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The Illusion of Prosperity

May 18, 2012

It's not all doom and gloom Sarkozy is history, the Greeks are in paralysis, the Coalition has for the first time experienced mid-term electoral blues (just wait until May 2013 and 2014). This month has already been one of savage reprimand at the polls in Europe. Yet rather than a definitive judgement on the benefits or otherwise of austerity, I suspect electorates continent-wide are issuing a plague on all our houses.

We are reaping the rewards of decades’ worth of debt accumulation, implicitly supported by a generation that enjoyed an expanded welfare state, cheap goods, cosseting employment regulation, never-ending lines of credit and inflated house prices (in the UK and US, if not on the continent). All this has quietly torn massive rifts – between young and old, debtors and savers, East and West – and papered over the developed world’s declining competitiveness in the face of aggressive and dynamic new rivals.

Voters are furious that they were sold, and then readily bought into, a lie of prosperity. Nobody, left or right, seems to hold a solution. As we have sought to understand the roots of the financial crisis, focus has rested upon the role of bankers – their manipulation of and disregard for risk, their short-termism, their failure to respond to public anger and their apparent hostility to change – as well as the apparent willingness of politicians of all parties to give them free rein.

But there is another powerful group that has vigorously defended its vested interest in maintaining the status quo – highly leveraged homeowners. Just as bankers were broadly protected by the bailouts from the consequences of the risks they had taken, so too did policymakers move quickly to protect deeply indebted homeowners with even lower interest rates and mortgage protection plans once the financial crisis hit. The mortgage market had become ‘too big to fail’. We still are with the legacy of this after thirty-eight consecutive months of near zero interest rates – better to keep the economy on life support than risk millions of Britons crystallising unsustainable losses on property ‘investments’.

It represented the culmination of a decades-long march towards increased home ownership both in the UK (which I wrote about here a year ago) and the US. The conventional wisdom of recent decades is that everyone had the right to own a home regardless of income or personal history, and if the free market could or would not provide this, then the government should be duty bound to step in to assist. Politicians used various methods to increase lending – mortgage-related subsidies, the encouragement or forcing of lenders to provide mortgages to ‘subprime’ groups – creating an illusion of prosperity that became a deeply persuasive tool to use in any reelection campaign.

Leading up to the financial crisis of 2008, one of the most influential players was the United States’ department for Housing and Urban Development (HUD). This government body contributed to the creation of “affordable housing” (subprime mortgages). The HUD had the power to set quotas for lending giants Fannie Mae and Freddie Mac. They dictated minimum amounts of lending to be allocated to the “underserved population” (those with low incomes, poor credit histories, no deposit etc.). As Fannie and Freddie were government-sponsored enterprises, they had every duty and incentive to abide by government regulation and they did; year after year, targets set by HUD were met.

By 2006, HUD had Fannie and Freddie dedicating 53% of all loans to subprime borrowers. It was this debt that was then famously repackaged and sold onto investment bankers. Between 2005 and 2007 Freddie and Fannie took on $1trillion in non-traditional mortgages and in 2009 the two companies received $238billion in bailout funds. Furthermore, as Fannie and Freddie were the largest underwriters of US mortgages and as the two giants were pressurised to take on subprime debt, primary lenders were pressurised as well. Prudent, thoughtful lending – or borrowing – was no longer prized as volume dealing was demanded. In addition, primary lenders felt the pressure directly from the government to achieve their own social ‘goods’.

The US Community Reinvestment Act of 1977 was expanded so that primary lenders were either encouraged or forced to ignore traditional standards of creditworthiness. As the government actively encouraged “creativity” in lending, such things as adjustable rate mortgages (ARMs) gained in popularity. ARMs became notoriously problematic when low interest rates began to rise. Other forms of lending, such as “stated income mortgages” (also known as liar loans) proved to be even more toxic. As the name suggests, stated income mortgages allowed borrowers to take a loan without providing any proof of income.

As these types of relaxed lending standards became increasingly popular with primary lenders, less and less was known about borrowers’ circumstances. Fannie and Freddie began underwriting large amounts of debt with unknown levels of risk in order to meet quotas and this debt was repackaged and sold onto Wall Street. These were the building blocks for the financial crisis in which we were all complicit. Although bankers took part in buying and leveraging this debt, it was government obsession with home ownership that created much of the culture of debt to begin with.

Even as individuals it seems that we have not learned from our mistakes. So compelling is the dream of home ownership that in a proposal reminiscent of Fannie and Freddie across the Atlantic, the Coalition government has recently proposed to commit taxpayers’ money to underwrite mortgages. These mortgages are dedicated to borrowers who do not have enough money saved for a down payment and are intended to encourage lending. Naturally – and with some relief – this new proposal is on a much smaller scale than the United States, but the principle is the same; taxpayers are underwriting loans which the market, through the absence of willing lenders, has implicitly deemed too risky.

Yet we should not shy away from the fact that in this way the Coalition has made a political decision to override the natural economic break that capitalism has put in place. The short termism borne of electoral cycles makes the temptation to sell unrealistic aspiration over more unpalatable reality too enticing for most politicians to resist. How to tell young, aspiring homeowners that in unravelling the bubble created by previous generations, they are likely to be frozen out of the market for the foreseeable future? How to tell homeowners that an asset that has been reliably increasing in value is overpriced?

Rather than precipitate a rapid and painful bust, governments time and again opt for the emollience of long term stagnation. In short, while capitalism oversees the frequent inflation and deflation of bubbles, the magnitude of the property bubble and its toxicity says more about the weakness of politicians than the viability of the capitalist system.