How was it that instritutions such as Fannie/Freddie were able to make bad choices? And how, assuming they did not know about an inevitable government bailout, did they expect to make good on these decisions? This seems to be a case of inflation and tax distortion (as well as other distorion) leading financial advisors and lenders to make what turned out to be wildly inaccurate predictions. From what I have read and seen regarding the housing bubble, it seems that the sub-prime lenders for the most part weren't doing anything illegal, even though the lending sheme does resemble a ponzi in many ways. Conditions were good for home investments: the dot-com bust steered investors toward a more "safe" home investment, increasing demand for housing. Rising house prices increased supply of new homes all over the country. Interest rates favored lenders. Tax breaks and increased short term profits provided extra incentive. More buyers lead to prices driving up at an alarming rate, though the recent reductions in inflation seemed to mask the extent that this was at (see some neat charts). As the value of houses went up, lenders felt more secure in lending to sub-prime borrowers, aka those with low credit ratings. Combine that with ARMs and confused buyers that are told that refinancing will be available before the payments go up, and disaster starts brewing. When the interest rate on the ARM begins to float in a few years, and lenders actually can't refinance, the increase in mortgage payments puts many in default and prices go down.
The toll this took was huge, but not necessarily forseeable (although some economists were expressing doubts as early as 2004, when the rate of increase in house prices became clear). Either way, a company that makes bad decisions in the free market sinks. Before the gov't stepped in, F/F should have had to bail themselves out by selling assets to other firms until they had matching assets and liabilities. That would really have cut them down to size! Instead, the gov't injected cash into their systems so that they could maintain operations at their current levels and the promise of being paid back plus interest. I hope this never happens again, although for practical purposes it does seem to have helped. Paying morgages for households just seems to be in the gov't best interest at that point, since the money they pay keeps the F/F afloat so that they will be able to repay their debt to the public. But if you think into it deeply enough, your tax dollars went toward keeping these companies from ruin and potentially sinking the economy, and they are also going toward maintaining these companies so that people can keep their homes. Realistically, this merely rewards ppl who tried to live beyond their means and punishes others who pay a similar portion of their income toward a mortgage on a house they could actually afford. The deadweight loss on the increase in property taxes-now or in the future-will also be bad for the housing market and increase the price paid up-front by homeowners who already couldn't afford their purchases, forcing them to dedicate a larger part of their income toward payments, even without govt help. The results are that those getting help from the govt will not be able to actually build wealth or add to their investment (renovations and the like). So in the long run the housing market will remain depressed for longer than if the invisible hand were allowed to guide without tax dollars in it, but in the short run it does seem to help.
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