Yves here. It is a great source of frustration to see the global financial crisis depicted again and again as a housing crisis. Had it merely been a housing crisis, we would have had worse-than-savings-and-loan-crisis bust (which was seen as a lot scarier at the time than it is in hindsight), but not the sort of near-collapse of the financial system that took place in September and October 2008.
Credit default swaps on the risky tranches of subprime at the level of 4-6X real economy lending. These were dressed up as largely AAA risk though heavily synthetic CDOs (there was not enough of a market for pure synthetic CDOs to have satisfied the demand for subprime shorts). The de facto guarators were highly leveraged firms who were themselves vulnerable: monolines, AIG, Eurobanks, and US investment and commercial banks.
Nevertheless, this IMF paper makes an important policy point, that merely regulating mortgage finance won’t prevent dangerous housing booms and busts. Another noteworthy feature of this analysis is that it rejects the use of the loanable funds model, which was debunked by Keynses but remains a fixture at central banks. Indeed, you’ll see Martin Wolf at the Financial Times relying on this hoary canard in Don’t blame central banks for negative rates which invokes Bernannke’s the savings glut hypothesis of the crisis, which is something numerous parties, including your humble blogger, have shredded. (The best shellacking comes in the Claudio Borio-Peti Disyatat BIS paper, Global imbalances and the financial crisis: Link or no link?; see Andrew Dittmer’s layperson summary here).
By Leith van Onselen who has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs. You can follow him on Twitter at twitter.com/leithvo. Originally published at MacroBusiness
he International Monetary Fund (IMF) has released a working paper entitled “Mitigating the Deadly Embrace in Financial Cycles: Countercyclical Buffers and Loan-to-Value Limits”, which shows that “household demand for housing, house prices, and bank mortgages are intertwined in what we call a ‘deadly embrace’” leading to “housing boom and bust cycles”. The IMF argues that macroprudential measures can assist in mitigating these risks, but that they are not a panacea.
Below are the key extracts from the IMF’s paper.
The financial history of the last eight centuries is replete with devastating financial crises, mostly emanating from large increases in financial leverage (Reinhart and Rogoff, 2009).
The latest example, the Global Financial Crisis of 2008-09, saw the unwinding of a calamitous run-up in leverage by banks and households associated with the housing market (Mian and Sufi, 2010 and 2015). As a result, the financial supervision community has acknowledged that microprudential regulations alone are insufficient to avoid a financial crisis. They need to be accompanied by appropriate macroprudential policies to avoid the build-up of systemic risk and to weaken the effects of asset price inflation on financial intermediation and the buildup of excessive leverage in the economy.
The Basel III regulations adopted in 2010 recognize for the first time the need to include a macroprudential overlay to the traditional microprudential regulations (Appendix I). Beyond the requirements for capital buffers, and leverage and liquidity ratios, Basel III regulations include CCBs between 0.0 and 2.5 percent of risk-weighted assets that raise capital requirements during an upswing of the business cycle and reduce them during a downturn. The rationale is to counteract procyclical-lending behavior, and hence to restrain a buildup of systemic risk that might end in a financial crisis. Basel III regulations are silent, however, about the implementation of CCBs and their cost to the economy, leaving it to the supervisory authorities to make a judgment about the appropriate timing for increasing or lowering such buffers, based on a credit-to-GDP gap measure. This measure, however, does not distinguish between good versus bad credit expansions (see below) and is irrelevant for countries with significant dollar lending, where exchange rate fluctuations can severely distort the credit-to-GDP gap measure.
One of the limitations of Basel III regulations is that they do not focus on specific, leveragedriven markets, like the housing market, that are most susceptible to an excessive build-up of systemic risk. Many of the recent financial crises have been associated with housing bubbles fueled by over-leveraged households. With hindsight, it is unlikely that CCBs alone would have been able to avoid the Global Financial Crisis, for example.
For this reason, financial supervision authorities and the IMF have looked at additional macroprudential policies (IMF, 2014a and 2014b). For the housing market, three additional types of macroprudential regulations have been implemented: 1) sectoral capital surcharges through higher risk weights or loss-given-default (LGD) ratios;3 2) LTV limits; and 3) caps on debt-service to income ratios (DSTI), or loan to income ratios (LTI)…
We show how lending to the housing market, house prices, and household demand for housing are intertwined in the model in a what we call a deadly embrace. Without macroprudential policies, this naturally leads to housing boom and bust cycles. Moreover, leverage-driven cycles have historically been very costly for the economy, as shown most recently by the Global Financial Crisis of 2008–09.
Macroprudential policies have a key role to play to limit this deadly embrace. The use of LTV limits for mortgages in this regard is ineffective, as these limits are highly procyclical, and hold back the recovery in a bust. LTV limits that are based on a moving average of historical house prices can considerably reduce their procyclicality. We considered a 5 year moving average, but the length of the moving average used should probably vary based on the specific circumstances of each housing market.
CCBs may not be an effective regulatory tool against credit cycles that affect the housing market in particular, as banks may respond to higher/lower regulatory capital buffers by reducing/increasing lending to other sectors of the economy.
A combination of LTV limits based on a moving average and CCBs may effectively loosen the deadly embrace. This is because such LTV limits would attenuate the housing market credit cycle, while CCBs would moderate the overall credit cycle. Other macroprudential policies, like DSTI and LTI caps, may also be useful in this respect, depending on the specifics of the financial landscape in each country. It is, however, important to recognize that all these macroprudential policies come at a cost of dampening both good and bad credit cycles. The cost of reduced financial intermediation should be taken into account when designing macroprudential policies.
The RBA’s and APRA’s long-held opposition to macroprudential measures, which was only overturned recently, is looking increasingly foolish.
Do you think that the IMF has a good enough model yet of financial instability and what happens when debt cascades into a major crisis?
I’m trying to understand this
“It is, however, important to recognize that all these macroprudential policies come at a cost of dampening both good and bad credit cycles. The cost of reduced financial intermediation should be taken into account when designing macroprudential policies.”
The balance it strikes seems to be between regulation & regulation’s cost to borrowers and/or lenders. It all seems comfortably, technocratically doable in line with policy makers’ preference for policy solutions couched in comfortably solvable terms.
Is there instead a question of scale, structure, uncertainty & maybe inevitability that they’ve just not touched on. But the IMF is a bank with a history of bad advice, and commandeering the lifeboats. Are they making baby steps (but will come right in the end) or do we need something considerably better?
The response to the boom and crash in Ireland has been a focus on LTV limits – mostly stricter regulations on the amount of cash a buyer must have up front and particular limits on first time buyers. While the Central Bank is enforcing these, it seems pretty clear that the banks aren’t objecting because they don’t have the money to hand out anyway.
However, this, along with other issues, has created a huge problem in the Irish market (and this probably applies to the other weaker euro countries). Put simply, the amount of money banks are willing to lend to people on an ‘average’ income is now less than the cost of building a typical three bedroom family house. This has made it almost impossible for people without existing assets to buy. As the Irish housing market is very private sector oriented, the result has been soaring rents and high prices for prime properties (those bought by people with lots of cash to hand), and a stagnating construction sector. There is currently a huge mis-match between what is available to purchase/rent, and what people want and need.
A key issue here has nothing to do with financial markets, but is driven by the deflationary model of the euro. The standard myth in Ireland (you also find this in the UK), is that the drive behind constant rising property prices has been weak protection for renters and a cultural drive to ‘own’ your own home – in contrast to northern European countries where there is a much larger and more protected rental market and social housing provision. In reality, its now become clear that the real driver has been inflation expectations. Borrowing the max to buy your house makes sense when inflation will eat away your core debts in 10 years or more. Generations of families have made themselves wealthier through this process.
However, in Ireland (as with other weaker Euro countries), its now become clear to the financial sector that they can no longer rely on inflation driving people into housing debt. The figures just don’t add up for people, especially those who are younger and don’t have assets behind them. The logical thing is for the development of a larger rental market and more social housing. But for all sorts of reasons, its become very difficult to change the structural forces which favour house purchasing over renting (although in Ireland, there has been a rapid movement in the apartment market – builders no longer sell them to individual buyers, but sell them to institutional renters). But its slowly become clear (in Ireland anyway) that the housing market needs to be radically changed by the government in order to ensure there are enough housing units built in the right places.
The related problem of course, is for the banks. The mortgage business is no longer easy money for them. They’ll have to find some other way to make money. I don’t think they’ve figured that one out yet.
Hey PlutoniumKun, thanks for your interesting comment. I wonder if you, or someone could expand on this quote:
“In reality, its now become clear that the real driver has been inflation expectations. Borrowing the max to buy your house makes sense when inflation will eat away your core debts in 10 years or more. Generations of families have made themselves wealthier through this process.”
Now I think I understand how inflation can help the mortgage when their interest rate is FIXED — ie wages etc increase, where as principle/interest remain unchanged. Hence, loan becomes relatively “easier” to pay as time passes. However, when mortgage rates are FLEXIBLE. would not lenders inevitably increase their rates to “compensate” or negate the wealth/inflation effects ? Hence the mortgagee obtains no/negligible inflation benefit ?
Thanks in advance.
Not altogether relevant to this article but which I find interesting, was a recent discussion between Dr. Michael Hudson and Chris Hedges about finance.
Dr. Hudson mentioned the historical legacy of the British and German banking systems from the 19th century. British banking was focused on loans for collateral (housing/property) and German banking had more leaned towards lending for R & D and industry.
Hudson says that after WWI bank lending in general tended to move more toward the British collateral model, and less to the (riskier) German industrial investment banking.
If all of the banks have moved more in step with the collateral model since the early 20th century, one should absolutely expect property asset bubbles to rise again and again.
Perhaps it is very difficult for some new international regulations to undo several hundred years of economic thinking.
This was a very good recent discussion:
Chris Hedges talks with Dr. Michael Hudson – Days of Revolt: How We Got to Junk Economics
The Housing Boom was deliberately created in US/UK Zones to improve profitability and solvency of Banks following Dot.com Meltdown. The Central Banks knew what they were doing and simply failed to keep the Boom in check for political reasons. The S&L Crisis was irresponsible but Thatcher unleashed a repeat of the situation by demutualising Building Societies and demutualising TSB with a very inadequate deposit insurance scheme.
There is nothing Exogenous about this politically-inspired disaster.
I think rather than being deliberately created, the regulatory and legal authorities that could have put the brakes on the bubble were willingly looking away. It’s quite clear that at high levels it was decided that too many people were making so much money that it would be irresponsible to pull away the punch bowl.
I recall a Frontline special on the housing crisis in the US where an FBI agent was interviewed about been hamstrung in investigations of mortgage fraud. That type of work that the FBI is tasked with was downplayed so that they could focus on terrorism. So whether it was the SEC, the DoJ, Congress, the Fed, you name it, nobody was out there to prevent the fraud that allowed the bubble to grow to such an astronomical size.
If everyone is a millionaire then we are all back to being average. we cant solve our problems by having more Winos buying more Porsches.
better plant your victory gardens, live with in your means and get set for the long haul.
Nothing about our markets make sense. FEDs are trying force inflation. THEY are trying to force everyone into risky invedtments with zero % interest. they are jacking up home prices and now are forceing the minimum wage to 15. In the end we will get deflation back to 1980 levels on homes, wages, cars, stocks, and commodities when we cant pretend anymore. kicking the can wont work any more.
“The Central Banks knew what they were doing and simply failed to keep the Boom in check for political reasons.”
My take is the boom came first which provided political reasons for not reeling in the banks. Bush and politicians had been warned by the FBI of massive amounts of mortgage fraud as early as 2004. How did the banks work around those warnings? My guess is huge political donations forced the will of politicians to look away and/or pass legislation to support it – which is what happened. The central banks work hand in hand more often with the TBTF banks than they do with politicians because they know who’s really in control during a bubble. They are not without fault.
Adults w no children in big houses and kids in mobile home parks, paying the RE levy, hmmm.
How are kids supposed to develop a work ethic with no one in the home working, at a university for make work jobs?
Money is a mob franchise operation, living on the work of others, and it didn’t just sprout up yesterday. We now have a culture of disabling others first, where the objective is to tax everyone else, on the basis of simulated intelligence, which is why budgets exist, to set your distance from the implosion.
Empires don’t work, and no amount of 1s and 0s, no policy, is going change the outcome of peer pressure, derivative behavior.
More paper pushers and fewer people working, lower wages, increasing welfare and runaway debt, for decades. You can’t change habits in a debate, or by passing another law.
“It is a great source of frustration to see the global financial crisis depicted again and again as a housing crisis. Had it merely been a housing crisis, we would have had worse-than-savings-and-loan-crisis bust (which was seen as a lot scarier at the time than it is in hindsight), but not the sort of near-collapse of the financial system that took place in September and October 2008. ”
Yes. The housing bubble was a proximate cause, not the cause in fact. Tulip bulbs, or any financialized bubble commodity, could serve as the starting point for the debt based financial engineering frauds, imo. For a while there was interest in SLABS – Student Loan Asset Backed Securities.
From the IMF paper (my emphasis) – “One of the limitations of Basel III regulations is that they do not focus on specific, leverage driven markets, like the housing market, that are most susceptible to an excessive build-up of systemic risk. Many of the recent financial crises have been associated with housing bubbles fueled by over-leveraged households.”
I think the IMF is wrong here. Considering the financial sectors have toyed with plans for creating CLOs/CDOs on student loan debt (which can amount to nearly the cost of a starter home), credit card debt, and auto debt, I think regulations should deal with leverage driven markets in general and not just specific areas. my 2¢.
‘Interest’ implies gain. Negative interest implies loss. Sell high and buy low works to make money tho’. you just have to have some asset you can sell first before you can get a real steal for your money. What we really need an economic lobotomy. And new terms. Like what’s the difference between ‘housing’ and ‘real estate’? Housing is a necessity, not an asset, and real estate is an asset, not a necessity. It should be a law of economix that necessities cannot be speculated on, cannot be counted on to inflate for retirement, etc. We use derivatives to smooth out commodity prices for producers; we subsidize food in various ways… because we know there are certain things we must have. Housing is one of those things, clearly. Yet everytime the economy sputters, speculation in housing is encouraged. This has gotta be as devastating to an economy as negative interest rates because it does the same thing. It drives bubbles which burst and go negative and anyone with money makes a killing and then does it again in a downward spiral. The only difference between boom and bust is that in a boom you buy first and sell second, in a bust you sell first and buy second. And this is allowed to happen repeatedly. It’s the only thing we know how to do.
I believe that laws which allow international speculation on foodstuffs, especially basic necessities such as rice, wheat, milk etc are, with little exaggeration, plain “evil”. Yes, I understand there is a need for for such functions as a futures market to hedge against market volatility, however that’s a long way from being able to intentionally drive markets and prices up and down by financial manipulation.
As a normal American without a financial degree, I find it instructive to rewrite financial gobbledygook to try and understand it and teach what’s been said to other normal Americans who are quietly sharpening their pitchforks.
“Credit default swaps on the risky tranches of subprime at the level of 4-6X real economy lending. These were dressed up as largely AAA risk though heavily synthetic CDOs (there was not enough of a market for pure synthetic CDOs to have satisfied the demand for subprime shorts). The de facto guarators were highly leveraged firms who were themselves vulnerable: monolines, AIG, Eurobanks, and US investment and commercial banks.”
Is my translation accurate?
Bets, with a value 4 to 6 times “normal” consumer and industrial bank lending, were made that some good housing mortgages mixed together with trash, would pay off. Sort of like cow lips, hoofs, tumors and assholes being stamped “USDA Prime Hamburger”.
“These pieces of paper were guaranteed by rating agencies that were corrupt. The paper was bought with our real money in our pension plans and the pool to pay our future insurance payments.
Then new bets that the original bets would drop in value were taken out by the slick operators on Wall Street. In addition, they borrowed these original bets back from the market, sold them on to other suckers that rushed to put them in their pension plans and insurance portfolios. When the housing market imploded and the original paper became worthless, the guarantors had to pay for their failure. The Slick Operators also collected big on their bets that the original bets would go down in value.”
“In the end, we taxpayers paid off the guarantors’ payout for the original paper. So we got screwed thrice, overcharged for housing, our pension and insurance funds were stuffed with garbage and our tax dollars guaranteed the Slick operators’ profits.”
Is that accurate?
This is generally correct, and very good, but the subprime bets were 4-6x the subprime market, not all commercial and industrial lending. Depending on how you defined it, the subprime market was $1.3-$2 trillion.
Yves, I don’t know if you have ever read my old IPE Professor Herman Schwartz’s book Subprime Nation, but he argues that a great deal of this was encouraged in order to provide assets to soak up the huge volume of dollars circulating in the global economy because of Fed cuts following the dot com crash and huge US balance of trade deficits. Housing securities were seen as a great way of repatriating the funds and offered better returns to foreign institutions like pension funds and insurance companies (and banks) than Treasuries. So everyone in sight had a huge incentive to keep churning out mortgage backed securities, even after the pool of sound US borrowers had been exhausted.