House of Debt - How They (and You) Caused the Great Recession, and How We Can Prevent it from Happening Again (Anglais) Relié – 13 juin 2014
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1. Always quoting relevant research, but never attempting to talk over your head, they start by explaining how the poorest 20% of homeowners on average lost their entire net worth in the crisis, all while the richest 20% came out unscathed. How come? Simple: 1. The top 20% mainly hold financial assets that were protected by the Fed 2. The top 20% are indirectly the guys holding on to the mortgages that the poorest 20% are still paying or alternatively the US government guaranteed by taking over the obligations of Fannie and Freddie. All the recent talk about inequality? Go no further. The authors have it covered by page 40. Next!
2. They then explain that the poorest 20% have a marginal propensity to consume that is a large multiple of that of the richest 20%, an effect that also works in reverse and explains most of the fall in consumption (and thus aggregate demand) in the economy once their home equity had wiped out their lifetime savings. Yes, I'm confusing wealth effects with income effects here, but only for the sake of brevity. The authors do not! In short, the way you lose your house is you lose your income first (for example, divorce cuts it in half or illness in the family keeps you from working), next you miss payments, then you lose the house, which represented all your wealth to cap it all off. Alternatively, it's all set off when your monthly payment rockets up. And that's how the spending stopped! Charts are provided that measure this impact and irrefutably demonstrate that this process was in full swing, with spending on cars, furniture etc. on its knees a good 2 years before anybody knew the word Lehman.
3. It does not end there. Banks sell foreclosed homes into a weak market, forcing prices lower, which drives everybody's house price down, forcing people's home equity down to below zero who have done nothing wrong. These are people who can make their mortgage payment, and indeed mostly carry on doing so. Meantime, however, they are in negative wealth, with the inevitable negative effects on spending, especially among the poor.
4. Lots of lower spending all-round then forces companies to trim production and triggers unemployment. This was to me the most fascinating part of the book. Through little parables about countries linked through trading etc. the authors demonstrate how lower spending in conjunction with three distinct inflexibilities in the labor market (1. It's easier to fire people than to cut pay 2. It's difficult to move labor around, especially when it's wedded to a house it cannot sell 3. Retraining does not happen instantly) inevitably leads to job losses even in parts of the country or indeed the whole planet where no overleveraging and no housing bubble ever occurred.
I'm probably making a total hash of explaining this here, but the authors don't; they totally rock.
5. Next, they explain how debt not only doomed the poor, it actually triggered the whole housing bubble to begin with. Their work here is, for lack of a better word, forensic. They go state-by-state, nay, ZIP code by ZIP code splitting America by (i) high/low leverage (ii) high/low constraints in expanding city limits (iii) high/low credit score and demonstrate that credit expansion led price house appreciation. NOT the other way round. The analysis is fascinating and totally convincing. Leverage came first, house price appreciation followed. Page 83 is where to look. But, needless to say, higher house prices of course subsequently also led to further borrowing by households who famously "used their house as an ATM."
6. My second-favorite part of the book comes next. It explains how even those who believe homes are overpriced are left with no choice other than to get involved if irrational buyers use leverage: It's pages 110 to 113 and I won't spoil it for you here, it's a total gem of an argument. And it's followed by an equally elegant argument (originally by Andrei Shleifer, the man who best refuted the efficient market hypothesis AFAIC) on who would lend into this type of boom: investors who are misled into doing so by investing in securities specifically designed by the banking sector that provide enhanced yield by dint of over-exposing them to "neglected risks." Like -10% HPA, for example.
And so on... I still can't believe how much they've managed to pack in. In summary, the Great Recession was not caused by the Lehman incident. Contrary to the literature about the "breakdown in financial intermediation" theory promoted by our self-styled saviours, it was caused by debt, and in particular by the overindebtedness of the poor.
Next, they train their laser onto the inadequate response of policy makers. In one sentence, the most efficient thing to have done would have been partial debt foregiveness. Period. A chapter is dedicated to how hopeless all other policies (fiscal response, monetary response, you name it) are in comparison. And the blame is laid at the feet of those in charge.
This is so persuasive, that in response Larry Summers took it upon himself to review the book in the FT, lavishing it with praise, but also pointing out 5 (count'em) reasons his hands were tied.
All in the space of 187 pages.
Admittedly, the book could have been even shorter. The authors dedicate a fair few pages to the purpose of debunking the "save the banks, save the economy" theory that informed the policies of the Paulson / Bernanke / Geithner response to the crisis. They needn't have. More people believe in UFOs today than in the importance of Citibank, AIG or Goldman Sachs in our future prosperity, let alone their propensity to hold up the economy through the provision of credit. On the other hand, if you ever bump into somebody who chooses to defend the indefensible, you can always mail him his own personal copy of "House of Debt" and if he is remotely honest or open-minded that should settle the argument.
It's all capped by a rather lengthy proposal regarding Shared-Responsibility Mortgages. I work in the markets and I have no idea who will buy them, especially since the Fed has had to buy the much simpler paper that nobody wanted.
But from where I'm sitting the contribution of the book is elsewhere. It's both the definitive account of what happened to the American economy from 2006 to 2014+ and a powerful punch in the stomach for anyone who advocates the "democratization of debt" as a path to prosperity.
Buy it, read it and lend it to a friend. Spread the word!
Chapters 1-7 present this theory and the supporting evidence. I came to this book holding this belief to begin with, so not surprisingly, I find the thesis persuasive. In my review of the book "Guaranteed to Fail' on this website back in 2011, I wrote: "From 1986 to 1995, the annual growth in US residential mortgage debt averaged less than $200 billion per year; considering inflation and population growth, the rate of growth relative to demand declined significantly over that period. In 1995, when mortgage growth was only $150 billion, the then administration launched its "National Homeownership Strategy" to expand home ownership in which [GSE] financing played a major role. By 1998, mortgage growth more than doubled, past $300 billion; by 2001 it was over $500 billion, and in 2005, it exceeded $1 trillion. In other words, annual mortgage growth went up more than 600% in that decade." And, as is well known, beginning in 2006, many players in the domestic private sector began cutting back on funding subprime mortgages, whereupon the GSEs, who were not subject to market discipline because of the implicit government guarantee of their debt, deliberately stepped up their subprime exposure and rendered themselves insolvent, triggering global financial fears that a week later mutated into full-scale panic when Paulson deliberately chose not to rescue Lehman Brothers, and the recession then underway became the Great Recession.
Here, in the same vein, the authors write (3): "the United States witnessed a dramatic rise in household debt between 2000 and 2007 - the total amount doubled (itals) in these seven years to $14 trillion." And (6): "growth in household debt is one of the best predictors in household spending during the recession." The authors conclude (12) "debt is dangerous" (I agree), and therefore "we must fundamentally rethink the financial system" (which does not necessarily follow from the prior statement; to reduce household debt relative to income can be done in any number of ways without fundamental change to the financial system). To some extent, I suspect, there is a bit of marketing and attention-grabbing behind the statement that "we must fundamentally rethink the financial system". It generates a few more news articles and sales than just saying "homeowners should make higher down payments, and GSE's and banks should hold more capital against mortgages that are less creditworthy".
In that spirit, however, the authors advocate imposing debt forgiveness on creditors. Not being lawyers, they do not recognize the Constitutional barriers to doing so (doing so retroactively to existing mortgages requires "just compensation" of the amount written down under the takings clause of the Fifth Amendment). They heap scorn on Ed DeMarco who refused to implement such programs while overseeing the GSE's at FHFA, but they fail to recognize that, in a democratic republic, it is not the proper role for 1 appointed official to write down trillions of dollars in government's legal claims and forsake billions of dollars in revenue to stimulate the economy (if you believe it is, then you should also support the head of the IRS cutting tax rates on his or her own to stimulate the economy). That's what Congress is for.
In arguing for the macroeconomic benefits of this kind of debt reduction, the book doesn't distinguish well between the "underwaterness" of a mortgage and the monthly serviceability of that mortgage. This is important because it is not clear whether the desired macro benefits flow from the permanent impairment of principal or just a short-term reduction in monthly servicing burden. By way of illustration, back in the 1990's, I lived with an underwater mortgage for several years without it impacting my spending, because I was fortunately able to service it monthly. This distinction was not addressed, AFAICT
The authors cite dozens of research papers in support of their argument, although I am aware of other research beyond that cited in the book that challenges the assertions the authors make rather breezily (e.g., on multipliers there is a ton of work on the topic, not just the one or two papers they cite; one can pretty much pick the work one likes. Similarly, on the effect of "the stimulus", or ARRA, legislation in 2009, there is much more than the authors reference. So be aware of the advocacy embedded in the exposition of data in these sections). Still, it is an interesting thesis that claims to find support in both Reinhart & Rogoff and Paul Krugman. Oddly, though, while their thesis overlaps in part with that laid out by Rajan in Fault Lines back in 2010, the authors do not, AFAICT, link their analysis to his. I could not find him or it cited in the index, & there is no bibliography. Similarly, I was surprised not to see a fuller discussion of the role of government in shaping the terms of housing finance in America, which seems to me essential to the thesis. There are references to the subsidization of mortgage debt through the tax code, but not much at all on the GSE's, on the low down payments required by FHA, or on the incentives supplied by Basel II to hold mortgages and mortgage-backed securities by deeming them risk-free for regulatory capital purposes.
The book is eminently readable if you have any background in economics or finance at all, and, by background, I mean a layperson's, not an academic's. But, when it comes to complex subjects, like causation in economics, readability is always a mixed blessing, often and here most definitely, achieved through tremendous over-simplification. Example at 12: "One of the main purposes of financial markets is to help people in the economy share risk." That's the purpose of insurance, but insurance is just a subsector of finance. The rest of the book proceeds as if that's all finance is about. But an essential component of a financial system is to convince the holders of surpluses that they are going to get their savings back if they take them out of the safe and put them to work in the economy, or at least they are being compensated for the risk they take.
In contrast, they advocate the development of a "shared risk mortgage" whereby the amount due on the mortgage and its monthly payment would adjust (downward only) to the extent housing prices in the local zip code went down. The balance would come back to the original amount if neighboring prices came back. To compensate the lender for the risk of loss, which they calculate at being equal to 1.4% of the mortgage amount, they propose the lender receive a bonus payment when the house is sold equal to 5% of the "capital gain" that occurs. They don't explain why the household shouldn't just pay the 1.4% as a closing cost upfront and be done with it. They estimate this mechanism, had it widely been in effect in 2008, would have generated $204 billion in additional consumer spending (keep in mind to appreciate the impact this would have, that the ARRA was a $787 billion program, but, to be fair, was also a multiyear program).
This proposal - which the reader quickly recognizes is just a home equity insurance program whereby those whose homes appreciate compensate the lenders for losses on mortgages in zip codes that decline in value - has drawn attention to the book. It has a lot of issues: (1) not all homes in the same zip code are equal, nor do they move equally in price simultaneously) so the mechanism mismatches gains (based on individual home appreciation) vs losses (based on zip code home depreciation); (2) it clearly incentivizes taking on bigger mortgages and subsidizes more expensive homes - they get bigger writedowns - which creates both a subsidy effect and a moral hazard, contrary to their protestations which were very weak; (3) it doesn't work well if there is a second mortgage or home equity LOC, although I could imagine tweaking it so that the second mortgage would bear all the downward adjustment; (4) not all mortgages are alike in terms of systemic risk - the real problem is the relatively small subset of marginal homebuyers, so why not just impose some rigor in credit quality instead; (5) their calculations why this is "fair" to the lender are horribly superficial ones based on backward-looking, nationwide, macro-level averages - exactly the same kind of superficial analysis that led many investors and policymakers to treat mortgages as good investments in the run up to the financial crisis; (6) for example, many mortgage originators are local lenders, and their risk - reward calculus will be determined by a few zip codes, not some more diversified nationwide portfolio; (7) they do not seem to understand capital gains very well - depending on how much a homeowner puts into a house after purchase, the house may appreciate in price without a capital gain (my first house sold for 20% more than I paid for it, but over a decade we had invested 35% of the original price in remodeling and capitalized repairs, so there was no capital gain to us); (8) there are many ways to deliver economic stimulus to households that would make it easier for them to service household debt, including tax cuts and helicopter drops; they spend a few pages trying to distinguish some of these alternatives, but not very persuasively, imo; (9) the proposal helps people who lose a little income but doesn't address what happens if you lose your job and have a bigger loss of income; (10) renters?; (11) they argue their mechanism is a superior way to stimulate the economy without raising government debt, but when the government is also the predominant mortgage insurer, as is presently the case, that isn't true at all; the government has to borrow money to pay the mortgage losses triggered by this mechanism. They seek to insure borrowers against losses through the "shared risk" that transfers some of those losses to the mortgage holders, but the GSEs insure mortgage holders against loss and the government backs the GSE's creditors against loss, so ultimately this is a government-backed insurance program in the current configuration of housing finance in America. That is in fact one of the puzzlements of this book, how it would interact with the GSE system. The authors don't discuss that at all.
In sum, I liked the diagnostic sections a good deal, but found the policy prescription overly baroque, when there are many tried and true alternative mechanisms that appear to deliver the desired result with much less disruption. I came away somewhat surprised to have been told that the trick to avoid another financial crisis is to disseminate widely a novel financial product.
The final third of the book described the authors' solution to the problem. The authors assert that creditors did not absorb their fair share of the losses as a result of the collapse of housing. Their solution was a new mortgage contract they named a "shared-responsibility mortgage" (SRM) which essentially places the lender in a partial equity position. The lender could absorb future losses through reduction of mortgage principal if the underlining property fell in value and additional profits if the home appreciates. All the subtracting would result from changes in various indices that the authors claim can be developed. The additions would be recognized at the time of sale. (What happens if the owner does not sell his home? Is he presented with a bill by the mortgage holder at the time the mortgage is paid off? What happens if the owner dies does the note holder have a claim against the estate)?
The authors were heavy on the positive macroeconomic effects of such a program and light on detail. The complexity of these products would be well beyond the ken of the vast majority of the American public, who couldn't understand the workings of a simple ARM, according to the media. I can not image the required regulations, new federal agencies, political demagoguery, and potential fraud by lenders and homeowners of such a complex product.
The debt orgy that we experienced in the first decade of this century would not have happened a generation ago. Prior to the GSE's and securitization, lender's where much more prudent dispensing credit since they anticipated holding the mortgage until redemption. A far simpler solution would be to require lenders to maintain an significant stake in any mortgage orginated by their institution. Adam Smith and Nassim Taleb would understand!
I come from the Austrian economic tradition, with a libertarian political orientation. And although the authors are mainstream liberal, And I don't agree with all of their policy prescriptions or assumptions, I think this is the best book written on the subject of the housing/financial crisis: why it happened, how it could have been avoided (both before and after the fact), and what policy reforms are necessary to escape it and prevent in the future.
The authors have realized, as hardly any economists or policy makers have, that the problem is debt: how it's hanging over households, making any recovery impossible. They demonstrate this through facts and empirical evidence, and have a brilliant, well-crafted solution: the transition from debt-financing, with its concentration if risk and perverse incentives, to equity financing writ-large, which more equitable and systemically sound risk distribution.
I would pair this book with a study of the intricacies of Austrian Capital theory to show why some of their positive treatment of traditional government intervention to save an economy (which they then say is inferior to the equity solution) ultimate makes the problem worse by warping an economy's capital structure further than the bubble already has. But their insight that debt is the real culprit is right on. And their solution is bold, brilliant, and effective.
My only critique: they call Murray Rothbard a historian, his Econ PhD from Columbia notwithstanding.
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