At MoneyWatch, some brief comments (and links to other discussions by Calculated Risk, The Big Picture, and Free Exchange) on today's news that existing home sales rose 10.1 percent in October:
Existing Home Sales Rise 10.1%
I just posted this at MoneyWatch:
Housing starts fell unexpectedly last month. The Census report gives the details:
Privately-owned housing starts in October were at a seasonally adjusted annual rate of 529,000. This is 10.6 percent (±8.7%) below the revised September estimate of 592,000 and is 30.7 percent (±8.3%) below the October 2008 rate of 763,000.
Single-family housing starts in October were at a rate of 476,000; this is 6.8 percent (±7.5%)* below the revised September figure of 511,000. The October rate for units in buildings with five units or more was 48,000.
This graph shows the recent trend in housing starts:
As the graph shows, starts bottomed several months ago, and have been "moving sideways" ever since. What is causing housing starts to move sideways rather than recover? Calculated Risk, one of the best sites for analysis of the housing industry, gives this explanation (which I agree with):
Total housing starts were at ... the all time record low in April of 479 thousand (the lowest level since the Census Bureau began tracking housing starts in 1959). Starts had rebounded to 590 thousand in June, and have move sideways (or down) for five months.
Single-family starts were at 476 thousand (SAAR) in October... Just like for total starts, single-family starts have been at this level for five months.
As he notes, an important piece of the puzzle is that the percentage of vacant units has been climbing and is now at a record level (see this report):
It is very unlikely that there will be a strong rebound in housing starts with a record number of vacant housing units.
The vacancy rate has continued to climb even after housing starts fell off a cliff. Initially this was because of a significant number of completions. Also some hidden inventory (like some 2nd homes) have become available for sale or for rent, and lately some households have probably doubled up because of tough economic times.
It appears that ... starts are now moving sideways - and will probably stay near this level until the excess existing home inventory is reduced.
This raises the question of whether the overall economy will echo this pattern of falling backwards after apparent improvement, i.e. of moving sideways for a period of time. This is something I don't think we can or should rule out as we think about the appropriate economic policies that we should have in place to help the economy recover from the recession.
Ed Glaeser explains some of the lessons he's learned from the recent crash of housing markets:
What We’ve Learned: Ugly Truths About Housing, by Edward L. Glaeser: ...What have we learned from the great housing bubble and crash of the aughts? Most obviously, we have learned that housing prices can be extraordinary volatile. This was less obvious from previous housing cycles. ...
So let no one ever again say foolish things like housing prices never fall. In the current drop, eight of the 20 Case-Shiller areas had housing price drops of 40 percent of more. ... Buyers and bankers should never again think that an area’s recent price increases are the sign of a strong market where prices have nowhere to go but up. In the long run, price increases are followed by price drops, and special caution, by regulators as well, needs to be taken in booming markets.
In places like Las Vegas and Phoenix, there are no fundamental constraints on building new homes — like a shortage of land or onerous restrictions on construction... I once thought that this obvious lack of limits on building meant that such open areas would sit bubbles out,... but I was wrong. The logic of supply and demand can be ignored for longer than I thought, but it ultimately reasserts itself.
The second lesson of the housing debacle is that there is extraordinary pain in both housing price busts and booms. When housing prices soared, ordinary Americans found it increasingly hard to afford a house. ... [This] logic pushed me to boo when housing became outrageously expensive. During the boom, I hoped that housing prices would stop rising and even decline.
Yet I didn’t understand the terrible impact that declining housing prices would have on our financial sector. While rising housing prices weren’t particularly good for America, declining housing prices were particularly bad for the country. The lesson seems to be that large swings in housing prices, in either direction, can be extremely painful.
The third lesson is that American housing policy has been monumentally foolish. We have used public resources to encourage ordinary Americans to bet all they could on highly risky housing markets. Fannie Mae and Freddie Mac, the home mortgage interest deduction, even the willingness to bail out financial firms..., can all be seen as policies that encourage ordinary people to risk it all on real estate.
I had once thought that these policies were misguided, but not terrible. We now know that encouraging buyers and lenders to bet on housing can impose vast costs on the country. ...
I think that we have not yet fully faced the fact that our tax code encourages people to finance their homes with as much debt as possible, and that our financial regulations abet irresponsible lending.
Now that we have backed away from the abyss, we can consider making much-needed reforms, like reducing the upper cap on the home mortgage interest deduction, that could depress housing prices in the short run, but make future housing bubbles and crashes less likely.
I don't think much of the blame for the crisis can be placed on the home mortgage interest deduction, there was no big change in this deduction that corresponds to the start of the bubble. As for eliminating the deduction, though it's possible to make an argument that there are positive externalities to home ownership such as taking better care of the property, something that benefits surrounding properties, or having more involvement in the community, I don't think the case is very strong, particularly when the inequity between owners and renters is taken into consideration.
Tim Duy turns from Fed Watcher to Press Watcher. Will more regulation in mortgage markets lead to outcomes like Vermont's?:
Odd WSJ Story on Vermont, by Tim Duy: The Wall Street Journal has an odd piece on the Vermont mortgage market today. Odd in that the thesis appears to be completely unsupported by the rest of the piece. The story begins:
In plenty of other states, Andrea Todd would have been a homeowner years ago. Here, she bought just this month -- a difference that helps explain how Vermont avoided the housing bust, and shows the possible pitfalls in President Barack Obama's plan to tighten mortgage regulation…
...Vermont's strict mortgage-lending laws largely prevented the state's residents from signing the types of dubious home loans written in other markets across the country. Its 1990s legislation made mortgage lenders warn customers when their rates were relatively high, and put the brokers who arranged loans on the hook if their customers defaulted. Now, by at least one measure, the state has the lowest foreclosure rate in the U.S.
It came at a cost. The rules also kept some Vermonters like Ms. Todd from buying homes, keeping this rural corner of New England on the sidelines of the housing boom and the economic bonanza that came with it. Vermont's 10-year growth trails the national average.
The tenor of the article is that Vermont has overregulated the mortgage market preventing…wait for it…the unforgivable error of restricting loans to those who can prove an ability to repay. Worse yet, consumers receive explicit notice of high rates and brokers are held accountable:
In laws passed between 1996 and 1998, Vermont required lenders to tell consumers when their rates were substantially higher than competitors', with notices printed on "a colored sheet of paper, chartreuse or passion pink." And in what officials believe is the first state law of its kind, Vermont declared that mortgage brokers' fiduciary responsibility was to borrowers, not lenders. This left Vermont brokers partly on the hook for loans gone sour.
The insanity. The horror. Encourage personal responsibility? Hold people accountable for their behavior? Unthinkable. While of course such policies would limit defaults, the economic consequences would be disastrous:
Vermont's economy grew 60% in the 10 years ending in 2008, just behind the 63% rate nationally, according to the Commerce Department. Vermont lagged Arizona, Nevada and California over the decade but outpaced most of its New England neighbors.
That's right, Vermont's growth trails the national average by an astounding 3 percentage points over a decade. They truly missed the economic boom. Why surely Vermont would have outpaced Arizona had it not been for the stunningly tight mortgage markets. The snow didn't have anything to do with it.
Of course, homeownership rates in Vermont are dismal. A state of renters, virtual serfs in this medieval land. The author forges bravely ahead:
Vermonters didn't see the same sharp rise in home ownership that swept much of America in recent decades, which, despite the bust, buoyed economic growth. And while part of the increase in U.S. home ownership reflected excesses in lending and borrowing, some of it represented real progress in the form of more Americans achieving the cherished goal of getting -- and keeping -- a home of their own. By 2007, the percentage of owner-occupied households as a whole reached 68.1%, up from 63.9% in 1990, according to U.S. Census data. Vermont started at a higher base but saw ownership rise just 1.1 percentage points in that span, to 73.7%.
The according to the article, the "pitfalls" amount to: Informed consumers, fewer foreclosures, healthier banks, higher rates of homeownership, and virtually no impact on average growth. Those are some "pitfalls" - truly, greater consumer financial protection would spell ruin for us all.
Should the government mandate that lenders offer "plain vanilla" mortgage contracts as an option?:
Thaler Responds to Posner on Consumer Protection, by Paul Solman: Paul Solman: Earlier this month, I was pleased to learn that ... the University of Chicago's Richard Thaler ... had entered the rotation of the NYT's weekly "Economic Scene" column. His initial public offering, Mortgages Made Simpler, applied his gargantuan expertise in behavioral economics ... to home mortgage regulation. ...
A mere 17 days after Thaler's NYT debut, I opened the Wall St. Journal op-ed page and spotted an essay by ... Richard Posner... I was all eyes, and the headline -- Treating Financial Consumers as Consenting Adults ... intrigued me. ...
[W]hat dumbfounded me, and occasions this post, was the extent to which Posner took personal aim at Thaler and his argument. ... So I emailed Thaler to see if he had written a rejoinder. When I found that he hadn't, I invited him to do so, promising that I'd publish it. And so, here it is.
Richard Green:
Michael Lacour-Little says it's all about the refinances, by Rickard Green: He points me to:
Why are so many homeowners underwater on their mortgages?
In crafting programs to prevent foreclosures, policymakers have assumed that the primary reason homeowners owe more on their home than it is worth is that they bought at the top of the market. In other words, they’ve lost equity primarily through forces beyond their control.
A new study challenges this premise and finds that excessive borrowing may have played as great a role.
Michael LaCour-Little, a finance professor at California State University at Fullerton, looked at 4,000 foreclosures in Southern California from 2006-08. He found that, at least in Southern California, borrowers who defaulted on their mortgages didn’t purchase their homes at the top of the market. Instead, the average acquisition was made in 2002 and many homes lost to foreclosure were bought in the 1990s. More than half of all borrowers who lost their homes had already refinanced at least once, and four out of five had a second mortgage.
The original loan-to-value ratio for these borrowers stood at a reasonable 84%, but second and third liens left homeowners with a combined loan-to-value ratio of about 150% by the time of the foreclosure sale date.
Borrowers, meanwhile, took out around $2 billion in equity from their homes, or nearly eight times the $262 million that they put into their homes. Lenders lost around four times as much as borrowers, seeing $1 billion in losses.
“[W]hile house price declines were important in explaining the incidence of negative equity, its magnitude was more strongly influenced by increased debt usage,” writes Mr. LaCour-Little. “Hence, borrower behavior, rather than housing market forces, is the predominant factor affecting outcomes.”
If other housing markets across the country offer similar findings, then the study argues that current “policies aimed at protecting homeowners from foreclosure are misguided” because lenders, and not borrowers, have born the lion’s share of economic losses.
Borrowers that bought homes without ever putting any or little equity in their homes could have seen huge returns on investment simply by extracting cash through refinancing. “Why such borrowers should enjoy any special government benefits such as waiver of the income taxation on debt forgiveness or subsidized loan modifications to reduce their borrowing costs is at best unclear,” the authors write.
Michael is a co-author of mine (and was a student at Wisconsin while I taught there), and has a gift for slicing up mortgage data. On the policy question, we might think about treating the half who did not refinance differently, as they were drowned by the flood.
The Cleveland Fed's Yuliya Demyanyk says "most popular explanations for the subprime crisis turn out to be myths." I disagree on Myth 8, perhaps the crisis wasn't "totally" 100% unexpected, but it was generally unexpected and very few people got this right. As for Myth 10, I don't think anyone still believes that the "subprime mortgage market was too small to cause big problems," though that was believed at one time. Also, I'm not completely convinced that Myth 4 that "Declines in mortgage underwriting standards triggered the subprime crisis" is a myth, though that seems to be partly acknowledged in the discussion:
Ten Myths about Subprime Mortgages, by Yuliya Demyanyk: Subprime mortgages have been getting a lot of attention in the United States since 2000, when the number of subprime loans being originated and refinanced shot up rapidly. The attention intensified in 2007, when defaults on subprime loans began to skyrocket. Researchers, policymakers, and the public have tried to identify the factors that explained these defaults.
Unfortunately, many of the most popular explanations that have emerged for the subprime crisis are, to a large extent, myths. On close inspection, these explanations are not supported by empirical research.
These seem like reasonable ideas to me:
Two ideas for appraisal reform, by Richard Green: Lawrence Yun of NAR is complaining that appraisals are preventing legitimate real estate transactions from occurring. Because of the way appraisers sometimes choose comparables, I have some sympathy for this view. And as I noted in an earlier post, Rhonda Porter says the Home Value Code of Conduct is nothing more than a way to line the pockets of Appraisal Management Companies. I have some sympathy for this view as well.
But we should not go back to the days when appraisers were basically paid to stay out of the way of the consummation of a deal. So let me suggest two proposals:
(1) Appraisers should not be allowed to see the offer price of a house. This is the only way their valuation will be truly independent.
(2) Appraisers should use valuation techniques that allow them to report a standard deviation of their estimate. Subdivision tract houses will have small standard deviations; architect designed villas will have large standard deviations.
We could then move to a pricing rule where Mortgage Insurance will be required if (1) the LTV based on appraised value is greater than 80 percent or (2) there is a greater than five percent chance that the true value of the house implies an LTV of 95 percent.
Step (1) would be easy to implement, and I think would help a lot. Step (2) will require lots of training (and perhaps different parameters from those that I am suggesting).
We need to stop kidding ourselves that we can measure house prices precisely. We need to start measuring the level of imprecision.
Ed Glaeser says that if people were as smart as he is, they would have realized housing price increases were unsustainable and there wouldn't have been a housing bubble:
In Housing, Even Hindsight Isn’t 20-20, by Edward L. Glaeser: ...[Is] the housing market ... starting to hit bottom? ... One major point of economics is that predicting asset prices is extremely hard... Moreover, the last seven years should make everyone wary about predicting housing price changes. ...
The housing price volatility of the last six years has been so extreme that it confounds conventional economic explanations. Over a four-year period — from February 2002 to February 2006 — the Case-Shiller index increased ... about 50 percent in constant dollars.
Certainly, those price increases cannot be explained by increases in average income. Income growth was quite modest from 2002 to 2006. Nor can the boom be explained by a dearth of new housing supply. Construction rose dramatically during the boom...
A number of pundits place the blame for the bubble on ... Alan Greenspan. They argue that loose monetary policy caused housing prices to rise. While lower interest rates are correlated with higher prices, the relationship is far too weak to explain the price explosion that America experienced. ... To get a 50 percent real increase in housing prices, real interest rates would have had to decline by more than ...10 percentage points..., which is not what happened. ... Real rates actually rose slightly between 2002 and 2006.
While low interest rates, on their own, cannot make sense of the bubble, perhaps the increased availability of credit to subprime borrowers has more explanatory power. ... Yet the correlation between housing price growth and subprime lending across markets is as likely to indicate that lenders took more risks in booming markets as that those risks caused markets to boom. ...
The most plausible explanations of the bubble require levels of irrationality that are difficult for economists either to accept or explain.
For many years, the creators of the housing index, Chip Case and Robert Shiller, have argued that housing bubbles were fueled by irrationally optimistic beliefs about future housing price appreciation. More recently, Monika Piazzesi and Martin Schneider have documented the rise in optimistic beliefs about housing price appreciation over the recent boom. Using some elegant algebra, they suggest that overly optimistic beliefs could cause a boom even if those beliefs were held by only a small share of the population.
It is hard to argue with this view. The only way that anyone could justify spending bubble-level prices in Las Vegas was by having the incorrect belief that those prices would increase.
I once thought that the Las Vegas housing market was so straightforward (vast amounts of land, no significant regulation) that no one could be deluded into thinking that prices could long diverge from construction costs, but I was wrong. I underestimated the human capacity to think rosy thoughts about the value of a house.
Yet even if ridiculously rosy beliefs are a major part of bubbles, we cannot say that we understand those bubbles until we understand the sources of such beliefs. Economists like to link beliefs to reality, but these views weren’t grounded in sound statistics. The housing boom was a great wildfire that spread from market to market, but it is hard to make sense of its flames. ...
I don't think people believed that housing prices would never, ever go down, what they thought is that housing prices would go up in real terms, on average, over time - that housing was a good long-run investment. They knew there would be variation around that trend, but they expected the variation to be relatively mild, they didn't expect the severe variation in prices and associated problems that actually occurred.
But as Shiller argues, the belief that real housing prices rise over time is false, the evidence suggests that real housing prices are relatively flat over the long-run. Because people expected prices to rise on average when they should have expected them to remain flat, the correction - the variation in prices - was far larger than anticipated and many homeowners weren't able to simply ride out the short-run variation like they thought they would be able to do.
But this still leaves a question unanswered. Why did people have this false belief about the long-run trajectory of prices? Shiller explains that this happened because people believed that both land and building materials were becoming relatively more scarce over time, a belief he says is false, but that just pushes the "but why did they believe that" question back one step from housing prices to the prices of land and raw materials.
So let me take a quick stab at an explanation (I'm not pushing this, it's just a quick thought). People are told (or were at that time) that stock markets are a great long-run investment. If you have the time to ride out the short-run fluctuations you can earn 8% per year. Just dump your money in an index fund that duplicates the market portfolio, and forget about it until many, many years later and you will do fine. Risk adjusted real returns on assets ought to equalize across markets through arbitrage, so shouldn't housing yield a real return similar to stocks (adjusting for risk)? Shouldn't there be a real return on housing just like in stock and other asset markets, and if so, doesn't that mean real prices will rise on average over time? This still requires beliefs about long-run prices at odds with (Shiller's) evidence though.
One more note. I may be wrong to assert that people thought that housing prices would rise forever. If you know that there is a bubble in an asset market, but you believe you can sell fast enough once the market hits a turning point to still make a profit, or at least not lose much in any case, then you may be willing to make an investment that tries to exploit the short-term surge in prices. But while I think that may apply to stock markets, or other markets where assets can be sold quickly (the belief that is, the reality is quite different when everybody tries to sell at once), I'm not sure this applies to housing where sales can be notoriously slow. But it's still possible that people would know there is a bubble in housing prices, but still be willing to make an investment because they believe that housing prices would fall so slowly that, if necessary, they could sell their house before taking a loss. It just doesn't seem to me that this explanation works as well in housing as it does in stock markets.
Did the false belief that land suitable for building houses was becoming scarce help to drive the housing bubble?:
Unlearned lessons from the housing bubble, by Robert J Shiller, Project Syndicate: There is a lot of misunderstanding about home prices. Many people all over the world seem to have thought that since we are running out of land in a rapidly growing world economy, the prices of houses and apartments should increase at huge rates.
That misunderstanding encouraged people to buy homes for their investment value – and thus was a major cause of the real estate bubbles around the world whose collapse fuelled the current economic crisis. This misunderstanding may also contribute to an increase in home prices again, after the crisis ends. Indeed, some people are already starting to salivate at the speculative possibilities of buying homes in currently depressed markets.
But we do not really have a land shortage. Every major country ... has abundant land in the form of farms and forests, much of which can be converted someday into urban land. ...There are often regulatory barriers to converting farmland into urban land, but these barriers tend to be thwarted in the long run if economic incentives to ... become sufficiently powerful. It becomes increasingly difficult for governments to keep telling their citizens that they can’t have an affordable home because of land restrictions. ...
Many people seem to think that the US experience is not generalisable, because the US has so much land relative to its population. ... But, to the extent that the products of land (food, timber, ethanol) are traded on world markets, the price of any particular kind of land should be roughly the same everywhere. ...
Shortages of construction materials do not seem to be a reason to expect high home prices, either. For example, in the US, the ... Building Cost Index ... has actually fallen relative to consumer prices over the past 30 years. To the extent that there is a world market for these factors of production, the situation should not be entirely different in other countries.
The ... expectations for real estate prices ... during the recent bubbles were often totally unrealistic. A few years ago Karl Case and I asked random home buyers in US cities undergoing bubbles how much they think the price of their home will rise ... on average over the next ten years. The median answer was sometimes 10% a year. ... Home prices cannot have shown such increases over long time periods, for then no one could afford a home.
The sobering truth is that the current world economic crisis was substantially caused by ... speculative bubbles ... made possible by widespread misunderstandings of the factors influencing prices. These misunderstandings have not been corrected, which means that the same kinds of speculative dislocations could recur.
In general, even though I don't always share Shiller's psychological approach to economic problems, it seems to be a bad idea to bet against his forecasts, in this case that people will once again misperceive that the real cost of housing is flat or slightly declining in the long-run, instead they will forecast long-run increases, and this will generate yet another housing bubble.
Update: Richard Green says "Shiller is largely right but for two things."
Robert Shiller doesn't think real estate prices will turn around anytime soon:
Why Home Prices May Keep Falling, by Robert Shiller, Commentary, NY Times: Home prices in the United States have been falling for nearly three years, and the decline may well continue for some time.
Even the federal government has projected price decreases through 2010. As a baseline, the stress tests recently performed on big banks included a total fall in housing prices of 41 percent from 2006 through 2010. ...
Such long, steady housing price declines seem to defy both common sense and the traditional laws of economics, which assume that people act rationally and that markets are efficient. ... If people acted as the efficient-market theory says they should, prices would come down right away, not gradually over years, and these cycles would be much shorter.
But something is definitely different about real estate. Long declines do happen with some regularity. And ... we still appear to be in a continuing price decline. ... Why does this happen? One could easily believe that people are a little slower to sell their homes than, say, their stocks. But years slower?
Several factors can explain the snail-like behavior of the real estate market. An important one is that sales of existing homes are mainly by people who are planning to buy other homes. So even if sellers ... have no reason to hurry because they are not really leaving the market.
Furthermore, few homeowners consider exiting the housing market for purely speculative reasons. ... And they don’t like shifting from being owners to renters... Among couples...,... any decision to sell and switch to a rental requires the assent of both partners. Even growing children, who may resent being shifted to another school district and placed in a rental apartment, are likely to have some veto power.
In fact, most decisions to exit the market in favor of renting are not market-timing moves. Instead, they reflect the growing pressures of economic necessity. This may involve foreclosure or just difficulty paying bills, or gradual changes in opinion about how to live in an economic downturn. This dynamic helps to explain why, at a time of high unemployment, declines in home prices may be long-lasting...
Even if there is a quick end to the recession, the housing market’s poor performance may linger. After the last home price boom, which ended about the time of the 1990-91 recession, home prices did not start moving upward, even incrementally, until 1997.
According to this research, inequality raises residential segregation. This is worrisome in part because the increase in segregation can cause problems that feedback to both amplify and perpetuate the inequality:
Inequality and the Measurement of Residential Segregation by Income In American Neighborhoods, by Tara Watson, NBER Working Paper No. 14908, April 2009: Abstract American metropolitan areas have experienced rising residential segregation by income since 1970. One potential explanation for this change is growing income inequality. However, measures of residential sorting are typically mechanically related to the income distribution, making it difficult to identify the impact of inequality on residential choice. This paper presents a measure of residential segregation by income, the Centile Gap Index (CGI) which is based on income percentiles. Using the CGI, I find that a one standard deviation increase in income inequality raises residential segregation by income by 0.4-0.9 standard deviations. Inequality at the top of the distribution is associated with more segregation of the rich, while inequality at the bottom and declines in labor demand for less-skilled men are associated with residential isolation of the poor. Inequality can fully explain the rise in income segregation between 1970 and 2000. ...
Steven Gjerstad and Vernon L. Smith argue that the "events of the past 10 years have an eerie similarity to the period leading up to the Great Depression." More specifically, their argument is that contrary to the usual explanation that the troubles in the banking sector during the Great Depression were caused by stock-market speculation and a monetary contraction, they suggest that "both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt":
From Bubble to Depression?, by Steven Gjerstad and Vernon L. Smith, Commentary, WSJ: Bubbles have been frequent in economic history... Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. ...
But what sparks bubbles? Why does one large asset bubble -- like our dot-com bubble -- do no damage to the financial system while another one leads to its collapse? ... How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?
Chris Nekarda disagrees with Connor Dougherty's assertion that geographic mobility is procyclical, i.e. that more people move when times are good than when times are bad:
Cyclicality of Geographic Mobility, by Chris Nekarda: Connor Dougherty discusses a dramatic decline in geographic mobility during 2008 (via Economist’s View):
U.S. Migration Falls Sharply, by Conor Dougherty, WSJ: Migration around the U.S. slowed to a crawl last year, especially for this decade’s boom towns, as a weak housing market and job insecurity forced many Americans to stay put. ...
<p>HTML clipboard</p> As asset values rose fairly steadily in the past decade, Americans young and old moved around the country in search of jobs or better weather. In many cases, people living in higher-cost housing markets such as San Francisco and New York cashed in their real-estate winnings and moved to outlying counties, or to states like Florida and Nevada, hoping to find a cheaper house and pocket the difference. Now, “people are hanging tight; they’re too scared to do anything,” said Mr. Frey.Migration typically slows during recessions. But in past downturns, the slowdown has been more regional in scope, with workers fleeing weaker job markets for places where companies were still hiring. In the deep 1980s recession, for instance, laid-off auto workers fled the industrial Midwest for energy-rich states in the South with more plentiful jobs.
What’s unique this time is migration has slowed almost everywhere. The sharpest year-to-year changes were among what demographers call “domestic migrants,” people who moved within the U.S. That doesn’t count population changes that result from births, deaths or immigration.
Although I agree with the trend behavior described above, Dougherty is incorrect about the cyclicality of geographic mobility. In fact, geographic mobility is moderately countercyclical—that is, more people move during recessions than during booms (relative to trend). This may seem counter-intuitive but makes economic sense.
Geographic mobility is a means of reallocating resources, in this case labor, to more efficient uses. In the past, 70 percent of people who move indicated having moved for economic reasons and up to 50 percent of those moves occurred because of a job separation [Lansing and Morgan (1967); Bartel (1979)]. In particular, there is a significant positive relationship between unemployment and geographic mobility [Bartel (1979); Schlottmann and Herzog Jr. (1981, 1984)]. Thus, countercyclical mobility is consistent with reallocation of idle workers across space.
I assess the cyclicality of geographic mobility in a recent working paper. I the measure the rate of geographic mobility as one minus the share of persons living at the same address one year later reported by the U.S. Census Bureau. These data come from the March supplement to the Current Population Survey, so the 2007 data do not reflect much of the distress in mortgage markets—and any concomitant effects on mobility—that began later in 2007.
Removing the low-frequency trend is important because it represents structural changes—such as demographic changes or, say, innovations in mortgage finance—that are unassociated with the business cycle. I isolate the component of the time series that moves at business cycle frequency using an unobserved components model (see paper for details). The figure below plots the cyclical component of the mobility rate together with that of the unemployment rate for comparison.
The cyclical component of mobility tends to follow the unemployment rate, indicating that more people move during recessions than during booms. This is consistent with geographic mobility as a means for reallocating idle labor to more productive uses. The contemporaneous correlation of the cyclical component of the mobility rate with the unemployment rate is 0.50, indicating moderate countercyclicality. Also note that mobility is substantially less volatile over the business cycle than unemployment.
Of course, the problems in the housing market beginning in 2007, notably the dramatic decline in prices, will undoubtedly reduce geographic mobility during this recession. This will further slow recovery because unemployed persons cannot move to areas with more favorable labor markets as easily or quickly as before.
The end of the great migration:
U.S. Migration Falls Sharply, by Conor Dougherty, WSJ: Migration around the U.S. slowed to a crawl last year ... as a weak housing market and job insecurity forced many Americans to stay put.
Demographers say the dropoff in migration, shown in Census data to be released Thursday, is among the sharpest since the Great Depression. It marks the end of what Brookings Institution demographer William Frey calls a "migration bubble."
As asset values rose fairly steadily in the past decade, Americans young and old moved around the country in search of jobs or better weather. In many cases, people living in higher-cost housing markets such as San Francisco and New York cashed in their real-estate winnings and moved to outlying counties, or to states like Florida and Nevada, hoping to find a cheaper house and pocket the difference. Now, "people are hanging tight; they're too scared to do anything," said Mr. Frey. ...
Migration typically slows during recessions. But in past downturns, the slowdown has been more regional in scope, with workers fleeing weaker job markets for places where companies were still hiring. ... What's unique this time is migration has slowed almost everywhere. The sharpest year-to-year changes were among what demographers call "domestic migrants," people who moved within the U.S. ... The Census data show that the biggest falloffs were in the worst housing markets. ...
Having a key resource - labor - largely frozen in place doesn't help the economy at all. People are in no mood to take risks by moving to a new job, they probably can't find a job anyway, and if they do, will they be able to sell their house? And if all that goes right, they find a job, it's a good enough opportunity to be a risk they're willing to take, and they found a buyer for their house, will the loan be so far underwater that they can't afford to sell it?
Richard Green versus Christopher Thronberg:
Last Dust-up Point Counterpoint: Point: Christopher Thornberg
The homeowner rescue plans so far have been failures. Either few troubled borrowers have signed up or, more significantly, within just a few months of having their loans modified a shockingly large portion of the borrowers are back in default. The entire rescue process has accomplished little more than increasing the cost to the banks by extending the foreclosure process that much longer.
There are two possible explanations for this re-default problem. One is that the programs simply don't acknowledge that with loans sharply underwater, folks have little incentive to maintain their mortgages even when payments are being lowered to something more affordable.
It has been claimed that past studies have shown that being underwater is a necessary but not sufficient condition for foreclosure. I would argue that we have never had ... people so desperately underwater, and we have never had so many families with such small stakes in the game (witness no-money-down mortgages with initially negative amortization payment levels). As such, past data points offer little in terms of comparison to the current situation. From this perspective, borrowers go along with the mortgage modification plans simply to maintain their housing situation for a few extra months.
The second potential explanation is that these mortgage programs do not screen their applicants for other potential issues, such as the loss of income due to the downturn, debt burdens outside the mortgage or perhaps even verifying income to see if the new "affordable" payment is in fact affordable. As we now know, even with mortgages where incomes were supposedly verified, brokers quickly learned how to game the system in such a way as to not trigger further verification efforts. ...
President Obama's plan is another one-size-fits-all scheme without much effort to distinguish between those who have a reasonable chance of having a workout succeed and those for whom the workout represents little more than a few extra months of free rent. ...Is there a better way? Should we study these mortgages on a case-by-case basis? Perhaps -- but the industry has little incentive to make the investments to deal with such complexities. ... This simply isn't realistic.
The other option is to have the government pony up even more cash to facilitate the process, with the intent of simply shrinking the potential pool of applicants. And of course we will still have the legal and ethical minefield to negotiate as we work to rescue people from their own really bad financial decisions.
If this sounds like a hopeless situation, you know what? It is! And it is about time we have an honest and open discussion that acknowledges the hopelessness and stops using expensive knee-jerk policies in place of rational approaches. As a nation, we need to allow this process to take place naturally.
Do we need to worry about empty homes and depressed neighborhoods? Sure. But this process is much easier on the back end than the front. How about a national tax break for buying not just any home, but only a foreclosed property? How about generating a new group of potential buyers by simply not allowing current defaults to be recorded on people's credit reports? How about streamlining the foreclosure process, making it quicker and easier for banks to clear properties and find a new buyers, thus reducing their losses?
And most important, we need to think ahead to the changes that need to be made so that we never end up with such a mess again. ...
Government inaction would only prolong the pain
Counterpoint: Richard K. Green
I disagree with you on a number of points, Chris.
First, we do have precedent for what is happening now: the Great Depression. While data from that time aren't as good as we would like, we do know that during the early 1930s, home prices fell at a rate similar to today and unemployment was considerably higher. Housing construction declined by 90% from peak to trough (if January's construction number is representative for the year to come, we are at about an 80% peak-to-trough decline now). Despite this, the federal government at the time developed a mortgage modification program that worked rather well, about which I will say more soon.
Second, I continue to think some of the older models of mortgage default are informative. University of Michigan economist Robert Van Order and National University of Singapore economist Yongheng Deng (among others) calibrated sophisticated models of default that looked at markets (such as Texas in the 1980s and California in the early 1990s) that went through substantial price declines. Although I agree that the new world in which we live means we should be modest about how much we actually know, it doesn't mean we should ignore the work that has been done before. The idea that families will not default if they have an equity stake in their house remains compelling to me.
Third, for the government to largely stand back and let nature take its course is, in my view, a really bad idea. Prices have fallen enough in many places that the cash-flow cost of owning now looks very favorable relative to renting -- at least by historical standards. Yet existing and new home sales in January were abysmal. Why? People lack confidence in the future. The Reuters-University of Michigan consumer confidence index is near a 28-year low. Even people who once considered themselves to be recession-proof fear they will be laid off. Under such circumstances, I am not sure we can expect people to run and buy homes whose occupants are in default.
I have long been an admirer of John Maynard Keynes, who talked about the importance of animal spirits to economic health. I do not see Americans' animal spirits recovering until house prices stop dropping. Prices will not stop declining until inventories stop rising. While home builders are doing their part (they have stopped building), allowing many more foreclosures to occur will not help this process.
During the Great Depression, the Roosevelt White House rolled out the Federal Housing Administration to insure mortgages and the Home Owners' Loan Corp. to buy defaulted mortgages. The HOLC bought the mortgages from lenders at prices below the value of the houses that were collateralizing the mortgages. It then modified payments, changing interest-only mortgages with balloon payments into 20-year self-amortizing mortgages. The HOLC worked: It bought mortgages from only 1933 to 1936, but it bought a large number during these years. It put itself out of business when the last mortgage it bought was retired in 1951. The program reduced the default rate on these mortgages by 90%. Because the government could borrow so cheaply, the HOLC actually turned a small profit for taxpayers.
To me, the HOLC (perhaps modified to include a claw-back provision) is the model for going forward
I'm between classes, so here's a few quick takes from here and there on the housing proposal:
A good plan, except.., by Richard Green:. I just watched the President outline his mortgage plan. I think it has two of the three key elements necessary: it will get people's loan balance below the value of their houses, and it will reduce payments to a sustainable level. What is missing (or at least I think it is missing), is a clawback provision for those homeowners who get a subsidized loan and then profit on sale later. I think this is critical for fairness. But perhaps I have just not digested the details of the plan yet.
It was so refreshing to see a President explain things so well, though...
Comments on Housing Plan, by Calculated Risk: There are three parts to the plan. For each part, I'll provide the Obama administration overview (from the WSJ) and then add some comments ... my objections are to part #2. [...continue reading...]
Housing repair, Free Exchange: Today, president Obama unveiled his long-awaited housing plan... the White House has provided a convenient four-page fact sheet (in PDF form)... Very generally speaking, there are three parts.
First, the administration will increase the number of homeowners able to refinance at current, low mortgage rates. Borrowers whose mortgages are owned or guaranteed by Fannie Mae or Freddie Mac will be able to refinance a loan up to 105% of the home's value (up from 80%, previously). This is expected to help about 4 to 5 million households... This seems like a reasonable step to take, though as Calculated Risk notes, it's a bit of a lottery. Those whose mortgages haven't been purchased by Fannie or Freddie are basically out of luck.
The second part is the one that's grabbed headlines; the president has dedicated $75 billion toward efforts to prevent foreclosures. Chief among these efforts is a plan to reduce monthly payments for troubled borrowers. For those spending greater than 38% of their income on mortgage payments, up to 43%, the government will ask lenders to reduce interest rates to bring payments down to the 38% level. The government will then match lender dollars, one-for-one, in bringing down interest payments until the borrower is only spending 31% of income. Both borrower and lender will be eligible for $1000 payments when payments are reworked, and if the planned payments are made. If it's necessary to reduce principle, then Treasury will provide assistance with this, as well.
This portion of the plan has drawn criticism, since many homeowners with too-large payments are those who took on irresponsible loan structures or who simply purchased too much house—who behaved irresponsibly... Ideally, officials would no doubt prefer not to help such borrowers... But frankly, that's not a top concern of mine. Rather, I'm interested in whether or not this is the best way to use $75 billion to halt foreclosures.
On that score, this is probably one of the better among a list of not-so-good options. Calculated Risk worries that this will only delay foreclosure, since interest payments are being reduced first, and principle written down only as a last resort... Perhaps, but by trying to leave principle alone, the government is avoiding excessive transfers of wealth to borrowers. ...
The final portion of the plan involves measures to "strengthen" Fannie and Freddie and to keep mortgage credit available and fairly cheap. All told, the plan will be funded to the tune of about $200 billion.
By itself, the plan is unlikely to turn the tide. In combination with the stimulus, the bank rescue, and the collapse in home construction, it has a chance. ...
Housing plan: "Clever," "smart," and "elegant", by Andrew Leonard: Some early, and mostly positive, reactions to President Obama's new Housing Affordability and Stability plan: The New York Times dubbed it "more ambitious than many housing analysts had expected," and "marks a sharp break from the housing policies of Mr. Obama's predecessor, George W. Bush." Felix Salmon, the influential financial blogger at Portfolio.com, described it as "quite elegant," and added that the "plan aims straight at the heartland, where it really matters." ...
At Tapped, The American Prospect's group blog, Tim Fernholz interviewed Barbara Sard, the director of housing policy at the Center for Budget and Policy Priorities, who said "the plan looks very good in a number of respects," and calls the various government incentives aimed at encouraging servicers to modify loan terms "smart" and "clever."
Barry Ritholtz at The Big Picture called it "a little better than I expected, but it still dances around an issue that is sacrilegious to many economists: Home prices are still way too high for any stabilization and/or housing bottom to form."
At Calculated Risk, the chief objection is that, while the plan explicitly aims not to bail out speculators or housing "flippers," it will still end up helping people who knowingly took on mortgages that under normal circumstances they could never afford. This is a valid criticism: Some people who don't deserve government will get it.
My own feeling is that it would be impossible to design a plan strong enough to provide any real stabilization to the housing sector that did not help out people who took advantage of exotic mortgage products and subprime lending standards to get into their McMansions. But the potential benefits for the economy as a whole from a successfully executed plan outweigh that drawback, in my view. The more critical dilemma is whether the plan is powerful enough to achieve its stated goals. The Obama administration plans to use $75 billion of TARP funds to pay for the incentives that will grease the desired loan modifications, and is extending another $200 billion to Fannie Mae and Freddie Mac via funding previously authorized by Congress. It seems clear that the Obama team is looking for ways to get the most bang for the buck, and $275 billion is nothing to sneeze at. But whether or not there is a thrifty way out of our current morass is still quite open to question. [Also: Obama's shiny new housing plan, by Andrew Leonard.]
And Now Homeowners, by Robert Reich: The two most important features of the administration's plan to help homeowners are (1) its support for amending bankruptcy laws to allow judges to modify mortgages. This will give homeowners bargaining leverage with mortgage servicers (and give the servicers more leverage with securitized creditors on up the line) to get better terms; and (2) a massive expansion of the government's commitment to Fannie Mae and Freddie Mac -- allowing F&F to buy more mortgages by increasing the government's guarantee against losses to $400 billion. ...
The Obama plan will help prevent a tsunami of foreclosures this year and next, but no one knows how big the wave may get notwithstanding. Nationwide, home prices have fallen 17.5 percent... But ... home prices probably could easily fall another 5 to 10 percent before bottom is reached.
And then what? Whether we're talking about the bailout of Wall Street, of the auto industry, or of homeowners, the biggest questions are (1) how long will it be until the business cycle turns up again? and (2) how long until the median value of financial assets, the demand for automobiles produced by the Big Three, and median home prices all return to where they were at the height of the bubble?
The answer to (1) is likely to be a year or two. But a turnaround is just the beginning. Taxpayers who are shelling out trillions of dollars (including, indirectly, commitments by the Federal Reserve Board), as well as people who are saving for retirement, many autoworkers, and a large number of homeowners won't be -- or feel -- safe until the economy at least returns to where it was in early 2007, and then continues to move upward from there. When will this be? It may take five to ten years, or longer; as to the Big Three, maybe never.
Obama’s Housing Plan: Who Will Benefit?, by David Leonhardt: In his speech in Phoenix today, President Obama emphasized that his plan would help those homeowners who had acted responsibly. “It will not rescue the unscrupulous or irresponsible,” Mr. Obama said. “And it will not reward folks who bought homes they knew from the beginning they would never be able to afford.”
The political reasons to describe the plan in this way are obvious. ...
But the lines aren’t quite as clear as Mr. Obama suggested. In fact, his plan will end up helping a fair number of people who bought homes that they should have known they would never be able to afford. ... Which homeowners will benefit from this reduction?
Certainly, some who took out a reasonable mortgage and later lost their job will be helped. But people who bought too much house — and banks that allowed people to do so, or even encouraged them to do so — will also benefit. As distasteful as this may be, it’s the only way to make a serious dent in foreclosures and, in the process, to help the financial system.
These same political calculations help explain the public emphasis that the White House is giving to the relatively modest steps it is taking to help underwater homeowners — those with a mortgage worth more than the value of their house — who can afford their monthly payments.
These homeowners ... seem like innocent victims of the housing crash. The new plan will help some of them refinance their mortgage at a lower rate. But only loans backed by Fannie Mae and Freddie Mac — not many of the subprime loans at the heart of the foreclosure problem — will be eligible. ...
In fact, the number of homeowners that the White House estimates will be helped by the refinancing part of the plan — between four and five million — includes many who are not now underwater. Their mortgages are worth between 80 percent and 100 percent of their house value, which means they are above water but cannot refinance. (On many refinancings, banks require the equivalent of a 20 percent down payment, in the form of house value.)
So this plan will not help most underwater homeowners, and it will provide only a modest subsidy to those it does help. But as I wrote this morning, such an approach has many advantages. About $500 billion worth of mortgage debt is now underwater, and the number may eventually get close to $1 trillion. A plan that tried to put this debt back above water would be vastly more expensive... It would also deliver less bang for the buck, since a great majority of underwater homeowners are likely to continue making their monthly payments.
Obama's Housing Plan Unveiled, by Felix Salmon: I have to say I like the look of Obama's housing-bailout plan. It's quite elegant, and makes full use of the fact that Fannie and Freddie are now owned by the US government -- which means they can be forced to offer 105% loan-to-value mortgages even when the borrower isn't creditworthy at all.
Obviously, all of this comes at a cost to the US government: the figures being bandied around today range from $75 billion in the NYT to $275 billion at Bloomberg. But really nobody has a clue how much it will cost: that's entirely dependent on whether or not the plan succeeds in arresting the fall of house prices.
I especially like the idea of offering loan servicers $500 if they modify a loan before it becomes delinquent, especially if it's accompanied by an easy and streamlined mechanism for getting such modification requests into the Fannie and Freddie systems.
This plan isn't designed to directly help borrowers who are massively underwater: if your first mortgage is more than 105% of the value of your house, you're ineligible. That will help reduce some of the costs to the government, and move them over to the lenders, who now look as though they will be bailed in to bankruptcy proceedings -- a long-overdue development.
Incidentally, this plan is certain to increase the astonishingly high delinquency rates on non-agency mortgages, since it's basically designed to take most of the remotely viable non-agency mortgages and refinance them into agency mortgages, leaving only the complete and utter nuclear waste behind.
So far, there's not even a glimmer of a plan for how to get private-sector lenders back into the mortgage market in any significant quantity -- and that's going to hurt markets like Manhattan, where most mortgages are non-conforming. But Manhattan property owners are rich enough to look after themselves. This plan aims straight at the heartland, where it really matters. It's a good start, but it might well yet prove to be insufficient. We'll see.
Update: Tyler Cowen rounds up more reactions, and adds his own.
From the SF Fed:
House Prices and Bank Loan Performance, by John Krainer, FRBSF Economic Letter: The current financial crisis in the United States has its roots in falling real estate values. Indeed, a number of studies have shown a strong link between house price depreciation and defaults on residential mortgages (Doms, Furlong, and Krainer 2007). This Economic Letter reports on new research (Krainer 2008), which looks at the performance of commercial banks and finds further evidence on this link. The study also finds that the performance of land development and construction loans is even more sensitive to house prices than the performance of residential mortgages, consistent with very high delinquency rates on the former set of loans. At the same time, the study finds little evidence that spillovers from falling house prices have materially affected the performance of other types of loan categories at commercial banks.
Continue reading "FRBSF: House Prices and Bank Loan Performance" »
Ed Glaeser:
The GOP Has a Dumb Mortgage Idea, by Ed Gleser, Commentary, WSJ: ...Today, the Senate Republicans bear the heavy burden of providing the primary check on one-party rule in America. For that reason, it is particularly disappointing to see Senate Minority Leader Mitch McConnell embrace "providing government-backed, 4% fixed mortgages to any credit-worthy borrower" as his alternative to the Barack Obama/Nancy Pelosi stimulus package. ...[T]his idea is bad economics...
We are in the ruins of a housing market made worse by subsidized lending. The government has no business egging people on to borrow as much as possible to bet on housing prices. There is plenty of room to criticize the current stimulus plan, but Republicans need to adopt Ronald Reagan or Dwight D. Eisenhower, not Harold Ickes, as their intellectual role model.
One attractive, Reagan-like alternative to the stimulus package is to focus on a temporary reduction in the payroll tax, particularly for less wealthy Americans who are most likely to spend the money quickly. ... It would be both libertarian and egalitarian.
A second alternative is to be like Ike and embrace public investment in human and physical capital. Republicans could distinguish themselves from their opponents by insisting that investment put national interest ahead of parochial politics. Republicans could insist on cost-benefit analysis and emphasize investments that will make it more likely that the U.S. will remain an economic leader in the world.
Our country needs a robust two-party system, and the Senate Republicans are our best chance for healthy political debate. However, when they abandon economic sense and party tradition for a mortgage plan that will be wildly expensive and ineffective, they do neither their party nor their country any good.
And the good ideas don't end there:
Tax break for homebuyers?, by Tyler Cowen: I'm not sure I understand the proposal, but here is what the NYT says:
The Senate on Wednesday voted to expand the economic stimulus package with a tax credit for homebuyers of up to $15,000, a provision championed by Republicans as addressing a root cause of the recession.
Like Arnold Kling, I wish to shift the economy out of housing, not into it again. ... So far I say boo to the Republicans. ...
Susan Woodard and Robert Hall on what should happen to Fannie and Freddie:
What to do about Fannie Mae and Freddie Mac?, by Woodard and Hall: Here are our recommendations. A discussion follows.
- The GSEs should be preserved, mainly because they are the most effective institutions for providing liquidity to the mortgage market. Most mortgage investors, including depositories, prefer to hold liquid securities rather than illiquid whole loans. Wall Street securitization is not a substitute.
- Fannie and Freddie should be chartered as special-purpose banks, playing their historical roles of securitizing mortgages and holding some portfolio of loans. Their debt should be federally insured or guaranteed, as are the deposits of banks, and as with banks, the equity of the institutions should be the first backup to bondholders as the capital (or equity) of banks is the first backup to deposits. Their insured or guaranteed debt should not be counted as part of federal debt, as the insured deposits of banks are not. They should be subject to capital standards and supervision of their activities, and subject to restrictions on their activities, like banks. The capital standards, activity restrictions, and supervision need not be identical to those of banks.
- It is important to have two GSEs to assure competitive pricing of the guarantees on mortgages which go into MBS pools. Guarantee fees are not posted prices, but negotiated in secret. As a result, the pricing of guarantee fees is not collusive but close to perfect (Bertrand) competition with two GSEs. In the trade-off of standardization and homogeneity to promote liquidity (which calls for fewer GSEs) vs. competition to assure competitive pricing (which calls for more), two gets an excellent result, likely the best result.
- There are three choices for F&F ownership: 1) owned by the government, like FHA and Ginnie Mae; 2) owned as a cooperative, by member institutions, as both once were, and 3) owned by the general public. Fannie and Freddie should be owned by public shareholders, as banks are. We advocate ownership as public companies, but with explicit and priced federal backing, like banks.
[Update: Arnold Kling comments on Woodard and Hall's analysis (agrees) and policy proposals (disagrees).]
[Update: See also On the GSEs (again), by Richard Green.]
James Kwak says it's likely that the new administration will get behind the Hubbard and Mayer plan to have Fannie and Freddie buy mortgages and refinance them at 4.5%:
We Have a Winner?, by James Kwak: After seeing dozens of mortgage proposals emerge over the past several months, there are news stories that Larry Summers and the Obama economic team are converging on an unlikely candidate: the proposal by Glenn Hubbard and Christopher Mayer... Hubbard and Mayer published a summary of the plan in the WSJ last week; a longer version of the op-ed is available from their web site; and you can also download the full paper, with all the models.
I say “unlikely” not only because Hubbard was the chairman of President Bush’s Council of Economic Advisors, but because it doesn’t look like a Democratic plan; then again, it doesn’t look much like a Republican plan, either. ... Before getting to the policy specifics, though, I want to outline two of the premises...
Continue reading ""Effective Nationalization of the Mortgage Finance Sector"" »
James Kwak has had enough of people trying to blame the financial crisis on government attempts to help poor people through the Community Reinvestment Act:
Community Reinvestment Act Makes Bankers Stupid, According to AEI Research, by James Kwak: One might have hoped that one collateral benefit of the end of the election season would be the end of the attempt to pin the financial crisis on the Community Reinvestment Act, a 1970s law designed to prohibit redlining (the widespread practice of not lending money to people in poor neighborhoods). Unfortunately, Peter Wallison at the American Enterprise Institute ... has proven that some people will never give up in their fight to prove that the real source of society’s ills is government attempts to help poor people. Regular readers hopefully realize that we almost never raise political topics here, but sometimes I just get too frustrated. ...
This research is from the NY Fed. It finds that bankruptcy reform shifted default risk from credit card lenders to mortgage lenders and in doing so increased the number of foreclosures:
Seismic Effects of the Bankruptcy Reform, by Donald P. Morgan, Benjamin Iverson, and Matthew Botsch, Federal Reserve Bank of New York Staff Reports, no. 358, November 2008: Is it just coincidence that the surge in subprime foreclosures that has rocked financial markets came right after the bankruptcy reform in 2005 (Chart 1)? Is that surge just about falling home prices, bad mortgage decisions, and weak economic conditions? No and no. Indeed, we would be surprised if the answers were otherwise. Bankruptcy is about protection, after all, and foreclosure is what mortgagors most want to protect against. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the first overhaul of U.S. personal bankruptcy law in over a quarter century, made filing bankruptcy much less protective and much more expensive. How could that not matter?
Our specific argument is that the bankruptcy abuse reform (BAR) contributed to the surge in subprime foreclosures by shifting risk from credit card lenders to mortgage lenders. Before BAR, any household could file Ch. 7 bankruptcy and have credit cards and other unsecured debts discharged. Sidestepping unsecured debts left more income to pay the mortgage. BAR blocked that maneuver by way of a means test that forces better-off households who demand bankruptcy to file Ch. 13, where they must continue paying unsecured lenders. When the means test binds, cash constrained mortgagors who might have saved their home by filing Ch. 7 are more likely to face foreclosure. ...
The estimated impact of BAR on subprime foreclosures is substantial. [It] translates to just over 32,000 more subprime foreclosures nationwide per quarter due to BAR. Auxiliary findings suggest BAR also contributed to subprime foreclosures through another channel. Before BAR, the difference between the par value of an automobile loan and the current value of the automobile securing the loan could be discharged under bankruptcy.
BAR prohibits cram-down for cars owned less than 910 days. ... BAR contributed to foreclosures on subprime mortgagors by making auto lenders more secure. ...
Taken together, our research adds the bankruptcy reform to the list of reasons why subprime foreclosures surged. ...
There have been nearly twelve quarters since BAC went into effect in January 2006, call it 11 2/3. At 32,000 extra foreclosures per quarter, that comes to a bit over 373,000 additional foreclosures due to the new bankruptcy reform law.
That's on the negative side, but credit card companies are probably better off, and credit card abuse may be down. So what's the impact overall?:
The welfare impact of BAR is beyond our ken. That calculus depends firstly on the tradeoff between the insurance that soft bankruptcy laws provide and the moral hazard (abuse) such insurance invites, and secondly on how successfully BAR curbs bankruptcy abuse.
So it comes down to, basically, a comparison of the insurance benefit that is available when unforeseen catastrophic events hit a household (e.g. health problems), and the abuse induced by moral hazard. I place a high premium on the insurance value, and would rather leave it to the credit card companies to monitor credit more effectively instead of having them rely upon courts to do it for them, so I see the welfare change as negative.
Calculated Risk:
Tanta Passes Away: My dear friend and co-blogger Doris “Tanta” Dungey passed away early this morning. I would like to express my deepest condolences to her family and friends. ... David Streitfeld at the NY Times: Doris Dungey, Prescient Finance Blogger, Dies at 47 ... This is a very sad day...
Dean Baker will wonder why he was left off this list:
The vision thing, by Chris Giles, Commentary, Financial Times: It has been a bad year for economic forecasters. So bad that royalty wants to know what went wrong. “Why did no one see it coming?” Britain’s Queen Elizabeth asked during a visit to the London School of Economics this month. ...
Though there is great entertainment in looking back at the silly things economists have said, more is to be gained by examining the particular failings that contributed to forecasters’ general inability to warn of the current mess.
First is the unforeseen, but now evident, fragility of the global economy in the face of a systemic banking collapse. ... Second, as Stephen King, chief economist of HSBC, says: “Almost all economic models assume that the financial system ‘works’.” ...
Third was the deep squeeze on household and corporate incomes from the commodity boom of the first half of 2008, which almost no one predicted. This weakened the non-financial sector before banks had any chance to repair the damage from the subprime crisis...
Fourth, most economic models suggest the demand for money will be stable, but banks and households have now begun to hoard cash. This threatens to make monetary policy ineffective..., something that is not generally factored into forecasting models.
Fifth is an over-reliance on the output gap – the difference between the level of output and an estimate of what is sustainable – in forecasting. That allowed policymakers to believe everything was fine ... because inflation was under control and growth was not excessive.
Sixth is the natural tendency to seek rationales for events as they unfold, rather than question whether they are sustainable. ...
Mention must ... be given to the notable voices of doom, who got important bits of the puzzle correct even if the timing or other details eluded them. Prof Roubini ... wrote a paper with Brad Setser in August 2004 predicting that the world’s trade imbalances were unsustainable and likely to “crack the system in the next three to four years”. He has been prescient in understanding the links between financial markets and the real economy.
William White, the former chief economist of the Bank for International Settlements, the central bankers’ bank in Basel, Switzerland, was a persistent critic of lax monetary policy and the failure to stem credit expansion. Prof Rogoff also spotted the dangers of unsustainable global economic expansion in a 2004 paper with Maurice Obstfeld. In more recent work with Carmen Reinhart he has highlighted how policymakers fell into the “this time it’s different” trap that dates back to England’s 14th-century default.
Prof Persaud has made an honest living for many years warning about the fallibility of value-at-risk models and the tendency for them to encourage herd behaviour. And in the FT’s new year survey of economists for 2008, Wynne Godley of Cambridge university, also a permanent bear, said: “I think the seizing up of financial markets may well result in a collapse in lending in the US to the non-financial sector so large that it causes a recession deeper and more stubborn than any other for decades – and deeper than anyone else is expecting.” Quite.
Policymakers, too, have been far from consistently wrong. Mr Trichet dines out on stories of how he predicted the crisis and cites a Financial Times article as evidence... Mr King warned for years about the risks evident in the global economy and the IMF repeatedly warned about the unsustainable level of house prices.
Willem Buiter ... warns not to be too impressed by some forecasts that have turned out to be true, because they were lucky, not wise. “Hindsight is useless,” Prof Buiter insists. ...
Predictive Models: Blown Off Course by Butterflies
In the 1980s, it seemed that computers held the key to economic forecasting, writes John Kay. With large models and sufficient processing power, predictions would become more and more accurate.
This dream did not last long. We now understand that economies are complex, dynamic, non-linear systems...
So economic crystal ball-gazing remains unscientific. The trend is the forecaster’s friend. Extrapolation assumes that the future will be like the past, only more so. We project current preoccupations ... with exaggerated speed and to an exaggerated degree. ...
If extrapolation is the forecaster’s friend, mean reversion is the forecaster’s crutch. Much of the time, you can predict that next year’s figure will be somewhere between this year’s level and the long-run average. But mean reversion never anticipates anything out of the ordinary. Every few years, out-of-the-ordinary things happen. They just have.
Still, you might think there would be large rewards for those who succeed in anticipating these events. You would be wrong. People who worried before 2000 that the “new economy” was a bubble, or warned of the terrorist threat before September 11 2001, or saw that credit expansion was out of control in 2006, were not popular. They were killjoys.
Nor were they popular after these events. If these people had been right, then others had been blind or negligent, and the latter preferred to represent themselves as victims of unforeseeable events. As John Maynard Keynes observed, it is usually better to be conventionally wrong than unconventionally right.
I was kind of disappointed that Martin Feldstein didn't complete the hat trick by also getting an op-ed into the NY Times:
A Chapter For Detroit To Open, by Martin Feldstein, Commentary, Washington Post: The Big Three U.S. automakers need more than an injection of $25 billion from the federal government. Because of their ongoing losses, they would burn through that money in less than a year and would soon be back for more.
General Motors, Ford and Chrysler can make excellent cars, but they cannot sell them at prices that are competitive... The basic reason is the labor costs imposed by union contracts. ... And the health-care costs of current workers and retired union members are an enormous additional burden.
The simplest solution is ... bankruptcy. ... The bankruptcy court could require the unions to rewrite contracts... The firms' bondholders and other creditors would have to take losses. ... The claim that bankruptcy would mean the loss of millions of jobs is nonsense intended to scare the public and force legislators and the Bush administration to throw money at the auto industry's problems. ...
The goal should be to put the companies on a course that will allow them to survive for the long term... Administering bitter medicine is difficult for politicians. President Bush would do his successor a favor by forcing such a restructuring. It would relieve Obama of his promise to help the auto companies and in a way that improves prospects for the American automobile industry.
And:
How to Help People Whose Home Values Are Underwater, by Martin Feldstein, Commentary, Wall Street Journal: More than 12 million homeowners now have mortgage debt that exceeds the value of their homes. These negative-equity homeowners have an incentive to default because mortgages are generally "no recourse" loans. ... As a result, mortgage default rates are now rising rapidly and are expected to go much higher. ...
If house prices continue to fall at the current rate for the next 12 months, as experts generally expect, ... a very high fraction of negative-equity homeowners are likely to default. ... This is the primary cause of the dysfunctional credit markets. None of the existing proposals to help homeowners with negative equity would eliminate the incentive to default. ...
The key to preventing further defaults and foreclosures among current negative-equity homeowners is to shift those mortgages into loans with full recourse, allowing the creditor to take other property or a fraction of wages. ... Substituting a full-recourse loan requires the inducement of a substantial write-down in the outstanding loan balance. Creditors have an incentive to accept some write-down in exchange for the much greater security of a full-recourse loan. The government can bridge the gap between the maximum write-down that the creditor would accept and the minimum write-down that the homeowner requires to give up his current right to walk away from his debt. ...
With 12 million negative-equity homes and an average negative equity gap of $40,000, the total cost to the taxpayers of taking one-third of the losses would be no more than $156 billion. ...
The prospect of a downward spiral of house prices is the major risk facing financial institutions. It is also a primary source of the further falls in household wealth that will reduce consumer spending and depress the economy. Providing an incentive to shift the current negative-equity loans to full-recourse mortgages -- while also injecting mortgage-replacement loans to stabilize the current positive-equity mortgages -- should be Barack Obama's highest priority as he seeks to stabilize the economy.
One big concern I've had about the financial crisis is that it would result in some middle and lower income buyers being excluded from the home ownership market even though those individuals are relatively low risk. So I'm glad to see this type of activity expanding:
The Subprime Good Guys, by Daniel Gross, Commentary, Slate: In recent months, conservative economists and editorialists have tried to pin the blame for the international financial mess on subprime lending and subprime borrowers. If bureaucrats and social activists hadn't pressured firms to lend to the working poor, the story goes, we'd still be partying like it was 2005 and Bear Stearns would be a going concern. The Wall Street Journal's editorial page has repeatedly heaped blame on the Community Reinvestment Act... Fox Business Network anchor Neil Cavuto ... proclaimed that "loaning to minorities and risky folks is a disaster."
This line of reasoning is absurd for several reasons. Many of the biggest subprime lenders weren't banks and thus weren't covered by the CRA. Nobody forced Bear Stearns to borrow $33 for every $1 of assets it had, and Fannie Mae and Freddie Mac didn't coerce highly compensated CEOs into rolling out no-money-down, exploding adjustable-rate mortgages. Banks will lose just as much money lending to really rich white guys like former Lehman Bros. CEO Richard Fuld as they will lending to poor people of color in the South Bronx.
But the best refutation may come from Douglas Bystry, president and CEO of Clearinghouse CDFI (community-development financial institution). Since 2003, this for-profit firm based in Orange County ... has issued $220 million worth of mortgages in the Golden State's subprime killing fields. More than 90 percent of its home loans have gone to first-time buyers, about half of whom are minorities. Out of 770 single-family loans it has made, how many foreclosures have there been? "As far as we know," says Bystry, "seven." Last year Clearinghouse reported a $1.4 million pretax profit.
Community-development banks, credit unions, and other CDFIs—a mixture of faith-based and secular, for-profit and not-for-profit organizations—constitute what might be called the "ethical subprime lending" industry. Even amid the worst housing crisis since the 1930s, many of these institutions sport healthy payback rates. ... Their numbers include tiny startups and veterans such as Chicago's ShoreBank, founded in 1973, which now has $2.3 billion in assets... Cliff Rosenthal, CEO of the National Federation of Community Development Credit Unions, notes that ... "delinquent loans are about 3.1 percent of assets." In the second quarter, by contrast, the national delinquency rate on subprime loans was 18.7 percent. ...
In order to keep their doors open, they have to charge appropriate rates—slightly higher than those on prime, conforming loans—and manage risk properly. ... What sets the "good" subprime lenders apart is that they never bought into all the perverse incentives and "innovations" of the bad subprime lending system—the fees paid to mortgage brokers, the fancy offices, and the reliance on securitization. Like a bunch of present-day George Baileys, ethical subprime lenders evaluate applications carefully, don't pay brokers big fees to rope customers into high-interest loans, and mostly hold onto the loans they make rather than reselling them. ... Clearinghouse's borrowers must qualify for the fixed-rate mortgages they take out. "If one of our employees pushed someone into a house they couldn't afford, they would be fired," says CEO Douglas Bystry. ...
"We're in business to improve people's lives and do asset building," says Linda Levy, CEO of the Lower East Side People's Federal Credit Union. ... The average balance in its savings accounts is $1,400. The typical member? "A Hispanic woman from either Puerto Rico or the Dominican Republic in her late 40s or early 50s, on government assistance, with a bunch of kids," Levy says. Sure sounds like subprime. But the delinquency rate on its portfolio of mortgage and consumer loans is 2.3 percent, and it's never had a foreclosure.
Ethical subprime lenders have to look beyond credit scores and algorithms when making lending judgments. Homewise, based in Santa Fe, N.M., which lends to first-time, working-class home buyers, makes credit decisions based in part on whether borrowers have scraped together a 2 percent down payment. ... Of the 500 loans on Homewise's books in September, only 0.6 percent were 90 days late. That compares with 2.35 percent of all prime mortgages nationwide. ...
Ethical subprime lenders are now expanding beyond mortgages. ... Lending ... money carefully and responsibly to working-class people isn't a recipe for riches or grand executive living. ... Bystry, the CEO of Clearinghouse CDFI, earns a salary of $190,000 .... (Angelo Mozilo, former CEO of Countrywide Financial, was paid $22.1 million in 2007.) For all the growth, this remains very much a niche industry.
Still, the mortgage crisis has provided an opportunity for ethical subprime lenders to expand. ShoreBank has added staffers and in August 2007 rolled out a Rescue Loan program, which aims to move borrowers out of expensive adjustable-rate mortgages into fixed-rate loans. "We really believe we can help people caught in these bad mortgages,"...
Not too long ago, in response to a suggestion for a mortgage foreclosure voucher program, I said:
Whatever plan is ultimately implemented to stave off foreclosures, should taxpayers demand a share of any profit (equity) the bailed out homeowner makes if the house is sold later, much like the equity stakes taxpayers will have in banks that are bailed out? ...
My impression from comments is that people do not favor this approach.
Here's Andrew Caplin , Thomas Cooley , Noel Cunningham and Mitchell Engler in the WSJ:
We Can Keep People in Their Homes: ...[W]hile the rescue plan may help the balance sheets of financial institutions, it does nothing to help the balance sheets of households. Their problems must be addressed.
The way to do so is through the shared appreciation mortgage, or SAM. The concept is simple: Homeowners are offered the chance to write down a portion of their mortgage debt, but at the same time, they are required to share future appreciation gains with those who helped them out. ...
By the time housing prices stabilize, as many as 20 million households may be upside down on their mortgages, creating incentives to default.
These defaults set in motion a vicious cycle. Foreclosure is a slow and costly process. Foreclosed properties diminish the worth of nearby homes, driving yet more homeowners into default. Taxpayers are the next casualties. ...
The federal government needs to give taxpayers an ownership stake in the future. The SAM does just this. For example, a homeowner unable to support payments on a house purchased for $200,000 that today is worth only $150,000 might be offered a write-down of up to $50,000. But this would not be a free lunch.
With the SAM, once the value began appreciating above $150,000, the mortgage holders would be due their share. ...[O]ne way to give lenders a share of the upside would be to pay back some of the write down if the house is later sold, in the scenario above, for more than $150,000. This is a model in which both parties benefit, preventing default while giving future taxpayers a fighting chance at some real upside to the investment we're forcing on them. ...
The SAM was pioneered by banks in the U.S. some 40 years ago, but it has been allowed to languish due to an archaic, IRS-imposed block. (The IRS hasn't ruled whether such a contract is a mortgage because it combines elements of equity and debt.) This block could be removed at the stroke of the Treasury secretary's pen. ...
If someone has been paying rent month after month, year after year, and has a good credit record, it seems to me there ought to be some way for them to buy a house.
We are about to start passing rules and regulations to try to prevent another financial crisis from happening, and I don't want to see people excluded from home ownership unnecessarily. I know it's unfashionable to stick up for the poor right now, to advocate for increased home ownership, and in particular to say that it was not a mistake to try to increase home ownership rates at lower income levels, but (1) poor households didn't cause the financial crisis, though in many cases they were victims of it, and (2) it's the right thing to do in any case.
One thing I hear is that lower income households should just rent, as though that's equivalent to owning a home except for the financial arrangement. But renting is not the same as owning a home. I'm not saying one is better than the other, though I have a preference, but they are different. Each has advantages and disadvantages that suit different preferences, and those who prefer ownership shouldn't be needlessly excluded.
I would be willing to pay quite a bit not to have to ask if I can paint a bedroom the color that I want, change the landscaping, hang a picture securely on the wall, have a dog or a cat, not to even have to think about whether something is okay or not with the owner if I want to change it. I don't want to have to let someone in with 24 hours notice. If I want a basketball hoop above the garage, that's my choice. As an owner, I don't have to worry about my rent going up over time - I can lock into a fixed payment - or not having the lease renewed because the landlord has decided to do something else with the property.
However, if the roof leaks, the hot water heater stops working, a pipe breaks, anything like that, then it's my responsibility to pay for it. If I want to move it's a lot harder, I can't just give notice, pack up and go once the lease ends. Instead I have to worry about selling my house, and maybe losing money on it.
But there's something about owning I can't quite explain, but it's different, at least to me. I don't like that, when I rent, I'm only able to live somewhere so long as someone else gives me permission to do so. As long as I make my house payment every month, I have a place to live. Always. I don't know why that is comforting, but it is.
If we, say, require a 10% or 20% down payment for all buyers, that will impose a substantial barrier to purchasing a home. Many people can get access to a down payment somehow - real estate agents will fill you in on tricks such as how to borrow the money from family and have it look like a gift - but many others don't have access to those resources, and saving money when you are living close to the edge is not easy at all.
But what about all the lower income households who have never missed a rent payment, that have decent credit, but cannot possibly meet even, say, a 10% down payment hurdle, how do we ensure that they have a path to home ownership? They have shown themselves to be able to reliably pay a particular amount, and there ought to be a house they could buy with a similar payment profile.
I don't know the data well enough to conclude this for sure, but if my impression is correct, many of these households weren't sold houses they could afford, houses with payments, say, equivalent to the rent they had been paying. Instead, they were sold houses far above that rate, and probably sold a plan along with it for how they could meet the payments, and how they could escape if things didn't work out (since prices would, of course, continue rising). I don't know whose fault it is that the households ended up in highly risky positions that would, in many cases, lead to default - the homeowner surely wanted a dream house and to join in the money-making, the real estate agent certainly wanted a large sale since they earn more when the sales price is higher, the broker incentives were to get the deal done, and so on. But something went wrong and these households did not end up in the right houses, or with the right financial arrangements.
So let's fix that instead of excluding them from ownership. Households with a verifiable, reliable payment history and with decent credit need a way to buy a house if that's what they have their heart set on doing. But it has to be a house they can afford, the payments have to match their income and their rental history. The process has to ensure that this happens.
[Sketching something out quickly without intending to get every detail correct, perhaps something like the following would work. First, you only get one shot at this program. If you walk away or default, that's it, you can't ever use this program again. That probably means not buying a house again for a long, long time, if ever. The program would involve mortgage loans with minimal down payment requirements.
Second, if your household income is in the qualifying range, the government will grant you an equity stake in the house of, say, $5,000 (or pick an amount you like better). If you stay in the house for seven years or more, then the $5,000 is yours if you ever sell the house (perhaps as a tax credit). [There could be some payback mechanism if the homeowner makes an excessive amount on the sale, or not. Also, I don't like that there is an incentive to sell the house after seven years, so perhaps the $5,000 could go into an IRA or something similar if it is not used to purchase a new house, that way the cash would not be immediately available if the household went back to renting.]
Third, a big problem would be repairs - roofs, plumbing, that sort of thing. Big expenditures like that could cause problems and lead to default. Some sort of insurance against this could be made available and required as part of the house payment (along with co-pays to create better incentives but still keep the cost reasonable).
And so on, someone else can take the time to get all the details and incentives right, feel free to offer your own, but the main thing is to find a way to allow households with lower incomes to purchase a house with little or no down payment, yet still give the buyers some equity stake in the purchase so that they have something at risk giving them less incentive to walk away or default (hence the restriction on only using the program once).
There ought to be a way to get this done.]
Dean Baker on Greenspan's admission that he made a mistake in resisting regulation of credit markets:
Greenspan Follies: The World Is as Ayn Rand Would Have Predicted, by Dean Baker: Alan Greenspan has finally acknowledged that he may have made some mistakes in allowing an $8 trillion housing bubble to grow unchecked. (Look for rivers flowing upstream.)
This modest act of contrition should be welcomed, but analysts have been far too quick to describe Greenspan as a prisoner of his free market ideology and the current crisis as a story of the free market running wild. ...
First, insofar as Greenspan acted (or didn't act) out of ignorance of the true situation, it was because he was ignoring Ayn Rand, not because he was following her.
Let's set the stage. Bear Stearns, Goldman Sachs, Citigroup and the rest of the big banks are run by hotshot Ivy League business school types. These are bright, hard working ambitious people who want to make lots and lots of money.
The executives at these banks are sitting on enormous piles of money that they can get access to as a result of being at these huge banks. The hotshot executives know that they can get huge bonuses by taking risky gambles with the banks' money.
The executives can make bets, that if they pay off, will get tens of millions a year in bonuses and other compensation. Of course, if they lose they can bring down the house, meaning that they bankrupt Bear Stearns, Lehman, etc.
What would Ayn Rand expect to happen? On the one hand we have the hot shot executives, on the other hand the schmucks who own stock in these banks. Would Ayn Rand expect that the executives would put aside their ambition, their lust for success, their greed, in order to benefit shareholders who are too dumb to even know what a credit default swap is?
Not for a second; Ayn Rand would watch the Wall Street big boys run roughshod over their shareholders' interests and be applauding them every step of the way. That is how the game is played. If Greenspan didn't think the Wall Street crew would rip off their shareholders for every last penny, then he was not a worthy disciple of Ayn Rand.
As far as this being a story of the market having run amok, that is only partially true. The banks were able to get access to vast amounts of capital because everyone had faith in the "too big to fail" doctrine. In other words, all the people who lent Bear Stearns, Lehman, AIG, Goldman and the rest money felt secure because they thought the government would come to the rescue at the end of the day if the hotshots messed up big time.
With the exception of Lehman Brothers, these folks were right..., they were gambling with the taxpayers' money...
This is not to say that we would want a real free market in finance. It's not even clear what that would look like. But it is clear that Wall Street hotshots who brought us this disaster ... want to be able to operate with a government security blanket while not being required to contain risk or pay for this insurance. Calling them, or their patron Alan Greenspan, free market ideologues is far too generous.
I always wonder if the people making the decisions actually had these thoughts, i.e. if they explicitly made decisions based upon the assumption that there was a large possibility of a bailout if they blew things up. Do you think they did?
Update: Arnold Kling answers.
Tyler Cowen, contradicting Anna Schwartz, says it was private sector imperfections, not government policy that caused the imperfection. In particular, the Fed's decision to kep interest rates low is no the culprit:
Is the low Fed Funds rate to blame?, by Tyler Cowen: ...I don't side with Austrian Business Cycle Theory in citing loose monetary policy as the main factor in the artificial boom which preceded the crash. I view the boom as having been fueled by new global wealth, most of all in Asia, and the liquification of that wealth through credit and the desire for additional risk.
Note that if an increase in real wealth fuels the investment boom, consumption can be robust or even go up at the same time as the rise in investment. Now, in the boom preceding the current bust, was American consumption robust? Sure. If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here. (Try a rebuttal here.)
Loose monetary policy did contribute to the bubble. In that sense I would defend a modified Austrian theory. But other reasons also suggest that monetary policy was not the main driver. Money has a much bigger effect on short-term rates than long-term rates. Even long-term real rates have only mixed predictive power over real economic activity, including investment. The Austrians have never developed much of a theory of bubbles. Ideally you would have a good bubble theory, with Austrian-like monetary factors stirring up the bubble even more. But you can't get away with pinning so much of the blame on the government, as modern Austrians are wont to do. "Bubbliness" is a private sector imperfection and relabeling it as "government distorting price signals through monetary policy" doesn't much change that.
Speaking of trying to reassign the blame to government, Menzie Chinn says it wasn't Fannie and Freddie, and it wasn't the Community Reinvestment act, two of the three main points of attack for the 'government caused the problems' crowd (the Fed is the third target for those who want to blame government policy rather that the private sector) I will focus on the second part of Menzie's post - there's more in the original:
CRA and Fannie and Freddie as betes noire, by Menzie Chinn: There is so much chaff floating around about the roles of Fannie and Freddie and of the Community Reinvestment Act in the current crisis, despite the best efforts of economists like Jim Hamilton [0] [1], Mark Thoma and Janet Yellen, that it seems worthwhile to once again go through some of the arguments that have been forwarded. ...
What about the charge that Fannie and Freddie "made" the market so that all these subprime loans could be securitized? There's a grain of truth in there, but I think keeping in mind which loans are going bad is useful, when reading this excerpt.
This much is true. In an effort to promote affordable home ownership for minorities and rural whites, the Department of Housing and Urban Development set targets for Fannie and Freddie in 1992 to purchase low-income loans for sale into the secondary market that eventually reached this number: 52 percent of loans given to low-to moderate-income families.
To be sure, encouraging lower-income Americans to become homeowners gave unsophisticated borrowers and unscrupulous lenders and mortgage brokers more chances to turn dreams of homeownership in nightmares.
But these loans, and those to low- and moderate-income families represent a small portion of overall lending. ... Between 2004 and 2006, when subprime lending was exploding, Fannie and Freddie went from holding a high of 48 percent of the subprime loans that were sold into the secondary market to holding about 24 percent, according to data from Inside Mortgage Finance, a specialty publication. One reason is that Fannie and Freddie were subject to tougher standards than many of the unregulated players in the private sector who weakened lending standards, most of whom have gone bankrupt or are now in deep trouble.
During those same explosive three years, private investment banks -- not Fannie and Freddie -- dominated the mortgage loans that were packaged and sold into the secondary mortgage market. In 2005 and 2006, the private sector securitized almost two thirds of all U.S. mortgages, supplanting Fannie and Freddie, according to a number of specialty publications that track this data. [Emphasis added -- mdc]
Now, again, consider which subprime loans, in the graph below, went bad...
Figure 1.8 from IMF, Global Financial Stability Report, Oct. 2008.
Notice that the delinquency rate is highest in the years after Fannie and Freddie are constrained in terms of their subprime holdings. So, more regulation of F&F was a good thing, I'll say, with the benefit of hindsight.
Now, there are more sophisticated, game-theoretic based arguments. In particular, Jim has observed that the mere existence of GSEs with substantial portfolios of MBS's meant that the government -- by insuring Fannie and Freddie -- would implicitly insure the private firms as they expanded their operations, supplanting F&F's market share:
what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.
This is by far the most intelligent and plausible interpretations of how F&F could have contributed in a significant way to the current housing crisis (as separate from the overall crisis, which would have been triggered by some other market given the mixture of securitization, credit default swaps and high leverage [2]). In fact, Mike Dooley and I have made similar arguments about the expansion of contingent liabilities, in the run-up to the East Asian crises [3]. The challenge here is how to test this hypothesis against others; we need to measure the implicit insurance that these private firms felt they had directly from the Fed's intent keep the monetary policy sufficiently expansionary to keep housing prices going up, separate from the insurance committed directly by the Treasury to prevent individual banks from going under. (By the way, this is a separate issue from whether F&F made sense economically in their circa 2006 form; see the analysis by Frame and White. I tend to think the answer is no.)
Interestingly, one of the corollaries of this argument is that it would be hard to disentangle the balance of blame of F&F and the "Greenspan put".
One question I do (or will) have is the following: if the credit card or auto loan securitized markets blow up [4], who are the equivalents to the GSE's?
I think all of this leads to a more nuanced view of the role of CRA and the two GSE's in the crisis. If I had to identify the central factors, I wouldn't point to F&F alone, or CRA alone (if at all). Rather, I'd look to (i) monetary policy (including whether it was lax, and the implications of the "Greenspan put"), (ii) what drove down the returns at the long end of the maturity spectrum ("the conundrum") thus inducing the desperate search for yield, (iii) securitization in the absence of countervailing regulation and (iv) the development of a completely non-transparent and unregulated over-the-counter credit default swap market.
What if credit cards blow up?:
Credit Cards Follow Mortgages Into Delinquency, RTE: Credit cards are increasingly going the way of home mortgages — into delinquency.
Four quarter change in credit-card delinquencies. Red = Conditions have worsened; Green = Conditions have improved; White = No change (Source: NY Fed)
The Federal Reserve Bank of New York today released data showing that roughly 73% of U.S. counties had year-over-year increases in their mortgage delinquency rates in the first quarter (the latest period with full data available). A slightly smaller share of counties — about 71% — had higher delinquency rates for credit cards issued by banks than a year earlier. ... Delinquency rates for mortgages and credit cards are likely to continue rising into next year. ...
I didn't think I did a very good job of talking about the voucher proposal to prevent foreclosures, in particular, I thought I missed an important incentive in the model that would induce people to misrepresent their income or expenses in order to take advantage of the proposal.
So I decided to build a model to show how this works. Such models, or much better models, may (and probably do) already exist, but I didn't know about any since this isn't an area I work in, and I couldn't find any with a brief search, so I decided to just create one from scratch.
This is the simplest model of household mortgage payment default I could think of that can be used to illustrate the incentive for some households to intentionally default in order to get the benefits from the bailout program.
Continue reading "Household Bailouts and the Incentive to Intentionally Default" »
David Colander has a Trickle Up plan to reduce foreclosures:
Trickle-Up Plan Aims to Stem Foreclosures, Real-time Economics: Now that the easy part — temporarily propping up the banking system — is done, it’s time to start thinking about ... how to save millions of Americans from losing their homes in a way that will be politically acceptable but will also stop the economy from falling into a severe recession.
Sen. John McCain’s plan of a $300 billion dollar bailout is a non-starter. It subsidizes people who made lousy decisions about borrowing ...without giving anything to those who made the better decision to live within their means. Politically, it goes against what Americans are clamoring for — accountability... As was the case with the rescue of the banking system, however, some bailout for distressed homeowners will be needed to prevent continuing economic and social fallout from the housing debacle. For the U.S. economy even to start to think about recovery, the housing market has to stabilize...
Rather than the McCain proposal ... we should combine a mortgage assistance package that will ease some of the foreclosure pain with the sort of fiscal stimulus package that will be needed to reduce the depth of the coming recession.
The Trickle-Up Plan would ... help keep people in their homes and create demand for housing currently in foreclosure. By doing so, it will help stop the fall in housing prices, and also increase the value of the lowest elements of the mortgage backed securities — precisely what governments wants to do.
The Plan works as follows: Instead of giving people a tax cut or rebate as in a standard fiscal stimulus package, the government would distribute to taxpayers mortgage foreclosure vouchers. These vouchers can be used either by homeowners to pay mortgages on homes in severe danger of foreclosure, or to help homebuyers to purchase foreclosed homes.
As with other stimulus packages, these vouchers would be distributed to taxpayers based on their incomes with those with the lowest incomes receiving the largest vouchers and those with incomes of, say, over $200,000 receiving nothing at all. ... The vouchers, however, could only be fully used by homeowners facing foreclosure or interested in buying a house in foreclosure.
For the majority of taxpayers who cannot use them, the vouchers could be sold on a secondary market... [T]hese vouchers would likely sell at a discount, perhaps of about 25%. Since the plan will increase demand for foreclosed housing, it will stop the fall of housing prices, thereby helping to end the housing crises and starting the economy on the road to recovery. ...
Instead of a rescue scheme that relies on the benefits trickling down from Wall Street to Main Street, the benefits of this plan will trickle up from Main Street to Wall Street.
Whatever plan is ultimately implemented to stave off foreclosures, should taxpayers demand a share of any profit (equity) the bailed out homeowner makes if the house is sold later, much like the equity stakes taxpayers will have in banks that are bailed out? Everyone gets something from the voucher program, true, but if the vouchers are purchased at a 25% discount, then the benefits won't be equally distributed, i.e. some taxpayers will pay to bail out others. So should the people who are subsidizing others (in essence, giving them capital injections) in this or some other plan expect something in return if the bailed out homeowner profits later from selling the house? If we do demand a share, would that make some homeowners less likely to sell the house? (E.g. if they make $50,000 on the sale and had $25,000 in vouchers, they could be forced to sacrifice half of the equity, and that might make them less willing to sell, but perhaps this isn't much of a distortion, or not one we should worry about.)
I'm not so sure we should demand anything, but what is the argument for not asking for a share of any profit? One is that this is a case where people made, for the most part, good ex-ante decisions, it was rational to buy the house given what they knew, what they were told by people they should have been able to trust, and what they believed about the future, but ex-post it was a horrible choice. Here, homeowners in trouble are mostly victims of things outside their control, they didn't purposefully take a big risk knowing they could just walk away, or anything like that, they thought they were doing the right thing. If so, then I would argue that this is a case where social insurance is appropriate. When large disasters hit people and it is not their fault, we generally bail them out without asking for anything in return (e.g. we all pay unemployment insurance, then some people collect more than others when factors out of their control - a change in tastes, a business cycle downturn, technological change, etc. - causes their job to disappear. When there is a natural disaster that couldn't be predicted, we all pitch in and help.)
So I think whether we ask homeowners to pay something back if they ever do profit from the house depends upon whether we think homeowners as a group are victims of circumstances out of their control, victims of shady practices, etc. - they did nothing wrong in most cases except try to buy a house to live in - or we think that their behavior was a big part of the problem (and actually, even then, I find myself hesitant to say they should have to pay anything back).
What do you think? If a household is given, say, a $25,000 break on a loan to avoid foreclosure (and only paying a quarter of that amount to buy the vouchers), someone has to pay for it. Should we demand anything in return?
Afterthought: I should have noted that the plan provides a windfall to lenders - they get paid off through the voucher system rather than having to take losses on the loans they made. There's also an incentive to put a house into foreclosure even if yu plan to stay in it in order to be able to pay off the loan with coupons purchased at a discount.
Is Fannie the answer?:
Rescued by Fannie Mae?, by By Susan E. Woodward, Commentary, Washington Post: The most important task of the Federal Reserve and the Treasury right now is to restore confidence in bank solvency -- hence the Treasury's move to spend the first $250 billion of the Troubled Asset Relief Program (TARP) buying ownership stakes in a range of banks. Nonfunctioning markets and dried-up liquidity are symptoms of universal suspicion of insolvency, and lending among banks will resume in earnest only when banks are known to be solvent.
The original plan under TARP was for the Treasury to buy up suspect mortgage-related assets. Mortgages, by themselves or bundled into mortgage-backed securities, lack a functioning market. Any prices set in the near term are likely to be grossly below the true economic value...
The true values of mortgage assets are generally thought to be a mystery. But little-mentioned among discussions ... of the crisis is that the Treasury has access to the best resources in the business for estimating the hold-to-maturity values of mortgages and mortgage-backed securities. This team is at Fannie Mae, which the government now effectively directs.
Fannie has an underwriting and valuation shop with models for valuing mortgages that are up and running. Key inputs to these models are Fannie's own indexes of property values at the Zip code level -- others make do with prices in entire urban areas. The data needed are not difficult to assemble: current loan balances, the date loans were originated, original property value (or appraisal for refinances), loan type (fixed, adjustable rate, ARM features, loan length), borrower's credit score, Zip code and current loan status. These models project payments and proceeds from foreclosures and calculate the property's present value. Similar but less detailed models in recent academic work show that they do quite a good job of projecting defaults for prime and subprime loans, given changes in property values.
Some argue that Fannie is discredited for this work because it, too, has losses on riskier mortgages. But Fannie's losses arose from a failure to reserve adequately for losses that were anticipated by its models. Fannie's business people overrode the risk managers ... to keep reserves too low. The models were right. ...
In a few weeks, the right team could produce tens of millions of valuations, making a constructive plan of action quickly practical. Right now, many institutions are solvent but ... confusion about the value of their mortgage holdings hobbles them in credit markets... With valuations based on the best available current data, confidence would be restored in banks with truly adequate capital... If more equity or government insurance is needed to secure confidence, this can be provided on terms reflecting informed mortgage values. This step by itself could save taxpayers hundreds of billions of dollars unnecessarily pumped into institutions capable of dealing with mortgage losses on their own. It has not been the usual function of bank regulators to publish values of bank portfolios, but these are unusual times. ...
No other institution has as much data, so well organized and ready to address the specific problem the Treasury confronts, as Fannie Mae. Turning to Fannie for help is Treasury's fastest and least costly option to help our financial markets resume normal operation.
I don't know how much of an increase in confidence there would be from publishing model based valuations from Fannie Mae, I know I wouldn't rely on that alone, but it does seem like this is information the Treasury could use when it purchases distressed assets from financial institutions.
It wasn't Fannie and Freddie, and it wasn't the CRA:
Private sector loans, not Fannie or Freddie, triggered crisis, by David Goldstein and Kevin G. Hall, McClatchy Newspapers: As the economy worsens and Election Day approaches, a conservative campaign that blames the global financial crisis on a government push to make housing more affordable to lower-class Americans has taken off on talk radio and e-mail.
Commentators say that's what triggered the stock market meltdown and the freeze on credit. They've specifically targeted the mortgage finance giants Fannie Mae and Freddie Mac, which the federal government seized on Sept. 6, contending that lending to poor and minority Americans caused Fannie's and Freddie's financial problems.
Federal housing data reveal that the charges aren't true, and that the private sector, not the government or government-backed companies, was behind the soaring subprime lending at the core of the crisis. [...continue reading...]
The attempt to blame minorities for the financial crisis is "disgusting":
The New "Welfare Queens", by Ed Kilgore: Throughout this long presidential campaign, there's been endless discussion of race as a factor. But until recently, such talk revolved around hard-to-assess white fears about Barack Obama's racial identity, along with efforts to conjure up the ancient hobgoblin of the Scary Black Man via images of Obama's former pastor, Jeremiah Wright.
Now, in the wake of the ongoing financial crisis, racism has entered the campaign conversation from an unexpected direction. In the fever swamps of conservatism, there's a growing drumbeat of claims that the entire housing mess, and its financial consequences, are the result of "socialist" schemes to give mortgages to shiftless black people whose irresponsibility is now being paid for by good, decent, white folks.
Some of this talk is in thinly-veiled code, via endless discussions on conservative web sites (though it spilled over into Congress during the bailout debate) attributing the subprime mortgage meltdown to the effects of the Community Reinvestment Act of 1977, which was aimed at fighting the common practice of mortgage "redlining" in low-income and/or minority areas...
A closely associated and even more racially tinged element of the conservative narrative on the financial crisis focuses on lurid claims about the vast influence of ACORN, a national non-profit group active in advocacy work for low-income Americans. Among its many activities, ACORN has promoted low-income and minority homeownership, mainly through personal counseling. More to the point, though it's unrelated to any of the claims about ACORN's alleged role in the financial crisis, the group worked with Barack Obama back in his community organizing days on the South Side of Chicago.
Brad DeLong notes that McCain's new mortgage plan that he proposed at the debate is a 100 billion giveaway to the "worst-behaving mortgage financiers":
John McCain's New Mortgage Plan Is Worse than I Had Imagined Possibly, Even Given What I Know About John McCain: Douglas Holtz-Eakin says, this morning:
[W]e would in fact be taking the negative equity position and putting it on the taxpayers books instead of putting it on the private lenders books or the homeowners books. We think the balance of risk has shifted to the point where this is the way to go...
What does this mean? It means that John McCain wants to give $100 billion of taxpayers' money to America's worst-behaving mortgage financiers.
Let's back up. For the past month the debate about how to deal with the collapse of the debt-trading portion of America's financial markets has been between two plans: the Paulson plan and the Elmendorf plan:
An article in the NY Times, "Pressured to Take on Risk, Fannie Hit a Tipping Point," is causing many people to wonder if Fannie and Freddie caused the financial crisis.
First, let me clarify the question. We are asking what caused the housing bubble, and, by definition, the cause cannot be explained by changes in an underlying market fundamental. I don't mean that we can't point to, say, a rumor that led to a rapid increase in the price of some good as speculators rush in, just that bubbles - by definition - are divorced from market fundamentals.
I think a more interesting question is what sets the stage for a bubble to emerge - what allows the rumor, irrational exuberance, etc., to express itself as a bubble? One thing that is needed is liquidity and credit, some way of substantially increasing demand. This is the air that inflates the bubble. Even if all the other conditions for a bubble to emerge are present, if there is no way to inflate the bubble - no way for speculators to rush in and drive up the price - then it won't inflate.
We already know that there was enough available liquidity to inflate a housing bubble. So something went wrong in these markets that allowed the bubble to emerge and then pop, and this is causing us immense problems right now, but what was it?
I think the most important factors are agency problems, the mis-pricing of risk, and the failure of securitization to distribute risks across the financial system.
With respect to the agency issues, there is a long chain between the home buyer, the mortgage broker, and, ultimately, the sliced and diced complex securities that nobody fully understands. Let's take one step in the chain, that of a a bank or mortgage broker, either one. Suppose they are paid a fee, i.e. by the number of mortgages that pass through their hands each month (as, essentially, they were). The more mortgages they can push through, the higher their income. They are required to meet certain guidelines as they do this, but so long as their income depends upon the number of mortgages passing through their hands and not what happens to the mortgages later on - so long as it is a fee-based system - they have every incentive to push the guidelines as hard as they can and to find a way around them whenever possible.
If mortgage brokers had done their job and only made loans to people who could pay them back (i.e. with "reasonable" levels of default), we wouldn't have a financial crisis. So right away, in nearly the first step of the chain, we have to ask what went wrong, why they were willing to take so many questionable loans. The problem is what economists call an agency issue. The brokers had no stake in the outcome once the mortgages left their hands. The same with banks, all they had to do was process the mortgages, package them up, then sell them and collect their fee.
Think about the incentives here. Suppose you are a mortgage broker and you begin to suspect that the bubble will pop soon, that all this lucrative business might end. To protect the business, should you get worried and start checking mortgages more carefully to make sure that things don't get further out of hand? No, you should accelerate what you are doing, write even more mortgages - nothing you can do can stop the bubble from popping, you are just one of many, many brokers far down the chain - so why not collect as many fees as possible before the gravy train ends? What if everyone thinks this way, and they all rush to sell as many of these things as they can? Mania.
A solution to this is to give each person in the chain a stake in the future outcome of the mortgage. If mortgage brokers' income had been connected to a financial instrument that pays off according to the future performance of the mortgages they write, would they have behaved differently? Probably. (What about homeowners, why didn't they say no? Don't they have a stake in the future price of the home? Homeowners in non-recourse states - and more generally - were basically granted cheap options on their homes. The downside was protected and they had no reason to effectively monitor risk. If prices fell, they could just walk away and know that their other assets remained safe and that their credit reputations could be restored with time. Of course, if everyone walks away other assets such as retirement savings don't remain safe, but that doesn't change the incentive on an individual level.)
Ah, you say, but as you go up the chain why didn't people refuse to take the financial paper, why didn't they conclude it was too risky? The risky mortgages don't have to be stopped at the bottom, this is a linked chain, so why weren't they stopped higher up in the chain where the stakes are higher? Isn't that where Fannie, Freddie, and moral hazard rear their ugly heads? Did they encourage and allow this risky paper to pass through the system?
The mis-pricing and mal-distribution of risk played a key role here (along with poor management decisions in cases where alarms were raised). The agency issues above, and the consequences of the failure to predict and distribute risk are much more important than any moral hazard issues arising from the implicit government guarantee granted to Fannie and Freddie.
Institutions in the shadow banking sector were willing to take large volumes of risky loans as they came up through the system. Why?
The people at the top of this complex chain did not fully understand the risks the were assuming when they took on the subprime business, or, rather, when they took on the complex securities derived from the subprime business. When the bubble popped, it shouldn't have been a big problem if the risk assessment models they relied upon had been correct, and if securitization had distributed the risk as promised. As Brad DeLong notes:
So if the risks had been distributed fairly evenly, it's much less likely that we'd be in this mess (the losses of 2T - an intentionally high-balled number - are only 1/30th of global financial assets). It wasn't the misprediction of the level of risk that was the biggest problem, the losses could have been absorbed, it was the (unintended) concentration of risk through the failure of securitization that was the most problematic.
Fundamentally, then, it was the agency problems and the failure of risk prediction and distribution models that allowed the bubble to inflate and then cause big problems after it popped. But back to Fannie and Freddie. The willingness of the non-traditional banking sector - the shadow banking system - to take on these risky assets and still pay investors a relatively high return put tremendous pressure on Fannie and Freddie to follow suit. And their response was unwise - Fannie and Freddie followed the shadow banking sector downward. There is lots to fault in the behavior of Fannie and Freddie and in government oversight of them - the decisions of management, the lobbying efforts that were funded by their ability to extract a premium from the implicit government guarantee - all of this was a big problem. The bubble, and later the financial crisis expressed itself in these institutions, and they may have also contributed to it to some extent as they took on more risky securities when their business began to go elsewhere. But the agency issues and the failures of risk models and securitization would have created problems in the largely unregulated shadow banking sector even if these two institutions had taken on nothing but the safest of mortgages. The bubble still would have inflated in the shadow banking system - maybe it's a little smaller, I don't know - but it still would have been large enough to cause big problems when it burst. The best behavior of Fannie and Freddie would not have been enough to stop the bubble from inflating in other parts of the financial sector, and then turning into a full fledged financial crisis as housing prices plunged.
The problems we are having were caused when lots of available liquidity rushed past the checks and balances that proper agency provides in pursuit of promises that risk models and complex securities did not deliver. The unexpected losses alone might not have caused a crisis had the losses been widely distributed, but, the losses were concentrated and hidden in ways that created widespread fear and threatened the entire system. Getting rid of that fear is not going to be easy.
[Update: Given some of the responses elsewhere to this post and others like it, let me add one more thing. Asking the question "what caused the financial crisis," thinking about it, and then arguing that Fannie and Freddie were not the primary driving forces behind the financial meltdown (though they could have affected the size of the problem as noted above) is not the same as defending Fannie and Freddie. Whether are not Fannie and Freddie are performing a useful function, and if they are performing a useful function how they should be structured going forward is not a question I've fully resolved. The market failure they are addressing is not entirely evident to me, and until I understand how they improve the efficiency of these markets, I won't take a position. They certainly should not operate as private entities with an implicit government guarantee as before - that's what set up the situation where the implicit guarantee could be exploited profitably and used to fund lobbyists and ad campaigns to make sure the golden goose kept laying eggs. However, I have posted arguments from other people arguing for their existence, and I am thinking about those as well as arguments against their continuation. In any case, something to guard against, I think, is to inappropriately blame Fannie and Freddie for the financial crisis and then use that as a reason to shut them down irrespective of any useful function they might serve. So when I see those with an agenda against government intervention trying to do just that - arguing honestly in some cases and dishonestly in others that Fannie and Freddie were a big factor in the crisis so they can use them as an example of government intervention gone awry and also shut them down - a double bonus in their eyes - I have tried to present evidence and arguments that the cause lies elsewhere. But as I said, that is not the same as defending their existence. My interest is in understanding the true cause of the financial crisis and in stopping it from happening again - and to avoid getting stuck on wrong arguments along the way - not in using the crisis to argue about whether Fannie and Freddie ought to continue as government supported institutions. That can wait for another day.]
Coleman, Lacour-Little and Vandell argue that house prices made sense until 2004, by Richard Green: The abstract of their new paper:
The cause of the "housing bubble" associated with the sharp rise and then drop in home prices over the period 1998-2008 has been the focus of significant policy and research attention. The dramatic increase in subprime lending during this period has been broadly blamed for these market dynamics. In this paper we empirically investigate the validity of this hypothesis vs. several other alternative explanations. A model of house price dynamics over the period 1998-2006 is specified and estimated using a cross-sectional time-series data base across 20 metropolitan areas over the period 1998-2006. Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE's were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a "bubble" were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the "tail") of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the "dog").
This result is hardly consistent with the charge that the GSEs were the principal source of the problem. It also says something about having a purely private mortgage market.
Former Treasury Secretary for the Bush administration, John Snow:
"We don't believe in a 'too big to fail' doctrine, but the reality is that the market treats the paper as if the government is backing it. We strongly resist that notion.
"You know that there is that perception. And it's not a healthy perception and we need to disabuse people of that perception. Investments in Fannie and Freddie are uninsured investments."
Robert Reich makes an argument for including help for Main Street as part of the bailout package:
Why Paulson and Bernanke are only Partly Correct, and Why Main Street Needs More Direct Help, by Robert Reich: ...Here's Paulson's and Bernanke's logic, made explicit at the Senate hearing today: There's only a certain amount of bad debt on Wall Street's books, left over from the wild and woolly days of lax mortgage lending. Once removed from the Streets’ books, credit will flow again. And once credit flows again, even Main Street can breath a sigh of relief.
P&B failed to mention that bad debts are growing even among people recently considered good credit risks. At end of August, 6.6 percent of mortgages were at least 30 days past due. That’s up from 5.8 percent at end of June. We’re also seeing a growing amount of credit card and auto payments past due.
The culprit isn’t just those sub-prime loans. With jobs and wages are dropping across America, many people who had been able to pay their bills no longer can.
It’s no coincidence that states where mortgage delinquencies are highest are also states with the highest rates of job losses. ...[F]ewer jobs are listed on the nation’s payrolls than were there last year. Millions more Americans are too discouraged even to look for work. And as employers squeeze their payrolls, even people with jobs are putting in fewer hours. ...
Many of the average taxpayers being asked to take on Wall Street’s bad loans are the same people whose incomes are dropping, which means they’re struggling to pay their debts and potentially creating even more bad loans.
Congress should drive the hardest deal it can with Wall Street. But Congress also needs to pay direct attention to Main Street. It should extend unemployment insurance, freeze mortgage rates, and pass a stimulus package that generates more jobs.
Bottom line: Unless Americans on Main Street have more money in their pockets, Wall Street’s bad debts will continue to rise -- which means the Bailout of All Bailouts grows even larger, which means taxpayers take on even more risk and cost.
Bill Clinton on deregulation and the bailout:
Bill Clinton Revisits His Economic Legacy, Dana Goldstein: At a meeting with progressive bloggers and journalists ... Monday night, Bill Clinton ... spoke freely about the financial crisis, and reexamined his own administration's economic legacy in light of the meltdown.
"I have thought about that," Clinton told me when I asked whether he was reconsidering any of the de-regulatory economic policies his administration pursued under Treasury Secretary Robert Rubin. ...
Clinton said he has two regrets: First, not pursuing more aggressively an aborted attempt to provide stricter oversight of Fannie Mae and Freddie Mac. According to Clinton, the move was stymied by Democratic and Republican members of Congress and by mayors, who saw the lending giants as "the New Jerusalem" and "pure" because of their role in increasing home-ownership to historic levels. But "it just didn't feel good," Clinton said of Fannie and Freddie's outsized political influence.
Clinton also said he should have subjected derivative trading to more public oversight. "We would have failed, but at least we could've sounded the alarm."
One policy Clinton said he doesn't regret is his repeal of the Glass-Steagall Act in 1999, which, for the first time since the Depression, allowed commercial banks to engage in investment banking activities. Clinton said the commercial banks were an important moderating force on the risk-taking of the big investment firms that collapsed this week. "In the case of the current crisis, I believe the bill I signed allowed Bank of America to take over Merrill Lynch," he said.
Also during the interview, Clinton urged Congressional Democrats to work quickly to pass a bailout package for Wall Street, but said Democrats must lobby in the current weeks to pass a comprehensive package of "Main Street" economic measures, including a moratorium on foreclosures, and should create a homeowners loan corporation similar to the one active during the Depression. Such an agency would refinance sub-prime mortgages into traditional ones, but should do so only for borrowers with steady incomes, Clinton said. ...
The former president mentioned his wife frequently during the meeting... "Hillary called and said it's really interesting how this is going down [in Kentucky]," Clinton said. "She said, out here, they don't yet see it as a big crisis requiring an urgent response, because they've been in trouble for years."
That is why, Clinton reiterated, Democrats must sell the bail-out of Wall Street as an investment in regular Americans' retirement savings and the security of their mortgages.
From the Washington Post:
Near the end of the Clinton administration, some of its officials had concluded the companies were so large that their sheer size posed a risk to the financial system.
In the fall of 1999, Treasury Secretary Lawrence Summers issued a warning, saying, "Debates about systemic risk should also now include government-sponsored enterprises, which are large and growing rapidly."
It was a signal moment. An administration official had said in public that Fannie Mae and Freddie Mac could be a hazard.
The next spring, seeking to limit the companies' growth, Treasury official Gensler testified before Congress in favor of a bill that would have suspended the Treasury's right to buy $2.25 billion of each company's debt -- basically, a $4.5 billion lifeline for the companies.
A Fannie Mae spokesman announced that Gensler's remarks had just cost 206,000 Americans the chance to buy a home because the market now saw the companies as a riskier investment.
The Treasury Department folded in the face of public pressure.
There was an emerging consensus among politicians and even critics of the two companies that Fannie Mae might be right. The companies increasingly were seen as the engine of the housing boom. They were increasingly impervious to calls for even modest reforms.
As early as 1996, the Congressional Budget Office had reported that the two companies were using government support to goose profits, rather than reducing mortgage rates as much as possible.
But the report concluded that severing government ties with Fannie Mae and Freddie Mac would harm the housing market. In unusually colorful language, the budget office wrote, "Once one agrees to share a canoe with a bear, it is hard to get him out without obtaining his agreement or getting wet."
And, for those trying to blame Democrats for the problems with Fannie and Freddie, from the same article:
In June 2003, Freddie Mac dropped a bombshell: It had understated its profits over the previous three years by as much as $6.9 billion in an effort to smooth out earnings. ...[A]n outside accountant ... reported in September 2004 that Fannie Mae also had manipulated its accounting, in this case to inflate its profits. ...
The companies soon faced new bills in both the House and the Senate seeking increased regulation. ...
Fannie Mae and Freddie Mac succeeded in escaping once more, by pounding every available button. ... Most of all, the company leaned on its Congressional supporters.
In the Senate, Robert F. Bennett (R-Utah) added an amendment giving Congress the ability to block receivership, weakening that bill to the point where the White House would no longer support it. Bennett's second-largest contributor that year was Fannie Mae; his son was then the deputy director of Fannie's regional office in Utah.
It's time to run this again, and add a bit more to it:
Did Fannie and Freddie cause the mortgage crisis?, by Jim Hamilton: Some thoughts about the role played by the GSEs in the run-up in mortgage debt and house prices. ...
Fannie and Freddie had purchased $4.9 trillion of the mortgages outstanding as of the end of 2007, 70% of which the GSEs had packaged and sold to investors with a guarantee of payment, and the remainder of which Fannie and Freddie kept for their own portfolios. The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.
Sum of retained mortgage portfolio and mortgage backed securities outstanding for Fannie and Freddie (from OFHEO 2008 Report to Congress) divided by (1) total 1- to 4-family home mortgage debt outstanding (from Census for 1971-2003 and FRB for 2004-2007) and (2) annual nominal GDP.
The fact that the volume of mortgages held outright or guaranteed by Fannie or Freddie grew so much faster than either total mortgages or GDP over this period would seem to establish a prima facie case that the enterprises contributed to the phenomenal growth of mortgage debt over this period. Krugman nevertheless concludes that the GSEs aren't responsible for our current mess. ...
For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period?
Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off.
Is that the answer...? I'm not sure...
In the mean time, I very much agree with Krugman that the most egregious problems were not caused by anything Fannie or Freddie themselves did. But I disagree that their actions played no role in causing the underlying problem we face today.
Paul Krugman, also from the previous post:
Why Fannie and Freddie got so big, by Paul Krugman:...Jim Hamilton asks why Fannie and Freddie grew so much in the years before the surge in subprime lending. Justin Fox had already suggested that Fannie/Freddie were taking the place of the savings and loans, after the crisis of the 1980s. Well, if I’m reading this data (xls) right, that’s pretty much the whole story. This graph shows the share of savings institutions and “agency and government-sponsored enterprises-backed mortgage pools” in total mortgage holdings:
The big switchNow here’s the thing: S&Ls are private, profit-making institutions whose debt (in the form of deposits) is guaranteed by the federal government. Fannie and Freddie are private, profit-making institutions whose debt is implicitly guaranteed by the federal government. It’s not clear to me that the switch shown here led to any net socialization of risk. ...
What did happen was an explosion of risky lending by other parties, which crowded out the GSEs; you can see that at the end of the figure (which runs up to 2006). So I stand by my view that Fannie and Freddie aren’t the big story in this crisis.
Here's another graph with a bit more detail from the old post Jim Hamilton references above. Note the spike in asset backed securities at the end that matches the decline in lending from GSEs:
Richard Green says the unique hybrid nature of Fannie and Freddie - which gives it the implicit guarantee - isn't the problem:
Could we please stop saying that it was the hybrid feature of Fannie/Freddie that caused them to fail? I think we have enough failures across enough different types of financial institutions (Investment Banks, Commercial Banks, Thrifts,Insurance Companies and GSEs), and sufficiently (ahem) large rescue packages for them that we can say that the US financial system has very few purely private financial institutions (sorry Lehman Brothers).
But I want to go back to Krugman's point because it has been overlooked in this debate. If, as the data suggest, "Fannie/Freddie were taking the place of the savings and loans, after the crisis of the 1980s," then there was no change in the level of socialized risk. Since S&Ls also have a guarantee from the government, all that happened is that loans moved from one guarantee under S&Ls to another guarantee under Fannie and Freddie. So this could not have substantially changed the degree to which markets were distorted.
Let me add one more piece that may not be widely recognized. Brad Setser notes that since 2000, much of the new debt guaranteed by Fannie and Freddie has been absorbed by foreign central banks, leaving private citizens in the US with a riskier pool of assets:
Were the Agencies responsible for the current crisis?, Brad Setser: The role of the Agencies in the current crisis is something that has come up in the Presidential campaign. It is also something that can be assessed using real data — including the recent Flow of Funds data produced by the Fed.
I would argue that this data suggests a more complex story than is commonly told. The Agencies certainly played a role in turning US mortgages into an asset that credit risk adverse central bank were willing to hold: the availability of Agency bonds with an implicit government guarantee interacted with the acceleration of global reserve growth to help make too much credit available to American households.
At the same time, it wasn’t just a story of a market hopelessly distorted by the Agencies’ implicit guarantee. The Agencies implicit guarantee isn’t exactly a new development. Moreover, at the peak of the lending boom, regulatory restrictions kept the Agencies from growing their books rapidly. The big surge in risky, exotic mortgages was made possible by a surge in demand for so called “private” MBS — that is to say mortgage backed securities that did not have an Agency guarantee. ... Central bank demand for Agencies freed up private funds to invest in riskier assets rather than directly financing the most risky mortgages...
Agency lending has been absolutely essential to avoiding an outright recession over the past few quarters. A surge in Agency issuance has offset a total collapse in “private” MBS issuance. Without the Agencies, US households probably wouldn’t have had any access to credit over the past year. The US government actually started to intervene heavily in the market last fall, when it reduced limits on the growth of the Agencies to keep credit flowing. It isn’t an accident that the Agencies provided $1.1 trillion in new credit to the US last year, while ABS issuance fell from $900b a year to less than zero. ...
The overall result was that central banks took on dollar risk..., while private investors took on the credit risk associated with the housing boom. In hindsight, that looks to have been a bad trade on the part of private investors. Central banks have taken currency losses (though those are mitigated the more Asia sells off). But those losses are a lot smaller than the losses US banks (and European banks that borrowed in dollars to buy dollar-denominated MBS — i.e. institutions like UBS) took on their mortgage book. ...
Agencies remain modest relative to the total outstanding stock of Agencies. Central bank holdings of Agencies only surpassed US commercial bank holdings of Agencies in q2 2008... So why have I emphasized central bank demand for Agencies?
To start, central bank demand absorbed a significant share of the incremental growth in Agency bonds outstanding since 2000. If you believe flows matter — and I do — central banks have been big players...
But this effect - the concentration of risk in the US as the guaranteed assets issued by Fannie and Freddie went primarily to foreign central banks - is a consequence of our need to borrow from foreigners to finance our budget and trade deficits. Without those deficits, more of the safe assets stay home and the overall pool isn't as risky. So to the extent that this concentration of risk is a factor in causing the problems (and I don't know how important it was), it was caused by trade and budget deficits, not the actions of Fannie and Freddie.
So, overall, perhaps the implicit asset guarantee did distort markets, but those distortions did not start with Fannie and Freddie, and they did not substantially worsen when Fannie and Freddie took over where the S&Ls left off. And even if there was some distortion, it's hard to find any linkage between the onset of the financial crisis and changes in the net socialization of risk through Fannie and Freddie. There was, apparently, some concentration of risk due to central banks buying the safe assets and leaving the riskier ones behind, but even so, it's not clear to me that this was a primary factor in bringing about the crisis. And even if it is the cause, or part of it, the behavior of central banks was not driven by changes in the behavior of Fannie and Freddie.
This needs to be debunked again:
The New Talking Points, Washington Monthly: For about a week now, Republicans have been looking for a way to blame the crisis on Wall Street on Democrats. The search hasn't gone well...
But conservatives kept on trying. In fact, the right seems to have finally come up with a new line: Democrats forced banks to give mortgages to low-income minorities, those low-income minorities couldn't keep up with their mortgage payments, and the banks struggled as a result. Voila! Blame the Dems!
Fox News' Neil Cavuto helped get the ball rolling. Media Matters reported that Cavuto conflated giving home mortgages to minorities with risky lending practices...
The National Review is on board with a similar line of thinking, blaming the Community Reinvestment Act for much of the crisis: "The CRA empowers the FDIC and other banking regulators to punish those banks which do not lend to the poor and minorities at the level that Obama's fellow community organizers would like. Among other things, mergers and acquisitions can be blocked if CRA inquisitors are not satisfied that their demands -- which are political demands -- have been met. There is a name for loans made to people who do not have the credit, assets, income, or down payment to qualify for a normal mortgage: subprime."
All of this seems rather silly on its face, but thankfully, Matt Yglesias went to the trouble of setting the record straight.
For one thing, the timeline is ludicrous. The Community Reinvestment Act was passed in 1977. Are we supposed to believe that CRA was working smoothly throughout the Carter, Reagan, Bush I, and Clinton years and then only under Bush II did overzealous anti-"redlining" enforcement come into play, perhaps a result of Dubya's legendarily close relationship with ACORN? Or maybe overzealous enforcement back in the late 1970s is somehow responsible for a real estate blowout that only materialized 30 years later? It doesn't even come close to making sense.
Beyond that, the mere existence of "subprime" loans -- i.e., mortgages given to less-creditworthy individuals at higher interest rates -- isn't the problem here. The problems have to do with what was done with the loans after they were packaged, sold and used to make leveraged plays.
Sorry, conservatives, you'll have to keep looking for a way to blame Democrats for this mess. Good luck with that.
See also: Did Liberals Cause the Sub-Prime Crisis?, by Robert Gordon, and Ezra Klein:
As Robert Gordon shows,... this is crap. First, there's the timing. CRA came in 1977. The crisis came in 2007. Indeed, by 2004, the Bush administration had weakened the CRA -- and after that (though not, presumably, because of it), bubble lending really took off. Further, CRA only governs a certain class of federally insured banks. Problem is, half of the subprime loans came from mortgage companies with no CRA involvement at all. Another 25%-30% came from companies with very little CRA exposure. For those who left their abacus at home, that's 80% of the loans which were fully or largely outside CRA jurisdiction. More than that, the non-CRA mortgage firms made subprime loans at twice the rate of CRA-covered firms. Which basically leaves a stake in the heart of this particular theory. Indeed, until now, some conservatives have been moaning that no one is talking about the CRA part because it's so racially charged. Poppycock. It's just a false charge...
Luigi Zingales' reaction to the financial market bailout plan, "Why Paulson is Wrong," has been getting a lot of attention and a Vox EU version of the argument appears below (my initial reactions are here). The main point is that taxpayers should not pay for the bailout.
Several points on this. First, if the government does do a bailout, the size of the bailout won't necessarily be $700 billion, and it is unlikely that it will be. The government is using the money to purchase assets. Some of those assets will appreciate, some will depreciate, and we don't know for sure what the net result will be. We could make money on the deal, we could lose money, we just don't know. But one thing is fairly certain, it's unlikely that the value of every security the government purchases will fall to zero, and that would be required for the government to lose all the money it spends (invests). See knzn on this point.
However let me be clear, even if the expected value of this deal is zero, that is, even if we expect losses and gains to cancel over time, taxpayers still need to be compensated for the risk they are taking. There is a risk that this bailout could lose hundreds of billions of dollars, and, just like in any financial transaction, the parties assuming that risk need to be compensated for it.
Dean Baker argues that Fannie and Freddie should be run as public corporations. There are (at least) two ways to support this, one is as a means of promoting home ownership, and the other is to stabilize housing markets. Not everyone agrees with the first justification since it distorts markets (assuming the promotion of home ownership is not correcting a market failure in which case it would be hard to argue against). However, the second justification - stabilization - is, I think, harder to dismiss since volatility in these markets produces large welfare losses:
Freddie's dead, by Dean Baker, Comment is Free: Fannie Mae and Freddie Mac finally kicked the bucket this weekend, with the Treasury department stepping in to take over the companies. The top management is being sent packing (albeit with multi-million dollar severance packages), and the shareholders will stop seeing dividends, probably forever. ...
The big question is what these institutions will look like going forward. There is a strong argument for keeping these institutions publicly run. In effect, both Fannie and Freddie can be operated as public corporations, which was the case with Fannie Mae prior to its privatisation in 1968.
The current disaster should not lead people to forget the benefits that these companies conveyed to homeowners. By creating the secondary mortgage market, they created first a national and then an international market for home mortgages. This had the effect of equalising interest rates across the country and making homeownership affordable to millions of families.
Perhaps the private sector would have created a secondary mortgage market on its own, but it didn't. Furthermore, private issue mortgage backed securities have performed far more poorly in the current crisis than the securities issued by Fannie and Freddie. This is why private issue mortgage backed securities have virtually disappeared over the last year, and Fannie and Freddie are now financing almost 80% of the new mortgages being issued. Those who tout the virtues of the private sector in the secondary mortgage market are arguing based on faith, not evidence.
There is still a very big need for Fannie and Freddie to ensure a well-operating secondary mortgage market. ... Fannie and Freddie can best serve their role of providing the stable anchor of the secondary mortgage market...
Private banks would still be free to be creative and innovative in developing complex new mortgage derivatives, if they can find anyone to buy them. The difference is that the taxpayer would not be standing behind the private sector banks, prepared to absorb any losses even as the stockholders and top executives got rich off the gains.
The federal takeover of Fannie and Freddie will force a debate over their ultimate status. It is clear that many Republicans want to see them broken up and privatised, which has long been their explicit agenda.
The current crisis has shown the failing of Fannie and Freddie in their role as public/private hybrids. We should see that as reason for ending the private side of the equation. The only obvious value added by the private side is the tens of millions of dollars of compensation received by the CEOs. The CEOs can go to Wall Street if they want those salaries.
Debt deflation is bad news:
The Power of De, by Paul Krugman, Commentary, NY Times: ...The just-announced federal takeover of Fannie Mae and Freddie Mac ... was certainly the right thing to do — and it was done fairly well, too. The plan will sustain institutions that play a crucial role in the economy, while holding down taxpayer costs by more or less cleaning out the stockholders.
But Sunday’s action needs to be seen in a larger context..., the attempt by the Federal Reserve and the Treasury Department to contain the fallout from the ongoing financial crisis. And that’s a fight the feds seem to be losing. ...
[Since the housing bubble] popped two years ago home prices have fallen faster than they did during the Great Depression.
Falling home prices, in turn, have led to the much-feared phenomenon of “debt deflation.” ...[T]he prices of assets, which are what matter for balance sheets, are dropping fast.
As the economist Irving Fisher observed way back in 1933, when highly indebted individuals and businesses get into financial trouble, they usually sell assets and use the proceeds to pay down their debt. What Fisher pointed out, however, was that ... if everyone tries to sell assets at the same time, the resulting plunge in market prices undermines debtors’ financial positions faster than debt can be paid off. So deflation in asset prices can turn into a vicious circle. And one consequence ... is a severe economic slump.
That’s what’s happening now, with debt deflation made especially ugly by the fact that key financial players are highly leveraged — their assets were mainly bought with borrowed money. As Paul McCulley of Pimco ... put it..., just about every financial institution has been trying to reduce its leverage — but the plunge in asset values has nonetheless left these institutions with more debt relative to their assets than before.
And the numbers keep getting worse. ...
Which brings us to Fannie and Freddie. They’re the only big financial institutions that haven’t joined in the rush to deleverage, which is why they now account for about 70 percent of new mortgage loans. But their financial foundations have been undermined by debt deflation, even though their lending was more responsible than average. ...
So Fannie and Freddie had to be rescued — otherwise debt deflation would have gotten much worse. ...
But is it enough? I doubt it.
The current U.S. financial crisis bears a strong resemblance to the crisis that hit Japan at the end of the 1980s, and led to a decade-long slump... American economists ... wondered whether the same thing could take place here — and ... the Fed devised strategies that were supposed to prevent that from happening. Above all, the response ... was supposed to involve a very aggressive combination of interest-rate cuts and fiscal stimulus, designed to prevent the crisis from spilling over into a major slump in the real economy.
When the current crisis hit, Mr. Bernanke was indeed very aggressive about cutting interest rates and pushing funds into the private sector. But despite his cuts, credit became tighter, not easier. And the fiscal stimulus was both too small and poorly targeted, largely because the Bush administration refused to consider any measure that couldn’t be labeled a tax cut.
As a result,... the effort to contain the financial crisis seems to be failing. Asset prices are still falling, losses are still mounting, and the unemployment rate has just hit a five-year high. With each passing month, America is looking more and more Japanese.
So yes, the Fannie-Freddie rescue was a good thing. But it takes place in the context of a broader economic struggle — a struggle we seem to be losing.
Yesterday, after the latest data on housing prices were released, there were many analysts saying we might be nearing the bottom of the housing cycle. I have a guest post at The Big Picture on whether housing is anywhere near bottom.
The bottom line is:
Are we near the bottom? Is the end near? I wish I could answer yes, but I think we have a ways to go yet. Paul Krugman says:
When will it all end? The answer is, probably not until 2010 or later.
I'm hoping it won't be that long, but so far the crisis has unfolded in an almost eerily slow fashion - sort of like watching a train wreck in slow motion and being unable to do anything about it - and there's no reason to think that will change.
Update: Here's more on yesterday's price data from Dean Baker:
Two Items Missing in Coverage of the June Case-Shiller Data, Beat the Press: The coverage of the release of the June Case-Shiller housing prices indices overlooked two important items in the data. First, an examination of the tiered indices (these show separately the movement of house prices in each city for cheapest third of houses, the middle third, and upper third) indicates a sharp divergence within many markets. In several of the former bubble markets higher end home prices appear to be stabilizing, while prices for homes in the bottom tier continue to fall rapidly. ...
Ultimately, there must be some spillover in the sense that if the cheapest homes fall far enough, people looking to buy more high-end homes might instead opt for a cheaper one and then invest in major renovations. But the divergence that is showing up in the data at present is striking.
The other important point to note in connection with house prices is that inflation has picked up so that house prices would be falling rapidly in real terms, even if nominal house prices were flat. ... The bubble can be deflated either by a fall in nominal house prices or through inflation. There are important distributional implications for which route the collapse follows (borrowers will be helped by inflation, while lenders will be hurt), but either route can restore house prices to their long-term trend level.
Update: On Dean Baker's point about segmentation in the market and stabilization at the high end, a different perspective from Calculated Risk:
[P]rices are now falling for luxury homes too:
[E]ven luxury homes are now showing weakness. ... That "prestige homes" index found that in the second quarter this year, values on many such houses in San Diego dropped 2 percent from the first quarter and 7.8 percent from second quarter 2007. The average price among those homes has fallen to $2.02 million, from a peak of $2.19 million in the second quarter 2007.
No area is immune. The housing bust is now moving up the price chain.
Update: Free Exchange adds:
Bottom feeders, Free Exchange: In A guest post at Barry Ritholtz' Big Picture site, Mark Thoma gives it to us straight on the latest housing news. First, he says, lots of people have been calling a bottom since, well, since the top. Second, that wrongness doesn't obviate the fact that prices will cease falling eventually, at which point bottom callers will become correct and doubters incorrect. Third, based on prices and inventories, we don't have the support we need to call a bottom, yet.
Hard to argue with any of that. ... I would not counsel optimism at the moment.
But I will argue that optimism isn't an absurd state of mind. Looking at Case-Shiller home price data for the past year, and for 2008 in particular, we unquestionably see prices leveling off in recent months. For almost half of the markets involved, prices in 2008 have essentially been flat. ...
These moves may not portend an imminent recovery, but there are reasons to suspect that a recovery, once underway, will have a firm foundation. Potential homebuyers..., at present, ... generally see no reason to buy because the expectation is that prices will continue to fall. Why purchase now at $200,000 what you can get in two months at $190,000?
If it begins to seem that further declines are not a sure thing, however, those buyers will rush in..., the rush at the bargains will solidify the bottom, and potentially lead to a substantial upward revision in some markets.
The other critical point is in credit markets. As long as prices continue to fall, the full extent of the losses banks can expect is unclear. As such, banks will jealously guard their assets so as not to be caught undercapitalised by markets looking for blood. An apprent price bottom should begin to fix this problem. ... The combination of new credit with buyer interest should lay the groundwork for stabilisation. ...
And the other issue is this: once the credit crisis is resolved, housing needn't be a national issue anymore. Supply did not overshoot equally in all markets. When better borrowing conditions return, tight markets should quickly decouple from loose ones. That won't mean an end to pain for many, but it will mean an end to the national housing depression.
The question, of course, is when. I'm not foolish enough to guess. But there are reasons to find encouragement in the latest price data.
Update: From Richard Serlin:
Housing prices can't Drop too much. The Good far outweighs the bad.: In response to Mark Thoma's post today...:
"Are we near the bottom? Is the end near? I wish I could answer yes"
Mark, please think very carefully about this. Do you really wish housing prices would stop falling? Do you really think it would be better to have housing be more expensive? Do you really think the costs of lower housing prices outweigh the benefits? Do you really think it's better to preserve the wealth of a minority of wealthier homeowners and investors, at the expense of the middle class and poor, who are really hurt by high home prices? I know most of the middle class own homes, but they can't benefit from higher home prices unless they move to a smaller or otherwise less desirable home. Their children, on the other hand, can be devastated by high home prices. ...
Lowering of housing prices, over the long run, does immensely more good than bad. It's a great thing. They can't go too low. What if they went to 1 cent for the average home? That would be bad? Over the long run that would make almost all families and individuals immensely more financially secure, to have just a trivial mortgage or rent payment. The lower the better for housing prices. The good this does far far outweighs the bad. For more details, I have a brief paper regarding this.
Is housing near the bottom of the cycle?:
Home economics, The Economist: The American housing market has deteriorated so sharply in the past two years that it is easy to fall prey to profound pessimism. Recent weeks have brought yet more bad news. ...
Amid the despondency, however, supply and demand are moving towards balance. Sales of new homes, which had plunged nearly 60% from their average level of 2005, have been stable since March. Sales of existing homes stopped falling last autumn. ...[C]onstruction of homes built for sale, not counting units that already have a buyer, had dropped to 13% below the level of new-home sales in the first quarter... That is why the inventory of unsold homes, though still near recent highs relative to monthly sales, has fallen sharply in absolute terms.
By the standards of previous cycles, residential construction should be nearing the bottom. ... [H]ome prices have dropped about 18% from their mid-2006 peak ... and incomes have steadily grown, homes are returning to more typical levels of affordability in some regions. ...
There are numerous caveats, however. First, the scale of the housing boom means history is a flawed guide to how big a retrenchment is in store. ... David Seiders, chief economist at the National Association of Home Builders (NAHB)..., thinks that in normal times, 3.6% of America’s housing stock ... should be vacant. The figure is now 4.8%..., one reason Mr Seiders thinks construction is going to keep falling until the second quarter of next year.
Some believe that with banks and other lenders dumping huge numbers of foreclosed homes, prices could fall well below equilibrium. That is debatable. A recent paper by Charles Calomiris of Columbia University and Stanley Longhofer and William Miles, both of Wichita State University, argues that foreclosure sales will impact prices less than commonly thought. ...
Most serious is the prospect of a further squeeze on credit. The fate of the mortgage market has increasingly rested on the shoulders of Fannie Mae and Freddie Mac, as well as Ginnie Mae, their wholly government-owned counterpart. But they may not have much more staying power; last month, their issuance of mortgage-backed securities plunged by 41% from June... Even if Fannie and Freddie’s capital constraints do not stop them guaranteeing mortgages, they have tightened their underwriting terms. Banks, which lack capital themselves, are passing these tighter terms on to customers. ...
This has left both optimists and pessimists pinning hopes for a rebound on the federal government. Last month’s housing-rescue law offers up to $7,500 to first-time homebuyers... The law also made the government’s implicit backing of Fannie and Freddie explicit, if necessary by injecting capital into them. Ms Coronado admits her optimistic case goes out of the window if the two firms can no longer do their job. Which is why, she says, the government will ensure that they can.
I don't think we are there yet. Housing prices are still above historical trends, and the recovery from housing bubbles is notoriously slow.
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