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

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

Short of war or terrorism, this is by far the greatest risk posed to the American economy and to our way of life. Unfortunately, neither the Administration nor the Congress nor the regulators are prepared to act to stop this eventuality. The Administration has not set up the kind of proactive interagency working group that could monitor the mortgage market and put out the proverbial fires that are bound to erupt. Congress is about to hold the very hearings that will help to remind the markets about the political risks they face. And the regulators are decidedly behind the curve.

While the Federal Reserve has done a fine job of following Bagehot's advice regarding monetary policy, it has not been timely in its actions on the mortgage market. It was not until early March 2007 that the Fed and other banking regulators issued a rule regarding sub-prime lending with teaser rates with large interest rate hikes built in. No one could argue that subprime mortgages that reset at rates many hundreds of basis points higher than the initial qualifying rate are prudent things to issue in the first place. But they didn't suddenly become imprudent in the last few months. They were imprudent loans to make two years ago when they were all the rage and the Fed was say ing nothing. This might have been a clear case of closing the barn door after the cows had already left. But it gets worse, because now it is essential to get the cows back in the barn. To do that, the Fed and the other regulators must make it possible for the mortgage market to operate as freely as possible--in particular to allow and even encourage others to buy the paper that has already been issued or to encourage others to lend on a more affordable "reset" basis to the homeowners who otherwise face foreclosure.

It is vital that the Fed and other political actors recognize that this is a credit market cycle and not yet an economic or monetary policy cycle. Should the mortgage market actually break down due to the enhanced legal risks now looming, there probably is no reasonable change in monetary policy that could offset the downward spiral. The Fed, the Congress and the Administration would be well advised to make every possible legal assurance to market participants that they will not be subjected to massive and unquantifiable legal risk by "doing the fight thing" and participating in the mortgage market.

Sad to say, but this is the exact opposite of the political instincts of Washington. In the coming months the odds are high that we will hear pressure to "regulate and cut interest rates." This would be a policy of "restrict lending at a concessionary rate," exactly the opposite of Bagehot's suggestion of "lend freely at a punitive rate." The history of credit cycles is full of examples of countries that have ignored Bagehot's advice, and we may be about to add another chapter to that history. Homeowners, watch out.

The Price of Money.

Walter Bagehot (1826-77), 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.