Is tightening mortgage credit the solution?

Here's an interesting premise:

What if we slowed lending on purpose, what if we decided there wasn't any good reason to make it easier to buy homes? What if you had to have 30-50% down to buy a home? What if you had to show real income to get a mortgage again? What if you needed revenues for bank loans again? Would that be so wrong? Would it be a hardship?

In Europe folks need 50% down for homes. Perhaps too much, but 0-10% is clearly too little.

That's an interesting and often unexamined question. It's taken as gospel that we (meaning the government and public policy) should do everything possible to make it easier to buy a home. But isn't that what got us into the problems we're facing now? Doesn't that inevitably lead to a bubble?

I think the answer is no, or not necessarily. What if we just went back to the same system we had as recently as, say, 1995 or so? Historically it was typical to have about 20% down, maybe 10% sometimes, interest rates weren't kept artificially low by a Fed determined to flood the economy with cheap credit, and the people who wrote mortgages actually had their own money on the line if it turned out that someone couldn't make the payments, so they'd actually have incentives to make smart loans.

The concept of "disaster capitalism" may be applicable here. Perhaps not in the crash, but in the response to it. 

Market fundamentalists thrive by taking a system that has worked well and been stable for decades, with a solid private sector overseen by effective regulation, and then dynamite it. Then everyone stands around saying well the system failed, we have to do something new. So let's frame the debate with various pet theories and ideas, which we just happen to have studies and white papers for. 

For some reason people find it hard to just let's look back at what the system was before it went to hell, see how it changed, and do our best to change it back to the system that seemed to work for decades. Often the previous set of standards and regulations was hard-won, with small adjustments and tweaks over years each responding to one or another problem that had cropped up. 

From about 1945-1950 through the late 1990's the credit system both for mortgages and small business lending was for the most part relatively stable, with the notable exception being some shocks in the 1970's, and of course the S&L crisis, which eerily echoes the current one, with very similar underlying causes. Still though, despite occasional severe hardship it's fair to say most of our previous problems fell well within standard business cycle limits, and in fact the boom/bust cycle seemed even to be flattening out by the mid 90's.

And most notably, perhaps, is that the residential lending market has never -- in the modern era at least -- threatened to take down the entire commercial banking system. This in fact is unprecedented. 

But what's wrong with using a system that developed over time and with lots of tweaking, and worked pretty well? The reason to require 20% on a residential purchase is that to align the borrower and lender incentives, and it does that job fairly well. The borrower stands to lose real actual out of pocket money if they overpay or otherwise can't afford and end up in foreclosure. The bank is insulated from all but the worst swings in value and the primary risk stays with the borrower, who after all is actually the person buying the house and assuming the risk. 

If the bank wants to allow a lower down payment they can demand higher returns to compensate for the higher assumed risk. As long as they actually face that risk we can assume banks are competent enough to demand an appropriate risk premium. The bank faces risk of non-payment but it's mitigated by the equity component, or compensated for by higher rates. As far as bundling and selling the loans that's even fine too if there are provisions that keep underwriting risk actually with the underwriters, or are subject to strict and clear standards that amount to a defacto "re-underwriting" by the mortgage purchaser. This is the model -- in theory -- that justifies the existence of Fannie and Freddie. To allow banks to do what they do well, lend to their local communities, by repurchasing mortgages and freeing up the bank's capital to be able to lend again. 

  
But the "problem" that's endangered our financial system I think is still pretty mis-understood in the common discourse. There's much talk about mortgage backed securities as the root of the problem. I'd even say that when CNBC or the talking heads go on about "toxic paper" most people assume they mean these large bundles of residential mortgages. But bundling mortgages into securities was popular back in the 1980's too. I suspect many have read the book "Liar's Poker," where that innovation figures heavily. The concept is hardly new.

The "real" problem in my humble opinion was the swap market that rose up this time, in parallel with the CDO/MBS market. And the roots of this can actually be traced, possibly to a specific date, December 15th, 2000. Here's a quick backgrounder.  

These swaps, as practiced in the MBS market, were insurance. Period. They were an agreement to pay for a security if that security defaulted. There's no way these MBS instruments could have been sold so easily by the investment banks if they hadn't also been offering insurance. 

It was a great deal for the buyer -- hey I'm buying a bundle of mortgages that may or may not work out, but I have insurance on it, so if it doesn't pay out I still come out OK. What can I lose? 

Well if the MBS buyer isn't assuming the risk who is? Of course, the investment banks. But an MBS buyer thinks well what are the chances that Lehman is going to go out of business right? Inconceivable. I'll come out fine, and I don't have to consider my MBS portfolio risky, it's insured.  

But unlike insurance the swaps weren't regulated like insurance, which was not an accident as outlined in the link above. But they were insurance, and  there were no adequate capital reserve requirements. So the exact thing happened that you'd expect. Imagine if State Farm took all the premiums they get for homeowners insurance and called it profit and paid it out in dividends and bonuses. Then a hurricane comes along and with a couple billion in policies to pay out and oops, sorry we don't have that money any more.

Which is why insurance policies are regulated. Swaps weren't. They underpinned the sale of mortgage backed securities. Without those this would never have gotten so out of control, without that assurance the funds could not have flowed into the MBS market in such quantity.

And it all trickled down to main street as money just flooded the market.

But the solution isn't all that complicated. What we had before worked. 

The people taking out these risky mortgages were behaving rationally. There was free money being given away. Of course people took it. They had tremendous upside risk and little to no downside risk. And in many cases these are people who had no other obvious path to escaping their lot as medium level wage earners. This was the clearest and most direct path to wealth most people could see, and in fact an entire industry was built up to exploit this concept. Remember seeing a "make money in real estate with no money down" commercial when you're jetlagged and flipping through channels late at night? Of course you do. 

But the investment banks writing these swaps that were not being rational. That's why they were wiped out completely. There are no more standalone investment banks. Now a public policy type might say this statement falsely presupposes a "Rational Actor" which in this case is the bank itself. In reality the people actually making the decisions may well have been rational, they themselves lieke the borrowers above were also insulated from downside risk. Heads I make a ton of money, tails I lose my job, but still have a lot of money. But as institutions the investment banks behaved in a way that precipitated their failure, hardly something you'd consider rational. 

But borrowers and lenders are of course capable of being rational. Most of the time, for much of history, they have been. And it's not really that hard to go back, it just requires financial regulation that doesn't allow people to assume risk that they are not adequately capitalized to take on. 

Ensuring proper capitalization and reserves has been the entire freakin' point of financial regulation since the Great Depression. This just didn't happen, these results were predictable, and in fact were well predicted by some. But it's not like there's a need to throw out the entire basic system. Just recapitalize and do it right this time. Again. 

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