Fear and greed: why the American housing credit crisis is worse than you think

International Economy, The, Spring, 2007 by Lawrence B. Lindsey

As most homeowners know by now, it's a buyer's market in residential real estate. With the correction still underway, this could turn into the largest sustained decline in nationwide home prices since the 1930s. For students of credit cycles and housing, the last few years have been like watching an inevitable train wreck in slow motion. At this point there is still time to avoid real carnage. But there is every indication that all of those involved, particularly the political and regulatory leadership of the country, are following business-as-usual rules when what is really needed is some creative behavior.

Today we are witnessing the end of a fifteen-year expansion in the housing credit cycle. Cycles, by definition, go round-trip and this period of ever-easier credit terms will be followed by a tightening of such terms. Walter Bagehot, an editor of the London magazine The Economist, famously commented on the preferred policy reaction to credit cycles 130 years ago with the line "lend freely at a penalty rate." By this he meant that the central bank (our Fed, his Bank of England) should let the credit market correct itself in an unfettered fashion, provide ample liquidity for the market to do so, but charge market participants for the privilege, using the price of money and not heavy-handed regulation as a way of restoring some discipline.

Bagehot's recommendation was a contrarian point of view 130 years ago, and still is today. The more standard incentive for policymakers in charge is to let markets go to ever higher extremes without supervision on the way up. That way those in charge enjoy the popularity of a world in which everyone is making money. Then, when the cycle goes into reverse and things fall apart, they jump in and blame the market participants, sharply tighten regulations, and in the process drive the market down further. America did this in the stock market bubble of the 1990s letting all of the excesses happen with no regulatory interference on the way up, while our politicians claimed that we were in a new era in which the business cycle was repealed and an age of endless affluence was upon us, thanks to their sound policies. Then, when the market crashed they "rounded up the usual suspects," jailed some, and passed tough new rules so that "it will never happen again." We already know that the effect of those new rules has been to drive the financial services industry out of New York and overseas to London, and to a lesser extent places like Hong Kong and Singapore. True to form, some of the very politicians who brought the new regulatory environment into play are complaining the loudest about the results.

If we are not careful, the same sort of cycle will occur in housing. But with homeowner ship much more widespread and more integral to both our economy and our social fabric, the implications of simply replaying this process could be more profound. To begin, consider how we got where we now are.

OUR FIFTEEN-YEAR HOUSING BOOM

The current mortgage credit cycle began almost two decades ago in the wake of the collapse of the savings and loan industry and the enactment of two pieces of legislation--FIRREA in 1989 and FDICIA in 1991--that restructured the industry. The S&L industry had provided the financing that led to record-setting homeownership in the decades that followed World War II. But it was built on a business model of short-term borrowing and long term re-lending that could not survive the inflation and resulting high interest rates of the 1970s. After some failed experimentation with patchwork solutions during the 1980s, the whole home financing system was bailed out and redone by the politicians of the day. In the process they made sure "it would never happen again." Part of that process was to make credit terms quite restrictive and direct the bank regulatory agencies to force banks to purge their books of potentially bad credits. Regional real estate collapses resulted in Texas, New England, and California as banks stopped rolling over existing credits and gave new credit only under very stringent terms. In 1991, spending on residential construction amounted to just 3.4 percent of GDR down from a peak of 5 percent in 1987.

What bankers at the time called "this regulatory reign of terror" abated as the mortgage market stabilized and more normal credit conditions emerged. Financial markets are fabulous innovators at times like these. There were three problems with the S&Ls that both the regulators and the financial markets knew had to be fixed. First, they borrowed short-term and lent-long term so when short-term rates went up, they lost money. The solution to this was to increase the number and attractiveness of variable rate mortgages and to find a way to hedge the risks on long term mortgages. Second, the S&Ls were created to make and hold mortgages on their own books, leaving them particularly vulnerable to swings in the housing industry. The solution was to shift mortgage market risk onto institutions that were more diversified. Third, the S&Ls tended to operate on a very regional basis, leaving them vulnerable not just to national housing market and interest rate swings, but to local conditions as well. The solution was to create a national market that could diversify away from regional risks.