Monday, April 19, 2010

Financial Reform: Housing Market Edition

When considering any sort of government "reform", there's always a philosophical fine line. On the one hand, it's beneficial for the government to help people, solve problems, and prevent the sort of financial disruptions which endanger the market and ruin people's lives. On the other hand, it would be better to do nothing at all than allow the circumstances to be used as an excuse to enact unrelated takeover policies, give more power to ineffectual or corrupt organizations, and/or abuse the rights of the people under the guise of "security" or "stability". In that spirit, it's my hope that my musings will fall on the former side of the philosophical line, in stark contrast to everything being enacted and proposed by the contemptible scum in Congress, which clearly and repeatedly falls overwhelmingly more on the latter side.

So, then, how to prevent future housing bubbles/pops, if indeed possible, without pissing on the Constitution?

I would propose a couple things (in-part based on the success Texas had in limiting the housing bubble in their state, based on strict lending limits). First, I would mandate that home loans be categorized (by the GSE's or banking/lending oversight organizations, whichever is more appropriate) as follows:

Class A: Any loan for which all the following items are currently true:
- The borrower owes no more than 80% of the current value of the underlying asset on all loans secured, in whole or part, by the asset
- The borrower provided adequate asset/income information to verify payment ability for the loan at the time of borrowing, and that information is attached to the loan documents
- The maximum annual payment on the loan, at any time during the lifetime of the loan, and assuming current interest rates, does not exceed 35% of the income of the borrower
Class B: Any loan which does not meet all the above conditions

Second, I would impose the following restrictions on financial market participants, based on the above ratings:
- No organization which is supported by federal funds (eg: GSE's, banks in concert with FHA, banks borrowing from the Fed, banks with access to the Fed discount window, etc.) may make any loan which would not be ranked 'A' at time of inception.
- No security which contains, or contains any derivative of, any loan which is not ranked 'A' may be rated 'AAA' (or equivalent "investment grade") by any rating agency.
- No loan which is not ranked 'A' may be purchased by any GSE. The GSE's will also insist on "buyback" clauses if the loan falls below 'A' rank in the first 'n' months after purchase (probably 6-ish), re-evaluate loans near the expiration of this option, and insist on buyback if they are no longer rank 'A'.

Now, admittedly, this is only a partial solution, and does have some limitations. In particular, it doesn't prevent 95%+ financing, it just limits the ability of putting big money into these risky loans. It also does not entirely eliminate the possibility of taxpayers holding bad loans, although it should significantly reduce the magnitude. I'd also probably add a clause to ensure originators always hold some percentage of all loans, but the specifics of that would require more information and calculations than I'm willing to research/do.

Anyway, that's how I'd propose to [partially] prevent future housing bubbles, in contrast to all the unrelated power-grab and socialist crap Congress will label as "reform". Feel free to leave your thoughts too.


  1. I am not knowledgeable about what Congress is working on, but assuming we will bail out financial institutions in a crisis we need some kind of rules. Your rules get right at the core: people borrowing/lending too much money. I can't understand people who say that either banks, insurers, complex derivatives, or borrowers caused this. They all together built a house of cards. How many of the participants were so stupid they couldn't see they were betting on RE values rising without end? We've all made stupid mistakes at one point, but it's hard to get my mind around how so many people could be so stupid. When house prices were at record highs, people walked into a bank-like institution, signed up for negatively-amortizing loans with payments they could not afford after the loan recast, and the lenders gave them the money. It just boggles the mind.

  2. To be fair, though, not everyone was all that dumb, either in retrospect or at the time. The banks certainly weren't dumb: they made billions at the time, billions more from bailouts, and are now still making billions by arbitraging the government's free money; it's hard to see how anything they did could be characterized as dumb. Most dead-beat borrowers also weren't too stupid: they got to live in houses they couldn't normally afford, got a bailout when things went south, and are now getting handouts to compensate for any hardship, as well as the ability to borrow again soon, subsidized once again by the taxpayers. Hard to see how they didn't optimize their situations pretty intelligently. Same for the Fed and other regulators: it's not every day you can have the largest colossal failure in recently history at your purported job, and be given an effective promotion for it (as Congress is now considering); not too shabby work there. You could say the NAR was kinda dumb, but most Realtors made out like bandits during the boom, and the NAR turned ~$100 million in lobby money into more than $10 billion in post-bubble gratuitous government waste payouts to the housing market, most of which went into the industry's pockets, so hard to say they were dumb either.

    No, the only real stupidity I can see is from the government, who's continued colossal blundering is mind-boggling, and from people who bought into the "financial prudence" mantra which has been so utterly dismantled and denigrated that it might as well be the poster child for "ideas which work in capitalist economies, but are absolutely pointless and counter-productive under our new socialist regime." Invest in lobbying and influence, they are the [only] growth industries in the Obamanation.

  3. I thought about this post yesterday when I was reading a NYT article about fixing the financial system to prevent future bailouts. The article said something about the key being controlling complex instruments “which were at the heart of the crisis”. My understanding of the crisis, though, is that people making/taking loans that people could not repay. My admittedly crude understanding is that the complex financial instruments were on the periphery of the crisis, a way to move money around into these ill-conceived loans. If I am right and the NYT is wrong about this, then your approach gets to the true heart of the problem.

    My only question is whether these “complex” instruments and their ability to be used for leverage could be used to create a crisis unrelated to ill-conceived loans. In that case, the MSM have a point. I would like to know if the complex instrument really do present a risk or if it’s just easier to blame the crisis on something arcane than a straightforward mistake that many people personally participated in.

  4. The complex financial instruments (eg: CDO's) certainly increased leverage and risk, but they are by far not the first financial investment products which have done so; this is somewhat standard in the financial industry. The new thing this time, which is unprecedented, is the bailouts with public funds of the investment companies which were highly leveraged in risky gambles for short-term gains (and, I would speculate, they knew would eventually go bust, and were taking a calculated risk). By bailouts, of course, I mean both the direct ones, and the indirect ones (such as letting the banks borrow money for nothing, and thus generate billions in profits from public funds to repair their balance sheets).

    There's nothing inherently wrong or evil about complex financial instruments or leverage. The gamblers will buy them, and the smart long-term investors will avoid them (in fact, Buffet gave a couple speeches directly to that effect during the bubble). The huge problem is that the ultra-risky investments were allowed to be rated 'AAA' and/or have public funds used to purchase them: this is a monumental failure of regulation, and the primary base cause of the problem. The secondary cause (imho) are the bailouts, which compound the problem, waste more money, and greatly increase the likelihood of a similar event in the future. These are the problems which we should be addressing if anyone actually really cared about fixing the real problems.