A half-dozen proposals you won’t hear from the regulators.
Asset bubbles inflate because enough people believe that the good times of expanding credit and rising asset prices will last forever, but of course they don’t. In the midst of the bust that follows, it seems that the bad times of defaults, scarce credit and falling prices will last forever, but of course they won’t.
I don’t believe financial cycles can be avoided any more than business cycles can. We are still vastly better off with functioning markets, for all their boom and bust cycles, than with socialist stagnation.
“Our regulatory system has failed miserably, and we must rebuild it,” Congressman Paul Kanjorski said recently. After every bust, politicians enact new regulations and reorganize regulatory agencies. This is to make sure, they say, that the problems “will never happen again.” In time, they happen again anyway. In 1914, the then Comptroller of the Currency pronounced that with the new Federal Reserve Act, “financial and commercial crises or panics seem to be mathematically impossible.” They weren’t.
This is not to say there are not ways to improve the financial system, and mortgage finance in particular. Here are six suggestions, which in my view are much more important than reorganizing regulatory bureaucracies:
1. Countercyclical LTVs. Leverage at the mortgage borrower level is expressed as the Loan-to-Value ratio or “LTV.” An LTV of 80% means the homebuyer has borrowed 80% of the price of the house, and made a down payment out of savings of 20%. An LTV of 100%, not uncommon during the housing bubble, means the buyer has borrowed all the money and made no equity commitment. Did it make sense to make these loans? No, but it seemed like a good idea if you believed house prices would always go up.
There is a strong and reliable statistical relationship between LTVs and mortgage defaults. Not surprisingly, the higher the LTV, the higher the defaults. When the house price declines, the LTV automatically increases.
In a housing boom, as house prices rapidly inflate, the risk that they will subsequently fall is increasing. So in a rational system, LTVs would be lowered as house prices accelerate over their trend. What in fact happens in the boom is that as rising prices induce optimism in both lenders and borrowers, LTVs tend to rise, up to and including 100%: exactly the opposite of what should happen.
Reversing this perverse LTV behavior would make for a much sounder housing finance system.
2. Old-Fashioned Loss Reserves. We should return to the old-fashioned idea of building loan loss reserves in good times. As an old banker told me long ago, “Bad loans are made in good times.” This is just the time to be building reserves against the inevitable vicissitudes of any firm bearing credit risk.
Spain, now involved in its own housing bust, is glad that in 2000, it forced its banks to begin a system of countercyclical “dynamic provisioning,” building up reserves far beyond current losses to prepare for possible future losses. This system, old fashioned as it is, is becoming the international model.
Unfortunately, in this country the SEC went in just the opposite direction from what the Spanish regulators did. It actively opposed building large loan loss reserves, because it regarded them as undesirable “earnings management,” which would understate profits in good times, while providing a cushion for bad years. The result was to overstate profits in the bubble and to have insufficient cushion in the bust.
The reality of all businesses built on credit risk is that they experience, on a cyclical basis, periods of high losses, often far beyond expectations — like now. If you don’t reserve against this reality, you create, as American official accounting did, illusory profits in the good times. These in turn trigger bonuses and also induce financial firms to reduce equity through buybacks of their shares. Alternately stated, in the good times financial firms book what are really insurance premiums for bearing risk instead as profit in advance, while the risk builds without prudent enough reserves. This is obvious, now that the risk has come home to roost.
3. Risk Retention in Securitization. We should combine mortgage securitization with credit risk retention by the mortgage originators who perform the credit underwriting and make the credit decisions.
A prime lesson of the 1980s savings and loan collapse was that for financial institutions to keep long-term fixed rate mortgages on their own balance sheets was extremely dangerous in terms of interest rate risk, although it was not a problem in terms of credit risk. The answer was to sell the loans to bond investors through securitization and divest the interest rate risk to those better able to bear it. As a side effect, the credit risk was also divested.
In the wake of the mortgage bubble and bust, everybody now realizes that divesting mortgage credit risk created huge problems of its own, breaking the alignment of incentives between the lender making the credit decision and the ultimate investor actually bearing the credit risk. Some commentators have referred to the good old days when the savings and loans kept the loans themselves — displaying notably short memories.
A man of faith in a godless age is hitting Americans where it hurts.
Mr. and Mrs. American Spectator Reader, let P.J. O’Rourke talk sense to your kids.
In Britain, defending your property can get you life.
The debacle of this president’s administration is both a cause and a symptom of the decline of American values. Unless Congress impeaches him, that decline will go on unchecked. An eminent jurist surveys the damage and assesses the chances for the recovery of our culture.
It won’t take long for conservatives to scratch this presidential wannabe off their 2008 scorecard.
The American Christmas, like the songs that celebrate it, makes room for everybody under the rainbow. Is that why so many people seem to be hostile to it?
Was the President done in by the economy, or by the politics of the economy?
H/T to National Review Online