9

The politics of housing

An unproductive asset

Housing is important to everyone. It is the largest investment most people make, requiring the largest debt. A home is essential for everyone, whether you are renting or owning, and it is the basis for numerous support and development businesses such as construction, estate agents, landlords and DIY stores. Residential housing is also the main use of urban land. Politically, changes to housing stock have often accompanied the most far-reaching social change in a society. And at all times housing has been used to signify wealth. So whether we like it or not, housing is a political issue.

The primary function of housing started out as shelter; which, while essential, is almost entirely non-productive. If a house fulfils its role as a shelter it has achieved its main purpose; it does not make the owner or a nation wealthier, though it may act as a store of wealth. The creation of wealth relies on actions that add value to a process. Houses are repositories and do not, generally, add value. So, when house prices rise faster than the inflation of the rest of the economy, it is usually not because housing has become productive, but because there is greater confidence among buyers that their wealth has increased enough to pay more, and of course, this makes the sellers feel more wealthy too, because someone is prepared to pay more.

It is the combination of wealth and the lack of added value in housing that is probably responsible for the starring role that property seems to play in many financial crises: America in the 1920s; Japan in the 1980s; Thailand in the 1990s; America and Europe in the 2000s.

The latest boom – and crash – grew with the tension of wealth and added value, but was accompanied by an unusually marked ideological angle: housing, and house ownership, symbolised freedom and success, and the rejection of state interference. Housing markets and housing finance before and after the fall of the Berlin Wall became a political activity in a way that would not have been recognised by the preceding generation. Not surprisingly, many of the countries that experienced sustained housing booms were those in the vanguard against socialism; America and the UK in the 1980s, together with allies in the Anglo-sphere such as Australia and New Zealand and like-minded Western European allies such as Spain, plus the post-Communist Eastern bloc.

A unique housing model, with familiar results

America follows a unique model for housing finance; with mortgage lending directed through federal agencies, the Federal Home Loan Mortgage Corporation (FHLMC or ‘Freddie Mac’) and the Federal National Mortgage Association (FNMA or ‘Fannie Mae’), operating as quasi-official organs of state policy – at least since the Clinton presidency. When politics changed with the Bush administration, policies deliberately sought to undermine their power, and enhance a ‘free market’ solution, with the result that the quality of mortgage lending declined. The worst excesses therefore came after the political elite limited government agencies and encouraged the private sector.

In brief, subprime lending was lending to people who would not normally have been able to obtain a loan. As we’ll see, this lending was often encouraged by social and political pressure, and was made palatable by higher fees.

While the subprime lending spree was a particularly American response to a political requirement, similar effects appeared elsewhere. When the financial crisis first broke in August 2007, the Spanish, German and British governments all protested that there was no subprime lending in their countries. Their banks should not be threatened, it was claimed, by the US problems. They failed to realise, at least initially, how lax lending standards had affected their own financial systems. And they did not acknowledge the encouragement local politicians had given. In Spain, Britain and Ireland, politicians also gained benefits from the housing boom.

The politics of home ownership

Government support for the housing boom – and subprime lending – in all cases was political. It is often altruistic in the sense of wishing to expand the perceived benefits of home ownership to previously excluded members of society, but it was also associated with power over resources, taxable revenues, so-called developer ‘incentives’ and votes.

We’ve seen that housing is an important policy issue at all times, but it took on an additional philosophical value with the election of Margaret Thatcher in the UK in 1979. Beginning in 1980, the UK government introduced its ‘Right to Buy’ policy, which gave secure tenants of local authority housing the right to buy their rented accommodation. The aim was to encourage individuals to take personal responsibility for their homes, and introduce incentives to contribute to improving their environment. Margaret Thatcher’s most famous quote was given in 1987, long after the introduction of Right-to-Buy, but sums up the philosophy behind the policy:

‘As you know there is no such thing as society. There are individual men and women and there are families. And no government can do anything except through people, and people must look after themselves first. It is our duty to look after ourselves and then, also, to look after our neighbours.’

Offering house ownership was a fundamental political act of individualism, and, despite the financial crisis, is likely to remain so.

Practical support for housing from governing parties in America and Britain stems from the link between house prices and consumption. A rise in house prices may widen the gap between moderate and high-priced houses, and therefore limit movement from a small house to a larger house, but a rise in house prices reliably encourages all owners to feel wealthier, and therefore to spend more. More prosperous electors are generally more amenable to existing governments. Politicians always had a strong incentive to encourage house price rises.

Yet, the housing market was always of unreliable assistance to politicians. Housing booms and busts are common in all advanced economies, so much so that any study of recent history around the globe suggests politicians would be foolish to rely on permanently rising prices. The public perception that falls in house prices are exceptional is false. Japan’s house prices fell by a third after adjusting for inflation between 1990 and 2002 and it is not unusual; house prices in Italy and Canada followed a similar downward move for most of the same period. UK house prices fell much faster than those of Japan at the beginning of the 1990s.

Prices in the Netherlands fell much faster, and much further in real terms, in the late 1970s and early 1980s than in Japan. America itself had noticeable moves up and down through the 1990s. Since 1980 there has been only one constant; German house prices never go up.

House prices in most advanced countries rose and fell by half over the last thirty years; sometimes more than once. In some cases (Spain) the variation was much higher – 250 per cent. The politics of housing is, therefore, inherently unstable.

Not only the politics, but also the financing of housing is unstable. America, the UK, Spain, Australia, Canada, France and Italy all suffered large banking losses related to property lending in the early 1990s. Housing booms seem to act as an indicator of lending excess; if there are no productive investment opportunities left, invest in housing.

Clinton’s third way: social inclusion and market economics

The housing boom and crash of the late 1980s and early 1990s grew out of the Thatcher–Reagan doctrine of individualism and established a consensus about the success of market economics that would remain unchallenged for nearly twenty years.

Victory for Bill Clinton in the US presidential election of 1992 brought in an administration committed to social inclusion as well as the market economy. In his inaugural address as president Clinton identified the challenges that would define both his terms:

‘Today, a generation raised in the shadows of the Cold War assumes new responsibilities in a world warmed by the sunshine of freedom but threatened still by ancient hatreds and new plagues. Raised in unrivalled prosperity, we inherit an economy that is still the world’s strongest, but is weakened by business failures, stagnant wages, increasing inequality, and deep divisions among our people.’

With these two sentences, Clinton defined overall US domestic and foreign policy for almost a decade, until September 2001. The themes of pre-eminence, evangelical free-enterprise and global leadership in Clinton’s address reappeared throughout the 1990s, especially in Robert Rubin and Larry Summer’s foreign trade policy. They also anchored housing policy to the aim of reducing inequality and spreading of prosperity to those who had been excluded. It was a patriotic mission.

Clinton’s first election campaign is best remembered for his quip, ‘It’s the economy, stupid!’ Housing was so important to the US economy he could have said ‘It’s housing, stupid!’ By luck, the president entered the White House just as the economy was recovering from the recession of the early 1990s, and the housing market was bottoming out after the property bust that accompanied that recession.

Economic recovery further stimulated Clinton’s housing policy. In 1994, the president initiated a plan called the ‘National Homeownership Strategy’, sub-titled ‘Partners in the American Dream’. The strategy aimed to expand home ownership as widely as possible, which meant expanding it to include those parts of society that could not qualify for a mortgage and did not have enough money for a down payment. The administration flirted with the idea that buyers could use some of their personal pension money as a down payment.

The National Homeownership Strategy also encouraged lenders to offer interest rate costs lower than the market would normally charge for such high-risk borrowers.

‘Other households do not have sufficient available income to make the monthly payments on mortgages financed at market interest rates for standard loan terms. Financing strategies, fuelled by the creativity and resources of the private and public sectors, should address both of these financial barriers to homeownership.’

In other words, ‘Get creative about offering loans to people you would not normally want to lend to’. This initiative built on the Community Reinvestment Act of 1977, passed during the Carter presidency, which required mortgage providers to extend lending to borrowers and areas usually considered too risky. To be in the mortgage business from 1977 onwards required some exposure to subprime. So the progress of US mortgage lending in the past thirty years has been marked by systematic political interference under the banner of ‘house ownership for all’, whether the borrowers meet conventional credit criteria or not. We now know this was storing up problems.

Of course, the policies of both Clinton and Carter were part of an honourable tradition that sought to eliminate discrimination in lending. Services such as banking and insurance had been withheld or provided at higher cost to areas denoted by ‘red lines’, those deemed not creditworthy enough for normal services. ‘Redlining’ of districts had been a problem for minority communities from at least the 1930s. While the practice was illegal, it was very hard to stop if large numbers of low-credit families lived in close proximity. Banking is not well suited to implementing social policies, which are much better made by government agencies. Unfortunately, the mortgage agencies Freddie Mac and Fannie Mae straddled the banking and political spheres and seemed admirably suited to implementing the political agenda, beholden, as they were, to government for their survival.

The overlap of politics and bankers

The Clinton administration’s decision ‘creatively’ to finance monthly payments was a more daring step forward in mandatory subprime lending than had been seen before. It was an important precursor for the subprime lending that followed because it committed the mortgage agencies to a policy of lending to ‘unconventional’ borrowers. Moreover, by demonstrating to politicians that they could lend to lower-credit borrowers, the agencies could market themselves as the only means of delivering this policy, of providing the American Dream to the poorer sections of society. In a good move for the agencies, they acquired a patriotic mantle they did not have before, and so placed themselves firmly at the heart of the economic policy of the nation.

An important part of the Clinton administration’s strategy was to mandate the mortgage agencies to adopt ‘affordable housing goals’, to lend to disadvantaged groups within society. The agencies gained commercial benefits from the implied backing of the US government, including lower cost of funding, tax relief, greater leverage than private sector banks, exemption from some banking regulations and a direct line of credit from the Treasury. These were conditions well beyond what was considered prudent for commercial banks. The exemptions and lower prudential controls allowed the private shareholders to reap a benefit estimated to be worth in total perhaps $10 billion a year or more.

In return for these benefits of state approval, Freddie Mac and Fannie Mae were required to provide liquid and stable secondary mortgage markets. This role they performed well for many years. Fannie Mae was one of the first institutions to issue mortgage-backed securities in the early 1970s and in earlier chapters we’ve seen the significance of securities. These securities led to a big increase in credit to house owners, and a new class of asset for investors – the mortgage-backed bond. While this has been tarnished by the financial crisis, it was such a useful innovation that it will undoubtedly return. Financial life in the US has come to rely on securitisation to function. It is not an option for banks to function without asset-backed and mortgage-backed securities because the practice has become so embedded into the system. Though Europe is not as reliant on asset-backed securities, its continued financial advance probably requires extending the use of these assets in future.

The agencies were also required to support secondary mortgages for moderate and low income families and provide access to mortgages across the entire nation, including areas not normally served by lenders. The agencies were therefore directed, in spite of being nominally private companies, to follow a political agenda; to alleviate lending discrimination.

Affordable housing goals, originally set in the Housing Act of 1990, included targets, set by Congress, to provide lending to less creditworthy borrowers, and the goals were raised over time. Lending to moderate or low income families was set at 42 per cent of all lending in 1997–2000. This was a very high level, but it did not stop politicians from raising the threshold every time the Act was revised by Congress. The threshold was raised to 50 per cent between 2001 and 2004, and expected to rise to 57 per cent by 2008. Another goal was to extend lending to special groups that did not fall into the low to moderate income bracket but who might otherwise find borrowing difficult. In the first period, this target was set at 14 per cent, rising to 20 per cent by 2001 with a target of 28 per cent by 2008. These two goals alone meant that by 2005 70 per cent per cent of agency lending from the largest mortgage lenders was to be directed at borrowers deemed less creditworthy than a conventional borrower. Not all the ‘affordable housing’ lending was risky, but by 2007, the damage was cumulative and affordable housing goals increasingly led the agencies into poor lending. By then, about a third of the companies’ lending involved risky mortgages, compared with 14 per cent in 2005.

The concentration on affordable housing goals also meant conventional borrowers went elsewhere. So, the portfolio of assets held by the agencies deteriorated from the mid-1990s onwards, in line with the political pressure to provide lending.

Nor was the encouragement to lend to less robust borrowers limited to politicians; the Federal Reserve endorsed the wider remit, at least until Bush took office. In 2000, Fed governor Edward Gramlich addressed an audience of affordable housing specialists and said:¹

‘As a result of the good economy, various technological changes, and innovative financial products, credit to low-income and minority borrowers has exploded in recent years… Between 1993 and 1998, conventional home-purchase mortgage lending to low-income borrowers increased nearly 75 per cent, compared with a 52 per cent rise for upper-income borrowers. Conventional mortgages to African-Americans increased 95 per cent over this period and to Hispanics 78 per cent, compared with a 40 per cent increase in all conventional mortgage borrowing. A significant portion of this expansion of low-income lending appears to be in the so-called subprime lending market.’

At the time (2000) increased subprime lending was clearly cause for celebration. The speech reveals a worrying overlap of central banking, social engineering and political encouragement to lax lending standards.

The previous support, and cajoling, of Congress and Fed did not aid the mortgage agencies during their demise in 2008. The same people that had set the affordable housing goals were later to criticise lenders for their lax standards. Sometimes, they even criticised lax lending standards while complaining that the agencies had failed to meet the affordable housing goals. In September 2008, James Lockhart, director of the Federal Housing Finance Agency, reported to the Senate Banking Committee that the agencies missed the government-mandated affordable housing goals in 2007 and ‘the miss will be larger in 2008’. At the same hearings, Lockhart also complained that Freddie and Fannie in 2006 and 2007 purchased and guaranteed ‘many more low-documentation, low verification and non-standard mortgages than they ever had, despite regulators’ warnings’. Mr Lockhart could have added that the affordability goals led to a big incentive to the creation of the ‘private label’ mortgage products, which were to cause so many problems later. There was a contradiction in home-lending that even the regulator seemed unable to recognise.

Not surprisingly, the agencies were embedded in the Washington lobbying process. They employed large numbers of professionals to fend off criticism of their commercial advantages that appeared periodically from some members of the Senate. Their relationship with the Democratic Party was so strong that senior executives moved from the mortgage agencies into the administration. The administration also provided staff in the other direction. Sometimes it worked both ways for the same person. Franklin Raines became Fannie Mae’s vice-chairman in 1991, a post he held until he left in 1996 to join the Clinton administration as the director of the Office of Management and Budget (OMB). He rejoined Fannie Mae in 1999 as chief executive, the ‘first black man to head a Fortune 500 company’.

Raines’ move from Fannie Mae to OMB was no political coincidence. The OMB is the largest office within the executive branch of the US administration. Its role is to direct and monitor the performance of a large range of government programmes as well as to draw up the annual government budget. It is a powerful political position. The move from OMB back to Fannie Mae by Raines is an illustration of how important the agencies were in the domestic policies of Bill Clinton. It is also an indication of how important to the political process the agencies themselves had become.

Beyond domestic politics

Nor was it just domestic politics that were affected by the behaviour of the agencies. The size of agency issuance in the secondary bond market ensured they played an important role in capital markets. In the late 1990s, the government ran a budget surplus and agency issuance far outstripped Treasury issuance. As a result, the agencies took on the role of government bond proxies. The intertwining of political relationships and constant comparison with Treasury bonds imbued the agencies’ debt with the cachet of government debt, without any official support being offered.

For investors such as Chinese reserve managers, there was increasingly little to differentiate between the Treasury bond market and the agency bond market, which offered slightly higher returns. Both were apparently guaranteed by the most powerful government in the world and embedded in government policy. It was unthinkable that the agencies would be allowed to default on their own debt or the repackaged mortgage debt they offered, so any sensible investor, even one as risk averse as reserve managers, was better off buying agency as well as Treasury bonds. From 2003, reserve managers, and especially China, divided their US bond purchases between pure government debt and agency debt. To an outsider, as well as to the political elite within America, the agencies appeared as a privatised arm of government policy.

A change of politics; a change of subprime

The Bush administration initially pursued a similar, if uneasy, symbiotic relationship with Freddie Mac and Fannie Mae. The agencies were regarded as deeply Democratic institutions, but useful for the introduction of the Bush doctrine of an ‘ownership society’.

Bush’s second inauguration in 2004 spoke of giving ‘every American a stake in the promise and future of our country… and build an ownership society’. The Bush policy of ‘ownership’ merely reactivated a policy that had, in practice, been in place for years. The policy had been used to rescue the economy in 2001, by promoting housing finance as an agent to support consumption.

If the ideals of home ownership sat well with Republican ideology, the institutions of the semi-official mortgage agencies did not. The agencies were increasingly seen as quasi-monopolists whose allegiances were tainted by close ties to the defeated Democrats and impeded private sector providers of lending. Nevertheless, for most of the first term, the Bush administration was happy to consort with the enemy, and use the agencies to fund expanded mortgage lending.

A clear change towards the agencies emerged in 2003 when Freddie Mac and Fannie Mae were investigated by the Office of Federal Housing Enterprise Oversight (OFHEO) and found to have systematically under-reported the volatility of their earnings. Freddie Mac had understated profits in an effort to make its earnings appear more predictable, and bolster its share price. Six months later, regulators found Fannie Mae had also engaged in a ‘pervasive misapplication of accounting rules’. Regulators wrote that Fannie Mae ‘maintained a corporate culture that emphasized stable earnings at the expense of accurate financial disclosures’.²

The previous Democratic allegiance of the agencies now definitely counted against them. The similarity of the charges against the two agencies also indicated a degree of cartel-like behaviour. This was the other side of the intense political pressure placed on the companies; they worked together to extract the greatest economic advantage.

The companies attempted to fight the criticism of their accounting practices. Fannie’s chairman Franklin Raines dismissed the criticism, but the establishment had turned against them. The Securities and Exchange Commission’s chief accountant said the Fannie Mae was not even ‘on the page’ of allowable accounting interpretation.

Congress had been forcefully and regularly reminded of the risks in the agencies by Richard H. Baker, a Republican congressman from Louisiana. Baker’s response to the Fannie report was typical of his frequent scathing comments of both companies: ‘Investors have been fooled, homebuyers have been cheated, and taxpayers are at risk. Fool us once, shame on you. Fool us twice, shame on us.’

It was an opportunity for Republicans to limit the influence of the agencies and promote the true private sector. Both Fed chairman Alan Greenspan (a Republican) and the Treasury secretary, John Snow, called for tougher supervision of the companies, and a reduction in the size of their balance sheets – which would mean other companies having to step in to provide mortgages, including mortgages to those unable to qualify for conventional borrowing. In a speech in February 2004, Greenspan insisted that ‘most of the concerns associated with systemic risks (in the American financial system) flow from the size of the balance sheets that these GSEs (government-sponsored enterprises Freddie Mac and Fannie Mae) maintain’.³ After a decade of Democratic-influenced and agency-led mortgage policy, it was time to sample the Republican option, based on regional mortgage brokers originating loans and sending them to Wall Street for packaging into securities. This, of course, meant the expansion of subprime as well as the expansion of normal lending.

So the Bush administration – and Greenspan – wished to remove the agencies’ central role in housing finance and replace it with the purely private sector alternative. Greenspan specifically referred to such a plan in his February testimony the Senate Banking Committee:⁴

‘Fannie and Freddie can borrow at a subsidised rate, they have been able to pay higher prices to originators for their mortgages than can potential competitors and to gradually but inexorably take over the market for conforming mortgages. This process has provided Fannie and Freddie with a powerful vehicle and incentive for achieving extremely rapid growth of their balance sheets. The resultant scale gives Fannie and Freddie additional advantages that potential private-sector competitors cannot overcome… The current system depends on the risk managers at Fannie and Freddie to do everything just right, rather than depending on a market-based system supported by the risk assessments and management capabilities of many participants with different views and different strategies for hedging risks. Our financial system would be more robust if we relied on a market-based system that spreads interest rate risks, rather than on the current system, which concentrates such risk with the GSEs.’

In December 2004, both Freddie and Fannie agreed to manage ‘total balance sheet asset size by reducing the portfolio principally through normal mortgage liquidations, in order to limit overall minimum capital requirements’.⁵ The agencies’ reduction of their balance sheets also reduced the agency bonds available to investors, mainly through not replacing bonds as they were redeemed. Of course, it also limited the provision of mortgages backed by the agencies.

As expected, the need to continue production of mortgages meant the space had to be filled by non-agency lending and securitisation. The private sector saw that the highest fees and the greatest returns for investors (at the time) lay in the lower end of the credit spectrum – in subprime. In one year (2004) subprime originated from the private sector rather than the agencies rose from 7 per cent to nearly 20 per cent of total outstanding mortgage-backed securities.

Other ‘non-conforming’ loan types also rose sharply after the limits placed on Fannie and Freddie. Alt-A (a mortgage with better quality borrowers than subprime, but less good than prime) rose from less than 3 per cent to 8.5 per cent. The share of the market taken by both categories rose again the following year. The agencies’ market share of mortgage bonds fell in both 2005 and 2006. Non-agency mortgage issuance rose from 21.5 per cent of the market in 2003 to 55.3 per cent of the market in 2005. Chinese reserve managers were among the many investors who were forced to include at least some of the private sector mortgage bonds into their portfolio after a fall in the issuance of agency bonds.

Reserve managers, including the Chinese, by this time so dominated the agency and Treasury market that other investors were more-or-less forced into buying subprime mortgages, or accede to very low returns. The Bush administration’s restrictions on the agencies had forced investors – though not banks – to invest in private sector subprime mortgages.

We’ve seen that Bush and Greenspan supported the move to private sector mortgage providers because they thought it would reduce the risk to taxpayers. In fact, the move added to the momentum of credit competition that led to catastrophe in 2007. In the end, Freddie and Fannie were not saved because by then the entire mortgage system was compromised. In mid-2008, both companies were placed into ‘conservatorship’ – direct government responsibility, with capital injections from the taxpayer required to save them from bankruptcy. The agencies could not escape from their forced mandate into ‘affordable housing’, together with its less creditworthy lending. Their highly leveraged, relatively low capitalised business model was unable to survive the hostile conditions that accompanied the credit crunch.

The politics of housing destroyed the very policies it had set out to bolster. Rather than encouraging less well-off Americans into patriotic support for their communities, thousands were forced into, or volunteered for, default on their mortgages. Some were fraudulent and had benefited from a policy of inclusion. Many others had accepted the home-ownership policy endorsed by Washington at face value and been ousted from their homes, while banks and the mortgage agencies received billions in bail-outs. A policy designed to be socially inclusive led to one of the more divisive episodes of recent US history.

As 2008 progressed, reserve managers reversed their policy of buying agency debt. When the government effectively nationalised Fannie and Freddie in June 2008, reserve managers had already begun to sell agency bonds, rather than buy them, even though the implicit state guarantee, which successive administrations had been at pains to avoid making explicit, was now shown to be binding. In place of agency bonds, reserve managers turned particularly to ultra-low yielding – but highly liquid – Treasury Bills. Just as money changes its character in a financial crisis, emphasising the importance of ‘central bank money’ at the expense of all other types, so the focus of investors switches towards the centre of the system, with Treasury bonds and bills offering the safest investment of all.

European political distortions in lending

Did any other countries follow Washington’s model of residential mortgage production? There are no agencies similar to Freddie Mac and Fannie Mae in the UK. There were no such institutions in France, Germany or Spain. However, politics remains integral to property loans in these countries too. Depfa from Germany and Dexia in France ran similar – but even less robust – business models to Freddie and Fannie and, not surprisingly, both companies ran into problems in 2008.

Just as the US agencies built up a bond market comparable, or larger than, the US Treasury market, so European Depfa and Dexia built up the second-largest bond market in Europe through issuing bonds backed by public sector loans. Originating in Germany, the covered bond market – or Pfandbriefe – was designed by the Prussian state in the eighteenth century. Rather similar to asset-backed securities, they possessed more collateral so the bonds were deemed to be very safe and had never defaulted. Once again, that did not help the performance of the bonds when crisis struck.

Both European companies built their businesses as specialist financiers of public sector projects, so they gained a similar high profile and implicit guaranteed status to the US agencies – though in the usual European fashion it was less scrutinised. Just as the credit crunch proved the business model of Freddie and Fannie was woefully short of capital, so Depfa and Dexia failed in the aftermath of Lehman Brothers’ demise.

There were specifically European problems for Depfa and Dexia. After the single currency began in 1999, both turned their attention from public sector finance towards asset management. Backed by their status as financiers of the public sector, they could rely on a low cost of funding. After European monetary union, some government bonds, such as Italy’s, persistently offered returns that were higher than the cost of funding of both companies. It paid them, therefore, to buy Italian bonds and hold them to maturity. Depfa in particular was among the largest buyers of Italian debt. As their buying acted to ‘converge’ Italian yields towards Germany, so they were forced to buy longer and longer maturity debt, out to thirty years, which offered slightly more yield. Thus the two companies acted as the private sector conduits of the political aims of the architects of monetary union. In the process, they transferred long-dated Italian state debt into the ownership of Germans – who owned Depfa. Thus financial integration of the monetary union was effectively privatised.

The business model of both Depfa and Dexia depended on them maintaining low financing costs relative to the income from the bonds. Accounting norms allowed the companies to mark their holding on a hold-to-maturity basis. When money markets froze from August 2007, the funding levels of the companies rose, reducing the annuity they were paid on their portfolio. Given the very long-dated nature of their business, the rise in funding cost would have been manageable. However, both were undone when Lehman Brothers collapsed, forcing them to replace some of their interest rate swaps. In accounting terms, this forced a mark-to-market of the existing positions, which by this time were heavily loss-making. Within three weeks of the demise of Lehman, both Depfa and Dexia were forced to appeal for government help.

If these companies were the continent’s Freddie and Fannie, then financial integration was to Europe what ‘affordable housing’ and the ‘ownership society’ had been to the administrations of Bill Clinton and George W. Bush. Financial integration encouraged Spanish banks to collect mortgages on their balance sheets for issuance to German investors in similar covered bonds to the German Pfandbriefe. It also encouraged Austrian and Italian banks to engage in risky lending to Central and Eastern European countries. This was politics without parties, but driven by background support from governments, the European Commission and the European Central Bank.

Eurocrats and euro-lending

The increase in cross-border lending represented by Depfa and Dexia was part of a conscious plan by Eurocrats to deepen the financial markets within the single currency. Housing finance supported by cross-border lending was an important part of this plan. Measured by the volume of lending made until mid-2007 it was wildly successful, though certainly it came with major risks.

In November 1998, just before the single currency was launched, a member of the executive board of the ECB, Tommaso Padoa-Schioppa, spoke about the benefits of the single currency in the provision of housing finance, and discussed his vision for an integrated currency area that would emulate the market-based, liquid mortgage markets of America:

‘From the perspective of the euro area, attempting to establish a more integrated housing finance market is a desirable objective since it would bring benefits to consumers in terms of both a wider range of products on offer and reduced costs stemming from increased competition among lenders and lending practices. Whether the EU housing finance market will actually become more integrated under the influence of the euro will depend, to a certain extent, on the attitude of the institutions concerned. These institutions are expected, wherever and to the extent possible, to make use of the opportunity offered by the introduction of the euro to expand beyond their own home markets. Further integration will, of course, also depend on the degree to which remaining fiscal and regulatory differences across countries are eliminated. The sooner these differences can be reduced by the competent authorities, the faster the euro will have a perceptible impact. Second, it should be acknowledged that the introduction of the euro will trigger substantial changes in the European capital markets by fostering an increased width and depth of these markets. In general, financial institutions operating in the mortgage sector are expected further to increase their recourse to the capital market since it represents a possibility for more efficient funding. This also demands that those financial institutions which have not resorted to capital market funding so far, are invited to exploit this opportunity. Indeed, the issuance of securities as a form of funding mortgage lending might even become a necessity, if saving shifts increasingly away from bank deposits.’

This was a laudable aim, except that the enthusiasm with which the cross-border lending progressed between countries such as Germany and Spain, and the increased reliance on ‘capital market funding’, were both prime triggers in the financial crisis of 2007. To be fair to Padoa-Shioppa, he recognised the risks, even in 1998:

‘Finally, it should be pointed out that the changes in the financial landscape triggered by the introduction of the euro will bring numerous strategic challenges and risks for credit and financial institutions. The forecast increase in competition is also likely to affect the funding side and to reduce the share of cheap retail deposits. Therefore, all institutions should be aware of, and prepared to adapt to, changes in market conditions, fiercer competition and increasing demand for low-cost service. This will also apply to institutions operating in the mortgage sector. Against this background, it is important that the adjustment takes place smoothly, without any adverse effects on the stability of the financial system.’

While cross-border lending and housing finance leapt ahead in the next nine years, almost no progress was made in the area of European financial stability. Memoranda of understanding between the financial regulators of European countries gave the impression of progress without leading to anything more substantive. The euro area, led by the ECB, advanced its long-term experiment in financial integration, promoting securitisation, cross-border lending and novel financing methods without a proper regulatory safety net.

The politics of tax

The politics of housing permeated UK governments too. It is often assumed that the exit from the European Exchange Rate (ERM) mechanism in 1992 was the event that destroyed the John Major government. Most Britons did not care too much about the so-called humiliation of ejection and the following devaluation, particularly as it allowed crippling interest rates to be reduced. What did bother Britons was the fall in house prices that accompanied their participation in the ERM. House prices began to fall in 1990 and did not bottom out until 1995.

When Tony Blair was elected in 1997, house prices had begun to move higher, though this was not widely recognised. The claim of the incoming government that ‘things can only get better’ was perhaps founded on an unstated promise that middle-class concern for house prices would be central to their administration – together with ‘education, education, education’.

The Labour governments of Blair and later Gordon Brown were lucky to gain the upswing of a profoundly bullish housing market, backed by the expansion of securitised mortgage funding and international capital flows. Housing not only provided them with a backdrop of optimism with which to win successive elections, it also provided the Treasury with an increasing stream of revenue. In Labour’s first budget, higher rates of stamp duty were introduced. Subsequent rises in the higher rates plus house price inflation meant the politicians became increasingly dependent on the housing market for revenue. In the last year before Labour came to office in 1997, stamp duty on houses raised £675 million. Ten years later, the Treasury raised £6.5 billion. This figure is estimated to be roughly double the amount that would have been collected had the allowances been kept in line with house price inflation. The political opprobrium heaped on bankers by British politicians in the aftermath of the credit crunch is understandable given the direct benefits the government received, for the financial crisis had turned off a big source of tax income.

The indirect benefits were more substantial. Brown was regularly described as the best British chancellor ever, for his stewardship of an economy with low consumer inflation and consistent growth. In fact, the consistency of that growth, as in the US, Spain and Ireland, was based on continuing house price rises. This allowed foreign credit that had backed British securitisations to be recycled within the economy as consumer credit, liberated through home equity loans and second mortgages.

Is it the same everywhere? Why some countries boom

Political involvement in housing is perhaps a perennial issue, and the damage caused by distortion of incentives will not be curbed even with the largest international housing market crash in history. What is unique about the housing and mortgage boom of the past decade are the similarities across countries and across continents. The US, UK, Spain, Ireland, Sweden, Denmark, Belgium and Australia – and to a lesser extent Italy, the Netherlands, France, China and South Korea along with South American countries such as Argentina and Brazil – experienced similar housing booms, and busts, which suggests an unprecedented global co-ordination of real estate markets.

It is peculiar that a widespread boom could happen across such different legal systems, regulatory controls and social systems. It suggests that the common factor was not only lax lending practices but included other pervasive developments, such as globalisation, financial innovation, international banking and the level of real interest rates.

There is certainly a similarity in the fall in real interest rates between 2001 and 2005 for all the countries mentioned, but this similarity is shared with countries that conspicuously did not experience a property boom – Germany, Switzerland and Japan. Moreover, the fall in real mortgage rates never stayed below zero for any noticeable period for any country except Ireland.⁶ Why did the countries that experienced the booms show such similar developments, while some others were left out?

Part of the answer lies in the strong performance of real estate generally – not just residential property. Commercial property in all the countries with residential booms showed strong returns; often well above the returns gained from the stock market between 2002 and 2006. France returned 300 per cent and the UK returned 236 per cent over the period. Even Japan, with no residential real estate boom, showed strong gains; commercial real estate returned 262 per cent, compared with US returns of 216 per cent. What was common to these countries was the prevalence of real estate investment trusts (REITs) – pools of publicly traded property assets which often contained a high degree of leverage. The gearing both aided the financing of the investments, and also, of course, magnified the returns. Legislation supporting REITs has been introduced in most developed countries in the past seven years, suggesting the added interest in property was at least assisted by new investment vehicles.

There is something different about the residential housing booms. In particular, most of the booms occurred in countries reliant on international lending. Current account deficits seemingly were created specifically to boost the housing markets of Spain, the UK, Ireland, the US and Australia. Central and Eastern European countries all had current account deficits at the same time as housing booms. France too showed signs of a strong housing market only after its current account surplus had fallen below 1 per cent in 2003, and accelerated again once the current account had moved into deficit in 2005. Conversely, those developed countries that showed large current account surpluses – Japan, Germany and Switzerland – showed no signs of residential housing boom.

Borrowers in the US, UK, Spain, Ireland and, latterly, France were all so intent on raising the prices of their houses they were forced to borrow from foreign, surplus countries.

But why housing?

This explanation does not satisfy the question of why surplus country lenders kept the flow going year after year despite the clear risks in someone else’s housing market. We need to accept that foreign lenders were willing participants in the boom. In fact, we can almost certainly go further and say that the house price boom would not have occurred in the US, the UK, Ireland and Spain without willing foreign lenders. Those countries that missed out on the boom contributed to it elsewhere. Without current account imbalances there probably would not have been a housing boom, and therefore no housing bust.

There is no doubt that financial innovation such as securitisation aided the transfer of lending from surplus countries to deficit countries. It transformed inconvenient mortgage loans into attractive securities, offering high ratings and relatively high returns. The surpluses generated by Germany, Switzerland and Japan could readily be recycled into portfolios either held by banks or sold on to retail investors.

The transfer of lending from surplus countries to deficit countries also tracked a lack of earnings growth in the countries donating their savings to foreigners. Real wages in Japan were almost stagnant from 1997 till 2007 even though companies boosted their profits. The ageing of the population encouraged Japanese companies to retain most of their profits for investment into automation as a precaution against future loss of workers. Until 2008 real wages in Germany had been broadly static since reunification. Switzerland too has experienced low real wage growth for most of the past ten years.

Low real wages meant low consumption in all of these countries – and as consumption is such a large part of overall growth, it also meant low growth. A circular pressure on wages and consumption was initiated, which emphasised the need to export. The lack of consumption meant less attractive investment opportunities at home, which enhanced the investment offers from foreigners. Those open to lending therefore received the lion’s share of surplus country savings.

China was also a large surplus country. It differed from Germany and Japan in that Beijing used state-directed savings instead of private sector savings to lend overseas – mostly to America to keep the currency in check. In Germany, Switzerland and Japan it was companies that withheld wage increases from their workers. In China, it was the government’s currency policy that withheld from workers the returns from their export success. In all cases, the results were used not to enhance the living standards of their citizens, but those of other countries, particularly the US – albeit temporarily.

The mercantilist beliefs behind German, Swiss, Japanese and Chinese trade policy did not help their businesses in the end either. All these countries were hit by the fall in world trade that came with the recession of 2008–09. The fall in economic activity in the surplus countries actually exceeded the economic decline in most deficit countries. Also, the banking systems of Germany and Switzerland were both jammed with foreign underperforming loans, the counterpart to the previous lending – prudence really did not pay. Depfa, UBS and the German Landesbanks were the victims of imprudent lending by entire countries, not just imprudent lending by individual banks.

Housing booms in the US, Spain, the UK and elsewhere were characterised by receptiveness to foreign investment. The quantity of foreign lending had to find an outlet, and housing was chosen; partly because the returns of apparently high-grade bonds issued in support of the lending offered much better returns than comparable bonds from other sources.

Housing was also chosen because there was no alternative for the quantities of investment needed. China, in particular, found its surpluses growing so fast it could not buy enough Treasury bonds. Already the dominant buyer at Treasury bond auctions by 2003, the trade surplus with America drew China into buying agencies simply through its own ‘crowding out’ effect. And once it had switched to agency purchases, China dominated that too. By June 2008, China owned 48 per cent of all foreign-owned asset-backed securities issued by the agencies and 23 per cent of all other foreign-owned agency debt. As recently as June 2004, China owned just 8 per cent of foreign-owned asset-backed agency bonds. Moreover, the entry of China seems to have caused other foreign holders to shift their investments from agencies towards non-agency mortgage-backed securities – crowding out other investors into riskier assets.

Blinded by ratings

We now know these non-agency bonds are much riskier than agency bonds; but this was not necessarily known during the great credit bubble of 2003 to 2007. The ratings of most prime and subprime mortgage bonds were given AAA ratings by agencies such as Moody’s, Standard & Poor’s and Fitch. We’ve heard of all this before and in the last chapter we learned how rating agencies operated, and their relevance in supporting the investment in housing securitisations was crucial. Once again, without their approval, investors – including the banks who would eventually succumb to the credit crunch – would have had no incentive to invest in these products.

The conspiracy of housing finance

We’ve seen that all members of a truly free society should have an interest in the quality of the housing of all their members. The conspiracy of the past decade is that this concern either distorted domestic priorities in allocating loans to people who would not otherwise have had them or distorted international investment.

Almost without exception, the media have portrayed housing as a local issue, both in the expansionary phase of the boom, and in its bust. The problems of local borrowers and the difficulties among local banks garnered almost all the headlines. This is not surprising; there is a local component to the crisis, and there will be local suffering to provide headlines from the after-effects of the boom.

The most important effects, however, are spread globally and the conspiracy of housing is shown not just in the political dealings of institutions such as the US mortgage agencies, but in the construction of international capital flows. Without a booming housing and securitisation market in which to invest their trade surplus, the Chinese would have had to resort to other investment avenues. This might have meant buying equities, or direct purchases of companies or real estate. The quantities involved would probably have created difficulties for the Chinese, as their attempts to buy local American companies have shown.

The same international capital forces had a similar effect before the Asian crisis of 1997. There, too, an increase in current account deficits, created in part by very high foreign lending into the countries, had to find an outlet. There, too, it was property, both commercial and residential, that provided the investment vehicle.

Property seems to act as the investment of last resort for a financial system overflowing with liquidity. Perhaps this is natural. While property produces no wealth, it is a precondition for an acceptable lifestyle. Politicians can always find a reason to expand the benefits of affordable housing finance to members of society cut off from normal credit, and so they should. Faced with a determined inflow of money – as occurred in America and Spain as well as Thailand in the mid-1990s – it seemed an attractive option to direct it towards those people who had previously often been excluded from mortgage-lending. The conspiracy is that far from benefiting from the added international lending, many, if not most, of the low and moderate income Americans who obtained a mortgage as a result have subsequently lost their homes, and probably also lost faith in the American Dream that government initiatives were designed to support. In Europe, the enthusiasm shown by the ECB for cross-border lending might have jeopardised the project through the promotion of the colossal Spanish and Irish housing bubbles.

It is worth quoting Thatcher on the Asian crises in light of what happened in America itself:

‘Examination of what actually happened in Russia and the Far East shows that in all the most important cases there were very good reasons for investors to take fright, ones which relate to a multitude of shortcomings in the policies of governments of those countries. Lack of transparency, cronyism and corruption, corporatism, exchange rates pegged at unrealistic levels – these and other home-grown factors contributed to the collapse. Those weaknesses were exposed, but they were not caused, by the “contagion”… They were classically problems of government failure. They were not essentially problems of market failure.’

Much the same conclusion, including the role of cronyism, lack of transparency and pegged exchange rates, could be made about the American, British, Irish and Spanish housing collapses.