Bubbles & Banks & Zero Lending Standard Loans

Paul Krugman has an interesting OpEd in today’s NYT, one that I mostly agree with.

However, I take exception to his perspective on a few issues, one of which might ultimately prove to be crucial to understanding the crisis and putting the correct financial reform measures in place. Professor Krugman writes:

“A lot of the public debate has been about protecting borrowers. Indeed, a new Consumer Financial Protection Agency to help stop deceptive lending practices is a very good idea. And better consumer protection might have limited the overall size of the housing bubble.

But consumer protection, while it might have blocked many subprime loans, wouldn’t have prevented the sharply rising rate of delinquency on conventional, plain-vanilla mortgages. And it certainly wouldn’t have prevented the monstrous boom and bust in commercial real estate.

Reform, in other words, probably can’t prevent either bad loans or bubbles. But it can do a great deal to ensure that bubbles don’t collapse the financial system when they burst.” (emphasis added)

I disagree with many of my colleagues as to where the bubble actually was. I believe we did not have a national Housing bubble; rather, what we had was a national Credit bubble. (Understanding the difference becomes important, as you shall see shortly). And while much of the country had a housing boom, only a few areas — notably, SoCal, Las Vegas, Arizona and S. Florida — were full blown housing bubbles.

But that is a relatively minor quibble. The real disagreement is over the impact of sub-prime loans on the entire US Housing market, and whether lending standards can be adequately enforced. Had then Fed Chairman Alan Greenspan done his job properly, and prevented Zero Lending Standard loans from infecting the real estate market, we would have been looking at a very different housing situation — to the upside as well as to the down side.

Let’s look at the impact Sub-Prime had, then see what could have been done about it.

First, we need to consider that markets typically are in balance — there are a roughly equal number of buyers and sellers. Prices rise or fall as changes take place at the margins; If we were to add more supply (i.e., more sellers of houses) to what was a previously balanced market, prices fall; Add more demand (i.e., buyers), and prices rise.

What happens when you drop mortgage rates significantly? Monthly carrying costs become lower, and this attracts more marginal buyers (demand) — at least until prices rise to the point where the balance between buyers and sellers stabilizes prices once more.

Without the explosion of subprime, but with ultra low rates, we very likely would have seen a rise in housing prices, followed by a plateau. But it would not have been nearly as severe relative to historic price relationships (as an example, median income to median home price).

What the newfangled lend-to-securitize subprime model did, however, was to bring millions of previous non-buyers — people otherwise known as renters — into the housing market. On top of the rise in prices caused by 1% Fed Funds rates (~6% mortgages), this added an additional level of pricing destabilization to the Real Estate market.

This is evident in the charts I’ve shown again and again: Median income to median home price; cost of renting to ownership; Housing stock as a percentage of GDP — all of these showed a housing market several standard deviations above its historic pricing mean.

With that in your mind, consider how this sub-prime driven boom played into the securitization market, and eventually the Derivatives market (CDOs, CDSs, etc). Look at the 10 steps detailed here on Monday regarding the forming of the credit crisis.

The inevitable conclusion is that sub-prime was a major driver of not only the Housing boom and bust, but of the entire financial crisis and credit freeze, and the subsequent bailouts . . .

Could it have been prevented? Only if the Fed would have enforced traditional lending standards, i.e., the borrowers ability to service the mortgage. They should have regulated those non-bank lenders whose model was based not upon the borrowers ability to service these loans, but upon the lender’s ability to subseqeuntly sell the loan off top securitizers on Wall Street.

So, the answer is yes, appropriate regulation could have prevented the entire mess . . .

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Previously:
Bernanke Still Does Not Understand Credit Crisis).
http://www.ritholtz.com/blog/2010/01/bernanke-cause-of-credit-crisis/

Source:
Bubbles and the Banks
PAUL KRUGMAN
NYT, January 7, 2010
http://www.nytimes.com/2010/01/08/opinion/08krugman.html