North America: Living in the political wake of the US housing bubble

Article Highlights

  • Government should encourage new bank creation, as new, little banks work with small businesses

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  • Saving, not just lending, is an essential part of housing finance

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  • A regulatory super-committee cannot change the reality of a recursive, unpredictable financial system

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The U.S. is living in the wake of the great 21st century bubble and its collapse, as a dominating influence in the financial, economic, and political spheres.

The financial consequences reflect the huge overhang (and hangover) of excess debt. The financial bubble included a vast creation of debt based on asset prices that no longer exist, particularly in the housing market. After the collapse, there was a $7 trillion correction in price (or a 30% correction) — this took U.S. average house prices back to their long-term trend line. If we continue along the trend line, we will reach the 2006 peak prices again in 2020.

While the asset prices have adjusted back to their long-term trend-line, debt has only partially adjusted. Here is Pollock's Law of Finance: when debt can’t be paid, it will default. Additionally, the collapse of the housing market has turned the Federal Reserve into the largest savings and loan institution in the world, owning nearly $1 trillion in mortgages, all funded short. The Fed, as Manager of the Banking Club, is also depressing short-term interest rates so banks can gradually work their way through their loan losses.

The bust slowed economic activity overall, of course. It has now resulted in a bi-modal credit market: bond markets are booming, but the banking system is clogged, reflecting procyclical banking and regulatory behavior.

The political aftermath of the bubble is a wholly predictable repeat of history. Following a crisis, there is always a political phase. The political phase involves first finding a way to assign blame and opprobrium, and then to “Do Something.” After the financial bust in the 1980s, Congress passed the Financial Institutions Reform, Recovery and Enforcement Act in 1989, the FIDC Improvement Act in 1991, and the Safety and Soundness Act in 1992. After this, the secretary of the Treasury said “never again” would a financial crisis happen — a poor prediction.

The Dodd-Frank Act is the latest “Do Something” event — an act that is reorganizing and greatly expanding the regulatory jurisdiction throughout the financial sector. At the top of this regulatory expansion is the “Financial Stability Oversight Council” (FSOC) established by the Dodd-Frank Act — a cumbersome, very political super-committee whose efforts will be spent mainly protecting turf and jurisdiction among its component regulatory bureaucracies.

One of the biggest causes of the bubble and financial crisis was the government itself. How will this highly political body be able to criticize the government? Let us recall the excellent question posed to Federal Reserve Chairman Bernanke by Senator Bunning: “How can you regulate systemic risk when you are the systemic risk?” On the whole, the real role of the committee may end up being just for show, to prove that the government is Doing Something, without doing much.

Moreover, the FSOC is unlikely to succeed at correctly forecasting and preventing crises. There is no evidence that regulatory bureaucracies can generate the superior knowledge of the future required to so. Regulators make the same cognitive mistakes as everyone else. They participate with private financial actors in “cognitive herding,” where everyone’s view reflects the same ideas.

The financial sector displays fundamental uncertainty: recursively interacting expectations and behavior cannot be accurately calculated. The recursiveness of financial markets means that everything you anticipate and do changes the market-- what you believe about the risk distribution changes the risk distribution. A regulatory super-committee cannot change this profound reality.

Although financial cycles cannot be eliminated, here are four suggestions to moderate future cycles:

First, develop counter-cyclical loan-to-value (LTV) ratios. The LTV ratio indicates how much one is willing to lend against the current market value of the asset. Typically, the LTVs in housing finance tend to go up as house prices rise, but they should go down when the prices go up rapidly. This will help dampen the cycle. Canada has actually implemented something along these lines, where they have reduced some maximum LTV ratios in reaction to their booming house prices.

Second, the practices regarding loan loss reserves should require that bigger loan losses be built during the good times. When optimistic loans are being made, we should be building up loss reserves, because loans made during a boom are certain to be the biggest losers later.

Third, the government should encourage the creation of new banks during the bust. Now, the bond market is booming but the banking market is restricted. New, little banks are needed to work with small businesses and entrepreneurs. Now is the best time to enter the banking business because credit is conservative. U.S. regulators tend to charter new banks in the boom and close off the creation of banks in the bust, mainly because then FDIC needs the capital for failed banks and doesn’t want to allow it to form new competitive banks instead. This is precisely the wrong policy, and should be reversed to help resume growth following a crisis.

Finally, saving, not just lending, should be encouraged as an essential element in housing finance.

These are things we should be working on in the political wake of the bubble.

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About the Author


Alex J.
  • 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.

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