Preventing another financial fire

The global financial crisis has inspired people to think of protections for the future, but it seems convincing people to study prevention methods is less enticing than analyzing the catastrophe

By Robert Shiller  / 

Mon, Jan 27, 2014 - Page 9

If we have learned anything since the global financial crisis peaked in 2008, it is that preventing another one is a tougher job than most people anticipated. Not only does effective crisis prevention require overhauling our financial institutions through creative application of the principles of good finance, it also requires that politicians and their constituents have a shared understanding of these principles.

Today, unfortunately, such an understanding is missing. The solutions are too technical for most news reporting aimed at the general public. While people love to hear about reining in or punishing financial leaders, they are far less enthusiastic about asking these people to expand or improve financial-risk management.

However, because special-interest groups have developed around existing institutions and practices, the public is basically stuck with them, subject to minor tweaking.

The financial crisis, which is still ongoing, resulted largely from the boom and bust in home prices that preceded it for several years — home prices peaked in the US in 2006. During the pre-crisis boom, home buyers were encouraged to borrow heavily to finance undiversified investments in a single home, while governments provided guarantees to mortgage investors. In the US, this occurred through implicit guarantees of assets held by the Federal Housing Administration (FHA) and the mortgage agencies Fannie Mae and Freddie Mac.

At an American Economic Association’s session at a recent meeting in Philadelphia, the participants discussed the difficulty of getting any sensible reform out of governments around the world. In a paper presented at the session, New York University professor of economics Andrew Caplin spoke of the public’s lack of interest or comprehension of the rising risks associated with the FHA, which has been guaranteeing privately-issued mortgages since its creation during the housing crisis of the 1930’s.

Caplin’s discussant, Wharton School real estate professor Joseph Gyourko, concurred. Gyourko’s study last year concluded that the FHA, now effectively leveraged 30 to one on guarantees of home mortgages that are themselves leveraged 30 to one, is underwater to the tune of tens of billions of dollars. He wants the FHA shut down and replaced with a subsidized saving program that does not attempt to compete with the private sector in evaluating mortgage risk.

Similarly, Caplin testified in 2010 before the US House of Representatives Committee on Financial Services that the FHA was at serious risk, a year after FHA Commissioner David Stevens told the same committee that “We will not need a bailout.”

Caplin’s research evidently did not sit well with FHA officials, who were hostile to Caplin and refused to give him the data he wanted. The FHA has underestimated its losses every year since, while proclaiming itself in good health. Finally, in September last year, it was forced to seek a government bailout.

At the session, Caplin was asked about his effort, starting with his co-authored 1997 book, Housing Partnerships, which proposed allowing home buyers to buy only a fraction of a house, thereby reducing their risk of exposure without putting taxpayers at risk. If implemented, his innovative idea would reduce homeowners’ leverage.

However, while it was a highly leveraged mortgage market that fueled the financial crisis 11 years later, the idea, he said, has not made headway anywhere in the world. It was then asked why creative people with their lawyers cannot simply create such partnerships for themselves?

The answer, he said, is complicated; but, at least in the US, one serious problem looms large: the US Internal Revenue Service’s refusal to issue an advance ruling on how such risk-managing arrangements would be taxed. Given the resulting uncertainty, no one is in a mood to be creative.

Meanwhile, there is strong public demand — angry and urgent — for a government response aimed at preventing another crisis and ending the problem of “too big to fail” financial institutions. However, the political reality is that government officials lack sufficient knowledge and incentive to impose reforms that are effective but highly technical.

For example, one reform adopted in the US to help prevent the “too big to fail” problem is the risk retention rule stipulated by the 2010 Dodd Frank Act.

In order to ensure that mortgage securitizers have some skin in the game, they are required to retain an interest in 5 percent of the mortgage securities that they create — unless they qualify for an exemption.

However, in another paper presented at the session, Federal Reserve Bank of Boston senior economist and policy advisor Paul Willen said that creating such a restriction is hardly the best way for a government to improve the functioning of financial markets.

Investors already know that people have a stronger incentive to manage risks better if they retain some interest in the risk. However, investors also know that other factors may offset the advantages of risk retention in specific cases. In trying to balance such considerations, the government is in over its head.

The most fundamental reform of housing markets remains something that reduces homeowners’ overleverage and lack of diversification. A separate session paper returned the idea of the government encouraging privately issued mortgages with preplanned workouts was, thereby insuring them against the calamity of ending up underwater after home prices fall. Like housing partnerships, this would be a fundamental reform, for it would address the core problem that underlies the financial crisis. However, there is no impetus for such a reform from existing interest groups or the news media.

One of the discussants, Federal Reserve Bank of New York executive vice president Joseph Tracy — co-author of Housing Partnerships — said: “Firefighting is more glamorous than fire prevention.”

Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending.

Robert Shiller is a professor of economics at Yale University and was the Nobel laureate in economics last year.

Copyright: Project Syndicate