The Housing Boom and Bust

Thomas Sowell

📚 GENRE: History

📃 PAGES: 192

✅ COMPLETED: October 28, 2020

🧐 RATING: ⭐⭐⭐⭐⭐

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Short Summary

Thomas Sowell takes a deep dive into the factors that contributed to ‘The Great Recession.’ The Housing Boom and Bust  explores the role banks, government, and consumers played in an economic collapse that had worldwide ramifications. 

Key Takeaways

1️⃣ Bad Mortgages — Banks giving almost anyone a loan was one of the primary factors that led to ‘The Great Recession.’ People that wouldn’t have normally qualified for a loan in the past were qualifying, which led to risky mortgages that were being bought, packaged, and sold to firms by Fannie Mae and Freddie Mac. When these loans defaulted after interest rates went up, the firms who had bought the mortgage-backed securities collapsed.

2️⃣ Unaffordable Housing — One of the illusions of ‘The Great Recession’ was that housing was unaffordable everywhere in the country. Property values were only extremely high in the areas where the government had imposed land restrictions, like the Bay Area.  

3️⃣ Interest Rates Are Powerful  — Although the Fed’s interest rate increase only set off a ticking time bomb in this case, ‘The Great Recession’ is a good example of how these rates can swing an economy. When interest rates spiked, property values tanked because the demand for houses plummeted. Taking on a mortgage become much more expensive with the increase in monthly interest payments.

Favorite Quote

"The traditional fixed-rate 30-year mortgages, which were once a majority of all mortgages, were no longer a majority during the housing boom, as ARMs and other “creative” ways of financing the purchase of a home grew rapidly to cope with soaring housing prices."

Book Notes 📑

Chapter 1

  • This book is about the 2008 financial crisis and what led to It.
  • The housing market is heavily impacted by interest rates and credit eligibility rules.
  • The Federal Reserve (Fed) regulates banks, controls monetary policy, prints money, controls interest rates, etc. 
  • Fannie Mae and Freddie Mac are government-created, privately-owned profit-making enterprises that buy mortgages from banks.
    • By selling these 30-year mortgages, banks can get money right away and not have to wait 30 years to get their money back in monthly installments from consumers.
      • Banks then use this money to create more mortgages to sell to homebuyers.
  • In 2004, more than 75% of mortgages were sold to various financial institutions like Fannie Mae and Freddie Mac.
    • One of the problems with selling mortgages in large quantities like this is that banks will just give out mortgages to anybody so they can then sell them off to the financial institutions.
  • Quote: “The traditional fixed-rate 30-year mortgages, which were once a majority of all mortgages, were no longer a majority during the housing boom, as ARMs and other “creative” ways of financing the purchase of a home grew rapidly to cope with soaring housing prices.”
  • Wall Street firms also buy mortgages and package them up to sell as securities that are based on the value of the mortgages.
    • Ex. REITs 
  • Mortgage debt is 82% of the total debt of the typical homeowner.
    • Owning a home is usually a liability in some ways. 
  • Because houses are almost always bought with other people’ money (debt via a mortgage), the interest rates set by the Fed have a big impact on the real estate market.
    • Remember, the Fed sets interest rates on banks (via the discount rate and the federal funds rate) and this gets passed on to consumers of banks.
  • Subprime Loans — Loans and mortgages that charge a higher interest rate to customers with bad credit to offset risk.
  • Declining and low interest rates enable more people to borrow money for houses and also enable people to buy more expensive houses.
    • Low interest rates = more demand for houses = home prices increase.
  • Early 2000‘s — Mortgage interest rates were super low, so house prices were super high.
    • This set the stage for the housing boom of the early 2000s.
  • One way to pay off a mortgage early is to sell the house (asset) and use the proceeds to pay off the mortgage (liability) and use the leftover equity (asset-liability) to put a down payment on a new home.
  • When house prices are high, it’s harder for new home buyers to afford the 20% down payment, which reduces the number of mortgages banks lend out, which hurts their bottom line.
  • 1970s — House prices in California became really pricey compared to the rest the country.
    • This is because land became really pricey due to government regulations and limitations on what land could and could not be used for.
    • These limitations limited the amount of land that could be used for housing, which drove up the price of the land that was approved to build houses on.
    • Texas has very few policies or restrictions on land. As a result, a house that costs $155,000 in Houston Texas would cost over $1 million in the Bay Area.
  • Basically, from 2000-2005, housing prices skyrocketed in areas where government restrictions on land were present and severe.
    • Down payments and mortgage payments each month were eating up half of people’s income in areas with such land restrictions.
    • For places like Houston, Texas, it was 13% of people’s income, on average. 
  • This “unaffordable” housing perception was covered by the media and became a nationwide perception, even though really high house prices were only present in pockets of the country where government land restrictions were causing house prices to rise.
    • But politicians set out to fix the problem of unaffordable housing at the nationwide level, which, as we will see in this book, caused big problems.
  • From 2000-2005, in response to rising house prices in places like California, people turned to creative financing methods to buy a house, rather than get a traditional 30-year mortgage.
    • These creative financing methods allowed more people to afford houses, which led to a housing boom from 2000-2005.
  • Interest-only loans, for example, made up 40% of all loans in many states in 2005, up from 10% in 2001.
    • Interest-Only Loan — You only pay interest payments in the first two years of the loan. These payments are cheaper because and then you start making more expensive principal payments after two years.
    • The hope with these loans was that, because house prices were rising rapidly, people would have their new home appreciate in value a ton, to the point where they could sell the house after a few years and pay off the interest only loan and still make a profit.
  • These creative financing methods, coupled with low initial “teaser” interest rates and loan eligibility requirements led to lower income, less educated people being able to buy a house. Basically, anybody was able to buy a house.
    • Many of these people did not fully understand what they were getting into.
    • “Teaser rates” were super low initial interest rates that attracted lower income people who didn’t fully understand that interest rates would swing upward quickly. It was a trap for people who didn’t understand what they were doing.
      • Predatory lenders took advantage of these people. They lent money to lower income people because they hoped to get the house via foreclosure. Borrowers have to put the house up as collateral in the event that they can’t pay the loan.

Chapter 2

  • Government contributed to the problem by easing loan eligibility requirements to allow lower income people to qualify for a loan.
    • The idea was that having a higher percentage of the population labeled as “homeowners” was a good thing, especially among certain demographics like lower income people and minorities.
  • There was this perception that housing was unaffordable, but it wasn’t true in most areas.
    • Where government intervention was highest, housing was least affordable. Again, this was because of the restrictions the government was putting on land in some of these areas like the Bay Area.
  • Rather than stop putting restrictions on land, the government pressured banks and lenders to ease lending standards so more people could afford housing.
  • The government was essentially forcing banks to show that they were lending to moderate and low income people. It wasn’t enough to say they were considering these groups — there were set quotas that the banks had to meet.
    • These lending easements were because the government claimed lenders were not lending to minorities enough.
  • All of the reductions in loan standards meant Fannie Mae and Freddie Mac were buying mortgages from banks that were very risky.
  • In 2005, The Economist, a London-based magazine, predicted an economic collapse, stating that America’s housing prices had reached dangerously high levels that put the world economy at risk.
  • A big problem was that tons of financial firms bought the mortgage securities that Fannie Mae and Freddie Mac had purchased and re-packaged them as securities.
    • These securities were incredibly risky because the underlying mortgages were subprime and risky mortgages involving lower income people.
  • Another problem was that tons of people were taking out home equity loans on their house. A downturn in housing prices could cause major problems.
  • In 2004, many economists begged Congress to reel in Fannie Mae and Freddie Mac and increase the mortgage qualifications because they could see the problems that were piling up.
    • Democratic government leaders defended the two institutions and praised them for allowing more people to buy homes via easier mortgage qualifications.
      • 76 Democratic Party leaders sent President Bush a letter defending the two institutions after Bush expressed a concern with what was going on.

Chapter 3

  • To summarize so far, mortgage requirements were reduced considerably to allow lower income, risky, uneducated groups that wouldn’t have normally qualified for a mortgage to qualify and therefore buy houses, reducing supply and driving up housing prices across the country.  This was done because politicians wanted to make homebuying more affordable to lower income and minority groups so they could brag about the increase in home ownership statistics. Additionally, in some pockets of the country, like California, land restrictions imposed by local governments made house prices skyrocket.
    • All of the above factors set the stage for a big collapse. The trigger was when the Fed slowly raised interest rates from 1% in 2005 to 5.5% by 2006.
      • Mortgage interest rates then followed suit and rose as well. When interest rates rose, mortgages became more expensive and fewer people then wanted to buy a house, which increased supply and drove the inflated home prices down. 
        • This led to a huge decline in housing prices in 2006.
  • Foreclosures began in huge numbers. Foreclosures were happening everywhere.
    • This hurt banks. Banks lose money on foreclosures because they repossess the house and sell it for cheap to unload it from their books.
  • It was a cyclical effect that drove housing prices across the market further down.
    • Ex. Across the state of California, the average house price dropped $100,000 from 2007-2008.
    • California was hit hardest. House prices declined by a huge amount.
    • Dallas, Texas — House prices only dropped 3%.
  • Home values dropped so much that people chose not to pay their mortgage because their home value was now below the price they bought the house at originally. 
    • Why pay a mortgage at a rate that was designed for a house that was more expensive than it is now?
    • This also contributed to more and more home foreclosures.
  • Financial institutions that bought mortgage-backed securities from Fannie Mae and Freddie Mac were now also getting screwed because of all the foreclosures.
    • The stock prices for these institutions dropped considerably as a result.
  • The result of the crisis was massive government bailouts using taxpayer money.
    • Fannie Mae and Freddie Mac had to be bailed out.
    • Bank of America, Chase Bank, and Citibank had to be bailed out.
    • Lehman Brothers collapsed altogether.
  • The housing market crash led to a huge financial crisis throughout the United States economy and the world economy.
    • The stock market tanked. Unemployment rose sharply.

Chapter 4

  • The “lenders are racially discriminatory” storyline was simply false.
    • This was the claim that government politicians used to enforce lending quotas on banks.
    • Asian-Americans were given loans at a higher percentage than the white demographic. The Asian-American demographic has historically had a higher credit score.
  • Preservation of “open space” was the government’s rationale for making land restrictions that drove housing prices up.

Chapter 5

  • Government intervention is usually not a good thing. Politicians have their own agendas. They don’t necessarily care about the consequences of their policies — they just want votes.
    • Instead, let the market work itself out. People in the market almost always react correctly to things.
  • The idea that the United States had a nationwide unaffordable housing problem in the early 2000s was an illusion. The illusion was caused by overpriced housing in some areas of the country where government-imposed land restrictions existed. This illusion led to the government to attempt to make housing more affordable, especially among minorities and lower income people. The government-imposed lending quotas on banks.
    • This led to some people getting loans they should not have qualified for.
      • This led to a huge number of foreclosures and an economic collapse. Financial institutions crashed because they were buying mortgage-backed securities from Fannie Mae and Freddie Mac that were extremely risky due to all the people with a loan that shouldn’t have had one in the first place.
  • Ironically, it was house flippers and real estate investors that benefited the most from the economic collapse. 
    • Minorities and lower income people got the loans that the government wanted them to get, but most ended up filing for foreclosure because they couldn’t pay their mortgage. 
      • Real estate investors and flippers scooped up these properties for cheap.