In an article in today’s New York Times, Yale Professor Robert Shiller makes a very important point: the remedies proposed by the powers that be for the burgeoning housing mess are woefully inadequate:
….our reaction to the current crisis is anemic….The “Super S.I.V.” rescue plan, instigated in October by Henry M. Paulson Jr., the Treasury secretary, in an effort to prevent a meltdown of the market for so-called structured investment vehicles, will be less than a tenth the size of the Federal Home Loan Bank System that is still with us from the 1925-33 debacle.
The FHASecure bailouts announced by President Bush in August, to help borrowers whose adjustable-rate mortgages are resetting at prohibitively high rates, will likely amount to only roughly 2 percent of the amount of mortgages guaranteed by Fannie Mae.
Congress is already on track to eliminate the provision — Section 1322 of Chapter 13 of the bankruptcy law — that prohibits courts from adjusting terms of first mortgages. But there could be more fundamental changes to bankruptcy law than that.
Shiller is spot on. One of the things that has been disconcerting as we’ve watched conditions in the housing and credit markets deteriorate is the lack of willingness to consider regulatory remedies. It is quite clear that one of the major causes was the lack of oversight and specifically, unwillingness to impede “innovation”. As we have said before, innovation is not a virtue. The Titanic, thalidomide and lobotomies were all innovative.
Regulators have become oddly unwilling to supervise, and it isn’t simply the result of the Bush Administration’s antipathy to any restraints on corporations. Regulators have become hostage to a free market ideology and seem unable to recognize that it is merely a belief system, not an immutable truth. Hopefully articles like Shiller’s will give them some badly-needed perspective.
Shiller offers some proposals to illustrate the scale and scope of measures needed. My favorite is the establishment of a Financial Products Safety Commission, the brainchild of Elizabeth Warren.
One areas he omits, however, and he may have considered it to much to bite off in a piece of this length, is securitization. Securitization has become an integral element of the mortgage market, yet it is a flawed process, with misaligned incentives, information loss, insufficient accountability, difficulty in pinning liability on culpable parties. More and more securitized products are becoming the subject of concern, yet there is not enough bank equity for them to step back into their “buy and hold” role. But for some bizarre reason, regulating aspects of the securitization process is treated as a third-rail issue. Things will likely have to break down further before anyone will take the need for reform seriously.
Although no one wants to touch the issue of what to do about the rating agencies, if their credibility drops any lower, investors may stop believing the ratings. Ironically, it may become imperative to subject them to a new regime if they are to be trusted again.
From the New York Times:
Bankruptcy law is a risk management institution, and such an institution should adopt more modern practices. For example, Andrew Caplin, professor of economics at New York University, has proposed that in personal bankruptcy proceedings, the courts should be allowed the latitude to substitute real estate equity — a share in the ownership of the property, to be realized when it is eventually sold — for first mortgage debt. This could let troubled borrowers stay in their homes, and might be better in terms of efficient risk sharing: it would provide incentives for the mortgage industry and would be friendlier to prospective home buyers who would otherwise face higher mortgage rates to pay for others’ bankruptcies.
In light of modern financial theory, this would also be a good time to think about the nature of the implicit subsidies given to government-sponsored enterprises like Fannie Mae and Freddie Mac and whether they provide enough incentives for them to properly manage their own risks as guarantors of mortgages. We should think about whether the F.H.A. should be encouraged to take on a bigger role that might compete with activities of the subprime lenders that have grown so rapidly over the last decade. We might create a new consumer-oriented regulatory authority, like the Financial Products Safety Commission that Elizabeth Warren, a professor at Harvard Law School, has been advocating. It would monitor financial products for consumers and draft regulations to prevent practices like the recent widespread issuance of adjustable-rate mortgages to low-income borrowers who couldn’t afford the rate resets.
The real estate appraisal industry needs to rethink its methods. How did it happen that appraisers acquiesced in valuations that were more and more discordant with economic fundamentals? Basic concepts and procedures need change.
Beyond that, we should think creatively about how to use vastly improved tools for risk management and apply them to mortgages. For example, I and my colleague Allan Weiss (now C.E.O. of Index Capital Advisors) proposed in 1994 to make home equity insurance — insurance on the market value of a home — part of a home mortgage contract. Had our proposal been put into place on a large scale, it would have gone a long way toward ameliorating the current crisis and reducing the need for personal bankruptcies.
The radical financial innovations of the 1930s were possible because the real estate crisis and other economic problems of the Depression created a sense of urgency. Innovation, after all, tends to come in troubled times.
We should take full advantage of the innovation opportunities stimulated by our current troubles. We would emerge much stronger and better for it.