The history of government intervention aimed at making homeownership—the American Dream, if you will—an affordable reality reaches back to the late 1930s and early 1940s. Recognizing the lingering economic effects of the Great Depression on the availability of home mortgage lending, the Roosevelt administration mandated that the newly created Federal Housing Administration (FHA) sponsor a new type of mortgage contract, one featuring a lower down payment, longer borrowing period, self-amortization and, most importantly, affordability. As history attests, the resulting response was nothing short of spectacular: ownership rates rose from roughly 48 percent to 64 percent in the 20 years following. While this increase was not solely attributable to financial product innovation, the results were compelling nonetheless.
Since that time, a second homeownership boom emerged and is the one which is now (painfully) unraveling. Could it be that the most recent expansion in homeownership might also be largely the result of financial innovation? The answer, according to a recently published working paper by researchers Matthew Chambers, Carlos Garriga and Don E. Schlagenhauf from the Federal Reserve Bank of St. Louis,1 is unequivocally yes.
The study intends to explain the recent rise in homeownership during the period 1994 to 2005, but I believe there is an alternative interpretation. In my view, the data presented offers a serious challenge to those choosing to classify the Federal Reserve’s recent response to the dislocation in the nation’s mortgage financing markets as a moral hazard. In other words, these critics argue that investors will be motivated to take unnecessary risks in the belief that the Federal Reserve will bail them out of trouble by lowering interest rates. Rather, I suggest a better description: the law of unintended consequences.
Consider the backdrop that preceded the most recent housing boom. As the chart accompanying chart from Ned Davis Research depicts, housing affordability differs widely by region of the country.2 Though the average home price in the early 1990s was generally within the financial wherewithal of the average household, by 1998 the trends in the western regions began shifting. Within a few years, the average household income could not support the purchase of the average home in all areas of the country. As I see it, this regional variation created an air of urgency amongst politicians looking for ways to empower homeownership for their constituents (read: voters).
However, as the law of unintended consequences suggests, sometimes good intentions have bad outcomes. In 1999, with full sponsorship from both government sponsored enterprises, Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), mortgage lenders began offering a new type of mortgage. Dubbed the combo loan, the loan combines a senior fixed rate loan on 80 percent of the property with an adjustable second-lien loan on the remainder of the property. The down payment, if there is one, becomes a secondary consideration to the goal of achieving homeownership. Indeed, as the
authors point out, the combo loan had its intended effect. Homeownership rates approached a record 69 percent in 2005, giving Chambers, Garriga and Schlagenhauf reason to conclude, “The pure demographic effect accounts for 15.9 percent of the total change, while the financial innovation effect accounts for 69.8 percent. The remaining 14.3 percent is the joint effect.”3 Simply put, financial innovation once again made the American Dream livable.
Of course, not everything went according to the plans heartily endorsed in the political arena. The unintended effects are now well known to investors and homeowners. Foreclosures have accelerated, lenders have gone bankrupt or have reported financial difficulties, some hedge funds have imploded and the markets have been extremely volatile.
All of which raises, at least in my mind, a reasonable doubt that the current actions undertaken and contemplated by the Federal Reserve Bank, the U.S. Treasury and the Office of Federal Housing Enterprise Oversight constitute a moral hazard. You see, lenders, borrowers and investors were merely reacting to new avenues of financing made available by a government attempting to increase homeownership. Therefore, if the government created and/or acknowledged the financial transactions at the root of the current market dislocation, are they not also responsible for resolving and rectifying the imbalances? As it see it, the answer is yes.
Economists learned a long time ago that there really is no such thing as a free lunch. If only politicians would learn the same lesson.
1 Chambers, Matthew, Garriga, Carlos, and Schlagenhauf, Don E., “Accounting for Changes in Homeownership Rates,” Working Paper Series 2007-034A, Federal Reserve Bank of St. Louis, August 2007. http://research.stlouisfed.org/wp/2007/2007-034.pdf.
2 Ned Davis Research, Chart B659E, Ned Davis Research, Inc., ©2007. Data range 1/31/1989 to 7/31/2007.
3 Chambers, Garriga and Schlagenhauf, page 41.
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