Despite all the wrangling in Washington, Davos, and elsewhere about regulatory overhaul, one holy grail remains: U.S. housing policy. Some maintain that while mortgages were present, they were benign without securitization and leverage, so that those latter elements are more the culprit than mortgage policy, per se. Others argue that mortgages could only have been benign in isolation from Federal housing policy, which consciously sought to push home ownership rates to historic highs.
As it stands, however, the debate lacks structure. Economic historians are taught that every crisis has both impulse and propagation mechanisms. The impulse causes of the crisis. The propagation mechanism perpetuates the crisis. Usually the impulse is a decline in real value in the economy, or at least a realignment of nominal and real values, i.e., a bursting bubble. Propagation mechanisms are the policy bungling and systematic transmission mechanisms after that point.
In every crisis there are both impulse and propagation mechanisms. In the Great Depression, the primary impulse was a bubble bursting in asset markets. Propagation mechanisms included contractionary Federal Reserve policies used to preserve the value of the dollar on the gold standard and inefficient bank failure mechanisms, as well as systemic effects that put substantial losses on unsophisticated bank depositors.
In the Thrift Crisis, the impulse was commercial mortgages (for Thrifts) and sovereign debt (for banks). Some propagation mechanisms, to name a few, were inadequate regulatory resources (which led to forbearance) and Basle I implementation (which led to greater capital accumulation before banks would lend for growth).
It is hard to argue that the impulse in the present crisis was not mortgage growth, fueled by Federal housing policy that tried achieve record-high homeownership rates by pushing homes on people who, “lack… cash available to accumulate the required down payment and closing costs,” or “do not have sufficient available income to make the monthly payments on mortgages financed at market interest rates for standard loan terms.” The Strategy’s unbridled pursuit of “Financing strategies, fueled by the creativity and resources of the private and public sectors,” actively promoted the practices that expanded poor mortgage underwriting and servicing practices to those that contributed to the crisis. (US Department of Housing and Urban Development, “The National Homeownership Strategy: Partners in the American Dream,” Chapter 1, July 11, 2000, obtained from http://web.archive.org/web/20010106203500/www.huduser.org/publications/affhsg/homeown/chap1.html.)
That policy advocated using additional sources of leverage and industry financing to fuel mortgage growth. Interest rate policy, unsound securitization practices, and other forms of leverage all worked in concert with the Homeownership Strategy to create the housing bubble, but mortgages were still at the core. Without mortgages, securitization, collateralized debt obligations, repurchase market, credit derivative, and other market problems would not have been adopted so widely. All other factors were and are propagation mechanisms.
The view has important implications in the context of Congressional and other regulatory proposals. Note that none of those include addressing housing policy. Some attempt to limit individual counterparty risk by moving new derivatives trading to exchanges. Others propose to remove credit ratings from regulatory language. Yet others establish resolution regimes for large bank holding companies. More recent proposals attempt to move proprietary trading out of financial services holding company-owned investment banks. All are novel efforts. All helped propagate the crisis, once it got started. None, however, address the underlying impulse mechanism: mortgages.
Today, we remain loath to sacrifice the mortgage policy that caused the crisis. We are addressing the market overhang of housing inventory by building more housing, keeping interest rates low, and giving away housing value in the name of “keeping people in their homes.” Moreover, the policies we are applying are rooted not in economics, but in unbridled populism.
As a result, while we are discussing exit strategies for other Federal Reserve and Treasury bailout policies, no one has discussed exit strategy for the main policy cause of the crisis. Exit – or at least limitation – strategies for outdated and problematic housing policies are the subject of the most important debate that needs to be engaged. But like the Tea Party activist recently holding the sign that read “Keep your hands off my Medicare,” the public just might not be ready for fiscal reality.