Russell Roberts on the housing bubble and financial crisis

Here's a new paper on the housing bubble by GMU economics professor Russell Roberts.

Here's a summary of the paper by GMU economics professor Tyler Cowen:

1. It isn't "too big to fail" that's the problem, it's the rescue of creditors going back to 1984, encouraged imprudent lending and allowed large financial institutions to become highly leveraged.

2. Shareholder losses do not reduce the problem even when shareholders are the executives making the decisions

3. These incentives allowed execs to justify and fund enormous bonuses until they blew up their firms. Whether they planned on that or not doesn't matter. The incentives remain as long as creditors get bailed out.

4. Changes in regulations encouraged risk-taking by artificially encouraging the attractiveness of AAA-rated securities.

5. Changes in US housing policy helped inflate the housing bubble, particularly the expansion of Fannie and Freddie into low downpayment loans.

6. The increased demand for housing resulting from Fanne and Freddie's expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.

Skimming the paper, it looks like it may have interesting points, but I worry that it's a case of a researcher finding what he wanted to find.

David Brooks on financial regulation

From David Brooks via Greg Mankiw:

Between 1997 and 2006, consumers, lenders and builders created a housing bubble, and pretty much the entire establishment missed it. Fannie Mae and Freddie Mac and the people who regulate them missed it. The big commercial banks and the people who regulate them missed it. The Federal Reserve missed it, as did the ratings agencies, the Securities and Exchange Commission and the political class in general. ...

The premise of the current financial regulatory reform is that the establishment missed the last bubble and, therefore, more power should be vested in the establishment to foresee and prevent the next one.

Some Bubble Meter readers may think that I oppose financial regulation. Quite the opposite, I support it. But, there's a difference between effective regulation and ineffective regulation. I believe some parts of the proposed financial reform bills—such as a Consumer Financial Protection Agency—are an improvement on the current system, but I fear the bill may be mostly ineffective. Democrats are too prone to believing in the ability of government bureaucrats to spot trouble before it occurs. At the same time, some simple and important policies—such as requiring banks to issue contingent convertible bonds, banning teaser rates, and requiring home buyers to make sizable down payments—are missing.

Note: Despite David Brooks' claim, home builders didn't help create the bubble. They simply took advantage of it. By increasing the supply of housing, they were actually acting to suppress the bubble.

In search of fairy tale regulators

Arnold Kling echoes my skepticism of regulation:

Kevin Drum writes,

From a systemic point of view, the real issue is that predatory lending on a large scale helped to massively inflate the housing/credit bubble of the aughts. If the home loan market had been regulated stringently enough to keep mortgage lending relatively sober, the bubble most likely would have been half the size it ended up at...

Well, yes, if a regulator had stepped in and required 10 percent down payments, the bubble would have been much smaller. That is excellent hindsight. But in the real world, with real politicians, there is no way that a regulator would have done that. The result would have been to drive first-time homebuyers, particularly minorities, out of the market. That was an inconceivable policy decision in 2004 or 2005.

One of the assumptions about the "markets fail, use government" folks is that government always knows what it's doing. I guarantee you that the next financial bubble will be something that the regulators miss, just as they missed the last one.

For the record, I think a regulation requiring larger down payments would be the most effective way of preventing future housing bubbles, but of course none of the politicians want to go down that route. Quite the opposite, they're actively encouraging 3.5% down payments and $8,000 tax credits (which can be used toward the down payment).

Hat tip to an anonymous commenter for the second link.

Home sales leap as tax credit nears expiration

Offer potential home buyers other people's money, and they will use it:

New-home sales rose 26.9% to a seasonally adjusted annual rate of 411,000 last month, compared to a upwardly revised annual rate of 324,000 in February, the Census Bureau said. ...

New-home sales spiked in every region of the United States. The South saw the biggest jump in new home sales, up a stunning 43.5%, while the Northeast region saw sales climb 35.7%. The West and Midwest regions both saw single-digit growth.

The Census Bureau data followed a report from the National Association of Realtors on Thursday that showed existing home sales soared nearly 7% in March, as new homebuyers raced to buy up properties before a tax credit expires on April 30.

I usually don't like month-over-month numbers, but these are at least seasonally adjusted.

Is now a good time to buy a home?

No. Maybe.

One correction for David Leonhardt. He writes:

Markets often overshoot, on both the upside and downside.

Actually, financial markets often overshoot on the downside. Real estate markets don't.

A libertarian view of financial regulation

In The Wall Street Journal, Gerald P. O'Driscoll writes:

Public choice theory has identified the root causes of regulatory failure as the capture of regulators by the industry being regulated. Regulatory agencies begin to identify with the interests of the regulated rather than the public they are charged to protect. ...

Congressional committees overseeing industries succumb to the allure of campaign contributions, the solicitations of industry lobbyists, and the siren song of experts whose livelihood is beholden to the industry. The interests of industry and government become intertwined and it is regulation that binds those interests together. Business succeeds by getting along with politicians and regulators. And vice-versa through the revolving door.

We call that system not the free-market, but crony capitalism. It owes more to Benito Mussolini than to Adam Smith.

His point is correct and well-documented, but I get a chuckle out of the fact that the author appears to be an example of what he criticizes. According to his short bio, he "has been a vice president at Citigroup and a vice president at the Federal Reserve Bank of Dallas."

Regarding housing he writes:

In the U.S today, we are moving away from reliance on honest pricing. The federal government controls 90% of housing finance. Policies to encourage home ownership remain on the books, and more have been added. Fed policies of low interest rates result in capital being misallocated across time. Low interest rates particularly impact housing because a home is a pre-eminent long-lived asset whose value is enhanced by low interest rates.

Distorted prices and interest rates no longer serve as accurate indicators of the relative importance of goods. Crony capitalism ensures the special access of protected firms and industries to capital. Businesses that stumble in the process of doing what is politically favored are bailed out. That leads to moral hazard and more bailouts in the future. And those losing money may be enabled to hide it by accounting chicanery.

For the record, I don't agree with the author's conclusion in the final paragraph of the WSJ article. The author opposes government regulation. I favor regulation, but believe it should be based primarily on proactive and consistent automatic rules, rather than reactive and fickle human judgment.

A big flaw in the proposed financial reform bills

Mark Thoma writes:

When I was asked what was missing from the proposed financial reform legislation, I should have mentioned the lack of effective reform measures for ratings agencies, particularly the incentive to provide high ratings to encourage future business. As noted below, part of the reform legislation is directed at the ratings agencies, but it doesn't get at the main problem, which is the incentive to tell its customers what they want to hear, i.e. the incentive to deliver higher ratings than deserved. For some reason ($$$???), the ratings agencies seem to be escaping the legislative and regulatory attention they ought to be receiving.

Regulatory capture

Why depending on human regulators is doomed to fail, continued...

Yes, Virginia, there is a housing bubble

...in China.

And on Wednesday, the government said housing prices had risen 11.7 percent in March alone, the fastest rise ever recorded.

Leading indicators point to another housing downturn

Robert Shiller makes the case for another downturn in housing, including the fact that leading indicators are negative:

Today, we need to worry about strong headwinds, as the government begins to withdraw its support of a still-troubled lending industry and as foreclosures are dumping millions of homes onto the market.

Consider some leading indicators. The National Association of Home Builders index of traffic of prospective home buyers measures the number of people who are just starting to think about buying. In the past, it has predicted market turning points: the index peaked in June 2005, 10 months before the 2006 peak in home prices, and bottomed in November 2008, six months before the 2009 bottom in prices.

The index’s current signals are negative. After peaking again in September 2009, it has been falling steadily, suggesting that home prices may have reached another downward turning point.

It seems, perhaps, that the people inclined to be seduced by the first-time home buyer tax credit (yeah, I'm talking about you David) took advantage of it early, causing a temporary blip in a longer downtrend.

House hunting in DC

Megan McArdle is shopping for a home:

We've been dipping our toes into the DC housing market recently, but after this weekend, I think I'm just about ready to give up. Anything that comes on the market at a decent price is snapped up almost immediately—by my count, mean time from listing to contract is under seven days.

From a supply and demand perspective, if a house is selling in seven days, it means the price is too low. It may be too high from a long-term discounted cash flow perspective, which means potential home buyers should rent instead, but on a short-term supply and demand perspective the price is too low and the sellers should raise their prices.

The only things that stay on the market long enough to look at fall into one of two categories:

1. The owner bought the house between 2004 and 2007, and wants to get their money back out, hopefully with a little profit . . . and has therefore priced their home at least $100,000 above what the market will bear.

2. The house has been rented, and the tenants, familiar with their copious rights under DC housing law, are essentially refusing to allow the house to be shown. ...

I get the sense that Megan is being unrealistic about what the market will bear. How long are these supposedly overvalued houses staying on the market? Months or years? The $100,000 figure seems dubious because, according to Zillow.com, the median value of a house in DC has fallen by only about $65,000 since the market peak. High-end homes have generally been more resistant to price declines than low-end ones.

Why can't we find anything?

In part, because that shadow inventory isn't coming on the market. There are two components to this, one DC-specific, one not. The specific part is the aforementioned tenant laws, ... The only way to break a lease is to be a single-family owner who wants to take occupancy. The bank has to let the tenant's lease run before they are evicted, as well as give them ninety days notice of the intent to vacate the property....

I don't see how this is bad, unless you're a house buyer who wants to kick someone else out of their home just so you can have it. If a bank has foreclosed on a home that is occupied by a responsible renter, why should the bank rush to sell? Isn't the bank earning rent on the home in the meantime? Renters who adhere to the conditions of their lease should be protected by the law. Besides, most leases only last for 12 months anyhow.

Note to Megan: Pay up, rent, or move to Manassas.

Google economic search trends

From a Wall Street Journal article on new ways to read the economy:

One rich repository of predictive data is Web searches, said Hal Varian, Google Inc.'s chief economist. Jumps in such queries as "unemployment office" and "jobs" can help predict increases in initial jobless claims, he said. Other search terms, he added, can anticipate traditional data on travel behavior and sales of cars and homes.

Using Google Trends, I decided to try it out for some key terms. Click on any image to see a larger version.

Google searches for "housing bubble" within the United States. Notice the spike at the 2005 housing bubble peak, followed by the long-term downtrend since then.

Google searches for "real estate" within the United States. Notice the annual cyclical pattern, as well as the long-term downtrend since 2005.

Google searches for "foreclosure" within the United States:

Google searches for "recession" within the United States:

Why regulators have incentive to look the other way

I think people who expect human regulators to step in and rein in the next bubble are deluding themselves. The Washington Post's Sebastian Mallaby helps elucidate the point:

As the Fed chairman in February 2000, Greenspan appeared before a Senate committee and explained why he was raising interest rates. Inflation had yet to pick up, but the powerful advance of technology stocks had fueled such strong growth that price pressure seemed likely. Of course, Greenspan could not know that he was right. ... Greenspan was greeted with a torrent of abuse. Then-Sen. Paul Sarbanes, Democrat of Maryland, charged that the Fed's preoccupation with runaway tech stocks harmed the job prospects of inner-city youths. Sen. Jim Bunning, Republican of Kentucky, railed that higher interest rates threatened the economy more than inflation. "I think people hear what you are saying and conclude that you believe that equities are overvalued," said then-Sen. Phil Gramm, the committee chairman. "I would bet that equity values, given what's going on, are not only not overvalued, but may still be undervalued."

Remember, this exchange took place in February 2000 — one month before the tech bubble spectacularly imploded. If Greenspan was assailed for raising interest rates then, imagine the reaction if he had increased rates really aggressively around 2005, when the real estate bubble was a good deal less obvious than the tech bubble had been. Or imagine the reaction if Greenspan had unleashed a regulatory clampdown on home lending in the teeth of the consensus that rising homeownership was wonderful. Regulators cannot anticipate bubbles with certainty, as Greenspan rightly says. And they may not act even when bubbles seem probable, as Krugman contends, because the lack of certainty makes it difficult to face down angry members of Congress.

While I dispute some of Mallaby's finer points, such as the housing bubble being less obvious than the tech bubble, it does demonstrate the social incentive to look the other way. As I've said before, when everybody's getting rich, nobody wants to step in and stop the party.

Human regulators are human-beings before they are regulators, and humans are naturally herd animals.

More of Meredith Whitney on housing

The Fed claims to be on the lookout for new bubbles

It sounds as if the Fed might have abandoned its old policy of ignoring bubbles:

Federal Reserve officials at their March meeting stressed the need to make sure record-low interest rates don't feed new speculative bubbles in stocks or other assets. ...

To aid the recovery, the Fed held the target range for its bank lending rate at zero to 0.25 percent. It's stood at that level since December 2008. And it maintained a pledge — in place for a year — to keep rates at rock-bottom levels. ...

Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, for a second straight meeting was the sole member to oppose keeping that pledge. Analysts saw Hoenig as concerned that holding rates too low for too long could feed some new speculative bubble in assets such as stocks or commodities.

Fed members noted the importance of closely monitoring financial markets and institutions to help detect risks at an early stage. They cited, in particular, the need to monitor asset prices and loan levels.

Information collected by Fed staff hasn't revealed significant threats in the financial markets or widespread high-risk-taking, the minutes concluded. Still, Fed officials said they would be on the watch for any such threats.

The Fed, though, has been attacked on Capitol Hill and elsewhere for failing to detect risks leading up to the financial crisis. ...

Some also blame for the Fed for feeding the housing bubble that eventually burst and plunged the country into the worst recession since the 1930s. Critics contend the Fed did so by holding rates too low for too long after the 2001 recession.

I do worry, however, that many people at the Fed still incorrectly believe that bubbles are impossible to detect until after they burst.

Update: More news suggesting the Fed may be gradually changing its stance on asset bubbles.

Why the experts believed bubbles can't exist

Where the bubbles are, and where they are not

Click on the image to see the full-sized version:

Source.

Larry Kudlow criticizes Obama's latest attempt to prop up housing prices

 Like me, Larry Kudlow doesn't like President Obama's latest attempt to subsidize irresponsible banks and homeowners:

Yet again, Team Obama is rewarding reckless behavior, punishing the 90 percent of responsible homeowners who are making good on their mortgages, and setting up a greater moral hazard that will surely lead to an expansion of bailout nation.

I’m talking about an add-on to HAMP, the $75 billion Home Affordable Modification Program, which has been a dismal failure. In fact, the entire foreclosure-prevention effort — including forgiveness of mortgage-loan principal — has been a failure.

The Office of the Comptroller of the Currency reports that nearly 60 percent of modified mortgages re-default within a year. And now comes a new, brilliant idea that if you live in your main residence, have a mortgage balance of less than $729,750, owe monthly mortgage payments that are not affordable (meaning greater than 31 percent of income), and you demonstrate a financial hardship, the government will subsidize you by offering TARP money to banks and other lenders to reduce your outstanding mortgage balance.

Former Bush economist Keith Hennessey highlights the outrage that Team Obama would actually subsidize people making up to $186,000 a year who have a mortgage balance of over $700,000. This isn’t even a middle-class entitlement. It’s an upper-middle-class entitlement. Actually, at $186,000, it’s virtually a top-earner entitlement, according to Team Obama’s definition of rich people eligible for tax hikes.

But Larry, don't we need to keep housing as expensive as possible?

Bloomberg financial columnist Caroline Baum argues that lower home prices are the key to solving the housing problem. Popular blogger Barry Ritholtz says we need more foreclosures, not fewer, to solve housing. Both are correct.