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.