Housing Crisis Humor

I was watching the Communism Channel (Bloomberg) and I saw something that made me think "ROFLMAO!!!" Of course, the commentator/comedian did not intend his comments as funny, but rather as a serious market analysis.

The quote was "In response to the subprime mortgage problem, the Federal Reserve and Federal government have tightened lending requirements. It is much harder to get a mortgage now. This new regulation will solve the housing crisis. Housing prices are still falling. The government needs to address this problem."

Do you get the joke? I'll give you a chance to figure it out on your own. Here's a good chance to test your understanding of real economics.

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When buying a house, most people buy the most expensive house they can afford. Since real interest rates are negative, this is normally a rational economic decision provided you can make your mortgage payments. When the entire housing market crashed 50% or more, many people wound up stuck with houses that were worth less than their mortgage. They made the rational economic decision to default on their mortgage.

When mortgage requirements are tightened, people cannot borrow as much. This causes housing prices to drop even further.

The analyst was praising a regulation that had the effect of pushing down housing prices. At the same time, he was lamenting the decline in housing prices. It was hilarious!

Let's pick a concrete example. Suppose you want to buy a house worth $500k, and mortgage interest rates are 6%. Suppose you make a 20% downpayment of $100k. Your monthly mortgage payment on a 30 year fixed rate mortgage will be $2400.

Suppose you make a 2% downpayment of $10k. In that case, your monthly mortgage payment on a 30 year fixed rate mortgage will be $2940.

Notice that changing from a 20% downpayment to a 2% downpayment has a small effect on your monthly payment. You were able to use 50:1 leverage instead of 5:1 leverage, but your monthly payment is only 20% more. (For a real mortgage, you'll be charged PMI and a slightly higher rate on the bigger mortgage. You're still better off maximizing your leverage.)

Suppose State regulations allow 2% downpayments. In that case, someone with only $10k in savings can afford a $500k house.

Suppose the State changes the regulation from "2% downpayments allowed" to "20% downpayments required". Now, the person with $10k in savings can only afford a $50k house instead of a $500k house. Housing prices will drop by approximately 90%, assuming most potential house buyers are buying the largest house they can afford.

By changing the amount of leverage individuals may use, the State exacerbates the boom/bust cycle. Ten or twenty years from now, the subprime mortgage crisis will be mostly forgotten. Eager to issue loans, banks will lobby to have the "20% downpayment required" regulation changed back to "2% downpayment allowed". In this manner, a new bubble will occur.

There were some other practices that allowed individuals to increase their leverage ratios. "interest only loans" and "Adjustable Rate Mortgages (ARMs) with teaser introductory rates" allowed individuals to load up on leverage. As long as the housing market boomed, people taking out such loans benefited from inflation.

The Federal Reserve credit monopoly distorts the market. By changing interest rates and changing the leverage ratio people are allowed to use, the State causes boom/bust cycles. Insiders always qualify for a bailout, but individuals lose their homes and their savings.

In a true free market, there would be no economic advantage to purchasing a home via debt or purchasing a home via accumulated savings. Negative real interest rates encourage would-be asset buyers to maximize their leverage. During the inevitable bust, individuals who maximize their leverage lose everything, while insiders qualify for a bailout.