Prevention Over Correction

September 26th, 2011 at 12:17 pm

The housing market is still bumping along the bottom.  As the figure shows, it’s not providing any support to the larger economy, as residential investment (basically, home buying) as a share of the economy is stuck at an historical low.

Source: BEA, NIPA tbl 1.1.10

Though policy measures to fix the problem have taken a lot of heat, some of it justified, this is much more a failure of preventive policy than of corrective policy.

The economically lethal combination of financial engineering, drowsy regulators, lousy underwriting, all amped up on fantasies about self-correcting markets, led to a lot of people got home loans they couldn’t realistically service.  Once the bubble burst and home prices stopped rising, this reality was only further amplified by the the worst downturn in generations. 

Add in some unique aspects of housing finance— the ability of banks holding non-performing loans to convince themselves that such loans will come back to life (“extend and pretend”), conflicting incentives by loan servicers, the banks screwing up the foreclosure process with robo-signing—and this was always going to be a slow, painful “correction.”

Of course, corrective policy could have done more—the fact that the locus of decision in most corrective policies lie with the banks/lenders themselves has always been a shortcoming.  We needed more policies, like cramdown of loans on primary residences, a policy that would have allowed homeowners (borrowers) to take action even while creditors dragged their feet.

There’s still good stuff we should do to help modify loans, reduce principal, and cut down the supply overhang—on that last point, I like this idea to move Fan and Fred’s foreclosed properties from the residential to the rental market.  Here’s a useful article that takes a look at these and other ideas worth pursuing.

But at the end of the day, the main lesson from all this is that when it comes to financial or housing markets, preventive policy is better than corrective policy.  The Greenspan Fed got this exactly wrong, arguing that the Fed can neither spot nor stop bubbles. 

Re spotting, that’s demonstrably untrue: foresightful members of the regulatory community and the central bank themselves were sounding warnings early on: Sheila Bair of the FDIC was working with Ned Gramlich of the Fed on this stuff starting in the early 2000s.

Re stopping, there’s little question in my mind that had we listened to folks like those just mentioned instead of hanging on every word of the maestro himself, regulators could have reined in lending practices that were clearly unsustainable, like negative amortizations, interest-only, and other greatest hits from the subprime slime.

Our best move would have been not to have a housing bubble.  Our next best move will be to not have another one.

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7 comments in reply to "Prevention Over Correction"

  1. Red Planet says:

    The housing bubble was neither a preventable error nor an act of God. It did not occur due to the myopia or nonchalance of regulatory agencies. It was an act of arrogance and greed, twin hallmarks of the Bush era and the Greenspan Fed.

    Who benefited most from the housing bubble? Bankers of all stripes and Wall Street. And the politicians they supported.

    How did politicians use the housing bubble?
    • To propagate the narrative that Americans are becoming a nation of investors.
    • To further weaken regulation.
    • To accelerate the transfer of wealth to the wealthy.
    • To replace middle class wages that were being exported overseas.
    • To support tax rate reduction on high earners and capital gains.
    • To paper over unfunded wars.

    The housing bubble was a Ponzi scheme, the biggest ever.

    It is a mistake to ask why it was not foreseen and prevented, because the housing bubble was intentional.

    Instead, ask who fostered it and why.

  2. Michael says:




  3. Sanchit Kumar says:

    You could extend the same conclusions on preventive vs corrective policy to spending on health care – good/great ways to keep health costs low, but so much savings could come from implementing policies that help prevent illnesses (including HPV vaccines!).

    Of course, the arguments over efficiency usually prevail.

  4. perplexed says:

    -“The economically lethal combination of financial engineering, drowsy regulators, lousy underwriting…”

    Referring to what went on here as “lousy underwriting” instead of the more accurate “criminal abandonment of underwriting” only aids in the concealment of the most serious long term problems, not only for housing, but for trust in government institutions as well. See my comment here questioning how Charles Ponzi and Bernie Madoff are still given “top billing” among fraudsters when they have been shown to be such amateurs in the modern world of financial fraud

    For most Americans, especially middle class Americans, the most important vehicle for their life savings was the equity in their homes. The fraud conducted by the mortgage industry was to put the equity of all current homeowners at risk by eliminating underwriting standards to increase their own profits, over and over until the scheme blew up. The investment banks & TBTF’s we’re just marketing in stolen goods with their eyes closed and paying the ratings agencies to keep quiet while they defrauded the investors. Like the old story about a company treasurer who takes a million out of the safe, takes it Vegas and puts it on red. If he wins, he’s up a million by risking the company’s money and he just puts their money back in the safe. If he loses, the company is out a million and he flees the country. That’s why they’re bonded. But if you can put the money (or equity) at risk without ever entering the house, and share the profits with your distribution network, its even easier; homeowners and investors take the risk, you and your accomplices get all the profits. The government allows you operate without any insurance and makes your victims bear the entire cost of your malfeasance.

    The problem now is that this fraud, and the government’s acquiescence in it, has permanently altered the risk and therefore the suitability, of an investment in residential real estate for most Americans. The only thing making such a highly leveraged asset suitable for the average American family was its perception of safety, and confidence that the government was protecting this market from fraud. They now know differently; and they also know the impact on liquidity.

    So even when the underwater mortgage situation is resolved, these other implications will persist well beyond. And we still don’t know what the exposure to the financial system of “synthetic mortgage securities” is do we? I guess its not our right to ask; we should just trust the government right?

    Probably not a good strategy to hold our breath and wait for housing to bail us out this mess is it?

  5. dpeterka says:

    The housing market is very obviously ground zero for this recession, yet we don’t hear economists continuously and directly placing the blame here. By that, I mean that this is, and continues to be, the root cause of the bubble, the crash, AND the continuing recession. Jobs aren’t the problem, they are the symptom, and attempts to address this recession via jobs programs seem doomed to mediocrity at best.

    The right is hammering the left over the poor state of this economy, but we don’t hear economists vociferously making the point that the current weak economy is inextricably linked to the continuing housing crisis; and that linkage has not changed in the 2+ years since the bubble. There is no “jobs knob” on the economic dashboard that can be turned up or down, yet all we hear about on the news is one side’s accusation that the other side is failing turn that knob, either to create jobs, or to allow them to be created. It’s hogwash.

    We will know we are out this recession when housing prices stabilize and begin to rise again. Plain and simple. People won’t begin to approach normal spending levels until their largest investment looks to be safe again. At least for those that weren’t caught and crushed by the collapse itself. For those people, it will be even longer before they can do so. With housing tanked, spending is curtailed. Without spending, jobs are curtailed.

    The problem is, no one seems to know of any way to resolve the housing problem, so we instead focus on jobs and regulatory policy. Why isn’t this deception being hammered back at the right from the left? We are very much mired in the continuing housing collapse and we are being manipulated into thinking we have some how moved away from that problem and are now being held down by some other problem. Something to do with jobs – yeah, that’s the ticket.

    • perplexed says:

      “The problem is, no one seems to know of any way to resolve the housing problem…”

      They do know how and are implementing the “fix” while a huge % of the population is busy chasing the same few “crumbs” that are today’s job openings. Jared is right, we’re moving towards renting our homes from the rentier class. But there’s really no rush; the prices aren’t low enough yet (single family homes are a maintenance and management nightmare for rentiers so they have to be pretty cheap in order to make money at it) We’re probably headed towards the lowest home ownership rates ever as more Americans realize that this is no longer a “safe” place to put their savings. The “all your eggs in one basket” strategy of home ownership has always been questionable but the risk was discounted because residential real estate had such a long history of safety and protection from financial frauds. That was a big part of the value of owning your own home, it was a safe place to store your “savings” and you had improved living conditions and control of where you lived as well. That’s all part of our history now. If your stockbroker sells you an “unsuitable” investment, you can sue them and recover your loses, but no such restriction constrains your real estate broker from selling you something that’s too risky for you given the leverage and your assets and income.

      They’re in no rush to fix it for another reason as well. Many underwater homeowners continue to pay their mortgages on time; this keeps not only these mortgages from defaulting, but keeps the CDS’s (synthetic mortgage securities) that are tied to them from becoming due as well (I haven’t seen anything to indicate that anyone but the bankers themselves know what the exposure is, and I’m not sure anyone knows the aggregate amount. If the government does, I don’t they’re telling anyone. I may be wrong, it may be out there hidden somewhere & I just haven’t been able to find it). As these mortgages get refinanced, the risk of the CDS’s coming due goes away. So look for more government money to go to bringing down underwater mortgages to a “slightly underwater” position that can be be refinanced and eliminate the risk of banks having to pay up on their CDS’s or take back fraudulent mortgages they sold to the GSE’s or other investors. As real estate prices continue to fall, they’ll get to point that rentiers can profit from and those with only slightly underwater mortgages might be able to afford to get out from under them. Problem (at least the problems of the banks & GXE’s) solved. We just have to be a little more patient so the bankers don’t have suffer anymore than they have already.

  6. Martha Retallick says:

    The ugly reality is that post-bubble recoveries are very, very, VERY slow. Look at Japan. They’re still recovering from their late 1980s/early 1990s housing bubble.