There’s always a point at which ideology and reality meet, and if we’re seeking a rational solution to Nevada’s economic problems then reality must inevitably trump ideological concerns. Nevada governor Sandoval is at this crossroads, and has chosen to direct his administration to explore ways to assist homeowners facing foreclosure. [LVSun]
One of the problems with supply side “invisible hand” ideology is that it offers only a One Size Fits All to economic issues. For example, the NPRI’s objections to Governor Sandoval’s suggestion are underpinned by the Moral Hazard argument:
“First, it’s unjust to use taxpayer dollars to subsidize the entities — the individual who can’t pay his mortgage and the bank that made or bought the loan — that are causing the problem. Now, this money is coming from the feds, so at least Sandoval isn’t spending state money. But this interference is still going to make things worse.
By financially rewarding those who are in or near foreclosure, you incentivize other homeowners to flirt with foreclosure and punish those who pay their bills on time. In turn, this depresses home prices, which hurts every homeowner who is doing his best to make on-time payments.”
This argument makes sense, but only superficially. Yes, people should be responsible for paying off their bills and contracts. Yes, some individuals made some irresponsible decisions in terms of financing, or refinancing, their homes. Therefore, why should there be any collective response to their individual problems? To address this question we need to take on some of the illusions of the Almighty Market.
When we strip all the tangential issues away from the troubles in the housing market what we find is that depressed home values have some homeowners “underwater,” if not already drowning in debt. We’ve come to speak of value, cost, and price when speaking of the housing market as if these were synonymous. They aren’t.
The differences in terminology aren’t merely semantic or academic, they go to the core of what we’ve come to believe about how capitalism should work.
For example, the value of a home is not only its market price but also incorporates the protection it affords the family, including the quality of life which can be attained while living in that residence and location. Part of the value of a home includes the quality of the neighborhood schools, the proximity of parks and recreational facility, and the networks of social relationships in the community.
The cost of a home isn’t measured purely in dollars and cents either. Paying off the mortgage is only one part of a home’s cost. There are expenses for insurance, upkeep and maintenance, and improvements which must also be considered in the total cost of a residence.
Now we’re down to the price. In terms of the housing market, the price of the home is the best offer from an immediate buyer. So, how does classical capitalism explain how the price is determined? Back to Econ 101: The market price is established by the interaction of supply and demand; and, the equilibrium price is that achieved when the demand is equal to the supply.
Here’s where the rubber starts meeting the road. If the ‘best’ price is one that can be derived algebraically from quantified inputs like how many houses are on the market, and how many people want to buy them, then we would probably not have created the Housing Bubble in the first place. However, we did have a housing bubble, just as we had a Stock Market Bubble, just as we had a Dot.Com Bubble, just as we had the Savings and Loan bubble, just as we had a Tulip Bubble, just as we had a South Seas Bubble…
We’re Forever Blowing Bubbles
Why? Without getting into all the particulars of each Bubble created, and then pricked, by our markets, they do have one thing in common: A Failure of Judgment. If we look back to the Housing Bubble we can see failures on several fronts. Potential homeowners were attracted into the market by a political decision predicated on the Ownership Society as perceived by the Thatcher government in Great Britain:
“She thought the housing would be better maintained, but more importantly she thought that homeowners would become more responsible citizens and see themselves as having a real stake in the future and in the quality of life in their communities.” [Cato]
U.S. policy since at least 1992 advanced the “better citizens through home ownership” theory. This amalgam of political and economic theory led to the promotion and marketing of the “Everyone Needs A White Picket Fence Around Their Own Subdivision Home” construction boom. Construction companies were attracted into the housing market with low interest rates for construction loans; banks got into the act with mortgage origination, more banks got into the act with mortgage servicing, yet more banks got on stage in the secondary mortgage markets, bankers enthusiastically joined in the game securitizing the secondary mortgage instruments, joined again by those making sideline bets on those securities, and we Bubbled right along. Where did the judgment fail?
Let’s take one step back before moving this argument further: In the bad old days a person buying a home got a 20% down 30 year fixed rate mortgage. In other words, the loan ratio was 80-20, with the homeowner having a 20% stake in the actual ownership of the residence. Also, in those bad old days, there was more knowledge than information in the pipeline, and we need knowledge to make good judgments.
Before the housing booms (and busts) in the 1980’s and the 2000’s, local bankers and homeowners were practicing the principles of an Ownership Society. The local banker knew more about the prospective mortgage seeker, knew perhaps not only the amount of his or her income but also may have had a better sense of the permanency of that employment. Underwriting standards were higher because the bank, which might have kept a significant portion of the mortgages on its own books, had an ownership stake in the process.
The problem in the early 2000’s was that the knowledge accrued by homebuyers and mortgage providers in a previous era was dissipated and diluted into statistics about “units” and “trends” and inserted into algorithms which sought to reduce that knowledge into formulaic whiz-bang fast fodder for investors. It was the economic version of observing statistical trends on the productivity of horses and applying the conclusions to automobiles.
Information regarding the statistical probability of defaults in the Fixed Rate Era was unfortunately applied to the probability of defaults in a milieu of subprime, Alt-A, no-doc, adjustable rate, pick a payment, creatively financed, mortgages. In short, we had Information about mortgages, but no Knowledge about how the new products were going to work. Judgment fails without knowledge.
The failures of judgment can be set at the doorsteps of not only individuals who didn’t carefully consider the ramifications of their indebtedness in 2005, but also at the steps of the financial institutions which were promoting the direct opposite of ownership — liability. At this point it’s probably a good time to repeat the maxim that one man’s liability (debt) is another man’s asset, and by the time we got finished distributing the risk of all these liabilities we created a situation in the Fall of 2008 in which ownership was so diluted that it was all but impossible to discern who actually owned what. We had lots and lots of “information” about the housing market, but frankly speaking, very little “knowledge.”
Prices, Impulses, and Peril
Now it’s time to ask another question relative to the Moral Hazard so feared by the NPRI: Why would anyone “flirt with foreclosure” and risk punishing those who pay their bills on time? Why would banks reduce their underwriting standards to accommodate the financial demands of those who would do so?
A simplistic, but unsatisfactory, answer is They Were All Greedy. Indeed, they probably were, however even good old fashioned human greed has its limits, which are generally reached as soon as a human being perceives good old fashioned danger. Why didn’t either side of the mortgage equation see the Danger Signs well before the situation became downright perilous?
The answer may come in two parts. In the first part, people purchased mortgages they thought they could repay, given the information they had at the time. Received wisdom, aka common sense, dictated that real estate values, which were defined as assessments or valuations and market prices, always increased. People were lulled into believing that the market price of their property would increase, because that’s what it had always done before — in the bad old days of the Fixed Rate Era. The idea that 1 out of every 180 properties in the Las Vegas, Nevada metropolitan area would face foreclosure was not just a Black Swan, but a four legged Black Swan with a teal blue head and pale green beak.
The second part of the answer is that bankers were also operating under the delusion that the statistics of the Fix Rate Era were applicable to the ARM Era. However, there is another facet to this element of the discussion. The promotion of adjustable rate mortgages and other financial products contributed to an overall decimation of actual ownership.
How does putting people into homes with 0% down payment “decimate” actual ownership? Because — 0% means they had Zero actual ownership of the property. The figures from the Fixed Rate Era showed that individuals who had from 0% to 5% ownership in properties were more likely to default than those who had 20%. Worse still, homeowners were invited to take out home equity loans — “Pay for Educational costs, Medical expenses, Vacations…” which further eroded the actual ownership of the very real property. Chickens do come home to roost, and they have in Las Vegas.
The recent CoreLogic report explains:
“released negative equity data showing that 10.9 million, or 22.7 percent, of all residential properties with a mortgage were in negative equity at the end of the first quarter of 2011, down slightly from 11.1 million, or 23.1 percent, in the fourth quarter. An additional 2.4 million borrowers had less than five percent equity, referred to as near-negative equity, in the first quarter. Together, negative equity and near-negative equity mortgages accounted for 27.7 percent of all residential properties with a mortgage nationwide. In the fourth quarter, these two categories stood at 27.9 percent.”
[…] Nevada had the highest negative equity percentage with 63 percent of all mortgaged properties underwater, followed by Arizona (50 percent), Florida (46 percent), Michigan (36 percent) and California (31 percent). The negative equity share in the top 5 states was 39 percent, down from 40 percent in the fourth quarter. Excluding the top 5 states, the negative equity share was 16 percent in the current and previous quarter.
Las Vegas led the nation with a 66 percent negative equity share, followed by Stockton (56 percent), Phoenix (55 percent), Modesto (55 percent) and Reno (54 percent). Outside metropolitan areas in the top 5 negative equity states, the metropolitan markets with the highest negative equity shares include Greeley, CO (38 percent), Boise (36 percent), and Atlanta (35 percent).
No surprise here, the numbers for the Las Vegas, NV area were among some of the worst in the nation. Thus much for the “common knowledge” that real estate prices never fall. We had all manner of information about the stock prices of home construction corporations, and copious amounts of data about bank equities, and even more information about default rates than anyone should have needed — but we didn’t use our judgment based on our knowledge of economic bubbles to avoid the Housing Bubble or its collapse.
The moral hazard argument might apply IF home owners and bankers KNEW that the products they were selling and purchasing were inherently dangerous, and were underpinned by dubious information and suspect analysis. We certainly don’t want to reward irresponsible behavior, but the mortgage purchasers thought they were getting “good deals,” and the bankers thought they were spreading the risk so no one was imperiled — in the end the mortgage product purchasers were underwater, and the bankers had only succeeded in spreading a contagion to everyone in the entire financial sector.
Systemic Problems Need Systemic Answers
It’s entirely too simplistic to insist that the Mighty Invisible Hand of the housing market will magically redress all the issues in the aftermath of the housing bubble collapse. The Invisible Hand theory assumes a market with accurate information upon which reliable assumptions can be made. In the recent housing catastrophe there was plenty of information, bits and pieces of data swirling through the bank computer algorithms, but there was obviously a paucity of knowledge about the actual condition of the economy.
The Invisible Hand works best when it’s guided by very human ones. There is a large difference between a Free Market and an Efficient Market. What the NPRI is implying is that an efficient market can replace human judgment with statistical manipulation, the “numbers will right themselves” if we are all just a bit more patient. To argue that financial markets should be free of all government intervention is to ignore the fact that government is one of the financial market’s biggest customers. Investment institutions on Wall Street were falling like dominos — some, like AIG weren’t “bankrupt” in the classic sense of the term, but they couldn’t prove to other financial institutions that they weren’t what is politely called “insolvent.”
When 10-K reports to the SEC were questionable at best during the Boom and Bust, and almost fraudulent at worst, or when balance sheets were composed of more fiction and hopeful thinking than accurate data, it would have been the height of folly NOT to have the financial sector’s biggest customer (government) step in to restore some sanity in the system.
It can be cogently argued that what failed during the last housing bubble collapse was NOT morality, but judgment. Consumers, institutions in the financial sector, and government regulators, were all dancing to the same tune. Unfortunately it was a Siren’s Song. When we assume that an efficient market bolstered by elegantly scripted algorithms is a better system than relying on good old fashioned and very human judgment we are all headed for trouble.
As if to put a layer of icing on this notion, consider the study of the Housing Bubble Collapse of 2008 by the Cleveland Federal Reserve. The study debunked ten simplified explanations, or myths, commonly cited as causal factors, and concluded:
“Many of the myths presented here single out some characteristic of subprime loans, subprime borrowers, or the economic circumstances in which those loans were made as the cause of the crisis. All these factors are certainly important for borrowers with subprime mortgages in terms of their ability to keep their homes and make regular mortgage payments. A borrower with better credit characteristics, a steady job, a loan with a low interest rate, and a home whose value keeps increasing is much less likely to default on a mortgage than a borrower with everything in reverse.
But the causes of the subprime mortgage crisis and its magnitude were more complicated than mortgage interest rate resets, declining underwriting standards, or declining home values. The crisis had been building for years before showing any signs. It was feeding off the lending, securitization, leveraging, and housing booms.”
Amen. No single subject comprises the proximate cause of the entire debacle. No single facet of the situation posed a proximate cause of the collapse. It seems to have been a failure composed of all the mentioned elements exacerbated by input from the processes themselves — or, again, a failure judgment in contrast to a failure of responsibility or morality.
If we now find the moral hazard argument to be (1) entirely too narrowly focused, (2) unconnected to the systemic issues inherent in the creation of bubbles, and (3) unhelpful in framing a systemic response to a systemic problem, then why not allow Governor Sandoval (or indeed any other agency of governance) to attempt to reintroduce some judgment into the possible solutions?
Recommended reading: Federal Reserve Bank of Cleveland, “Ten Myths about Subprime Mortgages,” 7/23/09. CAP, “Housing Refinancing Reforms Still Needed,” 11/22/11. The Economist, “Financial Economics: Efficiency and Beyond,” 7/16/09. The Motley Fool, “A Stupid Idea That Deserves To Die,” 11/3/11. Federal Reserve, “Re-Balancing the Housing Market: Lessons Learned,” 9/1/11. FDIC testimony “Challenging Environment for FDIC Institutions,” 8/16/11. FDIC, “The Challenge Posed By Short Termism,” 6/24/11. Senate Permanent Subcommittee on Investigations, “Financial Crisis Report, (pdf) 4/13/11. Brookings, “Developments in the Housing Market,” 12/12/11. Brookings, “Telling the Narrative of the Financial Crisis,” 12/14/11. Brookings, “Geographical Differences in Price Changes and Negative Equity, 11/29/11. EPI, “Wide Impact Of The Housing Slump,” 8/29/06. CEPR, “Clearing the Air on Too Big To Fail,” 10/17/11.