What caused the Great Recession, and could it happen again? These are the questions that motivate Martin Feldstein in the second lecture of his course “American Economic Policy” given to undergraduates at Harvard.
The good professor suggests that the housing sector is where we should look for an answer, and that we should appreciate that public policy played a role in both causing the recession, and in helping the American economy recover from it. But also important policy changes putting this sector on a more stable footing were reversed for political reasons, and this raises the risk that it could all go terribly wrong again.
Where are we? How did we get here? What next?
On Wednesday (January 25th, 2016), The Congressional Budget Office released a report called “The Budget and Economic Outlook: 2016 to 2016“. “I think this is the single most important document the government releases every year.” This is a highly recommended report, objectively written, and factual. This afternoon at 2:00pm the Federal Reserve will also release a timely report, and you could look at that to get a sense of the stance of monetary policy, a topic we will discuss later in the course
The Fed’s unconventional monetary policy worked successfully, but it brings with it risks. These are similar to what brought the economy down in 2007/08. Things don’t always repeat themselves, but these things could happen again. So it is important for us to understand what happened, to understand the risks going forward.
The key feature that caused the downturn was what happened in the housing sector, and there was a combination of three things different from previous cycles: (1) a high increase in housing prices during the decade or so before the recession; (2) an increase of leverage; and (3) securitization, which was quite new.
Could all this happen again? Perhaps not in the same way, perhaps not necessarily in housing but in other sectors.
1. House prices
[Professor Feldstein is decidedly low tech in his lectures, drawing a chart something like this one on the board for the students, with the exception that his started with prices measured relative to the year 2000, rather than 1991 in this version that I have taken from a news release by the Federal Housing Financing Agency. Click on the figure to go to the original source.]
There was a significant increase in housing prices after 2000, running up to an unsustainable bubble, which burst and was followed by a 30% fall, and then after 2012 began increasing. [Only just now returning to the peak level reached almost 8 years ago.]
Why did prices rise so much, why did we have this bubble?
Three factors were at work.
First, interest rates were kept at very low levels by the Federal Reserve, and this promoted borrowing. But this begs the question: why did the Fed keep rates so low?
Basically because of a fear that the economy would start falling. But also because this policy meshed up with a broader government objective of making housing affordable to all Americans, and particularly those with lower incomes. The Community Reinvestment Act embodied this objective. The government said it would punish banks that did not promote lending to low-income borrowers, so the banks created all sorts of credit instruments targeted to families who might be on the margin of affording a home.
These included so-called “teaser rates,” an offer of a lower rate in the first two years of a mortgage, that would then increase in subsequent years. But the story was that borrowers should not worry about the higher rates, because by the time they got to them their house would be worth so much more, and with this capital gain they could refinance.
They also included lending to pay the interest, so the size of the mortgage might actually rise. Borrowers could get into the mortgage market with a relatively small down payment, having to put down only about 20% of the total loan, the rest being backed by the government. And this was pushed to the very limit by so-called “piggy back” mortgages, in which an additional 20% could be borrowed.
Finally, there was a much more lax credit assessment of borrowers by the banks, leading in the extreme to NINJA mortgages extended to those with no income, no jobs, no assets.
There was strong political pressure from realtors, the mortgage banks and brokers, and the construction companies on Congress that encouraged these policies.
The third factor was “irrational psychology,” the kind of psychology that the economist Bob Shiller refers to as the fear of missing out. A bandwagon effect came into gear that generated higher returns, and encouraged players to get into the market and stay in the market. This played a role even for those who already had a house because they anticipated higher capital gains from having a bigger house.
This is not necessarily irrational. With house prices rising at 10%, interest rates at 6%, and tax deductable interest payments, a borrower would end up paying 4% or less to make a gain of 10%. But the incentive is even stronger because of leverage, you only have to put 20% down, but the gain of 10% is on the full value of the house.
A lot of people got on the bandwagon for all these reasons, and that is why house prices rose to an irrational level. We know that this is an irrational bubble because the price of houses were well above the costs of building them.
2. Leverage increased dramatically
Historically borrowers were required to put up 30% of a mortgage as a down payment, borrowing 70% of the value of their home. But this rose to 80% over time, and eventually came close to 100%. Why would banks make loans at close to 100% of the value of the house?
They had a continued expectation of higher prices, a self-creating perception that would lead the loan-to-value ratio to fall a couple of years after the loan was made. But when prices stopped growing this process reversed itself dramatically.
Mortgages are “no recourse loans.” That’s to say if the borrower stops making payments, the bank can only take away their homes, leaving any other assets untouched. It becomes very easy to walk away from loans when the value the home is lower than the mortgage. Our neighbours in Canada don’t have no recourse loans, and they did not have any of these problems. [Hmmm … well, there were also other things at play.]
When this process eventually reverses itself, house prices fall dramatically, we experienced a very sharp 30% fall.
There was a nice web site, youwalkaway.com that explains that it is your right as an American to walk away from your mortgage.
Increased leverage with no recourse loans are a part of the story explaining why housing prices fell.
Securitization is the most complex factor.
In the good old days the local bank held the mortgage it initiated. But this changed, and mortgages were securitized, that is sold off to others.
[OMG, here I am typing away frantically on my laptop trying to get every last drop of wisdom flowing from the fount, and the women sitting beside me has a parade of yellow slacks moving down her screen. WTF … is it true that education is wasted on the youth? Can’t be, she must already know that my notes will be available online, and besides the slacks look great. Never thought that about yellow. Oh shoot, securitization is the most complex factor. 🙂 ]
In the good old days with residential backed securities, if something goes wrong and the borrower couldn’t make a payment they could go to the bank manager and explain the situation. The bank would help out in some way to give the family the relief it needs to get past its temporary problems and return to regular payments.
But once the loan is securitized, the whole story changes and there is no scope to renegotiate. This led to defaults and foreclosures that would not have happened under previous arrangements.
Secularization can be a good thing because it spreads risks. And we might even think of it as a brilliant piece of engineering that almost worked.
This is what was going on.
Banks sold their loans, and big mortgage pools were sliced into synthetic tranches of risk. A bunch of sub-prime mortgages could be converted to have a much higher credit rating. Think of a pool of say 1,000 sub-prime mortgages. If you were an investor who was willing to take a lot of risk for the sake of a higher return, you could agree to buy into this pool, and accept the first 10% of defaults if they occurred. Another tranche could be sold in which the investor would carry the risk of the next 10% of defaults, that is to take a loss only beginning after 10% of defaults have already occurred. And so on, the next tranche taking on a risk that only kicks in after 30% have defaulted.
Eventually we get to pretty low risk, the bet being that 30 or 40% of 1,000 mortgages would have to default. These are pretty low risks, and the credit rating agencies rated the instruments highly, even better than AAA. High risk individual mortgages were packaged in a clever way. A lot of money was put into this, and the very secure tranches were sold around the world
When the rating agencies looked at the probability of default, they were using data from the recent past. And banks that took an independent look reached the same conclusion because they were also using data from a period in which prices were increasing.
This was not right thing to be doing, and as defaults started house prices fell, defaults exceeded expectations, and people said: “on my, we are in trouble.”
Put all this together and the result is that mortgages and mortgage-backed securities were very depressed after 2006, sending a signal to investors that risk had been under-priced. There was tremendous uncertainty. Banks didn’t know what they had, what their assets were worth. This was trouble because a good deal of lending is between banks. So as lending banks did not know what their assets or the assets of counter parties were worth, the inter-bank lending market collapsed. The banks stopped lending, as they didn’t we have the confidence in their own or others balance sheets.
The resulting collapse of the lending market impacted real economic activity.
4. Public policy
We now get to read the minutes of the Fed meetings, and the highest monetary authorities in the land did not get it. They were wrong. They did not start to significantly reduce interest rates until the end of 2008.
Why didn’t the fed prevent this bubble from developing. First, political pressure from interest groups like the building and construction community.
Second, the Fed Chair at the time, Alan Greenspan, said that it is hard to know if there is a bubble, and the right thing to do is to wait until it bursts and then put the pieces back together. Well to some extent it is hard to know if a bubble has taken hold in some markets. Think of the prices for art like a Rembrandt painting, where the market price is just what the richest collectors want to pay for it. Or think of stock prices. But for houses there is an objective standard for knowing if actual prices are out of line with fundamentals: the cost of production. And looking at the costs of production—which in the United States are pretty low because land is not in short supply—would have suggested that house prices were going up unsustainably.
The economy experienced a financial crisis and an economic downturn. Credit was not available, and this had an impact on real economic activity, and there was no monetary policy. So the Fed worked with the Treasury and introduced a lot of new stuff to revive capital markets, but this was not enough to re-kindle the recovery.
In short, the downturn had three causes.
First, credit was not available.
Second, the collapse of housing starts. Housing is an important component of economic activity, and there was a lot of stock coming on the market because of defaults. As a result construction fell by 1,000,000 homes, the equivalent of 1.5% of Gross Domestic Product. This was a big sucking out of aggregate demand.
Third, the stock market fell, and with it household wealth fell by 12 trillion dollars in a year. This resulted in falling household spending.
Certainly, there are automatic stabilizers, but these were small compared to the massive fall in demand that was taking place.
All of this is very different from previous downturns: its massive size, dysfunctional credit markets, ineffective monetary policies.
So what to do?
The Fed’s intervention was not enough, so the alternative was fiscal policy and unconventional monetary policy. There was a massive buying of government bonds, and a promise to keep short-term interest rates low for a long time.
Could we have another housing crisis?
The authorities changed the rules: so called macro-prudential policies were put in place in the housing market. They involved no more piggy back mortgages, and down payments of 20%. Banks were also required to have some skin in the game. They had to keep 5% on their books, and could not off load everything to the pool. Lastly, there were limits on the ability to make payments; monthly payments couldn’t be more than 30% of the income of the buyers.
But all three of these policies have been scrapped. Fanny Mae and Freddy Mac will accept mortgages up to 97%, there is no originator retention, and forget 30%, payments can be even as high as 40% of borrowers’ income.
Why did the government do this? Basically to appease the lobbying of realtors, the builders, and the banks, who all thought it was a good idea. I said to senior economists in the administration “Why aren’t you guys making some noise.” Well “word came down from above that this is above your pay grade, so they stayed quiet.”
It is now the taxpayer that takes the risk through Fannie Mae.
I had a conversation with a CEO of a Wall Street firm, and he said, “Marty you worry too much about this. Defaults will not hit the investment banks or the commercial banks. It goes to the government.”
But this is short-term thinking. If there are defaults more houses go on the market, and this spreads. I think there is a risk of downward spiral in home values. Maybe it won’t be big enough because we don’t have securitization, but there is a danger of a repetition, though it may happen in other markets, for example commercial real estate.
[So that is where we are, how we got here, and what might happen next.]
[ The reading list for this lecture is available in the course outline, but as far as I can tell the lecture seems to be based on the first reading: Martin Feldstein, “Housing, Credit Markets and the Business Cycle,” in the 2007 Kansas City Federal Reserve Annual Conference Volume, Housing Finance and Monetary Policy, 2008. This seems to be available as NBER Working Paper No. 13471, which was published in 2007.]