While trying to figure out what I should do, given the demise of my prior firm, I have been attending some events in Washington, DC to stay sharp, and consider what others are saying on public policy issues. So, on Monday I went to the American Enterprise Institute to listen to their presentation on “Preventing the Next Bubble.”
Now, if you’ve read me for a while, you know that I think that the boom-bust cycle can’t be repealed, but it can be modified. You can either get a bunch of moderate booms and busts, where the busts are allowed to burn out naturally, or you can try to suppress the busts (wrong strategy, try suppressing the booms), leading to anemic booms, declining marginal productivity of capital, and when bust suppression no longer works, you get a colossal bust, like the Great Depression or now.
There’s no free lunch in macroeconomics. Academic economists foolishly look for ways to optimize economic performance. They end up overinterpreting limited data, and given the biases of politicians that employ economists, suggest intervention where none is needed.
All that said, I enjoyed the presentations. I felt the discussions were worth the two-plus hours that I spent on the matter, as well as the people that I met.
Bill Foster (U.S. House of Representatives (D-Ill.)) led off, suggesting that if you can make LTV ratios in residential lending countercyclical, you can eliminate booms and busts. He wants to put that into law next year.
He is an engineer by training, and like most engineers and physicists, they adopt a mechanistic model to control the economy. My father-in-law, an eminent physicist, often suggests the same to me. I tell him that economics is more similar to ecology than physics. People hate having their freedom restrained, and so when arbitrary rules are imposed, even smart rules, they look for means of escape. But his proposal misses many items:
- Mortgage insurers will undo the tightening, and I can’t see a way to outlaw mortgage insurance.
- Fraud issues still exist — appraisal and application fraud will undo some of the constraint, as will seller financing.
- Monetary policy will be hindered by the countercyclical restraints on mortgage lending, and the Fed will loosen more aggressively as a result. (Yes, I am looking 20 or so years out here, to when monetary policy normalizes.)
In my opinion, any proposal for preventing bubbles that does not limit the Fed is not a real proposal. That said, the Fed had the ability during the housing bubble to constrain mortgage underwriting, and did not do it. Why should a new law change matters?’
The next presentation was from Jay Brinkmann, of the Mortgage Bankers Association. His presentation dug into reasons why demand for housing was unsustainable. Whether it was weak underwriting, tight spreads, teaser rates, fraud, or incompetent credit models, there were a lot of reasons for failure.
But the politics of fixing things is tough. Who wants to oppose the CRA, Realtors and Builders? I would note that really tough credit busts occur with secured lending, because lenders ge deluded by the seeming value of the collateral.
Next was Allan Mendelowitz, of the Federal Housing Finance Board. His presentation discussed how one could fight a mortgage bubble. I noted four ways to fight:
- Raise underwriting standards.
- Decrease the abilities of the GSEs to lend.
- Remove/decrease tax subsidies to home ownership, particularly those that allow for limited capital gains tax on house sales.
- Raise down payments.
I was most impressed with Mark Zandi of Moody’s. He didn’t just look at the housing market, but at bubbles generally. He noted three ways to discern a bubble.
- High turnover rates
- Rise in prices
- Increased leverage
He had three solutions:
- Modify Fed policy to incorporate asset signals, such that when high yield spreads are tight, Fed policy should tighten. (His rules were more complex than that.)
- Make Risk Based Capital more cyclical
- Genuinely regulate underwriting standards.
I thought Zandi’s ideas were the most comprehensive — after all it is unlikely that the next bubble will be in residential housing. Why focus on the last war? Why not aim for a generic solution?
John H. Makin, of AEI and Caxton Associates, gave the simplest presentation. Bubbles will always exist. Central banks will not see them. Booms militate against those who want to dampen them, because there are many who look for rewards without work.
A number of the presenters pointed to China and Israel, both of which are trying to run countercyclical mortgage policies. The jury is out here. Hopefully we can learn from their successes or mistakes.
I had my disagreements with the presenters. Rep. Foster think that we lost $17.5 trillion of wealth from the bust. My view is that we never had that wealth. That is the nature of bubbles and busts. Asset values can get pushed ahead by cheap credit. Once the cheap credit was gone, so was a lot of the “wealth.”
I believe that the way things are financed can help detect bubbles. It is almost always initially profitable to borrow short and lend long. Most bubbles have a lot of people buying long-dated assets and financing a lot shorter than the assets useful lifetimes.
Also, bubbles usually start with a good idea, where money can be made at a low level of leverage. But as prices get pushed up leverage levels rise for new entrants wanting to make money. As prices are pushed up further, new buyers use cheap short term finance to acquire assets. This is a sign that a bubble is nearing its end. Another such sign that a bubble is nearing its reversal is that new owners rely on capital gains to stay afloat. Owners have to continually feed the asset in order to hold it. Few can do that, so when you see that, the bubble is nearly complete. Sell with both hands.
Another disagreement that I had was that none of the speakers was willing to finger the Fed as a major culprit, given their overly loose monetary policy over the last 25 years.
I learned from one of the best, that with bank lending there is quality, quantity, and price. In good markets, you can get two of the three. In bad markets, you can get one of three. In the most recent crisis, lenders ignored that, and assumed that current profits indicated good business.
But, in the finance business, there are “yield hogs.” Yield hogs take for granted the stability of the financial system, and assume that they can ear an above average yield by taking more risk.
In general that does not work. Yield hogs take losses.
So, I am not optimistic about preventing bubbles. But, I can predict them on occasion, as I have described above:
The way assets are financed tells us a lot about their owners. Are they here for the long haul or not? Long term holders augur for positive price action, whereas stock renters argue for negative price action.