parallel with the past enthusiasm for foreign aid. Now we know that aid leads to dependency, indebtedness, and poor governance and rarely leads to growth.
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The new miracle solution is microcredit—lending to the poor through group loans, a system in which peer pressure from the group makes individuals more likely to repay. Although it has promise on a small scale, history suggests that when scaled up, and especially when used as an instrument of government policy, it will likely create significant problems.

So what should the United States do to deal with the waning of the American dream, with the shrinking of opportunities for the large mass of the American people? Ignoring the problem will only make matters worse. Inequality feeds on itself. Moreover, it will precipitate a backlash. When people see a dim economic future in a democracy, they work through political channels to obtain redress, and if the political channel does not respond, they resort to other means. The first victims of a political search for scapegoats are those who are visible and easily demonized, but powerless to defend themselves. Illegal immigrants and foreign workers do not vote, but they are essential to the economy—the former because they often do jobs no one else will touch in normal times, and the latter because they are the source of the cheap imports that have raised the standard of living for all, but especially those with low incomes. There has to be a better way than simply finding scapegoats, and I examine possible solutions in subsequent chapters.