Housing bubble controller

Article Highlights

  • To confront future over-leveraging now, we need to implement a counter-cyclical bubble controller.

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  • A counter-cyclical LTV rule would protect homeowners and mortgage investors by discouraging unwise mortgages in overheated markets.

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  • A great deal of human misery would have been avoided had a counter-cyclical LTV rule been in place during the last decade.

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The housing market is finally recovering from the six-year bust triggered by massive over-leveraging induced by bubble prices. Housing values dropped by $7 trillion from 2006 to 2009, causing home foreclosures to soar to record levels.

To confront future over-leveraging now, we need to implement a counter-cyclical bubble controller: an automatic requirement to reduce loan-to-value ratios in overheated housing markets, while allowing them to rise in more stable markets. Such "counter-cyclical loan-to-value limits" are one of the best suggestions to come out of studying the last crisis and would be a powerful fundamental reform.

In its simplest form, this reform could be an underwriting rule stating that a mortgage loan cannot exceed the value that the property had three years ago. Such a rule will have no effect under normal market conditions but will act as an emergency brake in out-of-control markets. In the overheated markets of the last decade, a rule like this would have forced down payments large enough to mop up the inrush of speculative capital.

The simple rule described above arguably raises the down payment too much in sharply rising markets. To address such issues, the American Enterprise Institute has an ongoing project to develop the best such approach, which will be debated at a conference there this summer.

A counter-cyclical LTV rule would protect homeowners and mortgage investors by discouraging the issuance of unwise mortgages in overheated market conditions and serve as a core feedback mechanism to dampen future "bubble and bust" cycles in the real estate markets. It is an example of what is called a "regulator mechanism" in engineering control theory — much like the governor who controls the speed of a lawn-mower engine.

A great deal of human misery would have been avoided had one been in place during the last decade.

U.S. Rep. Bill Foster, (IL-D)

Alex J. Pollock, American Enterprise Institute, Washington

Jonathan Reiss, Analytical Synthesis LLC, New York

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About the Author

 

Alex J.
Pollock
  • Alex J. Pollock is a resident fellow at the American Enterprise Institute (AEI), where he studies and writes about housing finance; government-sponsored enterprises, including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks; retirement finance; and banking and central banks. He also works on corporate governance and accounting standards issues.


    Pollock has had a 35-year career in banking and was president and CEO of the Federal Home Loan Bank of Chicago for more than 12 years immediately before joining AEI. A prolific writer, he has written numerous articles on financial systems and is the author of the book “Boom and Bust: Financial Cycles and Human Prosperity” (AEI Press, 2011). He has also created a one-page mortgage form to help borrowers understand their mortgage obligations.


    The lead director of CME Group, Pollock is also a director of the Great Lakes Higher Education Corporation and the chairman of the board of the Great Books Foundation. He is a past president of the International Union for Housing Finance.


    He has an M.P.A. in international relations from Princeton University, an M.A. in philosophy from the University of Chicago, and a B.A. from Williams College.


  • Phone: 202.862.7190
    Email: apollock@aei.org
  • Assistant Info

    Name: Emily Rapp
    Phone: (202) 419-5212
    Email: emily.rapp@aei.org

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