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POLICY MEMO
To: Interested Parties
From: Dean Baker, Center for Economic and Policy Research
Topic: The Collapsing Housing Bubble and Resulting Financial Fallout
Date: April 1, 2008
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In the decade from 1996 to 2006, the United States developed an enormous
housing bubble that had no precedent in the country's history. During this
decade, house prices rose in excess of 70 percent of their historic trend rate
of growth, creating more than $8 trillion in housing bubble wealth.
This bubble is now collapsing. Its collapse is throwing the economy into a
recession and threatening the stability of financial markets. In assessing the
various proposals and measures being put forward to address this situation,
there are several important factors to keep in mind:
* the housing bubble cannot be sustained - prices must be allowed to return
to trend levels;
* housing policy should be focused on helping homeowners who were often
tricked into buying predatory mortgages, not helping institutional holders of
bad mortgage debt;
* bailouts of financial institutions should focus on keeping the financial
system operating smoothly while avoiding as much as possible giving taxpayer
dollars to the people whose actions created the current crisis;
* the Fed should pursue a policy of maximum transparency - lack of
transparency was a major factor leading up to the current crisis;
* where it is impossible to avoid having the federal government provide aid
to troubled financial institutions, there should be an explicit quid pro quo,
with the government either accomplishing an important policy goal or getting a
return on their investment.
1. The bubble must be allowed to deflate.
It is important to recognize that the housing market experienced an
unsustainable bubble. There were no changes in the fundamental supply or demand
factors in the housing market that could explain the unprecedented run-up in
prices over the last decade. There was also no unusual increase in rents during
this period, which would have been predicted if the run-up in house sale prices
was explained by market fundamentals.
This means that prices must fall back towards their trend level. This fact must
inform housing policy. In cities in which house prices are still out of line
with trend levels, government programs to buy up or guarantee mortgages will
lead to large losses for the government, and will also cause homeowners to pay
far more in ownership costs than they would pay to rent a comparable unit.
Furthermore, since prices are still falling, homeowners who receive
"assistance" will almost certainly acquire no equity in their houses. Under
such circumstances, government support really only helps current institutional
mortgage holders, since it pays them a price for their mortgage that is almost
certainly much larger than what it would be worth in the absence of government
intervention.
2. Government policy should be tailored to help homeowners.
It is possible to structure a housing guarantee plan that would help
homeowners. The key would be to set the purchase/guarantee price at a multiple
to appraised rent (a sale-to-rent ratio of approximately 15 would be reasonable
and in line with historic trends). This would ensure that the government
doesn't step into the middle of a collapsing bubble.
An alternative mechanism for protecting homeowners would be to temporarily
change the rules on foreclosure. If homeowners facing foreclosure temporarily
had the option to remain in their house as long-term renters, paying the fair
market rent, this would provide an important element of security to homeowners,
and would stabilize neighborhoods facing large numbers of foreclosures. More
importantly, since banks do not want to become landlords, it would give
mortgage holders a very powerful incentive to renegotiate the terms of loans in
ways that allow homeowners to remain in their homes [1].
This proposal would cost the government nothing. It can also be targeted to
ensure that it only benefits low- and moderate-income families by setting a cap
restricting the rule change to homes that sold at less than the median house
price in an area, or some comparable cutoff. Such a cutoff could ensure that
only relatively low-income people benefit from this rule change.
3. The Fed should help the financial system, not the financial sector.
On the issue of financial bailouts, it is important to distinguish between
actions that protect financial institutions, and actions that protect the
financial system. The government's policy should rightly be focused on
preventing the collapse of a major financial institution that could lead to a
chain reaction within the industry.
The model for such intervention should be the takeover of the Northern Rock
bank by the British government. The bank was essentially bankrupt, even after
being given special low-interest loans from the Bank of England. To prevent a
chain of collapses, the government took over the bank and replaced the
management. The immediate task of this new management is to get the books in
order, at which point the bank will be resold to the private sector. The
original stockholders will be entitled to any money from the stock sale, net of
government infusions into the bank.
The Northern Rock takeover is a model because it sustained the stability of the
financial system while getting rid of the management who had driven the bank
into bankruptcy, and did not give any taxpayer money to shareholders.
4. Investors and the public deserve transparency.
The current actions of the Fed do not look good by comparison. First, the
creation of the Term Auction Facility (TAF) allowed banks to borrow large
amounts of reserves from the Fed without any public record. If a bank is in a
situation where it finds it necessary to borrow large amounts of reserve, this
information should be known to investors and the general public.
The terms of Bear Stearns' takeover also raise important concerns, especially
with the increase in the takeover price. It is not clear whether J.P. Morgan is
paying $1.3 billion for Bear Stearns, or for a $30 billion guarantee from the
Fed. If J.P. Morgan is actually interested in buying Bear Stearns and paying a
substantial price to its shareholders, then there is no obvious reason for the
Fed to get involved. The current terms make it appear as though Bear Stearns
shareholders are profiting at taxpayer expense.
Finally, the Fed has implicitly (almost explicitly) indicated that it will
guarantee the loans, credit default swaps and other commitments of the major
investment banks. In addition, it has made them eligible to borrow hundreds of
billions of dollars at low-cost through the Fed's discount window.
5. No free rides.
Under the circumstances, this may be good policy, but the public should demand
some return for the Fed's generosity. As a first and necessary step, the Fed
should regulate investment banks. The primary goal of this regulation would be
greater transparency in investment bank dealings, such as full disclosure of
the volume of their credit default swaps and other liabilities.
This step would be completely voluntary for the financial institutions. If they
do not want to take advantage of the Fed's implicit guarantee or have access to
the discount window, they can operate outside the Fed's purview. Of course,
they may find it much more difficult to get customers once it is known that the
Fed is not concerned if the bank fails.
The second part of the quid pro quo could be in the form of either a share in
the company, a social policy commitment, or both. It is important to remember
that the discount window is in effect providing banks with access to loans at
below the market rate of interest. Even more important, the Fed's guarantee is
effectively allowing banks to sell credit default swaps that are backed up by
the government - not by the banks themselves, since they lack sufficient
capital. In effect, the banks are selling the Fed's good credit, not their own.
It is entirely reasonable for the taxpayers to get something in return for
providing enormously valuable credit guarantees to the investment banks. One
option would be for the government or the Fed to get some amount of stock
options each year, so that it would share in any gains incurred by the bank. A
second option would be for the Fed to charge a fee for providing this guarantee
that would be proportionate to the bank's capital.
On the social policy side, the government could impose limits on executive
compensation at the institutions they assist with guarantees. For example, it
could prohibit the annual total compensation for any executive from exceeding
$5 million. These limits would ensure that taxpayers are not subsidizing
exorbitant salaries and bonuses. Since the exorbitant salaries on Wall Street
have been guideposts for other high-paying occupations, bringing these salaries
down to earth could go far toward reducing inequality in our society.
[1] This plan is outlined at
<http://salsa.democracyinaction.org/dia/track.jsp?key=-1&url_num=1&url=http%3A%2F%2Fwww.cepr.net%2Findex.php%2Fop-eds-columns%2Fop-eds-columns%2Fthe-subprime-borrower-protection-plan%2F>http://www.cepr.net/index.php/op-eds-columns/op-eds-columns/the-subprime-borrower-protection-plan/.
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Liz Chimienti
Domestic Policy Analyst
Center for Economic and Policy Research
1611 Connecticut Ave NW, Suite 400
Washington, DC 20009
Phone: (202) 293-5380 x110
Fax: (202) 588-1356 _______________________________________________
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