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Housing, Recessions and Sustaining Wealthcreation
Warsaw, Poland
December 3, 2010
Vernon L. Smith
Presentation based on S. Gjerstad and V. Smith at:
http://www.chapman.edu/ESI/wp/Recessions
_1929_2007.pdf
Economic Science Institute
Chapman University
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Bubbles are frequent in history and in the
laboratories of experimental economics. What causes them?
What can spark them?
What can sustain them?
How could the large dotcom stock market crash, 2000-3, do
no damage to the financial system, while the housing
market crash, 2007-8, devastated it? If bubbles cannot be prevented, can their collateral damage
be contained?
Experts, policy makers, economists were blindsided; failingto anticipate the current crisis.
Are there parallels: The Depression & Recessions?
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LESSONS FROM THE EXPERIMENTAL ECONOMIC PERSPECTIVE:
Important to Distinguish Two Kinds of Markets:1. Non-durable consumer goods markets: Most final goods and
services in the economy are notre-traded; costs and benefits are
realized then repeated over time; think of haircuts, hamburgers and
transportation services. Nondurable goods are 60% of gross output!
* Outcomes in Lab better than we economists expected.
* Price discovery processes are very efficient and stable.
2. Asset markets: Items like houses, and securities are re-traded.
* Outcomes in Lab worse than we economists expected.
* Price bubbles are common.
Both kinds of experiment results are echoed in U.S.historys largest housing bubble; its crash spread to
banks, then stocks, and finally to a well-functioning
consumer-producer economy.3
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Recession Starts,
Q4, 2007S
GDP
S
H
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What is different about asset markets? Stocks and houses are bought to
hold, or resell, and are vulnerable to price bubbles and crashes.
Besides fundamental yield value, prices may also depend upon how
people think others will value them in the future.
Assets market experiments with student, business, corporate andfinancial industry groups, even though informed of fundamental value,
have all produce bubbles; they disappear only with repeat experience.
Experiments show that market bubbles are more pronounced: if peoples initial endowments include more cash relative to shares.
or, if they are allowed to buy shares on margin i.e., borrow to buy
shares.
The Cause? We do not know whypeople get carried away with self-
fulfilling expectations of rising pricesa bubble.
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Looking back, what sparked the U.S. housing bubble
from 1997-2000? We see four stage-setting events:1. Laws required performance rating of mortgage-lenders for efforts
to lend to borrowers with incomes below 80% of medium income.
Objective: Help poor own homes; have stable neighborhoods?
2. In 1996, US housing agencies were assigned target goals to direct
their funding to low income borrowers; subsequently targets were
increased to 50% in 2000, and 52% in 2005. All actions received
bipartisan support from both Clinton and Bush administrations.
Very popular with voters
3. Taxpayer Relief Act (1997) which exempted home re-sales fromcapital-gains taxes (up to $0.5 million on each sale).
4. US trade deficit, with the resulting large inflow of foreign
investment capital starting in the early 1990s 6
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What may have sustained and continued the
housing bubble (2000-2006)?
1. Easiest monetary policy in 52 yrs, 2001-3;
2. Continued foreign capital inflow.
3. Uncollateralized Credit Default Swaps (CDS
derivatives) These were information, not
insurance, markets. E. g., AIG Co. had agreedto collateralize only if they lost AAA rating.
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Monetary
Ease
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Housing bubble also fueled by a large inflow of foreign investment, aconsequence of the US trade deficit.
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I. Why do stock market bubbles cause minor damage to thefinancial system?
Its all in the margin reserve requirements:
Stock purchases are subject to high cash reserve requirements
Any loan can be called by broker if reserve margin is short
Losses are therefore confined predominantly to investors
Banks and non-investors remain unscathed
It was not always so; institution found and not lost:
Margin reserves requirements (50% and more) first emerged in the self
interest of private brokers 1.5 years before the crash of Oct., 1929
Then they were adopted by the NYSE for its members, 1933
And finally, were codified by Congress, when the SEC Act of 1934
empowered Fed Res to regulate margins (Reg. T, 50%); brokers today
often require higher margins; up to 100% by discount brokers.Margin requirements became an entrenched tradition, a lasting property
right rule; limits the damage from the OPM (other peoples money)
problem
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II. Why do housing/mortgage market bubbles devastate financial
systems? Its a reserve failure:
Houses were bought with low or zero cash downBIG OPM problem
Loans are long term and foreclosure very costly to lenders
Losses impact banks, economy, all citizens, including those who only
rent homes, but lose employment because of the economy. Through finance and trade the distress spreads through the world
It was not always so; Institution found then lost:
In 1920s bank mortgage loans were like those in the recent crisis:interest only, or with delayed large balloon payments.
Corrective response, 1935-1939, was to require larger down
payments, loan amortization; reduced OPM problem.
This learned tradition was lost, 1997-2006. Also, we createdmortgage backed securities, as means to facilitate home ownership by
those of modest income; safety was sought via CDS. Illusion: CDS
protects against default.
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Impact on the poor? The Cheaper the House the worse the bubble;
and in crash, the greater the impact on bank losses
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Role of Credit Default Swaps (CDS Derivatives)
In 1998 CFTC Chairperson Brooksley Born issued a concept release
calling for revisiting the exempt status of derivatives; exemption
meant not listed and subject to margin requirements: this action wasopposed by Fed Res, Treasury and SEC. She was right, but brushed
aside.
In his July 30, 1998 congressional testimony against the CFTC,Deputy Secretary of the Treasury, L. Summers, argued that the
parties to these kinds of contract are largely sophisticated financial
institutions that would appear to be eminently capable of protecting
themselves from fraud and counterparty insolvencies.Fed Chairman,
B. Bernanke, offered same argument on Nov. 15, 2005.
The CDS market collapsed in early August 2007.
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What Was Wrong with Derivatives?
Nothing, except they were not exchange listed, like stocks;
were not margined and collateralized! Problem was identical to
that of house mortgages that were inadequately collateralizedby borrowers.
Derivative markets performed well as information markets,
signaling to all in August, 2007including Fed Res chairman
Bernankethat a crisis had occurred. (Earlier and smaller CDS
market declinestremorshad been ignored)
But derivatives were never insurance; that would have
required CDS sellersthose who guaranteed against defaultto
post reserve collateral. 14
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The Federal Reserve, Mortgage Bubble and Crash
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IFED
ACTIONS
II
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Parallels with the Great Depression: Mortgage Funds Declined beforethe 1929 Stock Market Crash, and 1931 banking crisis
Bank Panic/Failures
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Depression: Housing expenditure boom, 1922-26; collapse 1927-33;Decline impacts consumer spending, investment, and economy,
1929-33.
Depression
Starts, 1929
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Housing Expenditures, percent GDP, 1920-2010
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Shaded Areas: U. S. Recessions
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Some Conclusions1. Laboratory experiments have long demonstrated that
consumer goods and service markets are highlyefficient & stable, while asset markets are prone toprice bubbles and instability.
2. This experiment behavior is echoed in the US housingbubble, 1997-2006, and its collapse, 2007-10, withsevere negative consequences for under-reserved homebuyers, mortgage lenders, derivative market insurers.
3. This caused a freeze in credit markets and a broad declinein all private securities markets and in the economy inspite of Fed liquidity action in Aug 2007 and over a year
later, massive purchases of shaky assets, $1.2 trillion.
4. The Great Depression had similar origins. We arein the second household-bank-firm balance sheet crisis.Most post war downturns are led by housing;all recoveries are housing based.
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5. How do we return to the path of wealth creation?
A. Mortgages. Traditional standards: 25-30% downpayments; amortization of principal; no balloonpayments; loan originators fees based on borrower
payments.
B. Derivatives. They are securities, no exemption fromregistration and margin requirements.
C. Taxes. The U.S. has higher business taxes than anyEuropean countryeven France. Almost all net new jobgrowth in the U.S. comes from business start ups. They
should not be impeded by either taxes or unnecessarystart up costs.
http://www.chapman.edu/ESI/wp/Recessions_1929_2007.pdf