Guest Contribution: Reforming Banking by Reforming Housing

By Simon van Norden

 

Today, we’re fortunate to have Simon van Norden, Professor of Finance at HEC Montréal (École des Hautes Études Commerciales), continue as a guest contributor.


In my previous post, I wrote about some of the evidence linking serious banking crises to real estate market collapses. That evidence is far from iron clad; it is simply the observation that many banking crises in mature economies have their origins in a real estate boom and bust cycle. However, the idea is also intuitively appealing.

Remember that at the end of 2008, the Federal Reserve Board estimated that there was $12 Trillion of mortgage debt on residential properties in the US, with the Federal government and its agencies providing about 5% of the total, individuals 9% and the rest coming from the financial sector. The Case-Shiller composite index of housing prices has fallen 1/3 from its peak in 2006 and the latest the Mortgage Banker Association survey finds that 13.5% of residential mortgages in their survey are delinquent or in foreclosure.
Even if losses in the end are only 5% of mortgage debt, that’s a $600 Billion drop in equity on private sector balance sheets. It’s easy to see how losses of half a trillion dollars or more could push some banks into insolvency and many into illiquidity. That’s the recipe for a banking crisis. Remember that the FDIC’s Deposit Insurance Fund had reserves of just over $50 billion at the start of 2008 and of which approximately zero is left today. That’s the recipe for a costly banking crisis.
Like heart disease, there may be many different significant risk factors for banking crises. However, the evidence to date suggests that real estate volatility is one of the most important, if not the most important. Reducing the risk of future crises (and their drain on the public treasury) requires that something be done to address this risk factor. As I’ll discuss in a minute, there seem to be lots of ways to do this, but they boil down to some combination of (1) reducing the volatility of real estate prices, and (2) reducing banking sector exposure to real estate.
But first, stop and think about the kinds of proposals that are currently under discussion. There’s a long list that includes things like

 

 

  • The creation of a new Consumer Financial Protection Agency, a National Bank Supervisor, and an Office of National Insurance, which would join with several other agencies in a Financial Services Oversight Council.
  • Requiring reporting of all OTC derivative transactions, as well as clearing and transparent trading of all standardized OTC derivative products.
  • Expanding the mandate of the Federal Reserve to explicitly include all firms that pose systemic risks to the financial system.
  • Requiring registration of advisors to hedge funds and other pools of capital.
  • A reform of executive pay in the financial sector to reduce incentives for excessive risk-taking
  • The provision of explicit government insurance to mortgage derivatives
  • A ban on “naked” short-selling
  • Restricting the sale of CDSs and similar instruments to those with long position in the underlying asset.
  • [your favorite goes here]

 

Now ask yourself which of these will be effective in reducing the volatility of real estate prices? Which will effectively reduce the banking sector’s exposure to that volatility? With the exception of #6 on the above list, it’s not obvious that any of these proposals will do either (and #6 doesn’t appear to be high on the public agenda as far as I can tell.) Understand that the word “obvious” is an important caveat; for example, it’s conceivable that improving clearing of OTC derivatives might reduce the exposure of the banking sector to real estate collapses by preventing contagion within the banking sector, but it’s hard to know how much this will help. The same can be said for most of the items of the list; they might help or there might be other sound reasons for those reforms, but there is little that looks like it will reliably reduce volatility in the real estate market or reduce the banking sector’s exposure to those fluctuations.
What I find most surprising about the financial reform debate is that so much of it has focused on reform of regulatory agencies, banking laws and trading environments while so little attention has been paid to reform of mortgage regulations and mortgage-related securities. So to stimulate the debate on such reforms, let me suggest two kinds of measures that deserve further consideration.

 

1. Highly-leveraged mortgages increase the systemic risk in the financial sector and should be discouraged. This could be done in a number of ways, such as a tax on high loan-to-value mortgages, or compulsory insurance, or via regulation limiting the value of liens that can be attached to real estate, or simply by limiting mortgage-interest deductibility. Doing so should reduce the banking system’s exposure to the real estate market by ensuring that borrowers have greater equity investments (or are backed by insurance.) The reduction in leverage may also reduce real estate price swings.

 
2. The insurance of mortgages and mortgage-related products (including credit-default swaps on mortgage derivatives) requires tighter regulation. Such insurance is a critical buffer between downturns in the real estate market and the solvency of the banking system. While some mortgage risk is diversifiable, a substantial portion is a macroeconomic risk that is not diversifiable. This is particularly true for mortgage-backed securities, which pool risks across many individual mortgages. In the event of a national downturn in housing prices, it is not obvious that private-sector insurers will have the resources to honor their policies. At a minimum, the government needs to impose capital requirements for mortgage insurance and related financial derivatives that require a level of financial reserves commensurate with the degree of macroeconomic risk in this market. Others (such as Mehrling 2009) have argued that the government should simply provide such insurance themselves.

 

This post written by Simon van Norden.

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42 thoughts on “Guest Contribution: Reforming Banking by Reforming Housing

  1. Robert Bell

    Nice post.
    With respect to mortgages (highly levered and otherwise) and mortgage insurance, are you essentially trying to force all of the default risk to be priced? I.e. if the borrower can’t pay, the mortgage insurance kicks in, and if the insurer can’t pay, some sort of reinsurance kicks in etc so that overall, portfolios are sufficiently diversified so that spreads and mortgage premia are sufficient to cushion them from adverse events. (And in particular, those premia are set high enough to reduce the quanity of loans demanded so that system wide leverage stays at a manageable level?)

  2. DickF

    When one’s fundamental premise is in error one’s entire analysis is questionable.
    Answer a simple question. How could the “real estate” market overexpand as it did without loans from the banking sector?
    To blame the crash of the banking sector on a real estate failure is to get things exactly backwards. The banks, with the force of government excess and largess, financed a real estate bubble. As a consequence the banking and credit sector became highly exposed to a bursting of the bubble. Warnings were being shouted starting all the way back to 2006 and before, but did the banks adopt more cautious practices? Did the government reduce its real estate “stimulus?”
    The problem was the stimulation of artifically high consumption with the banks over-exposed to risk because the government was giving implict and explicit support for real estate credit.
    Today the government propaganda machine is in high production as thy attempt to shift the blame from the real cause, and this is the primary driving force behind increased regulation of the financial and real estate markets. None of the suggestions above would do anything to curb the government excesses that caused our current economic crisis, and government persists in makeing the same mistakes all over again as the talk of recovery is – amazingly – to revive the real estate bubble all over again.
    Economics is rife with the confusion of cause and effect (all too often as a political ploy).

  3. Simon van Norden

    DickF:

    “When one’s fundamental premise is in error one’s entire analysis is questionable. … Economics is rife with the confusion of cause and effect (all too often as a political ploy).”

    Once again, you and I are in complete agreement (at least on these points.) To try endlessly to blame the crisis on “government excess and largess” while ignoring all contrary facts (such as GAO reports mentioned in a previous post) is a dull game.

    BTW, Dick (mind if I call you Dick?), you know who I work for and act for. Would you do the readers of this blog the courtesy of mentioning who you work for?

  4. Simon van Norden

    Robert Bell:
    Yes, I think pricing all the default risk would be a good thing. However, just moving towards pricing more of it would also be a good thing.

  5. Cedric Regula

    Some clarifications:
    “Remember that at the end of 2008, the Federal Reserve Board estimated that there was $12 Trillion of mortgage debt on residential properties in the US, with the Federal government and its agencies providing about 5% of the total, individuals 9% and the rest coming from the financial sector.”
    You must be including Fannie and Freddie in the “financial sector”. But they aren’t really, of course. They crowd private banking out of writing “prime mortgages”. Banks, and “subprime lenders” have higher cost of money and invented riskier loans. Then finally in their ultimate wisdom, Fannie and Freddie started taking subprime stuff in order to “compete”. I don’t remember exactly the percentage of mortgages held by GSEs, but I think it’s something like half.
    Securitization via MBS or CDO/CDS allowed banks to get the loans off their books and just act as sales agents. The ones that didn’t do this were the first to go in 2007. That’s the “money” that created the “boom”. (we can call the upside move of real estate volatility, if you prefer.)
    And in the old days we did have a requirement that for less than 20% down mortgages you need insurance, and it became a 4% line item on your mortgage bill. Plus it was sold by insurance companies that were regulated as insurance companies.
    I don’t think anyone should underestimate how powerful a dynamic is created when you have both real estate agents and loan brokers working on commission, with little long term “skin in the game”.
    My California property went up 225% from 2000-2005. I was watching the market the whole time trying to figure out when to sell. I had lots of real estate data available on the web, plus a monthly tracking of the “affordability index” for Orange County.
    The OC affordability index went into record (unaffordable) territory in early 2005. A few months latter I read a news article about one of our local loan brokers who had checked into re-hab for cocaine abuse. He said it helped him keep going at a torrid pace, 12 hours a day, 7 days a week, while he canvased real estate brokers and agents for loan business, and processed their clients loans. I then decided it’s time to list my property. Sold it in a day. Since I did a “for sale by owner”, I wasn’t real sure what the bank appraiser would do, so I got together recent comps in my area. The appraiser came and I showed him the comps. He shrugged his shoulders and said, “I guess if that’s what they sell for.”, and the buyers loan was approved.
    I got my check and headed for Arizona.

  6. John Lee Hooker

    “… something be done to address this (future) risk factor. As I’ll discuss in a minute, there seem to be lots of ways to do this, but they boil down to some combination of (1) reducing the volatility of real estate prices, and (2) reducing banking sector exposure to real estate.”
    Prof. Simon van Norden, with all due respect, do not be naive. When the gang around Greenspan, Paulson, and their (GS) friends engineered the housing bubble to make some extra money, they would not have been so much happy with your ideas.
    Reduced price volatilty and reduced exposure to real estate to achieve future stability will not happen. Investment banking buddies want to make quick money. And banking friends in government and the taxpayers are those stabilizers needed, when things go ugly.

  7. ohwilleke

    Re: “The insurance of mortgages and mortgage-related products (including credit-default swaps on mortgage derivatives) requires tighter regulation.”
    You would think that the housing bubble collapse would have ruined private mortgage insurers. In reality, it didn’t. While almost every non-bank mortgage financing company involved in subprime lending no longer exists, and every single major independent investment bank is now gone or has joined or reorganized as a regulated commercial bank, none of the mortgage insurers collapsed. Their reserves were adequate, their policies were honored, their underwriting tightened a little. Their stocks took a hit, and they took losses, but the didn’t fail, despite being face on to an immense risk.
    Why? Private mortgage insurers were substantively regulated as insurers by state insurance regulators and had reserve requirements. Also, private mortgage insurers personally underwrote their own commitments. Regulatory requirements forced private mortgage insurance to rationally and carefully evaluate the risks they faced and set aside appropriate reserves, while second mortgage lenders and the derivative marketers who backed them were under no such requirement.
    In contrast, an increasing share of houses with low loans to value were structured with a conventional first loan, and a high risk (often subprime) second loan from the remainder of the loan beyond 80% LTV. Those second loans were turned into MBS securities, often with unrealistic bond ratings backed by promises on returns that were a mix of credit default swaps, excess default liabilities for the assembly underwriting mortgage finance companies, and further assurance from the investment banks.
    There was no substantive regulation, only disclosuure regulation, since this was taking place in the non-bank, non-insurance securities market, and the disclosures were inadequate.
    Tax law favored a second mortgage approach, for which there was a tax deduction for mortgage interest, over private mortgage insurance, for which there was no tax deduction at the time.
    The original post, which fails to recognize that private mortgage insurance is regulated and does have capital requirements, while financial derviatives were not and do not, misses a major lesson learned of the financial crisis and suggests that favoring private mortgage insurance over second mortgages has much to recommend it as public policy.

  8. Dr. D

    ohwilleke, you are completely correct with the exception of your statement that “the disclosures were inadequate.” Quite to the contrary, the loan-level disclosures provided with ABS/MBS (asset/mortgage backed securities) offerings more than adequetely disclosed PMI (private mortgage insurance), simultaneous seconds, and other factors: firms (like mine) that put in the effort and expense to thoroughly analyze these pools did very well, even when investing very low in the capital structure of these vehicles.

    However, these firms are in the strict minority; the vast majority of investors in this asset class didn’t do their homework, didn’t analyze the risk factors, and simply ‘waved it in’. That there was strong demand for investment product even as underwriting quality deteriorated was a harbinger of doom ignored by most….

  9. Hitchhiker

    Cedric already made my point. Namely, that Fannie and Freddie stepped up to the plate and bought sub prime mortgages formerly made by sup prime lenders and they did so by offering far easier terms (ie. lower price). This occurred under pressure from certain congress critters and their allies like Acorn which simultaneously went after former sub primer lenders in court and in PR campaigns labeling them predatory for charging higher rates and fees to higher risk customers which in the marxist democratic philosophy cannot be allowed.
    The answer, imo, is not more regulation but less. let the chips fall where they may. The bankers will make too many bad loans once again under pressure from the same old congress critters and then be bailed out when the bubble bursts. It will always be thus under government control.
    “Formerly we suffered from crimes, today we suffer from laws” Tacitus
    Somebody must be responsible for the quality of loans made. If it is the government, we will all suffer for it.

  10. jturner

    I personally find the whole system of govt support of private asset markets such as real estate ridiculous and a huge waste of time and money. I agree with those who say that there should not be a Fannie and Freddie, and that the govt should allow the buyers and sellers to determine prices on their own. This would prevent the series of booms and busts that we are now experiencing. And it would also prevent the misallocation of capital to nonproductive govt organizations that do not provide a useful purpose.
    Our banking system should also not be set up in a way such that a 20% decline in nationwide home prices could threaten the collapse of the entire system. Falling prices are part of the normal business cycle, but the Federal Reserve has mismanaged things for so long that they never let prices adjust in a normal recession, so that now the adjustment process is more severe.

  11. Simon van Norden

    ohwilleke:
    Thanks for the lesson! To be sure, I was thinking of “insurance” in the broader sense; that takes nothing away from the point that you’re making.

  12. Dr. D

    Simon, if your goal is to minimize real estate price volatility, it seems that all the approaches you list are simply far too indirect; why not simplify things vastly and go directly to the heart of the matter?

    Create a new Agency that is responsible for the review and approval of all real estate transactions; as your concern is a national housing deflation, this would probably be best as a Federal Agency. Of course, it would probably be best if this Agency operated with a very simple approval threshold, in order to eliminate the potential for political influence; statute could mandate that all transactions must comply with a 5% annual appreciation rate for real estate, exclusive of renovation but inclusive of depreciation. Alternately perhaps an appreciation rate could be based on GDP, etc….

    Sales transactions that fail to meet the hurdle would be rejected. Of course, a ‘market’ that fails to transact (clear) isn’t helpful either, so we could require the Agency to be the buyer of last resort, always buying at the minimum mandated price, then renting the premises out. With such a strictly controlled real estate base, rents would always be cashflow positive, making this whole program cashflow positive to the government and vastly cheaper than the current approach.

    Of course, such a system would still be at risk of borrower defaults, which would have to be controlled as well. But such control would be easy to effect: people desiring real estate, whether for housing or commercial purposes, to rent or to own, would have to approach this new Agency a priori and request that the Agency determine the appropriate real estate to match their needs and budget. With access to the IRS records, the Agency could make a maximally fair assessment of every persons needs and ability to pay, thus greatly improving the efficiency of the whole system, and eliminating once and for all future real estate bubbles and their associated financial crises.

    “From each according to their ability, to each according to their need.”

  13. HZ

    Banking 101: prudent lending is when you lend based on the borrowers’ ability to pay back; risky lending is when you lend based on collateral value. In the US we have higher income volatility which, while beneficial in making the real economy more flexible, does not support the leverage the central bank was pushing to generate sufficient demand. When most of the banks justify lending based on collateral value we know it is game over.
    Residential mortgage in the US is no longer about housing. It is about giving consumer access to cheap credit. Unfortunately tying consumer lending to housing induces the construction sector to periodically massively overbuild.

  14. HZ

    ohwilleke,
    It is still too early to tell if the reserves at the MIs are sufficient. One thing for sure though, the clogged foreclosure pipeline gave the insurers breathing room at least in terms of cash flow. Unlike banks, it is hard to have a run on the insurers. Their first loss underwriter value to the GSEs is therefore helping them to at least attempt to earn their way out. Such an opportunity is most often not afforded banks. A functioning bank is worth multiples of its capital because its banking relationships are worth a lot more than zero (analogous to the underwriting relationships MIs have with GSEs). But because the short term nature of banks’ liabilities and fear of bank run, only their tangible capital counts in a liquidity crisis.

  15. Simon van Norden

    Dr. D.
    You might think minimizing such volatility is a reasonable goal, but I’m just interested in preventing banking crises (remember?)
    I’m just suggesting some combination of less aggregate volatility and less exposure. There’s lots of reasonable ways to get there. If you want to create the agency that you describe, well, good luck with that.

  16. lilnev

    Currently, the Fed mostly considers production growth (GDP), unemployment, and inflation (CPI or PPI) when setting interest rates. This helps to counteract boom-and-bust business cycles by damping oscillations in production. But boom-and-bust cycles in asset prices are still destructive. So, would it help if the Fed explicitly considered asset prices when setting rates? The argument could be made that the Fed doesn’t know what prices should be (as if they know what unemployment or inflation “should be”). But there are measures like price/income or price/rent ratios for housing, price/earnings for stocks that can be compared to historical ranges. It just seems that making credit more expensive when asset prices are high would prevent the combination of “overleveraged and overpriced” without tinkering around with lower-level regulations (that are probably doomed to be “innovated around” anyway).

  17. Tom Hickey

    The problem is economic and social (and therefore political). Economic prudence (risk/reward) limits both economic growth and the availability of housing to more people. Therefore, getting the risk/reward ratio “right” is no only an economic issue but also a social one, hence, a political one.
    Lenders clearly exceeded the bounds of prudence, often to the extent of becoming predatory. However, they were encouraged in this by government (President Bush) and abetted by the Fed under Greenspan. Moreover, Democrats especially had pushed for government as lender of last resort (GSE’s). Finally, the government and Fed sometimes explicitly and sometimes implicitly put a floor on financial system losses, leading to moral hazard.
    Now we are in the unfortunate situation of millions of people losing homes they can no longer afford, dragging down the financial system and real economy as well.
    Obviously there has to be a happy medium in responsible lending struck along with more realistic government regulation and encouragement. There is a tendency to overshoot the mean in both directions. We have just overshot in the direction of imprudence and there is a tendency to overshoot in the direction of prudence to the degree that it restricts growth and availability.
    It was obvious to many that the market was “frothy” as Greenspan put it, but too little attention was paid to the incursion of predatory practices and fraud. As a result the problem became forensic instead of only financial and economic.
    How to resolve this problem is both economic and political because it has far reaching social implications. Clearly the existing model needs to be redesigned to balance economic prudence with social needs. Certainly, #1 and #2 above need to be taken into consideration a basic. But there is much more. Without accountability and reform, the game will go on.

  18. Simon van Norden

    There’s no shortage of comments on this blog deploring the effects of government intervention. I’m just a bit puzzled that, while there’s been plenty of mention of Fannie and Freddie and the Federal Reserve, there’s this odd (to me) silence about mortgage interest deductability.
    So, here’s my question for you “Formerly we suffered from crimes, today we suffer from laws” guys. Do you think mortgage interest deductability is a senseless, wasteful, distorting etc., etc. government intervention in the marketplace? or does that intervention do some good?
    Just wondering.

  19. Mark A. Sadowski

    @Dr. van Norden,
    I often feel alone in thinking that tax policy played a huge role in the real estate bubble.
    I don’t think it’s too surprising that the housing bubble started to inflate almost to the day that the Taxpayer Relief Act was passed in 1997. It led to greatly expanded real estate capital gains exclusions and granted tax expenditures (capital gains exclusions and mortgage interest and property tax deductions) to second homes for the first time in our nation’s history.
    And as for regulation of real estate lending I point to the following. The Garn-St. Germain Depository Institutions Act of 1982 legalized the insidiously evil adjustable rate mortgage. That, coupled with lax standards on down payments, helped fuel the speculative real estate frenzy once the tidal wave of tax expenditures was unleashed in 1997.
    We need to go back to “plain vanilla” 30 year fixed rate mortgages with 20% down payments. Very boring but incredibly safe. And we need to eliminate all federal tax preferences for real estate investments as well.

  20. PatR

    Simon, unlike many other professional economists, I think you are focusing on the right area. The biggest source of the recent instability in financial markets was bad loans; the biggest source of the bad loans was real estate, specifically residential real estate; and the biggest cause for those residential RE loans going bad was a large drop in RE prices. What you didn’t add, but is true, is that the drop in prices followed the largest RE bubble in recorded history.
    Now let’s take it one step further. What is the single action on residential RE lending what would both limit the systemic damage from a large nationwide drop in RE prices, and limit the inflation of a bubble in the first place? It’s not mortgage insurance, it’s not tighter income qualifications, etc. It’s higher minimum down payments. And I mean seriously higher, like 20% minimum for owner occupied homes, and more for other types.
    Requiring mortgage insurance just shifts the systemic risk, and costs, caused by overleveraging amongst homeowners to another party. Either that party won’t be able to pay, if it is private, or it will be the govt, and the costs of allowing overleveraging amongst homeowners will be transferred to taxpayers. And mortgage insurance doesn’t discourage bubbles forming in the first place, whereas large down payments do.

  21. PatR

    I forgot to add that encouraging the market to require higher down payments can be done in lots of different ways that could achieve the right result for systemic risk, while allowing a very limited market for low down payment loans.
    For example, we could disallow interest deductions on the portion of loans in excess of some LTV ratio, say 80%. And/or we would apply high capital requirements on lenders that provide more than 80% of the collateral value. I know, split loans and other issues would require some thinking, but it’s all very doable, if we wanted to get results. If….

  22. Cedric Regula

    The other thing they did to make houses more affordable was allow first time homebuyers to accumulate money tax free in a 401K and then withdraw it at no penalty for a down payment.
    So add that to mortgage deductibility, 3% down from FHA and all the other “incentives” mentioned here. Did anyone mention the $8K for first time buyers?
    Did we mention yet that Ben is buying $1.25 Trillion in MBS to keep mortgage rates low?
    The big problem is they CAN’T change any of this now without taking housing down another 30%-40% because doing away with breaks and subsides would make housing less affordable. Then we would have another Near GD3.
    We are hooked on the magic.

  23. Hitchhiker

    Simon wrote, “So, here’s my question for you “Formerly we suffered from crimes, today we suffer from laws” guys. Do you think mortgage interest deductability is a senseless, wasteful, distorting etc., etc. government intervention in the marketplace? or does that intervention do some good?”
    It is absolutely distorting. I would favor zero deductibility of mortgages. I would favor the complete eradication of Fannie, Freddie, etc. Let those who would buy bundles of mortgage backed securities evaluate and price the risk of those securities absent an implicit government guarantee. I do not like government meddling in any market for any reason not provably linked to simply enforcing a level playing field and helping prevent fraud. Determining home ownership to be of social value is a value judgment best left to those wishing to purchase a home and those willing to lend to them for that purpose.

  24. Steve Kopits

    If I interpret Cedric’s actions, his story poses an interesting problem which I have seen in practice a number of times. That is: good analysts tend to identify trends early and react or recommend a policy response too early, in my experience, by about 2 years. In Cedric’s case, he appears to have acted perhaps a year too early to have maximized his returns.
    From an institutional perspective, this tends to make the more sensitive analysts Cassandras and tends to damage their credibility with decision-makers during go-go markets.
    I would be interested if anything has been written on this topic of the time differential between trend identification and fruition (eg, from the identification of a housing bubble until it pops). As Menzie has posted earlier, the Fed was warned early and in no uncertain terms about the risks of a housing and credit bubble. The issue was therefore not the knowledge itself, but rather its dissemination (maybe) and implementation (absolutely) at the decision-making level.
    From the point of view of the young economist, understanding the timing issues associated with frames of mind would be useful in dealing with the often thorny matter of delivering and selling unpalatable policy prescriptions to senior managers.

  25. Dr. D


    You might think minimizing such volatility is a reasonable goal, but I’m just interested in preventing banking crises (remember?)

    Simon, um, no, your post specifically called for minimizing real estate volatility (and bank exposure to real estate) via regulatory reform. Please re-read what you wrote to see for yourself.

    Thus, I am forced to wonder, if you desire to manipulate a market to achieve specific statistics, why do you want to have a market in the first place? In your world view, it would seem most expedient and efficient to achieve your desired end-state (“some combination of (1) reducing the volatility of real estate prices, and (2) reducing banking sector exposure to real estate”) simply by shifting to a soviet-style system….

  26. Tom

    Here I think both you and the people you are criticizing are missing the point. Boom/bust cycles are monetary phenomenona, stemming from excess money supply growth, and though real estate is usually the most popular asset class for inflation, it is never the only one.
    Imagine your kid is spraying gushes of water out of your garden hose, your plants and soil are getting much too wet. You want to invent some kind of complex technology to prevent the water from landing on or under the plants? Would it ever work? If it did work, where would the water go instead, what other problems would it cause? Why not just take the hose away from your kid and turn down the water?

  27. Cedric Regula

    Steve Kopits,
    I did sell a little early, but CA was ahead of the national curve. Cracks in the market began early 2006, so selling at the end of the 2005 “summer selling season” would have been more preferable than at the beginning of summer 2005 as I did. Plus I wasn’t sure I would sell in one day. I did continue to look at the data, and I missed the top by maybe 5%-8%.
    But I didn’t mention the “selling pressure” that I perceived, from doing the analysis of risk factors associated with timing my sale. In 2004 we got the “conundrum”, where long rates didn’t rise tho we new they where supposed to. This led me to worry about when things would start working like the “old normal”, and higher rates would have driven housing more unaffordable, and thereby affect my successful sale timing.
    Then of course I was following all the reasons at the time that the financial gurus were proposing for low long rates…the trade deficit returning dollar for dollar from both China and the Middle East. I didn’t know how long that would last.
    Then a lot of the things that extended the boom nationwide, like ACORN, really bad loans being made(teasers, liar loans), and the fact that these were being turned into CDO/CDS and sold internationally started happening in a big way in 2005 and this new way of doing biz was unknown to me at the time.
    Then there is the “don’t get greedy and try to get out at the top” rule. I wanted to be on the safe side and get out with what I had, which was substantial.
    So the good news for economists is you don’t have to worry about timing when a bubble will pop, which is has a lot of unpredictability. All you need to do is show something unsustainable is occurring. So cheer up, it’s not that hard.

  28. Simon van Norden

    Dr. D:
    Simon, um, no, your post specifically called for minimizing real estate volatility (and bank exposure to real estate) via regulatory reform. Please re-read what you wrote to see for yourself.

    The word “minimize” is not in my post. “Reduce” is not a synonym for “minimize”, either.
    Please remember that this is a reality-based blog, Dr. D.

  29. Simon van Norden

    PatR
    I agree that lower leverage in residential would be a powerful way to reduce the risk of future crises. Personally, I suspect it may be a Very Good Idea. However, I’m trying to define what is required; it is possible to create a system with high leverage and low bank exposure (for example, by having the government insure all the downside risk.)

  30. DickF

    Simon,
    Yes, you may call me Dick if I can call you Simon. That should get around the “van” problem.
    You didn’t answer my question so I will repeat it.
    How could the “real estate” market overexpand as it did without loans from the banking sector?
    Then a companion question:
    How could the banking sector make excessive loans without injections from the Federal Reserve and foreign investment in Fannie and Freddie?
    No, I will not say where I work. If this were Dr. Phil it might be important, but I don’t watch Dr. Phil. I would rather discuss economics.

  31. DickF

    don wrote:
    Was real estate the cause of the banking crisis in GD1?
    Don,
    There was a Florida real estate boom/bust in 1925. There are still some large undeveloped fields with overgrown streets with cement curbs from the period. Some believe that the money from the real estate bubble shifted into the stock market contributing to the 1929 crash, almost the opposite of what happened with the dot.com bubble leading us into the 2008 real estate/credit crash.

  32. Simon van Norden

    Dick:
    Sorry you’re so shy. I ask only because I thought you stated that understanding political motivations are important to discussions. (And because I think politeness requires honesty and transparency.)
    I’ll gladly your two questions, but it will cost you an additional observation.
    1.) I don’t doubt that the increase in the supply of mortgage funds from the financial sector (and banks) helped fuel the house price appreciation in the US (and other economies, BTW.)
    2.) Happens all the time. Look at the excessive real estate investment by S&L’s in the 1980s. Another common way is to increase leverage.
    3.) Limiting the banking sector’s exposure to real estate has implications for the banking sector’s ability to fuel real estate bubbles.

  33. DickF

    Simon,
    Thanks for answering number one.
    Let me try again on number two.
    How could the banking sector make excessive loans without injections from the Federal Reserve and foreign investment in Fannie and Freddie?
    And two additional observation. On foreign investments in Fannie and Freddie see my response to JDH in his post Scott Sumner on the Fed’s mistakes. Second, does flipping burgers demonstrate a political motivation?

  34. Dr. D

    Simon, so you don’t want to minimize RE volatility, but you have decided that the historic/recent volatility is too high and that the banking sector has too much exposure to RE: could you perhaps relate what is an appropriate level of volatility and exposure in your model?

    Instead of trying to dictate market behavior and stats, why not try to understand how a properly transacting market came to be so comfortable with large exposures and extreme price movement? That to me sounds like a more ‘economic’-focused question, rather than determining which regulations and policies would be best at controlling a market.

  35. Lord

    While leverage is important, more important is documenting and verifying income and qualifying on fully adjusted rates. When have we ever had a bubble in incomes? When prices were doubling and tripling, incomes were falling. We had left behind speculative finance and were well into ponzi finance. The loans to deter are no documentation, stated income, and teaser qualified loans.

  36. ohwilleke

    Hitchhiker: “This occurred under pressure from certain congress critters and their allies like Acorn which simultaneously went after former sub primer lenders in court and in PR campaigns labeling them predatory for charging higher rates and fees to higher risk customers which in the marxist democratic philosophy cannot be allowed.”
    A working definition of an unconscionable deal is one that no one would was informed would enter into. A disclosure which doesn’t say “You are about to be defrauded,” is insufficiently emphatic. Many who got subprime loans were minorities who were overcharged despite the fact that they would have qualified for prime loans. In almost every case where a subprime loan was given to someone who did need one, in contrast, renting would be economically smarter. Market rents closely track the prime interest rates paid by landords which are generally superior to the cost of subprime interest rates and PMI, etc. Prepayment penalties (now basically banned) prevented the market from correcting these bad decisions when they were discovered; many subprime borrowers also don’t fully benefit from the mortgage interest deduction. And, we also know empirically, that subprime loans did very little to increase homeownership rates. ACORN and members of Congress were right to condemn subprime lending, and because they allowed its excesses, the subprime lending industry has for all intents and purposes ceased to exist because the market exterminated it (in less than a year). The deals made no economic sense to anyone in the long run.
    HZ: “It is still too early to tell if the reserves at the MIs are sufficient.”
    It is possible that this housing bubble collapse was so off the charts bad that absolutely everything on the map will be wiped out. But, PMIs have survived longer than any other player with anything like their portfolio which is 100% in low down payment residential lending.
    Mark A. Sadowski: Count me among those who think that tax matters. I recently presented a paper at the Law and Society Conference in Denver entitled “The Financial Crisis Was Brought To You By The Internal Revenue Code.” I wouldn’t necessarily agree with you regarding which provisions mattered. In addition to the preference for second mortgages over PMI, the preference for stock option compensation for executives which unbalances the balance of upside v. downside risk was probably next most important. In the same vein, the capital gain v. ordinary income distinction which reached new highs, was problematic, because it favored things like converting investment banks from employee owned form to investor owned form (which probably killed them in the end) and the rise of securitization v. investing in commercial banks that issued bonds to raise capital general (within the bounds of FDIC capital regulation).
    Another huge problem which hasn’t gone away, is the general tax bias towards debt rather than equity financing for publicly held companies that corporate double taxation creates (and capital gain/qualified dividend treatment addresses in only a clumsy, incomplete way). When big companies have low debt loads, the ability of the macroeconomy to deal well with a downturn is greatly enhanced. Tax preferences turbopower the incentive to leverage beyond the temptation that leverage offers even in a tax neutral environment.
    Discharge of indebtedness income rules (in which the non-bankruptcy default rule is to treat it as income) combined with CA’s general rule that residential mortgages are non-recourse debt also hasn’t helped. The allowance of the mortgage interest deduction itself, because it predates modern mortgage financing, is almost certainly not at fault, although the home equity loan provisions certainly weren’t helpful.
    The elimination of capital gains taxation on residences probably did more good than harm. It allowed those people who were prudent to sell out or downside without risk of a tax penalty. The evidence that financed second homes were important to this housing bubble isn’t too strong in most markets.
    It is also worth noting some other success stories like the FDIC. While bank failures are at post-S&L crisis highs and bank profits have been depressed, FDIC insured banks have still failed at a very low rate in absolute terms and compared to other institutions involved heavily in residential mortgage lending. The really stunning stories come from the non-bank side of the page and a very small number of reckless banks (WaMu and IndyMac most prominently. Equally important, the FDIC has done a very efficient job of damage control. Where the FDIC has stepped in, it has put out an order of magnitude less of federal money (in the tens of millions), while providing very real returns in financial stability, protected deposits (usually far beyond its legal obligation) and public confidence. It is even set up so that the federal funds spent do not burden the general taxpayer and instead are repaid from future FDIC premiums paid by covered banks relative to deposits. Credit union failures have been even more rare.
    Simon van Norden: It is not too hard to formulate policies that make the economy more robust in weathering business cycles, across multiple subject areas (tax, financial regulation, bankruptcy, etc.) A more robust economy may be a more attainable goal than an economy free of the bust-boom cycle.

  37. HZ

    ohwilleke,
    As you know MIs faced significant competition from securitization of second mortgages so they diworsified and they stretched (pool vs flow, subprime etc.) Since they don’t face a run unlike the subprime originators (most died instantly after credit lines were pulled) they are able to persist. And despite their junk credit ratings GSEs have little choice but to continue using them — so they can actually raise price on good risk and good credit and attempt to earn their way out. But if one looks at their old book of business it is not clear at all that they have reserved sufficiently even after upping the reserves massively last year. The clogged foreclosure pipeline (and reluctance of many to foreclose) is giving them a reprieve to really put the reserve to a stress test. Despite this I agree they did a lot better than subprime originators in underwriting. However their survival is more likely due to their competitive position and liquidity than underwriting acumen. One could compare Radian (one of the better performing MIs)legacy book with American General Finace (an AIG subsidiary and subprime lender but no securitization) to see my point: AGF’s subprime mortgage (default rate at around 6-7% despite no new lending for almost 2 years now) performs much much better than Radian’s yet AGF is practically liquidating because of its inability to access credit market while Radian is looking up because it is able to continue writing new policies, insuring prime credits. What a joke, when a junk rated company insures prime rated borrowers. In other words, I bet today’s high LTV prime mortgage pooled into uninsured MBS should be much better credit risk than junk rated companies. You can say they are surviving thanks to legal arbitrage since GSEs are not allowed to guarantee more than 80% of LTV.

  38. Doug Brown

    DickF nailed it. This was not a matter of a real estate crash producing a banking crisis, but rather one of the banks, through their lending practices, fueling a real estate bubble.

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