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Q: What caused this mess, exactly?
A: The intricacies of the mortgage market are quite complex, but before we tackle them let’s start with this: During the last two decades, housing prices in the United States increased dramatically nearly everywhere, most particularly in the states along the two coasts. Banks packaged and resold huge portfolios of mortgage loans based on those inflated prices, and when the housing bubble burst, so did the most highly leveraged financial institutions.
Q: But why did housing prices crater in the first place?
A: The short answer is that home prices had become artificially high, eventually losing touch with market-based realities. One of those ignored realities was construction costs—the actual outlays in material and labor that it takes to build a home—while another was wages. In other words, the sales price on homes in many places bore no logical relation to what it cost to build a house, while salaries earned by prospective homebuyers simply did not keep up with the hyper inflation in the home market. In the end, as the nation overbuilt, the supply of houses outstripped the demand. This was a precarious situation, with inevitable results.
Q: Did the government play a role?
A: Oh boy, did it ever. Where do you want to start?
Q: Can we start at the beginning?
A: Government’s original sin, if you want to call it that, might have been the passage of what is now every homeowner’s favorite tax break—the income tax deduction for interest on mortgage loans. After a lengthy legal challenge culminating in a constitutional amendment, Congress enacted the income tax in 1913—with the caveat that all interest payments over $3,000 a year were deductible. This certainly wasn’t done to spur homeownership (and credit cards did not exist); it was envisioned as a way to keep normal business expenses from being taxed. Most American homes had no mortgages on them at that time, and only a fraction of those would have been greater than $3,000 anyway. A good primer on this law is here.
In any event, the main effect the mortgage deduction has had in recent years is to prop up housing prices artificially, and to offer incentives for builders to build luxury second homes—and for wealthy people to buy them. A long and interesting look at the impact of the deduction (and the doomed effort to repeal it) is here.
Q: Was this an example of the “law of unintended consequences” at work?
A: You ain’t heard nothin’ yet. In 1938, as the nation endured its fifth year of the Great Depression, Congress and Franklin Roosevelt’s administration created the Federal National Mortgage Association to help ameliorate the collapse of the nation’s housing market. Fannie Mae, as it came to be called, was a government institution, which used government money to buy up mortgages from local banks. Think Jimmy Stewart’s Bailey Building and Loan Association from the movie “It’s a Wonderful Life.” Fannie Mae could pool mortgages from these small town institutions, freeing them up to make more loans. Presto! The secondary mortgage market was created. The system worked reasonably well for awhile. But in the years 1968-1970, Congress and the Johnson administration, coping with budget deficits brought on by the cost of the Vietnam War, privatized Fannie Mae and chartered a competitor, the Federal Home Mortgage Corporation. It wasn’t immediately apparent, but these two companies were troubling hybrids: They were universally perceived to be government-backed, but they were largely free of government control and oversight. And, oh yes, they were tax exempt. They had this innocent-sounding acronym, GSE, which stood for “government sponsored enterprises,” but their role in the economy would prove anything but harmless.
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