The Deep Cause of the Subprime Lending Crisis

Fred Foldvary

doi:10.4172/2168-9458.1000129

Abstract

The financial crisis induced calls to extend, strengthen and tighten financial regulations. This paper argues that the deep underlying problem is not in the financial industry, but in the real side of the economy, in real estate. The most important collateral for mortgage loans is land value, which then serves as collateral for packages of loans and leverage derivatives. The problem is that real estate has had periodic boom-bust cycles. The rise in land values becomes magnified as land speculators buy properties for resale at higher prices. Land then becomes priced not for current use but for expected future demand, which at the peak of the boom is overly optimistic. Speculators with the greatest expectations later suffer the winner’s curse. If taxation were shifted to tax almost all of the land value, the price of land would fall to a small fraction of the pre-tax price, eliminating gains from land speculation. Mortgage loans would be collateralized by the value of buildings and of income from tenants, rather than land value. The boom-bust real estate cycle would disappear.

Highlights

Most of the reporting and analysis of the subprime mortgage problem focused on the lending practices and the policies governing mortgages as the proximate causes of the subprime lending crises that began in 2007 and intensified in 2008
The Community Reinvestment Acts of 1977 and 1995 require banks to lend to lowincome communities which have higher risks. When conditions such as escalating real estate prices are ripe for a substantial increase in mortgage loans, these acts contributed to a greater increase in subprime mortgages by lenders such as Countrywide Bank than would otherwise have been the case
Land value serves as prime collateral for bank loans, and during an economic expansion, investing and speculating in real estate is a function of the expectation of increasing site values

Summary

Introduction

Most of the reporting and analysis of the subprime mortgage problem focused on the lending practices and the policies governing mortgages as the proximate causes of the subprime lending crises that began in 2007 and intensified in 2008. The expansion of real estate construction and increase in prices after 2001 was not an isolated phenomenon, but has to be seen in the context of a real estate boom-bust cycle which has been occurring in the US for two hundred years [1,2]. While neoclassical economics posits greater borrowing for investment with lower rates of interest, the Austrian-school theory refines the result to posit that the greater investment will be focused on the capital goods of highest order.

Results

Conclusion