Unlimited Subsidy to Land Values

The U.S. President’s administration announced on 24 December 2009 a holiday gift to American landowners. The government removed the cap it set on subsidies to Fannie Mae and Freddie Mac, the government-backed enterprises that buy mortgages from banks and other originators. The removal of the cap before 2010 avoided the embarrassment of needing Congressional approval.

This policy move can be understood if one recognizes the main aim of government policy since the beginning of American history. The main purpose of the U.S. government is to subsidize land values for the big players. The biggest subsidy is implicit: the public goods provided by government generate greater land rent and higher land values. This happens because only a tiny fraction of government revenues are paid for by direct taxes on land. Workers and enterprise owners are taxed to provide the public goods, and then they pay the higher rent generated by the public goods. Government thus redistributes wealth from workers to landowners.

The government generates a boom-bust cycle as land rent absorbs the gains from an economic expansion, and then speculators jump in to ride the surge in land values. This speculation lifts land prices even higher, until it is priced too high for those who seek to actually use real estate, and then land values collapse.

Almost all real estate is purchased with borrowed funds, so the subsidy to land values extends to the financial industry. Mortgage interest is tax-deductible in the U.S. to reduce the net mortgage interest cost. When the economy is depressed, the Federal Reserve expands the money supply to push interest rates low and thus subsidize the purchase of real estate.

But even those basic subsidies were not sufficient to prop up land values during the Great Depression. So the U.S. government promoted a secondary market in mortgages by creating Fannie Mae and later Freddie Mac. They buy mortgages from banks and then hold some and also package some into securities for sale to financial firms such as hedge funds. F&F now hold or guarantee about half the mortgages in the U.S.A., with a total value of $5.5 trillion.

Because Fannie and Freddie are backed by the U.S. Treasury, they can sell their bonds at a lower interest rate. The banks can thus keep lending mortgages to real estate buyers, sell them to F&F, and then make more mortgages. The government has thus created a perpetual mortgage machine.

During the real estate bubble preceding the Crash of 2008, financial innovation created trillions of dollars of clever derivatives based on mortgages, such as fake insurance on mortgage securities. A big problem with the government subsidy of land values is that it is not sustainable, as it has always created a boom followed by a bust. So government steps up the subsidy by propping up land values after the crash. That is what is happening now.

Fannie and Freddie suffered colossal losses during the Great Recession of 2007-2009, and they were bailed out by Congress, which provided over $110 billion to F&F. But the losses continue, with a projected total of $170 billion, since defaults in commercial real estate have followed those in residential real estate, and there could be more big losses in the last quarter of 2009. The chiefs of the federal government now realize that any cap on the bailouts would stop the bailouts or make F&F bonds more risky, and thus cause F&F to buy fewer mortgages. To keep the perpetual mortgage machine rolling, the government has eliminated the cap on bailouts to F&F. There is now in effect an unlimited government subsidy to land values. F&F losses of mortgages due to falling land values will continue to be subsidized by U.S. taxpayers.

Government chiefs say that F&F provide play a “vital role” in real estate markets. They do play a vital role in the scheme to subsidize land values, but real estate was bought and sold long before these government-sponsored enterprises were created. The government backing is no more necessary than is the government subsidies to farmers that push up the price of agricultural land.

Not all of the government subsidy to Fannie and Freddie goes to land rent and land prices. Some of the subsidy goes to the CEOs and other chiefs of F&F. These chief executive officers could each get “paid” about $6 million. The previous chiefs of F&F got even more remuneration before they got kicked out in 2008, and they would have gotten still more if the government had not blocked their “exit packages.”

Why do the F&F CEOs and financial officers get so much for running enterprises that make huge losses? Because other CEOs get similarly high payments. CEOs are now being paid multi millions of dollars just because that is what other CEOs are getting. The government has set some performance goals for the CEOs of F&F, but these are currently a secret. Perhaps the goal is to manage the losses efficiently. If you are an efficient loser, you will be given millions of dollars. This makes sense once you realize that the real losers are American taxpayers.

The losers include the typical American home owner. His property tax is low, but he pays high taxes on his wages and his interest income, and if not for the subsidy to land value, he would have bought his land for very little, and greatly reduced his mortgage payment. But not one in a thousand persons understands this, so the great American land subsidy goes on and on. Happy new year.