Thursday, August 18, 2016

Housing in the Great Financial Crisis, the Great Recession, and their Aftermath

In case you just woke up from a long nap in the Kaatskills, circa 2007-9 the U.S. (and much of the rest of the world) experienced a severe financial crisis, and the worst recession since the 1930s.

Since those events, the U.S. has been in a long, but by all accounts, disappointingly slow economic expansion:

The Great Financial Crisis and the Great Recession are events economists and others will study and argue about for decades.  There is already a huge literature on these events, some of which I'll explore in a future "Reading for Life" post.  Recently, I abandoned prudence to add my own current thoughts regarding these events.

I wrote the paper Residential Real Estate In the U.S. Financial Crisis, the Great Recession, and their Aftermath, at the invitation of Charles Leung and Nan-Kuang Chen for a special issue of Taiwan Economic Review

What caused the crisis?  Like the Great Depression and other such watershed events, it is unlikely that there will ever by a simple, tidy set of agreed-upon explanations.  In my own class notes on the crisis, I present four slides listing 91 potential “causes,” some proximate and some deeper; some economic, some financial, some political, some sociological, some psychological.  Examples, in no particular order, and without endorsing or ranking any particular “cause” here: the rise of subprime lending, “too-big-to-fail” financial institutions, financial deregulation, poor underwriting practices, risky mortgage designs (e.g. option ARMs), the Community Reinvestment Act, perverse incentives in Fannie Mae and Freddie Mac (“Government Sponsored Enterprises”), perverse incentives among private investors, myopic expectations, adaptive expectations, a global savings glut, political resistance to appropriate financial policies, non-recourse mortgages, a widening distribution of income, financial economists who failed to understand the operation of housing markets, housing economists who failed to understand the risks building up among counterparties in ever-more complex housing based derivatives, fraud by lenders, fraud by borrowers… and so on.

Jazz master Miles Davis famously said “It’s not the note you play, it’s the notes you don’t play.” In this paper I focus on two causes:  increased leverage, and a boom and bust (some dare call it a bubble) in house prices.

The figure above shows one of many charts we could present demonstrating that individual borrowers increased leverage substantially in the run-up to the crisis.  Other data and research are presented that examine at the level of individual institutions (e.g. the investment banks that levered up 30 to 1 and even higher, meaning that even a 3 or 4 percent decline in their assets could drive them into insolvency; and the increases in systemic risk associated with ever more counter-party risk, and less transparency.

Asthe figure above shows, from 1975 to 1995, average U.S. prices grew at about 0.4 percent per annum (inflation adjusted). During the boom, 1996 through 2006, real prices grew by about 7 percent per annum.  But “every housing boom is followed by something else that starts with the letter ‘B,’” as long run analyses have repeatedly demonstrated.  The second recurring theme of the paper is the role played by housing prices in the crisis; and the reasons we saw such an unusual and unsustainable boom in the early 2000s.

Why focus on those two, house prices and leverage?  Whatever your current beliefs about many potential causes of the U.S. crisis – subprime, mistakes in securitization, Wall Street, the GSEs, fraud, macro policy mistakes, and on and on… suppose that as in a classical Greek play, some deus ex machina had imposed the following conditions: (a) all mortgagors were required to retain significant equity in their houses, while all mortgagees were required to limit their own institutional leverage; and (b) that house prices followed time paths qualitatively similar to the 1970s, 80s and early 90s, i.e. with moderate growth and volatility.  On the face of it, how could we have generated the 2007-9 crisis without high leverage and volatile housing prices?  Moderate leverage and stable underlying asset markets can help protect the financial system and the aggregate economy, even when we make mistakes in other government and private actions and policies.

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