- The Washington Times - Monday, September 29, 2008

OP-ED

1) encouraging homeownership for all Americans regardless of whether they can afford the costs; 2) over-regulation of the financial community. Both policies have turned into a deceptively sweet bubble of air in the veins of the economy.

First, the government artificially inflated residential real-estate sales through several laudable - but sloppily executed - policies, such as: (1) tax breaks on interest and property taxes for homeowners; (2) implicit government guarantees of the debt of Fannie Mae and Freddie Mac to purchase conforming home-mortgage loans; (3) relaxed credit standards on home-mortgage loans permitted by the banking regulators; and (4) encouraging the collateralization and sale of mortgages to investors. In the short term, these policies had the beneficial effect of subsidizing housing costs and injecting extra liquidity into the housing market. Over the long term, these policies weakened the economy by inflating housing prices and by encouraging the financial community to make risky loans to homeowners who would not otherwise get a loan in the unregulated mortgage market. The results, as we now see, are disastrous.

Specifically, American consumers were encouraged to buy homes whether they could afford them or not. Homeowners were also lulled into believing that homeownership was an investment and not a housing expense. The annual costs of home ownership with mortgage payment, property taxes, insurance, utilities and maintenance can be more than 10 percent of the value of a home. That means a home has to appreciate more than 10 percent annually in order for a home to be a good investment. These housing policies significantly contributed to driving up the prices of residential real estate over the past 20 years. They also contributed to overleveraged homeowners and more risky mortgage loans held by banks and investors.

At the same time, the government contributed to the housing bust by instituting a series of ill-conceived regulations. After the meltdown of financial institutions following the Great Depression, a number of laws were passed to prevent runs on banks and Wall Street. For example, banks are required to have a certain amount of capital per dollar of loans. The regulators could also determine whether a loan was impaired and should be written down. Under today’s standards, loans that were made during a booming real-estate market become impaired when the loan value drops below the depressed collateral value of the home, even though the borrower is still paying and has the ability to pay the loan. In a simplified illustration of this concept, assume a bank made a $1 million mortgage loan secured by a $1.2 million house and the value of the house dropped to $750,000. The bank would be required to reduce the loan value of this asset on its books by $250,000. For every dollar of write-down of an impaired loan, the bank must provide additional capital reserves to cover the write-down or it must sell loans on its books to be in compliance with its capital-reserve requirements. In the above illustration, if a bank’s capital-reserve requirement is 25 percent of loan value, the bank’s capital is reduced by $250,000. So in order to be in compliance, it must raise an additional $250,000 or reduce the loans on its books by $1 million.

This reduction in capital causes banks to make fewer loans. Fewer loans mean potential homeowners cannot buy or refinance homes.

Under the economic laws of supply and demand, the reduced purchasing power of homebuyers means home prices drop to clear the market. When home prices drop, the collateral supporting loans drops and banks are required to write down additional loans and further reduce their capital. Reduced capital results in even fewer loans. The vicious cycle then gets worse for homeowners and the financial community by further reducing real-estate prices and liquidity. When liquidity becomes a problem for financial institutions, the run on the bank begins and a financial meltdown occurs.

This is how a financial meltdown became the unintended consequence of laudable housing and financial policies. The fault belongs to Republican and Democratic politicians, financial regulators, Wall Street and, yes, overextended homeowners. The seeds of this financial crisis have been germinating for decades.

As a civil-libertarian capitalist, I generally believe that the best way to solve market problems is to minimize government intervention. In this case, I fear that the government has so badly messed things up that they are the only ones who can rectify the situation. The recent activities by the Federal Reserve and Treasury Department will ensure that the financial community will not collapse. But more is needed. We have to figure out how to distribute the costs of the recovery package.

The world has changed drastically since the Great Depression. We can no longer rely on a regulatory system that was designed to solve problems that existed 80 years ago.

Armstrong Williams’ column for The Washington Times appears on Mondays.