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What lessons can we learn from the boom and turmoil?

Article Excerpt
The current financial crisis undoubtedly will inspire a great deal of research in the years ahead, and it may take some time before anything like a professional consensus emerges on causes and consequences. After all, it took several decades to document the causes of the Great Depression, and recent research continues to provide new perspectives. (1) Nonetheless, I believe the central questions that are likely to occupy researchers are plainly in view, and some tentative lessons have emerged already. And in any event, legislators are not likely to await the fruits of future scholarship.

I will divide my discussion into two parts, reflecting two distinct time periods--the boom in housing and housing finance and the subsequent turmoil in financial markets--and then conclude with some thoughts about what lies ahead.

The Boom in Housing Finance

The expansion in mortgage lending that preceded the recent turmoil in financial markets is best viewed as a component of the long boom in housing activity that began in the mid-1990s and peaked in late 2005 and early 2006. Hard work will be required to estimate the quantitative contribution of various causal factors to the rise in subprime mortgage lending and the increase in subprime losses. In the meantime, the list of plausible suspects is reasonably clear. First, real per capita income grew more rapidly in the decade after 1995 than in the decade before. Second, real interest rates were relatively low over this period, especially after the recession earlier this decade. Low real interest rates in part reflected large capital inflows, but the Federal Open Market Committee kept the federal funds target rate low in 2003, and raised rates only gradually starting in mid-2004. Some economists have argued that tighter monetary policy during that period would have led to better outcomes by preventing core inflation from rising. While I find this view plausible, I believe further research will be required to substantiate this hypothesis.

The third contributing factor was the technologically driven wave of innovation in retail credit delivery that allowed lenders to make finer distinctions between borrowers. This lowered borrowing costs for many borrowers and expanded the availability of credit to borrowers formerly viewed as unworthy of credit. (2) As in any industry undergoing significant innovation--credit cards in the 1990s are a good example--natural evolution can involve overshooting and retrenchment.

Fourth, the regulatory and supervisory regime surrounding U.S. housing finance probably contributed to the boom in housing and housing finance. Here, several factors deserve mention. Supervisory agencies, like borrowers, lenders, and investors, assigned a low probability to the possibility of an adverse housing demand shift of the magnitude and geographic extent that we have seen. Private sector incentives to foresee and protect against such shocks were to some extent dampened by the presence of the federal financial safety net, including the inferred prospect of support for Fannie Mae and Freddie Mac. The safety net probably also played a role in banks' involvement in the securitization process. Banks' use of off-balance sheet arrangements and provision of backup lines of credit created state-contingent exposures for the banking system that by design were most likely to be realized in generally bad states of the world, when the safety-net protection of the formal banking sector would be most valuable. Official policies aimed at increasing home ownership also provided at least some positive inducement to risk-taking in housing finance. In addition, the unscrupulous and fraudulent practices of some mortgage brokers outside of the banking sector may have contributed to the problem.

Although the housing boom will, as I said, inspire a great deal of research...

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