It Comes Back To Housing

This was a really lucid article from Steven Gjerstad and Vernon L. Smith explaining the role of housing in the financial crisis, in case you're having trouble explaining this to your friends and family:

The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

And that's where we are. The resets from all those ARMs could be foreseen pretty easily, but with rising prices, analysts who erred on the side of irrational exuberance thought people could just refi their way out of them and be saved by the price increase. It never was sustainable. And the securitization of the loans turned would could have been just a nasty problem confined to the specific sector into a global meltdown. When small towns in Tennessee and Alabama are swapping credit defaults and derivatives, you can see the problem clearly.

There's been a lot of talk about how we're saving the banks, but somewhat less on what we are doing at the root of the problem. There's a compelling argument to let this run its course and allow housing prices to revert back to the mean. That may be so, but rising foreclosures STILL destroy value in the market, because no buyers become willing to accept a property at anything but fire sale prices, constraining the ability of people who want to sell their home for other reasons and really upending the market. Today the President held a housing refinance roundtable and seemed to suggest that part of the solution lay in more refinancing:

What you've seen now is rates are as low as they've been since 1971. Three-quarters of the American people get their mortgages through a Fannie Mae-Freddie Mac qualified loan. And as a consequence of us being able to reduce the interest rates that are available, we have now seen some extraordinary jumps in the rate of mortgage refinancings.

And everybody here represents families who have saved hundreds of dollars a month, thousands of dollars a year in some cases, and that's money directly in their pocket. More importantly, what it's allowed them to do is to consolidate their loans in some cases, reduce the length of their mortgages in other cases. It has given them the kind of security and stability in their mortgage payments that a lot more people can take advantage of.

So the main message that we want to send today is, there are 7 to 9 million people across the country who right now could be taking advantage of lower mortgage rates. That is money in their pocket. And we estimate that the average family can get anywhere from $1,600 to $2,000 a year in savings by taking advantage of these various mortgage programs that have been put in place.

This makes sense in terms of economic stimulus but does absolutely nothing to restore the housing market, IMO. One can view pushing down mortgage interest rates and encouraging refinancing as a way to put money in the pockets of homeowners, money that they may be willing to spend. But the universe of people who just need a reduction in their interest rate to save their home is sadly pretty small. The loan modifications that have been interest-only frequently resulted in foreclosure down the road. Obviously this is not the only element of the Obama plan - and I see the point in highlighting it, because it could mean millions of dollars circulated into the economy, as well as a make-work plan for loan servicers - but it reflects a willingness to just tinker around the edges of housing policy instead of really attacking the problem.

Barney Frank's proposals to crack down on the types of loans servicers can offer by stopping 100% securitization and lots of subprime lending makes a lot of sense, but that's a second-order problem. The first-order problem is how to stop all these foreclosures. I'd like to see more attention paid to that.