Previously we looked at what occurs when there is governmental intervention that restricts supply for a product. Using crude oil as an example we saw how governmental restriction in the supply of domestic crude oil due to environmental regulations causes demand to exceed supply. When this occurs, prices must increase or shortages will occur. We had an opportunity to see the theory of supply and demand in action in this instance. We observed that when President Bush lifted the ban on offshore drilling of domestic crude oil, the futures price dropped. Subsequently, we observed that when President Obama reinstated the ban, the price began to increase.
In this lesson, we are going to study what occurs when governmental intervention artificially inflates demand. In this lesson, we will look at how governmental intervention led to a housing bubble that initiated the current economic downturn. We will then look at how the free market can correct this crisis.
The Community Reinvestment Act (CRA) of 1977 started with good intentions, as does most legislation. However, legislation such as the CRA usually have unintended circumstances that do not surface until later. The initial purpose of the CRA was to help banking institutions meet the credit needs of local communities (Kimball, 2000). Its focus was to insure financing of low and middle-income housing and business loans.
Executives in charge of compliance with CRA say that they meet with considerable challenges and cost to remain compliant. According to Alan Urie, a vice president at First Security Bank “It is one thing to be a good corporate citizen to low and moderate income customers in your service area; all reputable financial institutions should do that as a matter of course”. Mr. Urie goes on to say, “It is another thing to meet Community Relations Act requirements and yet another to prove you are doing it” (Kimball, 2000).
When private organizations face this type of regulatory requirement, they usually insure they more than comply with regulatory standards. Financial institutions seeking to comply with CRA standards would make sure to issue a high percentage of home and business loans to low income individuals in order to insure compliance. In other words, financial institutions had an incentive to make risky loans to low income individuals in order to avoid penalties.
Fannie Mae and Freddie Mac are government sponsored enterprises (GSE). GSE’s are private corporations operating under charters drawn up by Congress. As such, investors in these companies feel their investments are secure, believing the Government will not let them go bankrupt (McLean, 2005).
Fannie Mae and Freddie Mac do business in the secondary mortgage market. This market purchases existing mortgages from the originating banks thus relieving them of the risk. Fannie and Freddie then either hold on to the mortgages or bundle them with other securities and sell them on the market (McLean, 2005).
Financial institutions working to comply with CRA saw the opportunity to unload risky mortgages issued to low income individuals on Fannie and Freddie. This reduction of perceived risk by financial institutions led to the creation of adjustable rate mortgages offering a low introductory sub prime rate and interest only loans. These creative loan products offered low-income homebuyers an opportunity to secure a mortgage on a home with a low payment. The payment may increase after a certain number of years but homebuyers were told that their home values would increase and that they would be able to sell or refinance their home at a profit and pay off the mortgage before the increase. They would then be able to take the profit from the sale of their home and use it as a down payment on another home with a conventional fixed mortgage.
However, what the experts failed to consider is that the creation of Fannie and Freddie created an artificial gain in demand for housing because individuals who would normally be unable to afford a mortgage on a home could now secure a mortgage and buy a home. This caused demand to accelerate past supply, leading to inflated home prices or a housing bubble. As long as home values continued to increase, the house of cards would stay up, but what if home values declined?
As normally occurs with supply and demand, the market finds its equilibrium, and prices stabilize. Normally this is a positive thing for the market but since many homes were bought with ARM’s or interest only loans that debtors planed to unload at a profit prior to their monthly payments increasing. This leveling of prices meant they would not be able to unload their mortgages. When their payments increased to a point where they could not afford them, they defaulted and went into foreclosure. This increase in foreclosures caused home prices to begin declining, thus exacerbating the problem even further.
Once again, we see that government intervention, even if it has good intentions, results in market distortion of the natural law of supply and demand. This example also shows us that no matter what the government does, the market finds its equilibrium but with much collateral damage.
If there were no Community Reinvestment Act requiring banks to make risky loans and no Fannie Mae or Freddie Mac to secure these risky loans, lenders would not have made these risky loans. There would have been a normal rise in the demand for houses due to economic growth improving the financial condition of everyone. Home prices would have realistically risen at a steady rate, there would have been few foreclosures, and there would have been no need for the government to bailout the banks. Next, how taxes effect the market.
References
Kimball, T. (2000, September 11). Community Reinvestment Act prompts banks to make small business loans, low-income mortgages.. Enterprise/Salt Lake City, 30, p. 6. Retrieved March 8, 2010, http://web.ebscohost.com/ehost/pdf?vid=11&hid=11&sid=7f506710-667a-4bd6-9f4e-eb986d57458%40sessionmgr11
McLean, B. (2005, January 24,). Te fall of Fannie Mae. Fortune, 151, pp. 122-140. Retrieved March 8, 2010, http://web.ebscohost.com/ehost/detail?vid=5&hid=11&sid=b948e972-5b3e-4404-ae9a-08dc099ebb1f%40sessionmgr10&bdata=JnNpdGU9ZWhvc3QtbG12ZQ%3d%3d#db=f5h&AN=15626097#db=f5h&AN=15626097
No comments:
Post a Comment