The Inevitable Bailout

Alex Tabarrok explains why even if disaster is somehow averted this time around, a Fannie/Freddie bailout is essentially inevitable:

A government bailout of the GSEs should not be a surprise. After all, for a long time the markets have been predicting that sooner or later there will be a very expensive bailout. What do I mean? According to Freddie Mac (quoting the OMB) "mortgage rates are 25 – 50 basis points lower because Fannie Mae and Freddie Mac exist in the form and size they do." Now, that is almost certainly an exaggeration but to the extent that interest rates are lower due to the GSEs some significant part of that is due to the market valuing the government's implicit guarantee. In other words, interest rates are lower because the market is valuing the implied insurance. Now, the whole point of insurance is that sometimes the insurer must pay. Thus market has been telling us all along that sooner or later the taxpayer was going to pay.

Meanwhile, it's of course nice to have mortgage interest rates be lower rather than higher. But as a policy objective to devote actual resources to, this seems like a pretty poor choice of priorities. For the most desirable homes, cheaper mortgage rates is only going to bid up the price. And for every person at the margin who's able to afford a home this way, but wouldn't otherwise, you have a large number of people who are simply buying somewhat larger homes than they otherwise would have (and, concurrently, developers building somewhat larger homes).

A big house is nice, obviously, but that kind of thing is substantially a positional arms race. But beyond that, houses -- unlike most kinds of comparably durable infrastructure -- aren't really productive investments that do anything. If we had fewer schemes to subsidize home purchasing then, over the long run people would buy smaller cheaper homes and more of the country's capital would be devoted to productive investments making us all wealthier (on average) over time, albeit without quite so many extra rooms.

Comments

So because the market decided they were entitled to a bailout, they're entitled to a bailout? When were the taxpayers supposed to find out?

Posted by phil | July 15, 2008 10:54 AM

houses -- unlike most kinds of comparably durable infrastructure -- aren't really productive investments that do anything.

Uh, except for provide shelter? You know, one of those things without which people would, you know, die? Its like saying eating isn't a productive investment because you're just going to shit it out later anyway.

Posted by calipygian | July 15, 2008 11:00 AM

I don't think 25bp-50bp is an exaggeration. I'd be very surprised if it wasn't an understatement. Have you seen what long term fixed rate mortgages cost in the UK, if you can even get them? And they have hefty prepayment penalties.

Posted by Ginger Yellow | July 15, 2008 11:01 AM

Posted by calipygian | July 15, 2008 11:00 AM

Uh, except for provide shelter? You know, one of those things without which people would, you know, die? Its like saying eating isn't a productive investment because you're just going to shit it out later anyway.

Eating isn't productive investment ... because the food is consumed in the process.

Of course, as some have pointed out from time to time, there has been a tremendous amount of investment in housing that assumes ultra-cheap gasoline, so that when gasoline is merely moderately cheap instead of ultra-cheap, people living in those houses are feeling a pinch ... and if gasoline ever becomes expensive, they will be hurting very badly, and the value of that housing stock will plummet.

Still, we don't discriminate when tallying up factory investment based on whether its productive capacity for something that makes sense or not ... it would be inconsistent to discriminate against investment in real capital to produce housing services because in ten to twenty years time we will find that those housing services are available in places that people cannot afford to get to and from.

Posted by BruceMcF | July 15, 2008 11:12 AM

Bush needed to artificially prop up the economy since his tax cuts, the GOP spending that he approved, and his Iraq war of choice were skyrocketing the deficit. To do that, he pulled out the stops on every form of temporary stimulus he could think of, and made them permanent policy. The housing bubble and the false equity that it created were meant to last through his second term, since it was obvious that it was not sustainable. Instead, the house of cards fell before he could escape.

Housing has a long way to drop to get back to normal. Here's a normalized chart showing that average home prices, while now in the process of correcting, are still WAY overvalued. From 1975-2000, inflation adjusted prices moved roughly between $125,000 - $150,000. We peaked at $250,000, and we've only retracted to $200,000. We need to lose 25% off of current prices to get back to normalcy.

Posted by LFC | July 15, 2008 11:14 AM

Calipy - houses do fill a need. But they don't produce anything else on their own. A house is a necessary expense, not an asset (unless you're a landlord renting the house out to somebody). An apple that you eat isn't a productive investment, but an apple farm is.

Posted by Tel | July 15, 2008 11:14 AM

Matt-

You seem determined to continue fact-free analysis--perhaps a useful habit for a philosophy major, but less so for anyone aspiring to convince blog readers.

The housing GSEs are not intended to reduce the cost of loans--that's a side effect. What they are intended to do is create fluidity in the markets for mortgages. This does indeed make housing move available for purchase.

Posted by vorkosigan1 | July 15, 2008 11:16 AM

albeit without quite so many extra rooms

The increase in house size in the United States has taken the form more of larger individual rooms rather than an increase in the number of rooms per home.

Posted by Brian Watkins | July 15, 2008 11:20 AM

Posted by Tel | July 15, 2008 11:14 AM

Calipy - houses do fill a need. But they don't produce anything else on their own.

Its hard to tell whether you are confusing the financial market meaning of the term investment with the term in economics, or confusing "product" with "goods" and forgetting "services".

Houses are a durable produced asset that provides a stream of housing services. Whether they provide it to an owner-occupier or a tenant of a landlord is something that can change multiple times during the lifespan of the asset.

So, when an owner-occupied house has a room rented out, do you do a "count back" and increase the capital spending in the year that it was constructed to reflect that it is now 1/8 commercial and only 7/8 owner occupied? If an apartment building owned by a landlord goes under condominium ownership, do you do a count back and decrease capital spending?

Everyone knows that it is a distinctive type of capital spending, in part because so much residential housing investment is engaged in for sale to owner-occupiers, but then that is why it is in its own distinctive category, broken out just below the aggregate gross private investment figure.

Posted by BruceMcF | July 15, 2008 11:24 AM

An apple that you eat isn't a productive investment, but an apple farm is.

That's silly. The apple that you eat (collectively with other food) is a productive investment because if you didn't eat you couldn't work the farm to produce apples.

Posted by Al | July 15, 2008 11:24 AM

you should probably link to people whose arguments you lift wholesale

http://www.rgemonitor.com/roubini-monitor/252974/insolvency-of-the-fannie-and-freddie-predicted-here-two-year-ago-what-happens-next-or-how-to-avoid-the-%E2%80%9Cmother-of-all-bailouts%E2%80%9D/

Posted by hat tip? | July 15, 2008 11:31 AM

Fannie and Freddie encourage people to buy bigger houses only up to a point. They are not allowed to buy up "jumbo" mortgages over $417,000.

Rightly or wrongly, Fannie and Freddie are viewed as far safer than any of the other firms that buy and repackage mortgages. The going rate on conventional 30-year fixed rate mortgages today is 6.14%, and the rate on 30-year jumbo mortgages is 7.17%.

Posted by nodakdude | July 15, 2008 11:55 AM

The benefits provided to home ownership by the tax code far surpass any effect of a 25bp lower loan rate in influencing people to by a somewhat larger home or pay more than they otherwise would have (or buy a $25,000 stove that doesn't cook better than a $1,000 stove but looks really cool!). Not only the interest deduction, but also the ability to repeatedly roll capital gains forward tax free into more expensive homes. Factor in the leverage afforded by even old-fashioned conservative 10%-or- 20%-down lending and you have a formula for the over-investment in residential real estate, at the expense of other sectors of the economy and a now destablized financial system.

Posted by Tom | July 15, 2008 12:21 PM

I meant that with regards to the individual owning the house, or making the investment. I am taking most of this argument from Rich Dad/Poor Dad (by Robert Kiyosaki). I'm not an economist, but the arguments there seemed reasonable to me.

A house that you live in does not bring in any money for you, until you sell it - and then it's not guaranteed to have as much value as you paid for it. Eating, drinking water, buying clothes, and so on, are all consumable goods. You can't re-sell them after you consume the, but you must purchase them in order to survive. Durable goods are different in that you can actually sell them after you use them. But most durable goods start depreciating as soon as you take them home. Only in very specific circumstances can you make money off re-sale (like that guy who's buying up used SUVs at discount and shipping them to South America, where they're still in demand).

A home is probably the most durable good that a person will ever buy, but even so the person is almost never going to get more from a home when they sell it, than they've paid over the years in mortgage interest. If a home is an investment by the homeowner, it's an investment that nearly always loses money. It's still better than the alternative (renting) in most cases, since the renter doesn't even get to sell it at the end of 30 years. And it's certainly better than not having shelter at all. But that doesn't make it a productive investment.

Posted by Tel | July 15, 2008 12:32 PM

Posted by Al | July 15, 2008 11:24 AM, answering:

An apple that you eat isn't a productive investment, but an apple farm is.

That's silly. The apple that you eat (collectively with other food) is a productive investment because if you didn't eat you couldn't work the farm to produce apples.

That may well make it a productive input ... to be in the category of a productive investment, in the economic sense, it must be a durable asset that supports an ongoing stream of production ... as, for instance, a house provides an ongoing stream of residential services.

Posted by BruceMcF | July 15, 2008 12:37 PM

Posted by Tel | July 15, 2008 12:32 PM

I meant that with regards to the individual owning the house, or making the investment. I am taking most of this argument from Rich Dad/Poor Dad (by Robert Kiyosaki). I'm not an economist, but the arguments there seemed reasonable to me.

But this is not about whether a house is productive ... its about whether owning a house is lucrative. That's a key difference between the economic National Income Accounts meaning of "investment" and the ordinary business meaning of "investment".

For example, the investment in physical plant to produce a drug treating AIDS is just as productive whether that specific drug is under patent protection or the drug is a generic ... and, indeed, its likely to be more productive if the drug is a generic, and can therefore provide its benefit more widely ... but its likely to be far more lucrative if the drug is under patent protection.

Tracking national productive capacity requires economists to talk about the process of putting newly produced durable assets in place that allow for greater production. Economists use the term "investment" as a short-hand for that process.

Advising individuals trying to accumulate financial wealth requires the financial market press to talk about the process of buying financial assets with an eye to getting the best possible combination of income flow and financial capital appreciation. The financial market press uses the term "investment" as a short-hand for that process.

Nobody who understand what the National Income Account categories means is going to be confused, but a wide variety of snake oil salesmen and other political charlatans benefit from a confusion between the two, asking for subsidies for the accumulation of financial wealth as if it was the same thing as increasing the productive capacity of the nation.

Posted by BruceMcF | July 15, 2008 12:50 PM

I meant that with regards to the individual owning the house, or making the investment. I am taking most of this argument from Rich Dad/Poor Dad (by Robert Kiyosaki). I'm not an economist, but the arguments there seemed reasonable to me.

That book was massively overhyped. Yes, there is a difference b/w people who understand investment and those that don't (and it's not always a rich/poor split), but that book won't teach you much about understanding investment.

A house provides housing services. You consume these when you live there. MY's point, which is pretty simply, is that a house that provides extra housing services to a family (ie, a big house), does not help the economy to grow further. People aren't more efficient at work b/c they live in a bigger house (though this point is debatable). So as long as everyone has decent accomodations, larger houses are not good investments. Broadband, on the other hand, theoretically improves communication and allows people to work more efficiently. It's a reasonable argument to make, and when you compare the US to Europe with respect to housing size, probably also correct. But that's not to say that living in a large house isn't nice. It is.

Posted by mpowell | July 15, 2008 2:37 PM

And somebody has to quickly sideline the architects of the ugly houses going up. We could spend the same, or even less, and get attractive neighborhoods.

Posted by ferd | July 15, 2008 3:23 PM

Can it be - Republicans aren't interested in bailing out their wealthy wall street contributors?

Democratic Congressional leaders on Tuesday pushed back their timetable for approving emergency housing legislation after Republicans voiced growing skepticism and, in some cases, angry opposition to the Bush administration’s proposal to rescue Fannie Mae and Freddie Mac, the government-chartered mortgage finance companies.

Posted by scott | July 15, 2008 6:43 PM

Meanwhile, it's of course nice to have mortgage interest rates be lower rather than higher.

Well, it depends on who you are. Just like it depends who you are to determine if it would be nice for oil, wheat, or ipod prices to be lower rather than higher.

It's nice for interest rates, like most prices, to be function of supply and demand. (and in the specific case of interest rates, an accurate assessment of risk and reward)

And this is at least the second time that I recall you alluding to that the mortgage interest deduction and/or monetary policy has encouraged people to buy bigger houses. This is simply not true.

Posted by Kolohe | July 15, 2008 11:38 PM

"If we had fewer schemes to subsidize home purchasing then, over the long run people would buy smaller cheaper homes and more of the country's capital would be devoted to productive investments making us all wealthier (on average) over time, albeit without quite so many extra rooms."

And then what would we spend all that extra income on? Bigger and better houses, first of all. Why? Because that's where people live. Now, the great and obvious insight that shouldn't have to be spoken: this is precisely the situation we are in. When people in America were a lot poorer than they are today, housing was cheap. It got expensive because we started making a lot of money, and people began putting that money into their houses. Hence, housing prices went way up, and the more desireable housing went way way up. So we are already there. Is this a bad thing? No, it isn't. Fannie and Freddie did a great job until very, very recently, when underwriting standards were tossed aside because money was so cheap it seemed the Fed wanted this to goon forever. It certainly can be argued that they should be punished for making poor lending decisions. But the solution isn't to do away with them; rather, to make them go back to making good underwriting decisions, not bad ones.

Another way of putting this is that it's rather obvious Matt is a single guy who likes living in city apartments, rather than owning his own home. This will of course change when Matt grows up, gets married, and have kids. By then he will have completely different arguments for things he wants, and against things he no longer wants. I can't wait.

Posted by conradg | July 16, 2008 7:37 AM