Fate of the States: The New Geography of American Prosperity Read online

  Human capital is as important to a tax base as equity capital is to a corporation. Each acts as a primary source of tax receipts or cash flow. So think about what an exodus can mean. California—the most populous state in the country, with 12 percent of the population—contributes 13 percent of the overall U.S. GDP and generates over $100 billion in state and local tax receipts per year.7 From 2008 to 2010, California’s tax receipts fell from $118 billion to $105 billion, while overall state and local tax receipts dropped from $781 billion to $702 billion. In Riverside, California, sales-tax revenue declined by an incredible 17 percent in 2009 alone.8 It’s a decline that can be explained almost entirely by population shifts. In 2004 Riverside had the highest domestic net migration of any metro area in the country, gaining 95,000 new residents in one year, according to a Brookings study. Four years later, Riverside ranked 350th in net migration (out of 363 metro areas), with more than 7,000 people leaving for greener pastures.9

  The problem isn’t just the lost population and tax receipts. It’s who exactly is leaving. According to demographer Wendell Cox, California has been hemorrhaging high-income, well-educated residents, even though the net outflow has been masked to some degree by strong international immigration to the Golden State. Between 2000 and 2009, 1.9 million Californians left for other states, and based on demographic trends, a disproportionate number of those leaving appear to be well educated. Consider that California ranks 5th nationally in share of population 64 or older holding college degrees but only 23rd in college degrees among those ages 25 to 34. Between 2000 and 2008, California lost 370,000 jobs paying wages 25 percent or more above the state average. By comparison, the state gained 65,000 of those high-paying jobs between 1992 and 2000. California is even losing its status as the high-tech leader. Between 2000 and 2011, the state had zero employment growth in science, technology, engineering, and mathematics versus 5 percent growth in those fields nationally and 14 percent growth in Texas.10

  The point is that wealthier people have the means to move on, and their exodus hastens the demise of the cities and towns they leave behind—which prompts even more people to leave. It’s what I call the negative feedback loop from hell. The coastal and Sun Belt states that lived through the housing bust can no longer afford to spend as much on schools, police, and other services as when times were flush. Some residents are relocating to central corridor states, where business is booming and so too are tax receipts and spending on core services. These states are growing their economies at high-single-digit annualized rates, while the housing-heavy states have shown little growth or negative growth. A new American demographic shift is happening right before our eyes.

  Chapter 2

  Housing Revisited

  Give me your tired, your poor,

  Your huddled masses yearning to breathe free,

  The wretched refuse of your teeming shore,

  Send these, the homeless, tempest-tost to me:

  I lift my lamp beside the golden door.

  —EMMA LAZARUS, “THE NEW COLOSSUS,”

  INSCRIBED ON THE STATUE OF LIBERTY

  Rewind the clock one hundred, two hundred, three hundred years. When immigrants risked their lives to come to America, what drew them here was not the possibility of owning their own home. And it certainly wasn’t taking out a mortgage. They dreamed of a country that offered religious and political freedom and the opportunity to earn a better living. To have a better life in a new country where anything seemed to be possible. That was the original American dream. Fast-forward to today, and some immigrants are still risking their lives to make the trip, coming to this country for a chance at a better life. Once again, their American dream is not about homeownership. Some just want to earn a higher wage and send money back to their families. Others come here for political freedom or to provide a better life for their children. Whether they wind up renters or homeowners is not a pressing concern. And still today in pursuit of that dream, they are some of the hardest-working people who live in this country. Their dream has never necessarily been to own a home but simply to prosper from religious and political freedom, find a better-paying job, and have the opportunity to give their children a better existence than they have.

  Sometime in the twentieth century, the American dream was redefined in a way that made homeownership an essential part of the American experience. This didn’t happen by chance. The federal government explicitly promoted homeownership. The first step down this road was the Homestead Act of 1862, which enabled the federal government to give away land free of charge in an effort to entice people to move west of the Mississippi. The Homestead Act was rooted in the politics of the day, as its backers aimed to isolate the Southern slave states by spreading free, “yeoman” farming to the Western territories.1

  This wouldn’t be the last time leaders in Washington promoted homeownership for reasons that had little to do with the financial merits of owning property. On paper, lawmakers’ motivations were straightforward—to make the housing market safer for lenders and make mortgages more affordable for borrowers—but their ultimate goals were rooted in social engineering. “A family that owns its own home . . . has a more wholesome, healthful and happier atmosphere in which to bring up children,” President Herbert Hoover once said. His White House successor, Franklin D. Roosevelt, ratcheted up the pro–homeownership rhetoric another notch during World War II. “A nation of homeowners,” said Roosevelt, “is unconquerable.” I would argue a lot has changed since those days. Today, Roosevelt’s motto might be similar—just replace homeowners with employed citizens. After all, it doesn’t much matter whether you own a home if you can’t make the mortgage payment. But back then, homeownership became a bona fide national aspiration.2

  Before the 1930s, buying a home in the United States was prohibitively expensive, especially if you had to borrow money to do it. Mortgages back then were predominantly sold and underwritten by insurance companies, not banks. They required at least a 50 percent down payment, and borrowers had to pay off the loan in five years. These mortgages worked as “balloon payment” loans in which principal is paid off in one large balloon payment at the end of the loan, rather than amortized over its full length. When the Great Depression hit, this balloon structure of home loans practically invited defaults—in much the same way interest-only mortgages, option ARMs, and other teaser-rate products doomed homeowners during the last housing bust.3

  In 1940 the home-ownership rate in the United States was a modest 44 percent, much below the current 65 percent.4 Many prospective homeowners were simply unable to get a loan. They didn’t feel deprived, rather motivated by the goal of moving up the ladder of financial stability. But the mortgage market started to change in the 1930s. The U.S. government enacted policies aimed at making homeownership a more realistic goal for U.S. consumers. Congress began encouraging savings-and-loan banks—think Bailey Building & Loan from It’s a Wonderful Life—to extend the length of mortgages and therefore allow for lower borrower monthly payments. Also, by guaranteeing S&L deposits, the government effectively gave home lenders more money to lend out. This practice actually began in 1933 with the creation of the Home Owners’ Loan Corporation, which was a New Deal agency that kept people in their homes by allowing borrowers to refinance variable-rate, short-term, nonamortizing mortgages into fixed-rate, fully-amortizing, long-term ones. It was America’s first loan-modification program—a policy that, much like the post-2008 version, kept people in homes regardless of whether that was their best financial option.

  The establishment of the Federal Housing Authority (FHA) a year later expanded the role of S&Ls, also known as thrifts, in underwriting these new, borrower-friendly mortgages. For first-time home buyers seeking loans, these new mortgages initially had twenty-year structures, but by 1948 the maximum term was extended to thirty years, a structure that has since become standard in the American mortgage market. The rise of the thirty-year mortgage opened up the housing market to a segment of Americans who had neve
r before considered the possibility of homeownership. The net effect was not unlike that of those cheap T-shirts imported from China and sold at Walmart—which encourage people to buy a three-pack instead of the single shirt they actually need. The fixed-rate, long-duration, self-amortizing structure of the thirty-year mortgage allowed borrowers to spread principal repayment over a long period of time and eliminated the payment shock of the previous balloon structure. It also inherently lowered the monthly cost of a mortgage, sometimes at the expense of taxpayers, who were subsidizing the loan through FHA mortgage insurance. Borrowers knew that the size of their mortgage payment would not change over the life of their loans and that they could keep up with the new lower-monthly-payment structure, which made homeownership less daunting. Soon the mortgage-interest tax deduction that had been part of the federal tax code since 1913 became a home-buying carrot not just for wealthy Americans but for average ones too.5 The thirty-year mortgage was here to stay.

  By comparison, homeownership has never been so aggressively promoted in other countries. France, the Netherlands, Denmark, and Germany all have home-ownership rates below 55 percent, and their housing systems seem to work fine and are arguably more stable than those of countries like Spain and the United States, which have much higher home-ownership rates.6 There’s nothing inherently bad about homeownership, obviously. Problems arise when government encourages and promotes home buying, enabling citizens to take on a big slug of debt and all the risk that entails.

  The contrast between mortgage finance in the United States and Canada is particularly striking. Canada has a tradition of high-down-payment, variable-rate, short-term mortgage lending. The typical mortgage term is only five years, and mortgage interest is not tax deductible. Also, there isn’t much of a secondary market for non-government-guaranteed mortgages that have been bundled into mortgage-backed securities. Why is that important? Canadian lenders must hold mortgages on their own books, which constrains their ability to make additional home loans. They better feel highly confident in their borrowers’ ability to pay them back. Another key difference between U.S. and Canadian mortgages: Canadian banks have full recourse to a borrower’s personal assets. Default on a Canadian mortgage, and the bank can take not just your house but also your car, your jewelry, and your savings. The Canadian system even makes selling a home more onerous. Canadians who refinance or pay off their mortgages early not only have to repay principal but also owe some of the interest that would have accrued over the remaining life of the loan.7 The entire thought process of a home buyer in Canada has to be different.

  Of course, there is no “Canadian dream” comparable to the twentieth-century version of the American dream of homeownership, which is why a government role in promoting homeownership has been such a uniquely American phenomenon. The FHA provided mortgage insurance, giving banks the confidence to make home loans. The Veterans Administration gave returning soldiers insured loans with low down payments. The Federal Deposit Insurance Corporation guaranteed Americans’ bank deposits, allowing banks to raise money for mortgages more easily and inexpensively. (With a government guarantee, banks didn’t have to offer high interest rates to attract deposits.) Last but definitely not least, the establishment of Fannie Mae in 1938 provided a resale market for FHA-insured loans—and later for VA loans too—which freed up lender capital for even more new mortgage underwriting.8

  The homeownership push of the post–Great Depression/World War II era was effective, and home prices began rising year after year along with homeownership. By 1960 the home-ownership rate had climbed to 62 percent, a level at which it stayed until the mid-1990s (when it began to climb again, peaking at 69 percent in 2006).9 Fannie Mae had grown so large that in 1968, Congress spun it off into a semiprivate company. This new half-governmental, half-private market creation was known as a government-sponsored enterprise, or GSE. It was the ultimate “heads I win, tails you lose” setup. Ostensibly, Fannie was a company owned by stockholders, but its government charter meant taxpayers were implicitly on the hook for its debt. Shareholders wanted rapid growth, and the implicit government backstop made it a seemingly low-risk investment. Two years later it was joined by Freddie Mac, a competitor the government created to end Fannie’s monopoly in the secondary mortgage market. Together these two GSEs began to usurp the role—and the mortgage-lending profits—of the S&Ls.10

  The S&L industry collapse hardly slowed the growth of the housing industry. S&Ls were quickly eclipsed by Fannie and Freddie, which by 2001 controlled 50 percent of the mortgage market. Additionally, a new crop of subprime mortgage lenders emerged, eager to expand the business. By the 2000s, not only were the government and lenders aggressively marketing homeownership, but investors were also getting in on the action. After the dot-com crash in March 2000, investors were turned off from the stock market and now looked to real estate for returns. If the subject around the retirement-home bingo table during the late nineties had been the latest dot-com stock investment, the investment pastime of the 2000s became real estate. And everyone thought they were an expert.

  Even the actual experts made blunders. In 2000 and 2001, then–Federal Reserve chairman Alan Greenspan responded to the double economic whammy of the dot-com crash and 9/11 by engineering an unusually steep yield curve that stimulated the economy by encouraging banks to make more home loans. He cut short-term rates to 1.75 percent, a level considerably lower than the 5 percent yield on ten-year Treasury bonds.11 The mortgage market typically takes its interest-rate cues from Fed and Treasury rates, which meant that the rate on a traditional thirty-year mortgage was now far less attractive than the rate of a shorter-term, adjustable-rate mortgage. Greenspan himself was on record criticizing the growth of the GSEs, and in a 2004 speech to a meeting of the Credit Union National Association, the Fed chairman went so far as to encourage homeowners to take out adjustable-rate mortgages (ARMs) instead of thirty-year mortgages. Greenspan argued that many Americans would have saved “tens of thousands of dollars” by financing their homes with an ARM instead of a thirty-year fixed mortgage. “The traditional fixed-rate mortgage,” Greenspan said, “may be an expensive method of financing a home.”12 Of course, if thirty-year mortgages were in fact excessively expensive, that was due in large part to the steep yield curve Greenspan himself had helped manufacture. Moreover, those “tens of thousands of dollars” in savings he cited hinged on one of two assumptions: mortgage rates not going up after the teaser rates expired or homeowners being able to sell their houses for profit if the stepped-up interest rates proved unaffordable. Three years later, both of those assumptions would prove fatally flawed.

  By pushing more home buyers toward ARMs, Greenspan increased the role of securitization in fueling the housing bubble. Wall Street firms were making record fees from packaging mortgages as mortgage-backed securities, which were then sold as pseudo-high-grade bonds to yield-hungry investors. The problem was, there was a finite supply of traditional, qualified borrowers. In order to keep the volumes pumping, lenders had to go down the credit curve into subprime lending. In the 1980s and early 1990s, subprime mortgage lending was a relatively small portion of the overall securitization market. But between 2003 and 2005 sales, or “originations,” of subprime mortgages and near-subprime mortgages increased 135 percent. Adjustable-rate mortgages’ share of the total mortgage market soared from 26 percent to 48 percent.13

  Just think about how nonsensical this was. Rates were rising in 2004, and adjustable-rate mortgages were becoming more popular.14 Typically, in a rising-rate environment, the borrower would try to lock in a lower-rate mortgage in order to protect himself from the possibility of his mortgage payment rising over time. Anyone taking out this type of mathematically unsound financing product had to be doing so for one of two reasons: Either they couldn’t qualify for a traditional thirty-year mortgage or the only mortgage payment they could afford was an interest-only mortgage or some other initial-low-cost, teaser-rate product. The net effect was to upend the tradition
al hierarchy of the housing finance business, shifting market share away from the GSEs and toward mortgage-lending upstarts like Countrywide and Golden West Financial. Accelerating the growth of the ARM market was strong demand for higher-yielding bonds; this allowed banks and investment banks to repackage exotic mortgages into even more exotic mortgage-backed securities and collateralized debt obligations—products that would then be resold to investors, with the proceeds used to fund still more new mortgages. Uninsured by Fannie or Freddie, these new mortgage-backed securities were so complicated, so sliced and diced, that investors knew little about what they were buying beyond the credit ratings assigned to these securities by the credit-rating agencies. (Those ratings proved flawed.) Underscoring how incredibly opaque these securities were, Sheila Bair, the then-chairwoman of the FDIC—ostensibly one of lenders’ regulators—admitted in a 2008 interview with Fortune magazine that FDIC economists had failed at what seemingly should have been a simple enough exercise: identifying the underlying loans in CDOs held by banks.15

  The dramatic increase in subprime mortgage lending did not cause the housing bust, but it was the classic canary in the coal mine. The reason: Over 75 percent of the new subprime mortgages underwritten were ARMs. With the steep yield curve drawing more banks into the mortgage business—specifically into ARMs—competition heated up. Banks and other lenders started moving down the credit spectrum in order to get more business and feed the securitization beast. Between 2001 and 2006, the interest-rate gap between prime and subprime mortgages narrowed dramatically, from 3.5 percentage points to 2 percentage points.16 This in turn made home loans more affordable—at least during the teaser-rate period—for people who would not have qualified for a home loan just a few years earlier. Not only were the teaser rates low, but banks started competing over loan terms too, allowing people of all credit stripes to get mortgages with no down payment or no monthly principal payments (the infamous “interest-only ARM”) during the teaser-rate period. There were also the infamous NINJA loans: no income, no job, no problem. If my grandfather had lived to see this, he would have been horrified.