[Pen-l] The Housing Bubble and the Financial Crisis -- What Congress Can Do

[Liz Chimienti <chimienti@xxxxxxxx>]

POLICY MEMO

To:              Interested Parties

From:          Dean Baker, Center for Economic and Policy Research

Topic:          The Collapsing Housing Bubble and Resulting Financial Fallout

Date:           April 1, 2008

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In the decade from 1996 to 2006, the United States developed an enormous housing bubble that had no precedent in the country's history. During this decade, house prices rose in excess of 70 percent of their historic trend rate of growth, creating more than $8 trillion in housing bubble wealth.

This bubble is now collapsing. Its collapse is throwing the economy into a recession and threatening the stability of financial markets. In assessing the various proposals and measures being put forward to address this situation, there are several important factors to keep in mind:

1. the housing bubble cannot be sustained - prices must be allowed to return to trend levels;
2. housing policy should be focused on helping homeowners who were often tricked into buying predatory mortgages, not helping institutional holders of bad mortgage debt;
3. bailouts of financial institutions should focus on keeping the financial system operating smoothly while avoiding as much as possible giving taxpayer dollars to the people whose actions created the current crisis;
4. the Fed should pursue a policy of maximum transparency - lack of transparency was a major factor leading up to the current crisis;
5. where it is impossible to avoid having the federal government provide aid to troubled financial institutions, there should be an explicit quid pro quo, with the government either accomplishing an important policy goal or getting a return on their investment.

1. The bubble must be allowed to deflate.

It is important to recognize that the housing market experienced an unsustainable bubble. There were no changes in the fundamental supply or demand factors in the housing market that could explain the unprecedented run-up in prices over the last decade. There was also no unusual increase in rents during this period, which would have been predicted if the run-up in house sale prices was explained by market fundamentals.

This means that prices must fall back towards their trend level. This fact must inform housing policy. In cities in which house prices are still out of line with trend levels, government programs to buy up or guarantee mortgages will lead to large losses for the government, and will also cause homeowners to pay far more in ownership costs than they would pay to rent a comparable unit.

Furthermore, since prices are still falling, homeowners who receive "assistance" will almost certainly acquire no equity in their houses. Under such circumstances, government support really only helps current institutional mortgage holders, since it pays them a price for their mortgage that is almost certainly much larger than what it would be worth in the absence of government intervention.  

2. Government policy should be tailored to help homeowners.

It is possible to structure a housing guarantee plan that would help homeowners. The key would be to set the purchase/guarantee price at a multiple to appraised rent (a sale-to-rent ratio of approximately 15 would be reasonable and in line with historic trends). This would ensure that the government doesn't step into the middle of a collapsing bubble.

An alternative mechanism for protecting homeowners would be to temporarily change the rules on foreclosure. If homeowners facing foreclosure temporarily had the option to remain in their house as long-term renters, paying the fair market rent, this would provide an important element of security to homeowners, and would stabilize neighborhoods facing large numbers of foreclosures. More importantly, since banks do not want to become landlords, it would give mortgage holders a very powerful incentive to renegotiate the terms of loans in ways that allow homeowners to remain in their homes [1].

This proposal would cost the government nothing. It can also be targeted to ensure that it only benefits low- and moderate-income families by setting a cap restricting the rule change to homes that sold at less than the median house price in an area, or some comparable cutoff. Such a cutoff could ensure that only relatively low-income people benefit from this rule change.

3. The Fed should help the financial system, not the financial sector.

On the issue of financial bailouts, it is important to distinguish between actions that protect financial institutions, and actions that protect the financial system. The government's policy should rightly be focused on preventing the collapse of a major financial institution that could lead to a chain reaction within the industry.

The model for such intervention should be the takeover of the Northern Rock bank by the British government. The bank was essentially bankrupt, even after being given special low-interest loans from the Bank of England. To prevent a chain of collapses, the government took over the bank and replaced the management. The immediate task of this new management is to get the books in order, at which point the bank will be resold to the private sector. The original stockholders will be entitled to any money from the stock sale, net of government infusions into the bank.

The Northern Rock takeover is a model because it sustained the stability of the financial system while getting rid of the management who had driven the bank into bankruptcy, and did not give any taxpayer money to shareholders.

4. Investors and the public deserve transparency.

The current actions of the Fed do not look good by comparison. First, the creation of the Term Auction Facility (TAF) allowed banks to borrow large amounts of reserves from the Fed without any public record. If a bank is in a situation where it finds it necessary to borrow large amounts of reserve, this information should be known to investors and the general public.

The terms of Bear Stearns' takeover also raise important concerns, especially with the increase in the takeover price. It is not clear whether J.P. Morgan is paying $1.3 billion for Bear Stearns, or for a $30 billion guarantee from the Fed. If J.P. Morgan is actually interested in buying Bear Stearns and paying a substantial price to its shareholders, then there is no obvious reason for the Fed to get involved. The current terms make it appear as though Bear Stearns shareholders are profiting at taxpayer expense.

Finally, the Fed has implicitly (almost explicitly) indicated that it will guarantee the loans, credit default swaps and other commitments of the major investment banks. In addition, it has made them eligible to borrow hundreds of billions of dollars at low-cost through the Fed's discount window.

5. No free rides.

Under the circumstances, this may be good policy, but the public should demand some return for the Fed's generosity. As a first and necessary step, the Fed should regulate investment banks. The primary goal of this regulation would be greater transparency in investment bank dealings, such as full disclosure of the volume of their credit default swaps and other liabilities.

This step would be completely voluntary for the financial institutions. If they do not want to take advantage of the Fed's implicit guarantee or have access to the discount window, they can operate outside the Fed's purview. Of course, they may find it much more difficult to get customers once it is known that the Fed is not concerned if the bank fails.

The second part of the quid pro quo could be in the form of either a share in the company, a social policy commitment, or both. It is important to remember that the discount window is in effect providing banks with access to loans at below the market rate of interest. Even more important, the Fed's guarantee is effectively allowing banks to sell credit default swaps that are backed up by the government - not by the banks themselves, since they lack sufficient capital. In effect, the banks are selling the Fed's good credit, not their own.

It is entirely reasonable for the taxpayers to get something in return for providing enormously valuable credit guarantees to the investment banks. One option would be for the government or the Fed to get some amount of stock options each year, so that it would share in any gains incurred by the bank. A second option would be for the Fed to charge a fee for providing this guarantee that would be proportionate to the bank's capital.

On the social policy side, the government could impose limits on executive compensation at the institutions they assist with guarantees. For example, it could prohibit the annual total compensation for any executive from exceeding $5 million. These limits would ensure that taxpayers are not subsidizing exorbitant salaries and bonuses. Since the exorbitant salaries on Wall Street have been guideposts for other high-paying occupations, bringing these salaries down to earth could go far toward reducing inequality in our society.

[1] This plan is outlined at

http://www.cepr.net/index.php/op-eds-columns/op-eds-columns/the-subprime-borrower-protection-plan/
.

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Center for Economic and Policy Research, 1611 Connecticut Ave, NW, Suite 400, Washington, DC 20009
Phone: (202) 293-5380, Fax: (202) 588-1356, Home: www.cepr.net

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Liz Chimienti
Domestic Policy Analyst
Center for Economic and Policy Research
1611 Connecticut Ave NW, Suite 400
Washington, DC 20009
Phone: (202) 293-5380 x110
Fax: (202) 588-1356

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