How the Housing Market is Supposed to Work (absent government intervention)

How the Housing Market is Supposed to Work(absent government intervention)

Risky Borrowers

Commercial Banks

Safe Borrowers

Safe Mortgage

Risky Mortgage

Risky Borrowers

Commercial Banks

Safe Borrowers

Safe Mortgage

Risky Mortgage

Safe Mortgage

Risky Mortgage

Commercial BanksMortgage Backed

SecurityHedge Funds

Investment Banks(Lehmann Brothers)

Moody’sStandard & Poors

Commercial BanksMortgage Backed

Security

Investment Banks(Lehmann Brothers)

Hedge Funds

Pension Funds

Other Large Savers

Reinsurance Companies(AIG)

Commercial Banks

Reinsurance Companies(AIG)

Pension Funds

Other Large Savers

Investment Banks(Lehmann Brothers)

Hedge Funds

Risky Mortgage

Risky Borrowers

Safe Borrowers

Commercial Banks

Safe Mortgage

Risky Borrowers

Safe Borrowers

Safe Mortgage

Risky Mortgage

Mortgage Backed Security

Commercial Banks

Removing the intermediaries, we see that the end result is that entities with large

amounts of savings loan to people who, in turn, buy houses.

Risky Borrowers

Safe Borrowers

Reinsurance Companies(AIG)

Pension Funds

Other Large Savers

Safe Mortgage

Risky Mortgage

Safe Mortgage

Risky Mortgage

Mortgage Backed Security

Mortgage Backed Security

Mortgage Backed Security

Mortgage Backed Security

How the Market Polices Itself(absent government intervention)

Risky Mortgage

Risky Borrowers

Commercial Banks

Risky Borrowers

What if banks started making too many risky loans?

Risky Mortgage

Risky Borrowers

Risky Borrowers

Lenders would demand a higher interest rate to compensate for the greater risk.

This would increase the cost of borrowing andso fewer people would borrow.

Reinsurance Companies(AIG)

Pension Funds

Other Large Savers

Mortgage Backed Security

Risky Borrowers

Risky Borrowers

Reinsurance Companies(AIG)

Pension Funds

Other Large Savers

With less borrowing, demand for houses would be reduced.

Mortgage Backed Security

With a reduced demand for housing, housing prices would not inflate and no price bubble would form.

Summary: How the Market Polices Itself

More risky borrowers means lenders demand higher interest rates.

Higher interest rates limits the number of risky borrowers.

Limited number of risky borrowers means stable demand for houses.

Stable demand for houses means stable housing prices.

Stable housing prices means no housing bubble forms.

How the Housing Market Did Work(behold government intervention)

Two government (or government-type) players enter the game.

Lowers interest rates making borrowing less

expensive.

At the direction of Congress, buys mortgages with little regard for risk.

Risky Borrowers

Safe Borrowers

As the Fed lowers interest rates, more people seek loans.

Safe Borrowers

Safe Borrowers

Safe Borrowers

Risky Borrowers

Risky Borrowers

Risky Borrowers

As Fannie and Freddie ignore borrowers’ riskiness, risky borrowers find it very easy to get loans.

Risky Borrowers

Risky Borrowers

Risky Borrowers

Risky Borrowers

Commercial Banks

Summary: How the Government Short-Circuited the Market

The Fed drove interest rates to low levels encouraging people to borrow.

Fannie and Freddie bought high-risk loans from banks thereby encouraging the banks to make more high risk loans.

The resulting surge in demand for housing drove housing prices up making housing appear to be a good investment.

Encouraged by this apparent good investment, more people bought houses driving prices higher.

Data source: U.S. Census Bureau

On average, every 1% increase in the size of the Federal government (relative to the economy) reduces per-capita GDP by $4,000 (in 2008 dollars).

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1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

Federal Tax Revenue as % of GDP Top Marginal Income Tax Rate

But, over that same period, Federal tax revenue has averaged a constant 18% of GDP (plus/minus 2.3%).

Data source: Bureau of Labor Statistics, National Taxpayers Union

Since 1969, the top income tax bracket has ranged from a high of 77% to a low of 28%.

Source: www.treasurydirect.com and CIA World Factbook

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Adapted from pagetutor.com

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Adapted from pagetutor.com

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$100 million fits on a standard pallet.

Adapted from pagetutor.com

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About twice the amount of money the U.S. government spends on interest on the national debt in one year.

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The value of all goods and services produced in the United States in one year.Also, the U.S. national debt (as of 2009). Adapted from pagetutor.com

$65 trillion

Total debt and unfunded Social Security and Medicare obligations (as of 2009).Adapted from pagetutor.com