Housing Doom

Doom Transcripts: Index & Guide

Housing Doom is pleased to present a first selection from our under-construction transcript of the American Enterprise Institute’s October⁴ 9, 2009 event "No Way Out: Government Response to the Financial Crisis".¹ The event site has a number of resources, including an audio and video of the proceedings. There is as yet no official transcript.

This is the Panel I  presentation by AEI’s  Vincent Reinhart.

Vincent Reinhart: [0:03:50] So I’d like to set the stage [slide 1²] for these guys’ conversation about what just happened to us, and what’s the way forward by asking 5 questions relevant to where we go from here. And those are [slide 2] …

1. Why are US households so undiversified?
2. How should we manage the crisis?
3. How should we deal with troubled financial institutions?
4. What has been the role of the international sector? and,
5. How should the Federal Reserve respond to asset prices?

And I’ll take those in turn.

In some sense, we’ve seen the problem, and it is us. [slide 3] US households are undiversified, in part [slide 4] because the US goverment provides considerable encouragement to home ownership — mortgage interest payments are deductable for tax purposes, the housing-related government sponsored enterprises [GSEs] have created a market for mortgage securitization and hold a large portfolio of whole loans and [0:05:00] securities.

The Federal Reserve grants those two GSEs direct access to the payment system and facilitates the clearing and settling of their securities. Indeed, the securities of the GSEs are government securities, because the Federal Reserve says it.

Regulatory guidance over time has encouraged housing activity, especially in under-served areas. This encouragement was formalized in the Consumer Reinvestment Act, reporting requirements under HMDA, and affordable housing guidelines to the GSEs.

The American public has responded to those incentives in the sense that, if you look at debt secured by primary residence, as mortgages, they go throughout the income distribution. [slide 5] That chart reports from the Survey of Consumer Finances the share of households that have a mortgage. Starting at the top, the high income, those in the top decile, going down after that by quintile.

Lots of people have mortgages, and notice that it is across the income distribution. That’s even more striking if you look at family holdings of financial assets in the last reading we have, 2007. [slide 6] The left columns look at the share of families holding stock, that is direct ownership of equity. And the plain fact is, equity ownership doesn’t penetrate too far down the income distibution. Households in the top 80 to 100 percent hold … about 40 percent of them hold equities. But once you get below that in the income distribution, direct ownership isn’t that common. That’s not so for houses.

If you look at the column marked "Primary Residence," you see that households hold a lot of their wealth in the form of their homes. Indeed, the last column looks at house values as a share of assets. And for low income people, that’s at least a half.

The housing bubble, the financial crisis and the policy response have been shaped by the fact that the government encourages levered bets on housing and that avenues for wealth creation are limited for lower income households. [slide 7] What’s that mean? It means that for the lower income households, there aren’t many opportunities for capital gains. One, encouraged by the government in allowing leverage, is homeownership.

As a consequence, households are underdiversified, with much of their wealth in homes. The consequences of that, of this focus on housing, means it created retail encouragement to the housing bubble. It also erected a political barrier protecting the institutions facilitating the bubble, and raised the importance of protecting those same institutions when in distress.

The second question I’d like to ask is how should we manage a crisis? [slide 8] And I have 4 simple rules for bailouts.

First, don’t do ‘em. [slide 9] Economists have a pretty easy explanation for that, the possibility of government intervention has consequences for the private sector, the government and the political process. The private sector has less discipline on them to raise capital and address the underlying problems. Why? Because there’s less counterparty discipline. The counterparties see the government as the ultimate backstop.

The government has the problem of opening its agencies to political pressure — once they own an auto company, once they have particular equity intrests in financial firms. It also confuses the public about policy intent. For the political process, it tilts the political playing field toward intervention generally.

Now my second rule is, if you break rule 1, be consistent. [slide 10] And the problem in 2008 was that policy interventions by the Federal Reserve and the Treasury were ambiguous as to the scale and scope of the protections offered. Depending on which weekend, some firms were helped, and others not, depending on which firms on a given weekend, some creditors were made whole, and some faced haircuts. This created incentives for creditors and short-sellers to test the limits of intervention, and indeed, perhaps fostered speculative attacks.

Rule 3 is if you break rule 2, that is, [0:10:00] you’ve intervened and you’re not consistent, be prepared to spend a lot. [slide 11]

The bars at the right panel give a chart from a book my wife Carmen has just published with Ken Rogoff from Harvard, called This Time Is Different: Eight Centuries of Financial Folly,³ and what it lists is public debt 3 years after a financial crisis for 15 financial crises in the post-War period. And the bottom line message is, 3 years after a crisis, on average, the level of public debt is 86 percent higher. Governments have to spend a lot after a financial crisis because: the economy is weak, they don’t get tax revenues, they do fiscal stimulus, and there’s probably some form of assuming the losses on national champion’s balance sheets.

When you spend a lot, the possibility of intervention leads investors to delay capital investments, deepening the capital hole. And if private investors don’t do it, the government has to.

Rule 4, whatever you do, don’t add to uncertainty and worsen confidence. [slide 12] I think you can argue that the statements in the fall associated with facilitating or encouraging the Congress to pass the TARP legislation, and then justifying the interventions with regard to AIG added to uncertainty and damaged confidence. High frequency indicators like The Institute of Supply Management’s Purchasing Manager Index or Spending on Durable Goods essentially fell off the cliff that September and October. That’s a problem inherent in the brinksmanship of bailouts. Political salesmanship doesn’t align well with economic stewardship.

As a consequence, policymakers amplified the shock. They weren’t the victims of the perfect storm, or the hundred year flood. The better for it is to see our financial officials as the Army Corps of Engineers, making decisions on dikes and levees upstream, which has consequences for the floodplain. [slide 13] The government, as a consequence, has a considerable ownership stake in financial organizations, and has widened the perimeter of its safety net.

How should the government deal with troubled financial institutions? [slide 14]

There are three core issues … [slide 15]

1. When do you recognize the loss?
2. Who assumes that loss? and,
3. What protections are given to investors?

Taking those in turn, the government’s response has varied over time. [slide 16] I’ve given you a couple of examples in the rows of this table, and asked those same three questions again: who recognizes the loss? who assumes the loss? and what protections are offered?

In the first row, I give what is our stylized description of the Hoover days of the Great Depression. When was the loss recognized? Pretty quickly, because it was financial institutions that were facing deposit runs. Who assumed them? Well, the private sector. And what protections were offered? None. The consequences for that in terms of contagion and fostering deposit runs led to, in part worsened the economic crisis and led to the backlash associated with President Roosevelt, in which the losses were assumed part by the private sector, but part by the government, and government guarantees were offered to protect depositors.

The range of government responses have varied over the years, but generally, you’ll see in the last column, all governments about all the time offer deposit protection. Sometimes that safety net is porous, sometimes it is cast very wide and quite dense. But most governments do that, because deposit runs are seen as something that should be avoided.

And generally, since the Great Depression, losses have been assumed by a mix … shared between the private sector and the government. Unfortunately, in the last 30 years, the recognition of loss has also been delayed. When it’s the government that has to foot the bill, politicians don’t like to accept that there are losses associated with their [0:15:00] protections offered to the financial sector.

Now, this is another chart from my wife’s book, [slide 17] the blue line gives the incidence of banking crises in all countries since 1800. It gives the share of the total sample in which there’s banking crises. And banking crises are infrequently very common, but they occur pretty often, except in one stretch of time. And that’s toward the right of the panel, you see in the ’40s, ’50s, ’60s and even into the ’70s. There was about 4 decades in which significant post-Depression restrictions on finance slashed the incidence of banking crises.

So one question, one answer to the question how do you deal with financial institutions in crises is, regulate them a lot, restrict their range of activities so they don’t have crises.

We think there’s probably economic costs associated with that, but that’s a question we have to address, and the experience post-1980 has to be looked at rigorously compared to the pre-1980 experience.

Policymakers often, post-1980 policymakers have often opted to allow institutions to delay recognition of losses. That’s called forebearance. [slide 18] And forebearance, the argument runs, allows banks to repair their balance sheets and lessens their need to tap markets when their currently in disfavor. Forebearance, however, may indeed change the perception of markets about the health of banks. If they don’t have to admit their losses, maybe they’re not as much in disfavor in markets.

But it doesn’t change the understanding bank managers have about their losses, and their need to fill a capital hole. So even during periods of forebearance, bank managers still are reluctant to lend and support market activity, because they understand they need more capital.

It also freezes the market for the asset class you’re forebearing. Why? Because the regulators tell a bank, that asset is worth more on the books — its own books, than it is in the market. And there becomes an overhang of the market. And that leads to a growth cost. [slide 19]

There are a couple of episodes, again going back to the initial table, where forebearance was pretty important. The first was in the United States in 1981 and 1982. A lot of Latin American countries defaulted, and money center banks, many of them, were insolvent. But rather than force the recognition of that insolvency, regulators allowed them to muddle through. They were a drag on spending, they didn’t support markets, they didn’t make many new loans available. But the rest of the economy was in the midst of a powerful recovery, and could get by, past that.

And so, ultimately there was clean-up, clean-up in the form of the Brady Plan in 1988.

But that policy of forebearance, not significant for the US recovery, was significant for the Latin American countries in the Western Hem [Hemisphere]. Why? Because there was no effective market for their sovereign debt for a decade.

And the first reference to "the lost decade" came back in those years. In those years, Latin American countries grew 1 3/4 percent slower on average than the rest of the world, for a cummulative output loss of 17 percent.

Another big example of forebearance is the Japanese economy, in which real estate was driving a large hole through their large banks. Rather than immediately recognize the losses, those banks were able to carry them. But for 13 years, property prices declined as the overhang of those assets on bank balance sheets froze the market. And the Japanese economy, for those almost 15 years — rather for the — yeah, almost … grew 2 1/4 percent slower than the rest of the world, for a cummulative output gap of … loss of 30 percent. Forebearance can be expensive.

Let me go to the … in the interests of time … the Nordics, in the last two columns, are an alternative model, in which their [0:20:00] — rather than delaying recognition, there’s a relatively forceful movement by the government to accept the losses on bank balance sheets. There was a cost associated with that, 3 percent loss in output in Norway, 2 1/2 loss in output in Sweden, but it was short and protracted … it was short rather than protracted.

In this crisis, [slide 20] the government has assumed some of the loss by injecting capital and purchasing underwater assets. And it’s widened the perimeter of the safety net, effectively enshining too-big-to-fail, which is really too-complicated-to-fail, and the Treasury reform would indeed codify too-complicated-to-fail. As a practical consequence of this complexity, [slide 21] large complex financial institutions are hard to supervise, because it’s very hard to understand what goes on inside.

It’s hard for the market to discipline, because potential counterparties can’t really see into that black box, and it’s hard for management to supervise, creating incentive misalignments and suitability problems. So there are consequences for how you deal with the crisis.

Next I’d like to talk about — what’s the role of the international sector? [slide 22] And especially since the Asian crisis in 1997 and 1998, emerging market economies have been accumulating foreign exchange reserves at a rapid clip. [slide 23] Part of this is to build up a buffer for emergencies; the Asian Crisis told them they needed a bigger reserve. But part is to offset upward pressures on the exchange rate to foster a development strategy of export-led growth; and part is to diversify, given that many of the countries have a population with a high saving rate and very rapid growth in income.

As a consequence, the reserves of the emerging market economies have been moving up pretty rapidly, but those capital flows represent a fund … represent a mechanism to fund demands in the United States. [slide 24] About 2/3rds of those increased reserve demands have fallen on US government securities, effectively meaning the global investor funded the US current account deficit. The blue lines give that same reserve accumulation, now inverted, and the red line gives the current account. In many of the years, reserve accumulation was sufficient to fund the entire US current account. This altered the composition of finance, and kept the level of long-term interest rates lower than it would be otherwise.

If you look [slide 25] at the net creation of US Treasury securities — that’s just our deficit — and plot it as the red bars, compared to estimates of the net accumulations of reserves, there are several years in which foreign official accounts wanted more Treasury securities than the Treasury was creating.

What did that mean? [slide 26] It meant that the foreign private sector, if it wanted exposure to the US market, had to get private credit, and indeed foreign exposure to US private credit, the solid line there, moved up sharply as foreign official entities loaded up on treasuries and US financial engineers constructed triple-A exposure to the US for foreign institutions.

Global savings kept US long term interest rates low, [slide 27] and disconnected from the policy rate. [slide 28] If you just look at that left column, it gives the simple correlation between the monthly change in the Federal Funds Rate and the 10-year Treasury yield. In the 1980s, the 1st row, that correlation was about point 4. Into the middle part of the ’80s, the correlation was still point 3. But from ‘96 onward, that correlation was effectively zero.

That is, the Federal Funds Rate was unrelated to the changes in the 10-year Treasury in the sample since 1996.

So if you want to ask the question, the Federal Reserve missed an opportunity to fight the asset bubble. You have to address how, or why this correlation would change. [0:25:00]

That leads to Federal Reserve policy and how it should respond to asset prices. [slide 29] First I’d just like to outline the traditional view, and then talk about why it might have gone wrong.

US monetary policymakers follow a basic syllogism, [slide 30] favorite word for awhile, with regard to asset prices, whether those asset prices were the foreign exchange value of the dollar, equity prices, or home values. Works the same, that’s the … you can just fill it in whenever I say an asset price.

Monetary policy should act to offset potential slack or pressures on economy-wide resources. Such preemptive policymaking requires making a forecast. Monetary policy works with a lag, you make a forecast, and you try to offset unwelcome pressures in that forecast.

Asset prices may be important in making that forcast, because they may be important determinants of current and future spending and pressures on inflation. Therefore, asset prices do matter for monetary policy, but they don’t loom larger than their direct contribution to spending and inflation.

So for the last 2 decades, if you asked a monetary policymaker, don’t they care about asset prices? … aren’t they worried about a bubble? … they’d say, "Of course we’re worried about asset prices, only to the extent they matter for good economic performance in terms of spending and inflation."

This does not say a central bank should be indifferent to asset prices, it doesn’t say you shouldn’t use other tools if you have them, like margin requirements. And it doesn’t say you shouldn’t respond to the consequences of an asset bubble if it bursts. But this was the driving syllogism.

Why? [slide 31] Because, if think, policymakers were much impressed with the idea that the private sector was supposed to have a comparative advantage over the public sector in pricing and managing assets. Financial market participants devote a lot of resources to it, more than at central banks. And once you’ve got the asset, do you really want the government to run it? Indeed, the experience in many emerging market economies is, value quickly erodes when the government tries to run what was formerly in the private sector.

And also, once those assets are there, held by the government, there’s political pressure.

Why also might you follow the syllogism and not do anything more than that? Because asset prices are complicated, and markets were supposed to be rational. [slide 32] Asset prices have many moving parts — expected earnings, expected future earnings, a risk premia, risk-free discount rate, uncertainty matters. Asset pricing is supposed to be complicated. It was delegated to the market. And indeed, because asset pricing was complicated, it really wasn’t even clear how a change in policy would be associated with a change in an asset price.

That scatter plot, those dots at the upper right are just the monthly correlations between the policy rate and the change in the S&P 500. They fill out all 4 quadrants. It isn’t obvious that you have an obvious and predictable lever where you change a policy rate and the stock market moves, or house prices move, or the foreign exchange the value of the dollar moves.

Indeed, the little table at the bottom shows how the … how equity prices changed in the week that the Federal Funds target was changed since 1987. And you see in this yellow shaded part 30 percent of the time, the Federal Reserve changed the policy rate, that is, equity prices moved the wrong way. 30 percent of the time the Fed Funds Rate was increased, equity prices increased.

So it wasn’t clear that policymakers knew how to use the lever they had.

And then lastly, [slide 33] acting in specific markets might undermine the legitimacy of a central bank. How so? The Federal Reserve act tells policymakers to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. It doesn’t say anything about keeping homes affordable, or equity prices high, or the foreign exchange value of the dollar around a given range. So there’s no obvious rationale for a preemptive stike on asset prices.

But what have we learned since the period in which the syllogism was [0:30:00] dominant? [slide 34] Well, markets don’t always get it right. How come? The complexity of financial institutions lessens the effectiveness of supervision, market discipline and internal controls.

Foreign funding can facilitate excesses. And cleaning up after the fact can be expensive, particularly when crisis management is not done well and authorities are slow to acknowledge solvency problems.

The political impediment to preemptive action with regard to asset prices remains. I still find it hard to believe that Alan Greenspan couldn’t have gone to Congress in 2005 and said, "House prices are going up too much." And those … that political impediment could get severe … more severe over time through the extent that the Federal Reserve’s independence is eroded.

But, I think I’ve talked too much, and I’d now like to turn it to Greg. [0:31:02]

Notes and References

[1]: "No Way Out: Government Response to the Financial Crisis", AEI event homepage, October 9, 2009.

[2]: "Five questions relevant to where we go from here" (PDF slide deck), by Vincent Reinhart, AEI, October 9, 2009.

1. Title
2. The Five Questions
3. Q1 – Why are U.S. households so undiversified?
4. The U.S. government provides considerable encouragement to home ownership.
5. Debt secured by primary residence
6. Family holdings of financial assets in 2007
7. The housing bubble, the financial crisis, and the policy response
8. Q2 – How should we manage a crisis?
9. Rule 1: Don’t do them
10. Rule 2: If you break rule one, be consistent
11. Rule 3: If you break rule two, be prepared to spend a lot
12. Rule 4: Whatever you do, don’t add to uncertainty and worsen confidence
13. As a consequence of missteps in management of the crisis …
14. Q3 – How should we deal with troubled financial institutions?
15. There are three core issues in dealing with troubled financial institutions …
16. Governmental responses have varied over the years
17. Significant post-Depression restrictions on finance did slash the incidence of banking crises
18. Policy makers often opt to allow institutions to delay recognition of losses
19. The growth cost of delay
20. In this crisis, the government …
21. A practical consequence of this complexity …
22. Q4 – What has been the role of the international sector?
23. Emerging market economies have been accumulating foreign exchange reserves at a rapid clip
24. International capital flows facilitated funding the housing boom
25. Official demand tilted heavily toward government securities
26. The foreign private sector increased its exposure to U.S. private credit
27. Global saving kept U.S. long-term interest rates low …
28. … and disconnected from the policy rate
29. Q5 – How should the Federal Reserve respond to asset prices?
30. U.S. monetary policy makers followed a basic “syllogism” with regard to asset prices (whether the prices of equity, homes, or foreign currency)
31. Why? 1. The private sector was supposed to have a comparative advantage over the public sector in pricing and managing assets
32. Why? 2. Asset prices are complicated and were supposed to be rational
33. Why? 3. Acting in specific markets might undermine the legitimacy of a central bank.
34. What have we learned about asset prices and monetary policy?
35. (blank)

[3]: "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises" (PDF — 123 pages), by Carmen M. Reinhart and Kenneth S. Rogoff, Harvard, April 16, 2008. Here’s the Google preview of the 2009 book version, This Time Is Different: Eight Centuries of Financial Folly

[4]: not November.  Thanks to an alert e-mailer for pointing that one out.  We’re good, but not good enough to transcribe future AEI events.