The Perils of Easy Money
November 22, 2014 § 2 Comments
The House of Debt
I just finished reading a book recommended by my friend, Milton Lower. The book is The House of Debt by Atif Mian, professor of economics and public policy at Princeton, and Amir Sufi, professor of finance at the University of Chicago.
This is a short, well written book about the the housing collapse that precipitated the Great Recession of 2008. The writers identify the causes and recommend some policy changes that would prevent such calamities.
Their approach is similar to Thomas Piketty’s: They base their conclusions on carefully compiled and analyzed data. They patiently consider and discredit causation theories other than theirs and cite data-based reasons for rejecting them.
What Caused the Housing Market to Crater?
The authors present and reject three views about the causes of recessions. The first, and most popular, is the “fundamentals” view: That some disaster, radical political upheaval or other unexpected catastrophe caused it. But no such event occurred in 2007 to trigger the recession. The second is that “animal spirits” cause it. That is, buyers were guilty of “irrational exuberance”. They foolishly believed prices would endlessly rise. When they realized their folly, they panicked and the recession followed. Finally, some have argued that banks were to blame. They stopped loaning money thus thwarting economic expansion and the recession followed.
The authors offer convincing evidence that the latter two ideas don’t fit the facts. They cite ample statistical evidence that residential housing prices in some areas of the country sharply increased between 2000 and 2007. That price inflation followed a dramatic relaxation of requirements for mortgage loans, which fueled the price inflation of houses. That is, far from withholding loans, the banks eagerly offered money to borrowers, including many who, until the requirements were lowered, could not qualify for mortgage loans.
So, it was not “animal spirits” that caused the recession. It was lending money to people who lacked income to pay it back. Then, when defaults occurred, foreclosures followed, foreclosed homes depressed housing prices in surrounding neighborhoods and the downward spiral led to a general collapse of housing prices, diminished consumer demand and, hence, the Great Recession.
How Did The Housing Collapse Cause the Recession?
When residential housing prices fell, some owners continued making mortgage payments on homes that were worth less than the debt balances secured by them. Others walked away and tendered their homes for foreclosure. In either case, the principal assets of a giant class of homeowners, equity in their homes, were devalued and, in many cases, wiped out.
There were two classes of people involved in these transactions: The homeowner borrowers and the investor lenders who deposited their money in banks, who made the loans secured by the mortgages. The impact of the housing downturn was not equally distributed. For most of the homeowners, their only assets, the equity in their homes, were destroyed. For the investor lenders, their losses were only a fraction of their total wealth, which typically included stocks, bonds, investment real estate as well as their homes. Their losses did little or nothing to affect their propensity to spend and to maintain their lifestyles. The homeowners, by contrast, sustained close to total asset losses and they significantly cut back their spending.
The less wealthy homeowners’ propensity to spend was greater than that of the wealthier investors. That is, they spent a greater percentage of their income than the more wealthy investors. So, when the far more numerous homeowners lowered their rate of spending, the impact on the total demand for goods and services in the economy was significantly affected. In other words, the downturn in the housing market sparked a general downturn in demand throughout the economy and the Great Recession resulted.
What Was The Reason for the Relaxation of Credit Requirements?
This is the most interesting part of the book.
In 1990, the financial markets in Thailand, in the words of Mian andSufi, “went berserk”. There was a frenzy of inflation and speculation. The price of real estate escalated wildly. Foreign investors flooded Thailand with Dollars and Thailand banks grabbed them like ravenous wolves. In due course, the bubble burst. The foreign investors began withdrawing their money from the Thai banks.
Because the foreign investments were made in Dollars, they demanded withdrawals in Dollars. The Thai banks did not have enough Dollars to meet th0se demands. To avoid a complete collapse, the central bank in Asia tried to respond by making Dollars available to the desperate Thai banks, but they lacked sufficient stores of Dollars. So, they had to appeal to the IMF [International Monetary Fund] for help.
That help came with draconian requirements for painful austerity that plagued for decades those Asiatic central banks and the economy which they supported
Having learned a bitter lesson about the importance of ample caches of Dollars, the banks in Asia began to flood American banks with purchases of U.S. treasuries. Instead of responding to this influx of money by lowering the interest rate on treasuries, the U.S. central bank chose to use that flood of cash to funnel money into the home mortgage market. To accomplish this goal, it allowed and encouraged banks and other lending agencies to create mortgage backed assets and to market them as derivative securities.
This proved to be so profitable for Wall Street dealers in these securities that they sought more and more mortgages from banks. To satisfy the demand for mortgages, the banks lowered the requirements for obtaining mortgages. This opened up a large market consisting of people whose incomes had theretofore been too low to qualify for home ownership. This increased demand for homes, which resulted in increased home prices. The Wall Street bankers designed a wide assortment of complex combinations of mortgages and constantly pressured the banks to make more and more home loans to meet the demand for mortgages as fodder for the MBA’s.
The riskier mortgages made to low income borrowers were cleverly matched with safer groups of mortgages so that rating agencies could stamp the resulting cluster with AAA ratings. [I have described this widespread finagling in an earlier post entitled “The Bankenstein Fiends”] So, a mix of different risky and, in some ways, fraudulent schemes, combined to blow up the bubble that, when it popped, threatened the entire financial system of the Western industrial world. Crazy financial speculation 7,000 miles east of the United States thus triggered a series of events that ended in the Great Recession.
Wall Street banks made gigantic profits from the creation and marketing of the MBA’s. They not only made money selling them, they made money using market devices that enabled them to profit handsomely when the MBA’s were finally exposed as having been flagrantly misrepresented and mistakenly rated. They made money by selling the MBA’s and, when the value of the MBA’s lost value, they made more money.
There is a well known principle of equity, developed centuries before the birth of our country by judges sitting on the wool sack in English courts of Equity: No one may profit from his own wrong. This simple rule, so fundamental to any system of justice, was not only ignored, it was denounced as unwise and un-American by the ex-Wall Street bankers who advised both President Bush and President Obama when, amid a crisis, judgments had to be made about how to avoid a collapse of the financial system.
When the Wall Street banks were facing collapse the federal government had a choice: It could use taxpayer money to bail out the banks or it could take them over, wipe out the stockholders and enable the banks to continue performing their vital role in the domestic and the international financial system. This latter choice would have allowed the government, acting through the banks, to relieve the homeowners facing financial disaster by allowing them to postpone mortgage payments, reduce the principals of the loans secured by the mortgages, or both.
Presidents Bush and Obama chose to bail out the banks and leave the homeowners to their fate. Billions of dollars were handed over to the banks with no strings attached. The bankers suffered no losses. Instead of making changes in the mortgages to alleviate the homeowners’ financial problems, they used their blank check on the U.S. Treasury to fund record bonuses and watch their stock prices soar.
The net effect of these policy choices was a giant transfer of wealth from those at the low end of the wealth spectrum to those luxuriating at the very top.
Here is a brief summary of the remedy proposed by the authors of this book: They proposed a revision of the standard form of a residential mortgage. The new mortgage would be a Shared Responsibility Mortgage or SRM. It would provide downside protection for the mortgagor and corresponding benefit to the mortgagee.
If the value of the home decreased, the monthly payments would decrease proportionately. The extent of the decrease would be calculated by the average price of homes in the immediate neighborhood surrounding the home. The authors observe that extant agencies are already capable of monitoring those values in zip code areas. Regardless of the size of the monthly payments, the amortization table based on the original price of the home when the loan was made would remain the same. So, the effect would be the reduction of the amount being repaid.
The mortgagees would be protected by an entitlement to five percent of the sales price when the home is sold. The timing of the sale would be left to the homeowner but, if the lender had a diversified group of home mortgages in its portfolio, the five percent entitlement would result in a steady stream of return on its overall investment. The homeowner would sustain the five percent loss, but that would represent the value of the built-in insurance against loss of equity in case of a price drop.
The underlying thesis of the book is that housing bubbles cause general economic recessions because they result in losses of consumer demand that affects the entire economy.
For example, they point out that the tech bubble that popped in 2,000 caused many to lose money, but it did not cause a recession because the losers’ propensity to consume was not significantly affected. But the housing bubble of 2008 threatened a general collapse of the financial system.
The authors make a point that is obvious, but one I had never fully appreciated: The problem with debt, whether it’s mortgage debt or student college debt, is that, as presently designed, it is inflexible. When the economy experiences turbulence, the borrowers have no way to survive because their debts are like anchors that sink them.
The authors contend that recessions can be avoided if our most common debts are redesigned so that borrowers can continue to consume without sustaining crippling losses of their assets. When consumer demand is maintained, businesses will not be forced to lay off employees. In other words, redesigned debt documents will serve as an efficient method of distributing economic stimulus. Instead of waiting until the economy is in recession and millions of workers have lost their jobs, the authors propose measures to avoid the job losses by maintaining consumer demand.
The authors also propose rewriting the documentation for student debt to make its repayment dependent on the job market at the time of graduation and thereafter. They offer persuasive arguments that all pervasive debt should be designed to adjust in response to prevailing economic conditions. They call it “equity financing”.
I have not done justice to this book. I can only offer a taste and a suggestion that you read it. It is packed with interesting statistics and historical examples. It also is an example of some very sharp and disciplined analysis presented in an easily readable form. These guys are probably wonderful teachers. They are masters at making dense economic data interesting and understandable. If I were Thomas Piketty, I would incorporate their proposals into my remedy for wealth inequality.