How To Prevent The Next Asset Bubble

by: Shareholders Unite

Summary

Some blame the government and the Fed for the housing bubble that led to the financial crisis.

As a remedy, they want to abolish government regulation and force the Fed on tight monetary policy.

A careful look at history and the experience of other countries shows that this gets it backwards.

Perhaps these lessons could enlighten us to get it right the next time.

Free marketeers argue that it is simple to prevent asset bubbles. Any bubble is caused by the Fed, embarking on irresponsible easy money policies in a misguided attempt to stimulate the economy.

This is wrong, they argue. Markets don't get it wrong, so just let them do their work and get out of the way.

The same holds for misguided government policies, like the Community Reinvestment Act (CRA), or Fannie Mae and Freddie Mac underwriting mortgages.

Indeed, this long dead corpse is being revived by Larry Kudlow and Stephen Moore, now economic advisors to Donald Trump, and this is a reason their view matters, as it could be implemented into policy. For instance, Trump already said that he wants to abolish Dodd-Frank.

All of this stuff (which originated from Peter Wallison and Edward J. Pinto) has been debunked before (for sources, see here), but it is instructive to go through the main arguments.

For starters, let's not forget that it was actually Margaret Thatcher who, with her vision of an ownership society, started to introduce policies to get poor families onto the property ladder. This didn't start as some left-wing hobby.

But a look through history and the experience of other countries shows that housing bubbles are not generally caused by central banks and misguided government policies.

More important, it shows that tight money in times of a savings glut and deregulation isn't effective in stopping bubbles. Let's look at some of that.

1) The Fed causes bubbles

If asset bubbles are blamed on easy money policies from the Fed, then the way to prevent these is tighter money. This has several serious drawbacks:

  • The Fed must be able to recognize bubbles well in advance. Good luck on that. This is basically saying that the Fed must be wiser than the markets, an odd position for market fundamentalists to take.
  • The Fed must use tight money to squeeze out or prevent bubbles even if (as in the 2000s), there are no signs of inflationary risks or an overheating economy.

The latter is basically arguing that in order to reign in Wall Street, the Fed has to sacrifice Main Street, as tighter money will surely have an adverse effect on growth.

We think there are better alternatives: see 4) below.

This position also presupposes that bubbles cannot be formed without central bank complicity, which is running against a whole literature on financial market stability (or lack thereof).

We argued more extensively against blaming the Fed here. In summary:

  • The low rates are market driven, not Fed driven. They are the result of excess saving and rising demand for safe assets (from 2000 to 2007, worldwide fixed income investment roughly doubled in size to $70 trillion, but supply couldn't keep up, apart from securitization).
  • There wasn't any need for tighter monetary policy as there was no inflationary threat.
  • The Fed doesn't control the long end of the maturity spectrum.

On the first point, even people highly critical of central banks now seem to agree. Here is one of them, Jeremy Warner from The Telegraph:

Bill Gross, founder of Pimco and self-proclaimed king of the bond markets, calls this phenomenon "a supernova that will explode one day". I'd be inclined to agree with him, but for the fact that some years ago he said that UK gilts were "sitting on a bed of nitroglycerine". Since then, the yield has halved, and then halved again. This has been an implosion rather than an explosion, more black hole than supernova. Of all the explanations posited for declining global interest rates, the most plausible is that of the "savings glut".

In the eurozone and Japan one could possibly still blame central banks but the same is going on in the UK and the US, where central banks have long stopped doing this.

The savings glut not only explains the record low interest rates, it also explains the disappointing growth, investment and low inflation.

2) The CRA caused the housing bubble

The CRA forced banks to lend more than they otherwise would have preferred, or so goes the story. However, this doesn't stand up to scrutiny.

The CRA originated in the mid-1970s.

It's odd for it to have such delayed effect, causing a housing bubble only 30 years after its origination. The timing is much more compatible with the securitization cycle, which we (and many others, of course) argue has been the real force behind the housing bubble and subsequent financial crisis.

  • Many other countries (Spain, Ireland, the UK, the Netherlands) experienced housing bubbles as well, without a CRA being responsible.
  • Equally mysterious is that there was another (even worse) bubble in commercial real estate, which isn't subject to the CRA
  • In 2006, 24 of the top 25 mortgage lenders were non-banks like Countrywide and they didn't fall under the CRA.

Researchers at the Fed didn't find a relation between the CRA and sub-prime mortgages either:

Most importantly, only six percent of all higher-priced loans were made by CRA-covered lenders to borrowers and neighborhoods targeted by the CRA... Further, our review of loan performance found that rates of serious mortgage delinquency are high in all neighborhood groups, not just in lower-income areas.

3) Freddie and Fannie did it

This also doesn't sit with the facts. It was private-label securitization which was responsible for the boom.

For orientation purposes, here's a definition of private label securitization:

Private-label mortgage backed securities are securitized mortgages that do not conform to the criteria set by the Government Sponsored Enterprises Freddie Mac, Fannie Mae and Ginnie Mae. The mortgages that make up these securities do not have the backing of the government and as a result carry a significantly greater risk.

As David Min has written, private-label securitization

experienced a dramatic increase in market share that was exactly contemporaneous with the housing bubble, rising from about 10 percent market share in 2003 to nearly 40 percent by 2006. Overall, loans originated for private-label securitization have defaulted at about six times the rate of Fannie and Freddie loans. Indeed, Wallison does not explain--cannot convincingly explain--why the housing bubble occurred during a period when Fannie and Freddie's market share dropped precipitously.

And (from the Fed research):

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.

We might also mention that Wallison and Pinto use a peculiar definition of sub-prime by which over half (27M out of 54M) of all outstanding mortgages become sub-prime.

4) There is a simple alternative

What really happened isn't that hard to grasp. Financial institutions learned the trick of securitization. By packaging a host of mortgages into complex instruments (like CDOs, collateralized debt obligations), they managed to get risky mortgages off their balance sheets.

This drastically reduced the need to scrutinize credit risk and turned much of the mortgage industry into a volume business. This is exactly what happened at the worst of these financial institutions, like Countrywide (for a graphic description, see for instance here).

Since these derivatives markets were lightly regulated there wasn't much in the form of mandatory capital that institutions had to hold against positions, which made parties holding them on balance rather vulnerable. From Investopedia:

CDOs remained a niche product until 2003-04, when the U.S. housing boom led the parties involved in CDO issuance to turn their attention to non-prime mortgage-backed securities as a new source of collateral for CDOs. CDOs subsequently exploded in popularity, with CDO sales rising almost 10-fold from $30 billion in 2003 to $225 billion in 2006. But their subsequent implosion, triggered by the U.S. housing correction, saw CDOs become one of the worst-performing instruments in the broad market meltdown of 2007-09. The bursting of the CDO bubble inflicted losses running into hundreds of billions on some of the biggest financial institutions, resulting in them either going bankrupt or being bailed out through government intervention, and contributing to escalation of the global financial crisis during this period.

Part of the market explosion is also due to the fact that lower rated mortgage backed securities were difficult to sell, so these ended up in CDOs, which became the engine that powered the mortgage supply chain.

According to the Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States (the Financial Inquiry Report), the CDOs increased the demand for mortgage-backed securities without which lenders would have "had less reason to push so hard to make non-prime loans."

The role of the ratings agencies cannot be overlooked either. Although 70%-80% of the collateral of CDOs consisted of lower rated ('mezzanine') tranches, most of these were rated triple A, satisfying the demand for 'save' assets to absorb the global savings glut.

The ratings agencies, which get paid by the number of ratings, discovered a huge new profitable source of income: rating CDOs earned up to five times the fees compared to similarly sized CDOs backed by municipal bonds.

Moody's (NYSE:MCO) (one of the two big ratings agencies) operating margins were consistently over 50%, making it one of the most profitable companies in existence (Financial Crisis Inquiry Report).

In short, there was a big demand for save assets, the supply of which was delivered by securitization of mortgages, crucially vetted safe by ratings agencies, and this enabled financial institutions do turn the mortgage business into a volume business as they could get the risk off their balance sheet and start anew.

One should read (here, or in The Big Short, by Michael Lewis) some of the practices of the industry, where basically everybody who could "fog a mirror" would get a mortgage, often enticed by one or two-year "teaser" mortgage rates, after which payments skyrocketed.

Hard sell methods were used to entice the low and moderate income to sign up for mortgages, down payments, income documentation were often dispensed with and interest and principal payments were often deferred upon request, according to the Financial Inquiry Report.

After the crisis burst, many financial institutions didn't behave any better (Book review of The Great Foreclosure Fraud by David Dayen in Prospect):

the mortgage industry fundamentally ruptured a centuries-old system of U.S. property law; that millions of documents generated to foreclose on people's homes were phony; and that all those purchasing a mortgage in America were taking a gamble that they would be tossed onto the street with nothing, even if they made every payment and played by the rules. Virtually everyone to whom they presented this information reacted the same way: "That can't be true." Right up until the day the banks admitted it.

Deregulate!

The US hadn't experienced a major financial crisis since regulation in response to the Great Depression was put into place.

Only when it started to deregulate these did the underlying instability and market failures (like information asymmetries so clearly at play in the derivatives markets) become visible and ultimately resulted in a crash which we still feel until today.

This isn't a coincidence. Other countries that didn't deregulate their financial systems with anywhere near the same zest didn't experience anything like it. It really isn't rocket science.

Our exhibit B would be Denmark. Despite having record low (actually negative) interest rates of -0.65%, something which the blame-the-Fed crowd would surely point as a cause for alarm and stoking asset bubbles,

Compared with New York, London, and even Stockholm, Copenhagen real estate is still a bargain: $500,000 buys a decent two-bedroom. If Berg is correct, that's largely because the country regulates the housing market to a degree unimaginable in the U.S. It's nearly impossible for a foreigner with no connection to Denmark to buy property, preventing inflows of overseas money. Banks apply stringent financial criteria to mortgages for buy-to-let properties; it's hard for Danes to purchase homes they don't intend to live in. Regulatory guidelines require minimum down payments of 5 percent and stress tests of borrowers' finances against runups in rates. With the encouragement of regulators, banks have hiked fees on flexible-rate loans, nudging buyers into fixed-rate mortgages. The rules are even tighter for properties in Copenhagen.

- Bloomberg

So there is the simple proof. We have two policy prescriptions:

  • Market fundamentalists want to deregulate as much as possible, combined with tight monetary policy to prevent asset bubbles.
  • People less dogmatically inclined who simply look at history and/or other countries to see what works, and come up with exactly the opposite conclusion. In times of excess savings, excess capacity and no danger of inflation, monetary policy should be loose but asset markets should be well-regulated to prevent bubbles.

The Danish (or similar Singaporean) model could also offer important lessons for places like London, where locals are priced out of property as foreign hedge funds and rich private investors chase property prices to ludicrous heights but often leave the properties empty.

Will we get it right the next time? Difficult to say, there is a strong lobby that wants to do away with financial regulation, rather than look at other countries to see what works. We roughly know what works. It's getting it implemented that is the hard part.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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