HW: Everyone is searching for the bottom of the housing market, but is that the relevant question to ask?
Pollock: It is the relevant question. The new 21st century brought us (and a number of other countries, too) a truly remarkable housing bubble. Surrounded by amazing computer power, reams of data, complicated financial models informed by Nobel Prize-winning theories, credit ratings by companies officially recognized by the SEC, new international capital requirements, the application of plenty of brilliant intellects, and homeownership cheerleading by politicians of both parties, we collectively made mistakes which seem unbelievable in retrospect.
Picture the bubble, using the Case-Shiller national home price index, and add the long-term trend line. Using this index, U.S. house prices went up an obviously unsustainable 90 percent from 2000 to their peak in mid-2006, which was 55 percent over the trend line, and have fallen 32 percent from the peak since then. The bad news is that this represents a reduction of about $7 trillion in perceived household wealth.
The good news is that prices have now fallen about back to their trend line, which supports the idea that we may be coming along the bottom. We have now had the Wall Street Journal first page headline, "Home Prices Rise Across U.S." (July 29, 2009), and some other hopeful indicators. It has been three years since prices started declining, and two years since the first financial panic of August, 2007, so a lot of adjustment has taken place.
HW: As we try to climb out of the current crisis, what mistakes of the past do you see being repeated?
Pollock: The first is to believe that you can invent mechanical rules to ensure that financial excesses and the resulting busts "will never happen again." After every crisis, this is always said by politicians, but financial history shows that they always happen again anyway. Once the memories of the loss experiences, which are so vivid at the time, nonetheless fade, we will find new ways to run up leverage and make the same old mistakes. Moreover, financial cycles can be greatly aggravated, as the most recent bubble was, by the actions of the government itself.
Here's a familiar headline: "Banks Entering Era of Painful Change--More Bailouts, Bankruptcies, Layoffs Likely." The year? 1991. The then-Secretary of the Treasury announced that with the new legislation and regulation of the day, it would be "Never again."
Financial cycles are accompanied by political cycles. In the wake of the bust, finance always becomes intensively "political finance," as we are again experiencing.
HW: What would you recommend be done to improve things going forward?
Pollock: Financial cycles are natural and the future will have them, as the past has. However, I believe we could take a number of steps to help us do better in the next cycle. Some of these are:
- Create a systemic risk advisor (not as systemic risk regulator)
- Develop counter-cyclical LTV ratios
- Require national use of the Pollock one-page mortgage information form
- Use old-fashioned loan loss reserves built in the good times
- Encourage credit risk retention by mortgage originators
HW: The Obama Administration's "Making Home Affordable" initiatives are buzz topics. How do you see these modification and refinance programs affecting the situation?
Pollock: Before them we had the Bush Administration's "Hope for Homeowners" mortgage loan modification initiatives. These are all ways of trying to "bridge the bust" and get to the other side, where house prices can re-start their long-term rise.
In the bust, where we still are, the losses on the overoptimistic credit overexpansion have already occurred, economically speaking. The value is gone. But how will these losses be shared among lenders, borrowers, equity investors, debt investors, depositors, taxpayers, and the future depreciation of the dollar? That is the question we are trying to work out. It is as if we are in a gigantic national Chapter 11 reorganization of claims.
I would have preferred to the modification programs of either administration, to create an energetic new version of the Home Owners' Loan Corporation (HOLC), which refinanced mortgages from 1933 to 1936, as a temporary crisis intervention.
The HOLC made loans for its own account, with delinquent borrowers applying directly to it--typically there was a reduction in principal, based on the new, lower level of house prices, and the old lender thus took a realized loss, but did get cashed out for the rest.
Alex J. Pollock is a resident fellow at AEI.