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Alan Greenspan, the former chairman of the Fed, said in a recent Wall Street Journal interview that an end to the decline in house prices is “a necessary condition for an end to the current global financial crisis.” The question remains: How did we get into this mess?
When house prices increase at the rate of 15, 20, or 30 percent per year, as was the case in some regions during the boom, it should be clear that such a trend could not continue forever, or even for a long time. Nevertheless during the boom, homebuyers, banks, and financial markets behaved as if house prices would rise forever. Many people argued that in the worst case scenario, house prices would simply stop rising, but they would never fall.
According to the S&P/Case-Shiller National Home Price Index, the last time house prices declined nationally was in 1991, when they fell by slightly less than 3 percent. During the recent boom, many first-time homebuyers were under age 35. They were simply not old enough to remember a period of falling house prices. This does not explain, however, the behavior of banks and other financial institutions that seemed to give out mortgages without much concern about the ability of the borrowers to repay them. We usually assume that a bank cares about whether the loans it makes are repaid, and that therefore it would carefully screen the potential borrowers. In the 1970s and 1980s, this was the case: The bank that originated a mortgage usually held it long term and derived income from interest and from repayment of the principal. As a result, banks would originate only those mortgages that, in their opinion, had a reasonable chance of being repaid. Financial innovations such as the mortgage-backed securiiy changed all this. It became possible to break mortgages into component parts, such as by separating the principal from the interest, and then package the components into securities with various characteristics (maturity, perceived risk, etc.) that could be sold in financial markets. The market in the mortgage-backed securities developed quickly. Many banks and specialized mortgage companies (such as the now-defunct Countrywide) no longer held the mortgages they originated. For these entities, the main source of revenue was the origination fee, not the repayment of mortgage principal or interest. Since original lenders no longer held the mortgage, they were not worried about repayment. This created a toxic mix of incentives. The lenders (banks and mortgage companies) were interested in originating as many mortgages as possible, believing (or hoping) that they would be able to sell the mortgages before any repayment problems arose. An extremely loose monetary policy, which made it easy for lenders to raise funds for their operations, did not do anything to slow this process. Many homebuyers, not realizing that lenders’ incentives had changed, apparently believed that banks would only approve them for mortgages they were able to repay. Coupled with a too-optimistic view about the future of house prices, this led some, possibly many, people to buy a house based on the size of the mortgage they could get, rather than on what they could afford. Now we are in the aftermath of this collective delusion. House prices do fall. Falling house prices (and rising interest rates) made it impossible to refinance with better terms, which some homebuyers hoped they would be able to do. This left some people unable to pay their mortgages. However, the bank that issued the loan no longer held it. It had been packaged with other mortgages and sold, possibly many times, in the form of mortgage-backed securities. This made it difficult, if not impossible, to trace where every mortgage is.
This is also why the financial crisis has spread across many financial institutions. No one knows how many mortgages will be defaulted upon. But we cannot trace exactly or predict where those bad mortgages are. As a result, investors are scared of all mortgage-backed securities. Prices of all of these securities have fallen, and various financial institutions have had to write-off losses. It seems doubtful that we can design a regulation that would compel people before taking out a mortgage to think carefully about their ability to repay it. Regulators will probably focus on banks by creating incentives to give mortgages only to people who have a reasonable chance of repaying them. It is theoretically possible to outlaw mortgage-backed securities. However, it is impossible to outlaw financial innovations: Making a certain practice illegal will simply drive financial markets to come up with new ways of making money. This does not mean that nothing should be done to prevent such crises from occurring in the future. Rather, it means that the government regulations might not be as straightforward an answer as some would hope.
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If you’re tired of a lackluster stock market, there are a few things you can do:
First, get FASB to impose Mark to Market accounting rules; these don’t work so well in a down market.
Next, make banks loan money to people with no money and wait for the loans to go bad and get investment banks to package these loans so their actual value cannot be determined.
Next, pull all your money out of the stock market and wait.
Next, head for a down market and sell short on stocks you don’t even own.
Next, let security values go to zero according to your Mark to Market rule to create a liquidity freeze.
Next, give $ trillions of taxpayer dollars to your friends and benefactors, who are holding the investments your Mark to Market rule made worthless. Do this for 6 months. Let the stock market drop at lease 50%.
Next, relax your Mark to Market rule, announce that you and your friends are going to buy these worthless assets; then buy stocks at half their original cost make a lot of money and become a hero.
Outlaw Mortgage Based Securities
Rather than proposing government guarantees to support mortgage based securities, we need to return to the old system where mortgage companies hold home mortgages to maturity. There is no way to navigate the ups and downs of home prices and mortgage foreclosures without returning to a system that allows the mortgage company to deal with default and disclosure issues directly. Mortgage based securities is simply a bad idea. We taxpayers are not interested in supporting global crooks and swindlers
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