End the Credit Rating Monopoly
Earlier this week, SEC Chair Mary Shapiro appeared before Congress to suggest ways to fix the failings in our credit rating agencies. Sadly her proposals miss the market, although that shouldn’t be so surprising as her suggestions appear to rest upon a misunderstanding of the problem.
The thrust of the SEC’s current approach is more disclosure, such as releasing “pre-ratings” that debt issuers may get before final issuance. Additional disclosure of ratings methodology and assumptions is likely to be useless. Almost all that information was available during the building housing bubble. The problem is that the rating agencies had little incentive to go beyond the consensus forecasts of increasing to at most modest declines in home prices. These same assumptions were the foundation of almost all government economic forecasting as well, yet few believe that forcing CBO or OMB to disclosure more of their forecasts will cure our budget imbalances. What is needed is a change in incentives.
Bernanke’s Part in the Housing Bubble
Recent weeks have seen a swirl of speculation over whether President Obama will or will not re-appoint Ben Bernanke to the Chairmanship of the Federal Reserve Board, when his current term as Chair expires in January 2010. Almost all of the debate has centered on his actions as Chairman. This narrow focus misses an important piece: his actions, and words, as a Fed governor during the build-up of the housing bubble.
What should have been Bernanke’s greatest strength as a Fed governor and later chair, his understanding of monetary theory and his knowledge of the Great Depression, has ended up being a weakness. While correct in his analysis of the role of “debt deflation” — where the deflation increases the real burden of debts and correspondingly weakens the balance sheet of both households and businesses — in the deepening of the Great Depression; his obsession with slaying the Great White Whale of Deflation provided intellectual cover for the Fed’s ignoring and contributing to the housing bubble. Like the proverbial general, he was fighting yesterday’s battle, rather than today’s.
While core inflation was moderate and increasing at a decreasing rate between 2001 and 2005, this measure ignores the dramatic up-tick in house prices during those years. First, housing makes up the single largest expense for most households, ignoring housing, especially after one subtracts out energy and food from the definition of inflation, gives a narrow and distorted picture of inflation. Even if one were to focus solely on rents, the 2000s were an era of increasing housing costs.
Separate from the impact of housing prices on inflation is the role which housing plays as the collateral for the primary piece of household debt: a mortgage. Even were the US to suffer a bout of mild deflation and the real burden of their mortgages increased, this would likely have little impact on household balance sheets in an environment of increasing home prices.
Admittedly Bernanke was then only a “governor” and not yet Chair of the Fed, but he was the Fed’s loudest voice when it came to combating deflation and arguing for lower rates. Additionally there have been zero public acknowledgements by either Bernanke or the Fed that its policy earlier this decade contributed to the housing bubble and financial crisis. Without admitting to the occasional mistake, we have no way of judging whether Bernanke has learned from any of his mistakes, and hence less likely to repeat them.
In weighing Bernanke’s record at the Fed, judgement should not solely consider his actions as Chair, but also consider his words and deeds while the housing bubble was inflating. How one responds to a impending disaster is as important as to how one helps to clean up after the disaster has struck.
Consumer Financial Product Commission Distracts from Real Reform
Today the Obama Administration released a 152-page draft bill to create a new Consumer Financial Product Commission. While intended to protect against consumer confusion and reduce the likelihood of future financial crises, the proposed agency will at best have little impact and at worst contribute to the next financial crisis, with the added effect of decreased homeownership and increased litigation.
The president promises that “those ridiculous contracts with pages of fine print that no one can figure out – those things will be a thing of the past,” The president ignores that those “ridiculous contracts” and “fine print” are the result of previous rounds of so-called consumer protections. The disclosures one receives with a mortgage or a credit card are those mandated by some level of government. They don’t call those credit card disclosures a “Schumer Box” because they were invented by a baron of industry. In addition to the government-mandated disclosures that have failed, are the endless amount of fine print added to protect companies from frivolous litigation. The Obama approach to that problem is to increase the amount of litigation.
If the president were serious about avoiding the next housing bubble and financial crisis, he would propose eliminating some of the various federal policies that contributed to the housing bubble. For instance, how about requiring real down payments when the taxpayer is on the hook – as with Fannie Mae, Freddie Mac and the Federal Housing Administration (FHA). Talk about bad incentives; under FHA, a borrower can put almost nothing down and if the loan goes bad, the government covers the lender for 100 percent of their losses. No wonder we had a housing bubble. In addition, the proposed agency does nothing to address the underlying causes of any type of credit default: unemployment, unexpected health care costs or divorce.
Once again, when given the opportunity to address the real flaws in our financial system, the administration chooses to appease the special interests and provide a distraction from the underlying causes of our current financial crisis.
Senators Want to Delay Housing Recovery
As discussed in a recent Bloomberg piece, several U.S. senators from both parties are pushing to almost double the recently enacted $8,000 tax credit for first-time homebuyers to $15,000. The same senators are also pushing to remove the current income restrictions — $75,000 for individuals and $150,000 for couples — while also removing the first-time buyer requirement.
The intent of the increase, and the original credit, is to increase the demand for housing and to create a “bottom” to the housing market. The flaw of this approach is that it creates a false bottom, one characterized by government-inflated prices and not fundamentals. It was excessive government subsidies into housing that helped create the housing bubble, additional subsidies to re-inflate the bubble will only prolong the actual market adjustment.
If it were only a matter of prolonging the adjustment, then the huge cost of the tax credit might be easier to justify. Yet by encouraging increased housing production, the tax credit will increase supply when we already have a huge glut of housing. Despite housing starts being near 50-year lows, there is still too much construction going on. The way to spur demand in housing is the same way you spur demand in any market: you cut prices.
Removing the income limits makes clear the real intention of the tax credit, to help the wealthiest households. About three-fourths of existing families already fall under the income cap of $75,000. As we move up the income latter, home equity makes up a smaller percentage of one’s total wealth. The richest families can make do with a decline in their housing wealth and continue spending; they have other substantial sources of wealth. If we have learned anything from the housing boom and bust, it should be that continued government efforts to rearrange the housing market have been costly failures.
Fannie Mae and Freddie Mac: The Toxic Duo
Treasury Secretary Timothy Geithner has finally unveiled details about his bailout plan. Not surprisingly, he plans on propping up insolvent (but politically influential) financial institutions. Even worse, there is no effort to shut down — or even reform — the two government-sponsored enterprises that deserve the lion’s share of the blame for the financial crisis. Yet as Peter Wallison of the American Enterprise Institute explains in this new video from the Center for Freedom and Prosperity, Fannie Mae and Freddie Mac are at the epicenter of the housing bubble and subsequent damage to financial markets.
Cato on Facebook
Cato on Twitter
Cato on Google+
Cato on YouTube
