In a recent American Banker article, Rep. Carolyn B. Maloney asks what's hampering the economic recovery by referring to a recent speech by New York Federal Reserve President William C. Dudley that offers, among several other reasons, the "overhang of mortgage debt."
What is this overhang, exactly?
Turn the clock back five years to the fall of 2007, well over a year after the subprime securitization machine had started grinding to an eventual halt. In late October of that year, Dudley, then executive vice president of the New York Fed, asked: "How did the problems in the subprime mortgage market — with losses that ultimately will probably turn out to be in the range of $100 to $200 billion — lead to such broad market distress?"
This followed comments by Federal Reserve Chairman Ben Bernanke five months earlier that "we believe the effect of the troubles in the subprime market will be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or the financial system." Within a year of this forecast, financial institutions globally had taken a hit to capital of about $700 billion. Total credit losses to date are about $2 trillion, half taken by U.S. banks.
Was this solvency crisis really unforeseeable? According to The Economist, back in the summer of 2004, "the first law of bubbles is that they inflate for a lot longer than anybody expects …The second law is that they eventually burst." The magazine also wrote on June 16, 2005, "In come the waves: The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops."
If house prices reverted to the mean – as prices inevitably do when asset bubbles burst – then the $7 to $7.5 trillion inflation gain in the value of the housing stock would be reversed. In fact, the Fed's Flow of Funds data show that by mid-2012 almost $7 trillion in homeowner equity had been wiped out.
A failure to model reversion to the mean is a common human error, but one not made by speculators, writes Daniel Kahneman in "Thinking Fast and Slow." Even Nassim Nicholas Taleb, the author of "The Black Swan" repeated warnings about the coming crash and eventually shorted the housing market himself. As the de facto systemic regulator, the Fed was the regulatory agency charged with preventing this systemic crisis, but the Fed – and Chairman Bernanke in particular – was deeply implicated in the expansive monetary policies that fueled the bubble from the very beginning and, along with extensive GSE support, overwhelmed the attempts of speculators to deflate the bubble much earlier.
What does this have to do with the weak recovery? The housing market still hasn't corrected from the eleven year boom. If the glut of houses is anywhere near 6.2 million, as Rep. Maloney asserts, then house prices will plummet from current levels. I estimate the combined surplus of single and multi-family units to be closer to one million units. Either way, why did house prices start rising in the spring of this year when they were still above their long- term trend line, spurring a construction boost?
Part of the answer is the shortage of houses for sale because potential sellers with negative equity – meaning the house is worth less than the mortgage – are reluctant to take a loss, or simply can't afford to. Homeowner negative equity was still about $1 trillion dollars this spring including second mortgages, and that could have doubled had house prices fallen all the way down to their long-term historical mean or beyond. Noted forecaster A. Gary Shilling recently predicted a further 20% decline in house prices.
Homeowners with negative equity have little economic reason to continue paying on a no recourse loan, but remarkably, according to CoreLogic, 85% still do. That would change if they didn't think house prices would rebound, and/or if other households who stopped paying got their mortgage principle reduced to bring about positive net equity after house prices had bottomed out. That bailout could cost several trillion dollars, which neither the federal government nor financial institutions can afford. So the best the Fed can do is to try to at least postpone another financial crisis by pursuing essentially the same policy – again with GSE help – of keeping the housing bubble at least partially inflated with cheap credit. The Fed, in addition to its zero interest rate policy, has invested trillions of dollars directly in mortgage securities (quantitative easing) to keep mortgage rates relatively low.
Rep. Maloney also cites the "shortcomings of fiscal policymakers." Keynesian fiscal policy is reflected in the federal deficits of over a trillion dollars for each of the last four years. This has been financed mostly by the Fed, whose balance sheet has ballooned by over $2.5 trillion, with the remainder funded mostly by foreigners, including the Chinese, as U.S. domestic savings remains pathetic. The Fed claims it can shrink this balance sheet to avoid inflation when the time comes. But if real interest rates rise only to their normal historic level, the added interest cost – on top of current deficit spending projections – would likely cause the deficit to spiral out of control. The Fed could then be left with the choice of either trying to finance the deficit with inflation or raising interest rates, renewing the financial crisis.
John Maynard Keynes suggested digging holes and filling them in as a fiscal stimulus. We've just dug the hole a lot deeper.
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates and an executive scholar at the Burnham-Moores Center for Real Estate of the University of San Diego.