Friday, March 16, 2007

What the Subprime Crisis Shows

Here we go again. In any economic upheaval the government seeks scapegoats. Today it is the “subprime lenders.” A good economic analysis takes into account all simultaneous interacting factors and this is extremely difficult. But let me take a stab at it.

The structural problems with the housing market stem from over-regulation. Zoning and anti-growth laws limit supply in the face of demand stemming in part from a 10% increase of population growth decade over decade. This is exacerbated by harmful regulations that have limited corporate productivity: Sarbanes-Oxley, software anti-trust, and a myriad of minor regulations. Consequently, the liquidity from monetary easing didn’t go into industrial/commercial loans where the return was limited but into housing where the price appreciation was largely the result of supply constraints.

The housing bubble was government caused. The innovations used to fund that coordinated speculative excess are secondary. It was the underlying fundamentals caused by government regulation that directed mal-investment into a consumer good, housing. Yes, there were unwise lending practices during the tail-end of the investment cycle and this happened before in the sub-prime industry six years ago. However, coordinated mal-investment and coordinated liquidation is a result of macro-policies in the face of regulations.

The demagogues will pile on, just as they did in the face of the accounting irregularities exposed by the stock-market fall six years ago. These rabble-rousers will layer on another level of regulations to compound the mal-investment correction. What this exposes is the increasing inability to whether economic challenges without panicking. This is extremely worrisome and portends a grave problem if there were a major economic challenge.

What could create such an economic challenge? A significant attack on New York, perhaps by a dirty bomb, could make a large area unusable. The economic pain (far worse that New Orleans) would be accompanied by a demand for government control that would compound the damage by an order of magnitude. Such a downward spiral would be catastrophic. In essence we are unprepared and ready-to-fail if and when such an emergency arises. A healthy culture maintains its discipline and responds rationally.

Update 8/07: Let Thomas Sowell explain it.


Blogger Always On Watch said...

I hear that foreclosures are up in the DC area. A lot of people here bought outrageously expensive homes and relied on the boom market for "flipping." Meanwhile, the local jurisdictions make all sorts of inane zoning laws, which both drive up the costs of development and limit the number of houses which can be built on any given plat--not to mention the exorbitant hike in real-estate taxes squeezing out retirees and longterm residents.

3/16/07, 9:25 PM  
Blogger nanc said...

this would not be so frightening if forty percent of our workforce were not in the construction trades.

my husband's company is into all sorts of development and a couple of years ago, i begged him and still am to step away from it and concentrate on municipal work (which requires huge bonding, but guarantees payment).

i believe they are seeing the errs of their ways as the owner of the company is now sitting on over a million bucks (out of pocket) in undeveloped (no houses yet) property.

eighty thousand dollar lots ready to build on. i sure hope and pray he (the owner) doesn't have to suck it up or use other jobs going to keep these.

it's scary as we're going for an existing home loan right now and we're getting a deal on it.

3/17/07, 8:51 AM  
Blogger beakerkin said...

The housing bubble was caused by idiotic speculation. Prices do not rise forever in straight lines.

3/17/07, 10:03 AM  
Blogger WomanHonorThyself said...

Hi there..thanks so much for visiting and commenting on my site Jason..I'll be back!

3/17/07, 9:01 PM  
Blogger Jason Pappas said...

The point isn’t that there wasn’t any building of new housing but that the building supply was insufficient to keep prices down or keep price increases to levels comparable to the general inflation level. That occurred in part by the regulatory limits on building. Given supply limits increases in credit will bid up asset prices especially if alternative investments are not attractive. Coordinated economic mal-investment is usually the result of the heavy hand of government.

3/19/07, 5:17 PM  
Blogger Jason Pappas said...

Of course, you like Sweden’s cowardly refusal to contribute to defeating Europe’s great threat: Nazi Germany. They sat on the sidelines and parasitically benefited from the hard fighting of other nations. Why is it that the left doesn’t understand the concept of honor?

3/19/07, 5:20 PM  
Anonymous Anonymous said...

"Here we go again."

"Again" is the operative term. Again, and again, and again.

When will we ever learn that we MUST have separation of state and economy (and before certain elements among us, long-term victims of the postmodernists, begin whining about how you would ever handle criminal activity in a system where the economy and government are separate, let me hasten to remind you that crime is not part of the nature of, or endorsed by, economics)?

I'll tell you when: It's when our kids are taught the basic principles of economics, and the views of the collectivist/statists such as Keynes or Marx is properly compared with the free market of Capitalism.

Our failure to even minimally acquaint Our Young with basic principles of economics not only figures into the fact that:

1) So many of them are financial basket cases by the time they graduate from college,

2) So many cases of financial basket cases exist that they support an entire genre of TV programming, as exemplified by programs such as "Big Spender" (you've GOT to see at least ONE of them - the last one I saw addressed the case of a woman who was OVER $400,000 in debt!),

3) Government intrusion and micromanagement of the economy produces follies such as the Great Depression (and many others),

4) Government manipulation of the economy by such means as Minimum Wage Laws is responsible, in very large part, for the invasion of illegal aliens,

5) It bears direct responsibility for the current wave of housing foreclosures,

6) AND the chronic housing problems in New York City etc. etc. etc.,

BUT ALSO explains why we are beginning - realistically - to fear that our own robust economy has begun to weaken.

If ANYONE wants to learn more, here are some recommendations:

1) "Basic Economics" by Thomas Sowell. Clear, uncomplicated; written in language that anyone with a 7th-grade reading level can understand. Given the Man on the Street's acquaintance with economics, that's a good thing.

2) Walter Williams ten-part online course, "Economics for the Citizen"
(it's free from his website! Sort of a philanthropic effort on Dr. William's part).

3) "Economic Policy" by Ludwig von Mises, a short and very engaging collection of six lectures given by him in Argentina; it goes in and out of publication, and is easy to find.

4) "Ten Thousand Commandments" by Fleming (can't remember his first name just now). A monograph with lots of illustrations of the damage done by Anti-Trust laws. Out of publication, but not hard to get.

If you had only these four resources on your book shelf, you'd be SO FAR AHEAD of most other folks, AND you would see the importance of teaching our kids about this subject.

They will NEVER learn it in the government-run schools, since they controlled by the collectivist/statist postmodernists, who will continue to decry "materialism" and any economic system that smacks of productivity, creativity, prosperity and happiness.

The only way our kids will EVER learn this stuff is if they survive intellectually until they can enter graduate school at places like George Mason University, or take it up on their own.

3/19/07, 5:55 PM  
Blogger Jason Pappas said...

I've been meaning to read Sowell's book. People ask me for good intro books and I was wonder if his treatment is accessible.

I know he has written some articles on the housing market a few years back that support my explanation but I didn’t have time to search the 'net for them.

3/19/07, 6:59 PM  
Blogger unaha-closp said...

Consequently, the liquidity from monetary easing didn’t go into industrial/commercial loans where the return was limited but into housing where the price appreciation was largely the result of supply constraints.

No. This is disproven because the housing vacancy rate now (since 2002) is at higher levels than at any other time since 1956. It consistantly hits 9.5 - 10% a rate almost twice the average. Supply is not constrained wrt to available customers.

The current price appreciation is due to speculative demand due to the increased access to liquidity. Cash is available at historic lows that has led to speculation investment in property so that demand for buildings exceed the renting/buying market.

3/19/07, 7:55 PM  
Blogger Jason Pappas said...

Could you explain, unaha, what you're talking about? "Vacancy rates" usually has to do with rentals not home-ownership. With home ownership one usually looks at such measure as average months on the market, sales price compared to asking price, etc. The bidding up in home prices is mostly the bidding up in land prices. It’s the constriction of land use that hampers supply so that demand is not met at a lower price level.

As with increased liquidity, one can either buy more (increase production) or merely pay more (increase in asset prices) or some of both. I acknowledged the role of the credit expansion but what needs to be explained is why credit was used for X as opposed to Y or Z.

By the way, your link doesn’t work.

3/20/07, 10:13 AM  
Blogger Jason Pappas said...

A few articles on housing by Sowell: Afordable Housing, Statist Housing Policy, Housing Hurdles

3/20/07, 10:21 AM  
Blogger unaha-closp said...

Can't get links to work.

Vacancy rates show the oversupply of houses to customers for housing. The increase in vacancy rate (rental) shows that there the supply of housing is out stripping demand. Homes that are owned are not a seperate comodity to homes that are rented, they are interchangeable. Returns on property investment are determined by the rental income and capital gain. Rental incomes are becoming more and more difficult to obtain, but capital gains are increasing.

Capital gains independent of demand for homes. Housing is a less profitable investment to rent out now than in years previous. The reason I propose for the capital gains is that there are loans available at lower rates today than historically and that this lowers the requirement of return & market entry costs. Decreasing the costs of entry like you suggest, would encourage further investment to take advantage of the rising capital gains that are due to the increase in investment. It is a speculative market.

3/20/07, 4:57 PM  
Blogger Allen Weingarten said...

I agree with Cubed that we must: have separation of state and economy; learn the basic principles of economics; prevent government manipulation of the economy. These deal with the consequences of economic policies.

In addition we need to deal with the 'immorality' of current policies, such as the denial of liberties, and the theft of what is earned by individuals. That is, we ought to emphasize the moral dimension of capitalism, as did Ayn Rand and others. All of this could be subsumed under what I aver are the three fundamental principles of society:

The primary objective for society is ‘Justice’, namely that people get what they deserve (“As ye sow, so shall ye reap.”);
There ought to be separation of culture and government, where the former requires freedom, while the latter requires suppression;
Consequently, there should be minimal government and politicization, guided by the separation of powers, checks & balances, and equality before the law (“That government is best that governs least.”)

3/20/07, 5:31 PM  
Anonymous Anonymous said...

Cubed here.


Sowell's book is definitely accessible. It could easily be used by some middle school and most high school students as a textbook.

Once someone has read it, it's easy for that "someone" to understand why the collectivist/statist/postmodernists really don't want our kids to know about all this stuff.


"In addition we need to deal with the 'immorality' of current policies, such as the denial of liberties, and the theft of what is earned by individuals...we ought to emphasize the moral dimension of capitalism, as did Ayn Rand and others."

Yeaaa! Yes, yes, YES!

Thanks to the postmodernism that has been entrenched in the government-run school system, generations of Americans don't understand that just because a policy, law, regulation, ordinance etc. is legal, it doesn't necessarily follow that it is morally valid.

3/21/07, 4:01 PM  
Blogger Allen Weingarten said...

Tom Sowell writes " It is fascinating to hear subprime lenders being accused of "exploitation" while they are losing millions of dollars and some of them are going bankrupt."

3/22/07, 8:13 AM  
Blogger Jason Pappas said...

The subprime products are largely misunderstood. Those with low credit can get loans by paying a higher than usual interest rate to compensate the lenders for the risk. The borrower generally hopes to refinance within short order after they improve their credit (credit curing) and qualify for normal interest rates. Thus, the ever popular 2/28 arm (which resets after two years using prevailing rates) generally has a high number of borrowers using the refi option to get out of the loan. Other borrowers (as is typical with poor credit) who fail to make payments can, in a housing boom, avoid foreclosure by selling their homes for a profit and paying off the loans. Thus, investors see the loans as being resolved within the 1st few years.

The problem in the subprime sector isn't loans issued in 2003 (most of which have prepaid their loans or they still have equity in their homes even after recent price declines) but with the last vintage: 2006. These borrowers won't have the same opportunities as previous vintages since housing price appreciation has ended or declined depending on region. As the data started to reveal delinquencies (failure to pay) investors quickly demanded greater compensation to own these loans, (making refinancing less affordable) or greater quality control (limited credit to the most risky.)

This is the feedback mechanism of the market and it worked. Those that made the riskiest loans, or tried to stretch-out another year by forgoing due diligence, were the first to fold. Others have had to curtail operations as volume shrank. When the dust settles there will be a few lenders who will conduct a modest volume of business at the appropriate rate level.

If, of course, the government, which is already late to the game, decides to put even greater barriers to loan origination, the problem will be exasperated. As I said above, borrowers are short-term oriented and hope to find new loans on better terms. Limiting loan origination beyond the economics will lead to greater defaults, dumping of real estate, and a possible cascade of supply creating a government-induced crash to the government-fueled boom of the last half decade. If it is great enough it can depress the whole economy.

If history is a guide, one can trust the government to exaggerate (if not create outright) business cycles. What I can't tell, unfortunately, is the magnitude of the problem. But the government, which doesn't do so well with magnitudes, will surely compound the problem.

One detail I didn't mention was the use of subprime loans to consolidate credit-card debt. Given the tax breaks on home loans, it is advantages to use increases in home equity to refi into a larger loan and pay down credit card debt (cash out refi.) This ends when home prices stop increasing. This should have some effect on consumer spending but again I don't know the magnitude.

The subprime lenders were the marginal lenders and it is appropriate when marginal economics changes, this is where the action is. There will be a small effect in the Alt-A mortgage market and even smaller effect in the prime market. The pre-pricing has already occurred but just like the dot-com and Enron cases, the government will get involved after the problem is corrected and the economic punishment has been applied. If there is a Sarbanes-Oxley coming for the housing market expect a greater economic downturn.

3/22/07, 10:49 AM  
Anonymous Anonymous said...

Cubed here.


You probably already have this (Thomas Sowells' website) but just in case, here 'tis:

It has a link to his publications.

You can also reach him and a lot of other interesting Fellows at the Hoover Institution at:

Cubed here.


You probably already have this (Thomas Sowells' website) but just in case, here 'tis:

It has a link to his publications.

You can also reach him and a lot of other interesting Fellows at the Hoover Institution at: It's about the most user-friendly site I've ever seen.

3/25/07, 6:45 PM  

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