Joseph Stiglitz: "House of Cards"

Joseph Stiglitz, in a comment in the Guardian (hat tip Mark Thoma), tells us he would rather have been wrong about the housing bubble. And he anticipates that, since direct and indirect spending related to housing accounted for two-thirds to three-quarters of US economic expansion since the end of the tech boom, the unwinding of this bubble will make a big dent in growth. And he stresses that much of the consumer mortgage equity withdrawals went to consumption, rather than investment.

But cheap credit always leads to ill-advised spending, whether it’s greatly overpaying for otherwise decent assets (as the Japanese did in the US in the late 1980s), capital going to dubious uses (like dot coms that never planned to turn a profit) or the more recent version, using debt to fund consumption.

Stiglitz offers other insights in this solid piece:

There are times when being proven right brings no pleasure. For several years, I argued that America’s economy was being supported by a housing bubble that had replaced the stock market bubble of the 1990’s. But no bubble can expand forever. With middle-class incomes in the United States stagnating, Americans could not afford ever more expensive homes.

As one of my predecessors as chairman of the US President’s Council of Economic Advisers famously put it, “that which is not sustainable will not be sustained.” Economists, as opposed to those who make their living gambling on stocks, make no claim to being able to predict when the day of reckoning will come, much less identifying the event that will bring down the house of cards. But the patterns are systematic, with consequences that unfold gradually, and painfully, over time.

There is a macro-story and a micro-story here. The macro-story is simple, but dramatic. Some, observing the crash of the sub-prime mortgage market, say, “Don’t worry, it is only a problem in the real estate sector.” But this overlooks the key role that the housing sector has played in the US economy recently, with direct investment in real estate and money taken out of houses through refinancing mortgages accounting for two-thirds to three-quarters of growth over the last six years.

Booming home prices gave Americans the confidence, and the financial wherewithal, to spend more than their income. America’s household savings rate was at levels not seen since the Great Depression, either negative or zero.

With higher interest rates depressing housing prices, the game is over. As America moves to, say, a 4% savings rate (still small by normal standards), aggregate demand will weaken, and with it, the economy.

The micro-story is more dramatic. Record-low interest rates in 2001, 2002 and 2003 did not lead Americans to invest more – there was already excess capacity. Instead, easy money stimulated the economy by inducing households to refinance their mortgages, and to spend some of their capital.

It is one thing to borrow to make an investment, which strengthens balance sheets; it is another thing to borrow to finance a vacation or a consumption binge. But this is what Alan Greenspan encouraged Americans to do. When normal mortgages did not prime the pump enough, he encouraged them to take out variable-rate mortgages – at a time when interest rates had nowhere to go but up.

Predatory lenders went further, offering negative amortisation loans, so the amount owed went up year after year. Sometime in the future, payments would rise, but borrowers were told, again, not to worry: house prices would rise faster, making it easy to refinance with another negative amortisation loan. The only way (in this view) not to win was to sit on the sidelines. All of this amounted to a human and economic disaster in the making. Now reality has hit: newspapers report cases of borrowers whose mortgage payments exceed their entire income.

Globalisation implies that America’s mortgage problem has worldwide repercussions. The first run on a bank occurred against the British mortgage lender Northern Rock. America managed to pass off bad mortgages worth hundreds of billions of dollars to investors (including banks) around the world. They buried the bad mortgages in complicated instruments, buried them so deep that no one knew exactly how badly they were impaired, and no one could calculate how to reprice them quickly. In the face of such uncertainty, markets froze.

Those in financial markets who believe in free markets have temporarily abandoned their faith. For the greater good of all (of course, it is never for their own selfish interests), they argued a bailout was necessary. While the US Treasury and the IMF warned East Asian countries facing financial crises 10 years ago against the risks of bail-outs and told them not to raise their interest rates, the US ignored its own lectures about moral hazard effects, bought up billions in mortgages, and lowered interest rates.

But lower short-term interest rates have led to higher medium-term interest rates, which are more relevant for the mortgage market, perhaps because of increasing worries about inflationary pressures. It may make sense for central banks (or Fannie Mae, America’s major government-sponsored mortgage company) to buy mortgage-backed securities in order to help provide market liquidity. But those from whom they buy them should provide a guarantee, so the public does not have to pay the price for their bad investment decisions. Equity owners in banks should not get a free ride.

Securitisation, with all of its advantages in sharing risk, has three problems that were not adequately anticipated. While it meant that American banks were not hit as hard as they would otherwise, America’s bad lending practices have had global effects.

Moreover, securitisation contributed to bad lending: in the old days, banks that originated bad loans bore the consequences; in the new world of securitisation, the originators could pass the loans onto others. (As economists would say, problems of asymmetric information have increased.)

In the old days, when borrowers found it impossible to make their payments, mortgages would be restructured; foreclosures were bad for both the borrower and the lender. Securitisation made debt restructuring difficult, if not impossible.

It is the victims of predatory lenders who need government help. With mortgages amounting to 95% or more of the value of the house, debt restructuring will not be easy. What is required is to give individuals with excessive indebtedness an expedited way to a fresh start – for example, a special bankruptcy provision allowing them to recover, say, 75% of the equity they originally put into the house, with the lenders bearing the cost.

There are many lessons for America, and the rest of the world; but among them is the need for greater financial sector regulation, especially better protection against predatory lending, and more transparency.

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  1. Anonymous

    In Stiglitz’s example of a bailout I wonder to whom he is referring when he says “lenders.” Does he mean one of the many now bankrupt mortgage companies or mortgage brokers? Does he mean the investment banks that provided warehouse lines? Does he mean the banks that pooled and securitized the loans? Does he mean the pension funds, hedge funds, mutual funds or anyone that invested in the securities? Which tranche? Stiglitz has come up with an impractical example, and like some other recent proposals, one that would have a very chilling, contractionary effect on mortgage credit. In addition he doesn’t specify what he means by the catchphrase “predatory lending.” What are the specific practices to which he is referring, and is there a consensus on their predatory nature? Neg-am loans in and of themselves are not predatory, so what does he mean? Finally, Stiglitz, like so many other pundits, ignores the elephant in the room. What do you do when many participants in your economy have participated in a massive asset bubble and look set to lose large sums of money, with serious repercussions for the economy? The fact is that many people, from homeowners speculating on the value of their own residence to flippers purchasing multiple properties to Wall Street bankers providing the leverage for it all have all made very poor bets and a lot of perceived value is simply going to vanish, and continue doing so for some time. This doesn’t require fraud, predatory lending, or anything else calling for a regulatory quick fix. All it requires is a speculative mania with broad participation and deep economic entanglements. He states that low interest rates helped get us into the current situation, but from a monetary policy point of view with a price stability and employment mandate, how does a central bank avoid the zero bound, avoid inflating yet another asset bubble and avoid succumbing to runaway inflation or deflation? In this light predatory lending is a red herring. A more fruitful inquiry would look at the systemic risks and variable outcomes of the role asset inflation and the wealth effect play in low or negative real interest rate inflationary regimes where assets replace currency as a store of value. A serious investigation needs to look at international capital flows, globalization and currency regimes and international monetary policy. It’s time to lay the “subprime”, “predatory lending” et al meme to rest and tackle serious systemic issues.

    Will the real housing bubble please stand up?


  2. Anonymous

    Having done some research into living conditions I have made the decision to move to the US! Apart from the medical care (which having just watched the film Sicko I am slightly concerned about) I have decided that there are more positives then negatives and am therefore very excited about the prospect of moving.
    However I am concerned with purchasing a house, are mortgages over there the same as there are here? Do I need a large deposit and having spoke to a few people online I am concerned I wont be able to find a company to give me mortgage broker bonds.
    and if I cant can I buy a house? Also I am familiar with the term surety bond so is a mortgage bond just a guarantee I will pay on time or is it more?

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