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?
