Thomas Sowell: Housing woes caused by land-use restrictions and federal micro-management of lenders

by Greg Swann

Suburban Phoenix Real Estate Broker

Author website

Hoover Institute Economist Thomas Sowell:

Amid all the hand-wringing and finger-pointing as housing markets collapse, mortgage foreclosures skyrocket, and financial markets panic, there is very little attention being paid to the fundamental economic and political decisions that led to this mess.

The growth in risky “sub-prime” mortgage loans by people buying homes they could not really afford has been a key factor in the collapse of housing markets, when the risks caught up with both borrowers and lenders.

But why were home buyers suddenly taking out so many risky loans and lenders suddenly arranging so much “creative” financing for these borrowers?

One clue is the concentration of such risky behavior in particular places and times.

Interest-only mortgages, where nothing is being paid on the principal for the first few years, enable many people to get started on buying a home with lower mortgage payments at the outset.

But of course it is only a matter of time before the mortgage payments go up and, unless their income has gone up enough in the meantime for them to be able to afford the new and higher payments, such borrowers can end up losing their homes.

Such risky mortgage loans were rare just a few years ago. As of 2002, fewer than 10 percent of the new mortgages in the United States were of this type. But, by 2006, 31 percent of all new mortgages were of this “creative” or risky type.

In the San Francisco Bay Area, 66 percent of the new mortgages were of this type.

Why this difference in times and places? Because housing prices were skyrocketing in some places and times, so that people of modest incomes had to go out on a limb to buy a house, if they expected to buy a house at all.

But why were housing prices going up so fast, in the first place? A number of studies of communities across the United States and in countries overseas turned up the same conclusion: Government restrictions on building.

While many other factors can be involved — rising incomes, population growth, construction costs — a scrutiny of the times and places where housing prices doubled, tripled, or quadrupled within a decade shows that restrictions on building have been the key.

Attractive and heady phrases like “open space,” “smart growth” and the like have accompanied land use restrictions that made the cost of land rise in many places to the point where it greatly exceeded the cost of the homes built on the land.

In places that resisted this political rhetoric, home prices remained reasonable, despite rising incomes and population growth.

Construction costs were seldom a major factor, for there was relatively little construction in places with severe building restrictions and skyrocketing home prices.

In short, government has been the principal factor preventing the “affordable housing” that politicians talk about so much.

Sowell goes on to decry Federal regulation that prompted lenders to make high-risk loans:

Politicians have also been a key factor behind pushing lenders to lend to borrowers with lower prospects of being able to repay their loans.

The Community Reinvestment Act lets politicians pressure lenders to lend to people they might not lend to otherwise — and the same politicians are quick to cry “exploitation” when the interest charged to high-risk borrowers reflects that risk.

The huge losses of sub-prime lenders, some of whom have gone bankrupt, demonstrate again the consequences of letting politicians try to micro-manage the economy.

All this is fine, as far as it goes, but I don’t think it goes far enough. Sowell lives in Palo Alto, and his view is colored by the incredibly Stalinesque restrictions on land-use and development in the Bay Area. He has written cogently and passionately about the cost in human lives — in traffic fatalities resulting from 90-minute commutes — of those policies.

The problem with this analysis is that prices also shot up in places like Phoenix, where developable land is abundant, and Las Vegas, where barriers to development are set very low. And while the proportion of creative loans might be higher in the Bay Area, development restrictions promote a higher than normal appreciation rate, at least for now. The foreclosure rate in more moderately-priced cities is probably higher.

Which is not to say that I’m letting government off the hook. This is me in June of 2005:

Here’s an alternative lens, in any case, for looking at the market: Residential real estate has been persistently undervalued as an investment vehicle, and what looks like a price bubble from a short-term analysis is actually a long-term correction in misperceived value. Because of the deductibility of mortgage interest (adding value to interest-only loans) and the capital gain exclusion for personal residences and the IRS Section 1031 capital gain deferral for income properties — and because housing is a necessity of human life — both owner-occupants and investors are re-evaluating real estate against other investment options, coming to the conclusion that real estate is a much better investment than securities or more-fungible commodities. Residential real estate is not overvalued now, it was undervalued — particularly in terms of its tax advantages — in the past.

This is still true in certain markets, although it doesn’t play in Phoenix right now. The salient point is that the reevaluation of real estate as an investment vehicle came about because of government, because of the capital gains tax exclusion on personal residences and the capital gains tax deferral on investment properties. Through the tax laws, the Federal government put its thumb on the scale and weighed things to the advantage of real estate.

(And as bad as this might be for the overall economy, as a Realtor I have to take it into account for my own clients: Even in Phoenix right now, in the midst of a down-turn in home values, it may well be to the advantage of certain people — move-up buyers with good income and sizable equity in their homes — to make their move now. They’ll sell for less than they might have two years ago, but they’ll buy for less, too. Depending on the interest rates for their new mortgage and their old incidental debt — and taking account of the capital gains exclusion and the deductibility of mortgage interest — they may be able to get into more house for a lower net monthly out-flow. It’s sick, but it works.)

There’s more: The single most consequential negative influence on the American economy is the Federal Reserve Bank. A very young Alan Greenspan once wrote that, “Allowing the state to create paper money is like putting a penny in the fuse box.” Private banks of issue don’t prevent stupid investment decisions, but they do localize the ensuing problems. But since the deleterious effects of central banking are well-documented and no one cares, this is a windmill I will leave untilted for today.

It remains that the absolute best thing we can do for the real estate market is to get the government out of it — land use restrictions, loan policies, taxes, paper money — along with roads, bridges, parks, zoning, historic preservation — all manner of meddling with the allegedly inalienable right to own and use the land — but don’t hold your breath waiting for that to happen.

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