Housing, Recessions and Sustaining Wealth creation Warsaw, Poland December 3, 2010 Vernon L.

Smith
Presentation based on S. Gjerstad and V. Smith at:
http://www.chapman.edu/ESI/wp/Recessions _1929_2007.pdf Economic Science Institute Chapman University
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Bubbles are frequent in history and in the laboratories of experimental economics.

What causes them? What can spark them? What can sustain them? How could the large dotcom stock market crash, 2000-3, do no damage to the financial system, while the housing market crash, 2007-8, devastated it? If bubbles cannot be prevented, can their collateral damage be contained? Experts, policy makers, economists were blindsided; failing to anticipate the current crisis. Are there parallels: The Depression & Recessions?
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LESSONS FROM THE EXPERIMENTAL ECONOMIC PERSPECTIVE: Important to Distinguish Two Kinds of Markets: 1. Non-durable consumer goods markets: Most final goods and services in the economy are not re-traded; costs and benefits are realized then repeated over time; think of haircuts, hamburgers and transportation services. Nondurable goods are 60% of gross output! * Outcomes in Lab better than we economists expected. * Price discovery processes are very efficient and stable. 2. Asset markets: Items like houses, and securities are re-traded. * Outcomes in Lab worse than we economists expected. * Price bubbles are common. Both kinds of experiment results are echoed in U.S. historys largest housing bubble; its crash spread to banks, then stocks, and finally to a well-functioning consumer-producer economy.
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S H

GDP

Recession Starts, Q4, 2007

What is different about asset markets? Stocks and houses are bought to hold, or resell, and are vulnerable to price bubbles and crashes. Besides fundamental yield value, prices may also depend upon how people think others will value them in the future. Assets market experiments with student, business, corporate and financial industry groups, even though informed of fundamental value, have all produce bubbles; they disappear only with repeat experience. Experiments show that market bubbles are more pronounced: if peoples initial endowments include more cash relative to shares. or, if they are allowed to buy shares on margin i.e., borrow to buy shares. The Cause? We do not know why people get carried away with selffulfilling expectations of rising pricesa bubble.
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Looking back, what sparked the U.S. housing bubble from 1997-2000? We see four stage-setting events:
1. Laws required performance rating of mortgage-lenders for efforts to lend to borrowers with incomes below 80% of medium income. Objective: Help poor own homes; have stable neighborhoods? 2. In 1996, US housing agencies were assigned target goals to direct their funding to low income borrowers; subsequently targets were increased to 50% in 2000, and 52% in 2005. All actions received bipartisan support from both Clinton and Bush administrations. Very popular with voters 3. Taxpayer Relief Act (1997) which exempted home re-sales from capital-gains taxes (up to $0.5 million on each sale). 4. US trade deficit, with the resulting large inflow of foreign investment capital starting in the early 1990s
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What may have sustained and continued the housing bubble (2000-2006)? 1. Easiest monetary policy in 52 yrs, 2001-3; 2. Continued foreign capital inflow. 3. Uncollateralized Credit Default Swaps (CDS derivatives) These were information, not insurance, markets. E. g., AIG Co. had agreed to collateralize only if they lost AAA rating.
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Monetary Ease

Housing bubble also fueled by a large inflow of foreign investment, a consequence of the US trade deficit.

I.

Why do stock market bubbles cause minor damage to the financial system?

Its all in the margin reserve requirements: Stock purchases are subject to high cash reserve requirements Any loan can be called by broker if reserve margin is short Losses are therefore confined predominantly to investors Banks and non-investors remain unscathed It was not always so; institution found and not lost: Margin reserves requirements (50% and more) first emerged in the self interest of private brokers 1.5 years before the crash of Oct., 1929 Then they were adopted by the NYSE for its members, 1933 And finally, were codified by Congress, when the SEC Act of 1934 empowered Fed Res to regulate margins (Reg. T, 50%); brokers today often require higher margins; up to 100% by discount brokers. Margin requirements became an entrenched tradition, a lasting property right rule; limits the damage from the OPM (other peoples money) problem

II. Why do housing/mortgage market bubbles devastate financial systems? Its a reserve failure: Houses were bought with low or zero cash downBIG OPM problem Loans are long term and foreclosure very costly to lenders Losses impact banks, economy, all citizens, including those who only rent homes, but lose employment because of the economy. Through finance and trade the distress spreads through the world It was not always so; Institution found then lost: In 1920s bank mortgage loans were like those in the recent crisis: interest only, or with delayed large balloon payments. Corrective response, 1935-1939, was to require larger down payments, loan amortization; reduced OPM problem. This learned tradition was lost, 1997-2006. Also, we created mortgage backed securities, as means to facilitate home ownership by those of modest income; safety was sought via CDS. Illusion: CDS protects against default.
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Impact on the poor? The Cheaper the House the worse the bubble; and in crash, the greater the impact on bank losses

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Role of Credit Default Swaps (CDS Derivatives)

In 1998 CFTC Chairperson Brooksley Born issued a concept release calling for revisiting the exempt status of derivatives; exemption meant not listed and subject to margin requirements: this action was opposed by Fed Res, Treasury and SEC. She was right, but brushed aside. In his July 30, 1998 congressional testimony against the CFTC, Deputy Secretary of the Treasury, L. Summers, argued that the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies. Fed Chairman, B. Bernanke, offered same argument on Nov. 15, 2005. The CDS market collapsed in early August 2007.
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What Was Wrong with Derivatives?

Nothing, except they were not exchange listed, like stocks; were not margined and collateralized! Problem was identical to that of house mortgages that were inadequately collateralized by borrowers. Derivative markets performed well as information markets, signaling to all in August, 2007including Fed Res chairman Bernankethat a crisis had occurred. (Earlier and smaller CDS market declinestremorshad been ignored) But derivatives were never insurance; that would have required CDS sellersthose who guaranteed against defaultto post reserve collateral.
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The Federal Reserve, Mortgage Bubble and Crash

I
FED ACTIONS

II

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Parallels with the Great Depression: Mortgage Funds Declined before

the 1929 Stock Market Crash, and 1931 banking crisis

Bank Panic/Failures

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Depression: Housing expenditure boom, 1922-26; collapse 1927-33; Decline impacts consumer spending, investment, and economy, 1929-33.

Depression Starts, 1929

Housing Expenditures, percent GDP, 1920-2010

Shaded Areas: U. S. Recessions

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Some Conclusions
1. Laboratory experiments have long demonstrated that consumer goods and service markets are highly efficient & stable, while asset markets are prone to price bubbles and instability. 2. This experiment behavior is echoed in the US housing bubble, 1997-2006, and its collapse, 2007-10, with severe negative consequences for under-reserved home buyers, mortgage lenders, derivative market insurers. 3. This caused a freeze in credit markets and a broad decline in all private securities markets and in the economy in spite of Fed liquidity action in Aug 2007 and over a year later, massive purchases of shaky assets, $1.2 trillion. 4. The Great Depression had similar origins. We are in the second household-bank-firm balance sheet crisis. Most post war downturns are led by housing; all recoveries are housing based.

5. How do we return to the path of wealth creation? A. Mortgages. Traditional standards: 25-30% down payments; amortization of principal; no balloon payments; loan originators fees based on borrower payments. B. Derivatives. They are securities, no exemption from registration and margin requirements. C. Taxes. The U.S. has higher business taxes than any European countryeven France. Almost all net new job growth in the U.S. comes from business start ups. They should not be impeded by either taxes or unnecessary start up costs.
http://www.chapman.edu/ESI/wp/Recessions_1929_2007.pdf
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