Last month I wrote about Peter Wallinson’s book Hidden in Plain Sight, about the role that Federal government interventions, and mandates, in the US housing finance market had played in the US housing credit boom of the late 90s and early 2000s.  Wallison argued, pretty persuasively to me, that it was these interventions that drove down credit quality and which meant that when house prices in the US fell, the losses to lenders were large – much larger than has typically been seen when house prices have fallen sharply in other countries.  Those losses in turn –  and the uncertainty around them –  was the catalyst for the US-centred financial crisis of 2007-09.

The US government has had a very large role in the housing finance market for decades now.  That has become quite unusual by the standards of advanced market economies.  Take New Zealand, by comparison.  In the early post-war decades, most first home buyers got a mortgage from the State Advances Corporation.  Indeed, the Monetary and Economic Council in their 1972 report on Monetary Policy and the Financial System reported that in 1965 just over 50 per cent of all outstanding mortgage debt advanced by financial institutions was held by the State Advances Corporation.

That lending didn’t go bad for a variety of reasons –  overall debt levels were low (relative to GDP or household income), inflation increased, and credit rationing was pervasive (SAC dominated the market, but government policy was focused on administrative measures to restrain excess demand and so even SAC lending standards were not overly liberal).  By contrast, any government-provided or government-guaranteed mortgages in New Zealand now make up a derisory share of the market.  That has been the trend in most advanced economies in recent decades.  Housing debt is now initiated by private lenders, and while those lenders have at times made mistakes, or got over-exuberant, the losses on housing loans have not typically been large enough to threaten the health of the system.

The United States was different.  Not only did the government stay actively involved, but possibly in the worst possible way: mandating greater access to credit in a system where the private rewards from complying (and private costs from failing to comply) were very high.  State Advances Corporation managers did not have the sorts of bonuses and options at stake –  let alone the potential for merger approvals to be withheld –  that characterised the US.

But I’m not writing about this today simply to rake over history, but because in some respects the US government involvement in the housing finance market has just got worse since last decade’s crisis.  Around 80 per cent of all new residential mortgages initiated in the US now have a federal government guarantee.

This new short piece from Stephen Oliner, a former senior Fed official and now a fellow at the UCLA Ziman Center for Real Estate, outlines some of the facts and some of the risks.  (The FHA is the Federal Housing Administration, which accounts for a quarter of all government guaranteed mortgages.)   Oliner writes:

A few statistics about FHA loans are sufficient to dispel the myth that only pristine borrowers can get a mortgage. In recent months, the median credit score for borrowers who took out an FHA-guaranteed home purchase loan was 673. About two-thirds of all individuals in the U.S. have a higher credit score than that. FHA’s credit standards are loose as well for two other primary determinants of loan risk: the size of the down payment and the monthly payment burden. The median FHA borrower makes a down payment of less than five percent. If the borrower were to turn around and sell the home, the agent’s commission and other costs would exceed five percent. Hence, the median borrower is effectively underwater on day one. Second, many FHA-guaranteed loans have onerous monthly payments relative to the borrowers’ income. In fact, the payment-to-income ratio for more than four in ten FHA borrowers exceeds the ability-to-repay limit that was set in the recent Qualified Mortgage rule. This is a not a picture of tight credit.

The default rate on these FHA loans, while relatively low in today’s benign environment of solid job growth and rising home prices, would increase substantially in an ordinary recession and would skyrocket if we have another financial meltdown. To gauge the vulnerability of recently originated mortgage loans, AEI’s International Center on Housing Risk publishes every month the results of a rigorous stress test, the National Mortgage Risk Index (NMRI). The NMRI uses the default experience of loans originated in 2007 to estimate how recent loans would perform if hit with a shock akin to the 2008-09 financial crisis. The index shows that nearly 25 percent of recent FHA loan borrowers would default in that scenario. This would be exceptionally harmful, not just to the borrowers, but also to the neighborhoods in which they live and to the taxpayers who would have to make good on the FHA’s loan guarantees.

Note that well: the median FHA borrower –  and typical FHA borrowers have low credit scores –  has a down payment of less than 5 per cent.

The US systemic risks are not nearly as great as those in 2007.  The total stock of mortgage debt is growing much less rapidly, and so far most US housing markets seem less overheated.  But it is a reminder both of how hugely distorted the US housing finance market is, and a contrast to the sorts of housing finance markets we see in New Zealand, Australia, or the UK.  In those latter countries, private lenders make their own assessment of the riskiness of the loans they are making, and of the wider market.  And those private lenders have their own shareholders’ money primarily at stake.  The risks here are simply very different from those in the United States –  both pre-crisis, and now.  For that, we should be very grateful.  But we also need to recognise that it is not primarily a matter of grace, but of superior policy.  When governments stay out of markets things are  – generally – much less likely to go spectacularly wrong.

Peter Wallinson’s Hidden in Plain Sight (“what really caused the world’s worst financial crisis and why it could happen again”), had been sitting for a couple of months on the unread pile on the coffee table, when I found a reference to it on one of my favourite economics blogs/newsletters.  David Warsh’s Economic Principals is a weekly must-read, for his ability to put together succinctly enlightening perspectives on a range of issues in economics, including the history of economics.  So when, last week, in the middle of a column devoted to the American Enterprise Institute, I found a sneering attack on Wallinson, I decided it was time to read the book.  Without taking time to engage the substance, Warsh drips contempt:

He is, however, a lawyer, with no sense of what constitutes a satisfying economic explanation. What makes him a crank is the affable certainty with which he asserts a partial truth explains the whole.

No sensible analyst thinks that political pandering to poor people is a sufficient explanation of the crisis.

The book clearly polarises readers – when I checked on Amazon this morning, readers’ ratings were roughly evenly split between five stars and one star, with almost nothing in between.    That is something of a pointer to how much is at the stake in ongoing debates of how best to understand the causes, and handling, of the 2008/09 crisis.

So what is the essence of Wallinson’s story?    It is that without repeated, sustained and frighteningly successful US government efforts – under both Clinton and Bush administrations – to promote easier access to housing credit, particularly through the agencies (Freddie Mac and Fannie Mae), there would most likely have been no serious US financial crisis.  Wallinson documents how government mandates compelled the agencies to drive down their lending standards, and how because of the dominant role of the agencies in the market, this contributed to a sustained deterioration in the quality of new housing loans being made across the United States.  As late as 2004, new mandates were imposed, forcing the agencies to meet higher low income lending targets with loans for new purchases, excluding any refinancing or equity withdrawal loans.

Wallinson also explains how the distinction between prime and subprime was progressively eroded, and yet how difficult it was for anyone to be fully aware of the scale of what was going on.   Even in the early days of the crisis, data were interpreted as suggesting that the agencies had very little subprime exposure, and indeed that subprime exposures were a small part of the stock of housing credit.  But in fact commercial data providers treated all mortgages purchased by the agencies as prime by definition – unless they were purchased from explicit subprime lenders.   In other words a sustained deterioration in the quality of the agencies’ loan books was largely masked from outside observers –  Wallinson, who had worked on agency issues for some years, notes that he was himself in this category.

And he deals with an argument that the agencies themselves were responsible, pursuing profit-maximising strategies at least during the boom years.  In fact, the agencies constantly struggled, and often only narrowly met, the ever-increasing minimum legal requirements for the share of lending to low and below-median income borrowers.    If loan losses on agency-held mortgages were a little less bad than those in the market as a whole, that is also unsurprising  –  given the dominant position of the agencies, and their low (implicitly government guaranteed) costs of funds, they could typically out-compete other purchasers and get the best (least bad) loans available in any cohort.      The argument isn’t intended to elicit much sympathy for the agencies or their shareholders, who fought doggedly to protect their political position and government preferences, but they increasingly found themselves in an ever more threatening vice.  Their political position depended on being able to sell themselves as facilitating the “American dream” of widening home ownership, and this vulnerability was increasingly exploited by politicians who did not (or would not) appreciate the scale of the risk they were driving into the system.

I don’t agree with everything in Wallinson’s book, but that doesn’t detract from its value.  I think he overstates the importance of fair value accounting requirements – in a panic, fear and uncertainty will drive equity prices deeply lower, regardless of the basis on which institutions are formally valuing the assets in the spotlight – and I’m still not persuaded that, even given the Bear Stearns precedent, Lehmans should have been bailed out.

But if you are at all interested in the 2008/09 US crisis, this book is well worth reading.  It matters to New Zealand oriented readers for at least two reasons:

• The crisis was a hugely influential event, not just on near-term economic developments back then, but in influencing the global debate about markets, banks, regulatory policy, and the role of government.  It will be a reference point for decades to come, and which narrative dominates will matter.
• Graeme Wheeler’s perspectives on the New Zealand housing market seem very shaped by having lived in the United States through the boom and bust years.  But if the experiences of other countries are to shape policy in New Zealand –  and it is very important that we do learn from other countries’ experiences –  it matters greatly that we understand those experiences correctly.

The conventional wisdom of recent years has been that the crisis was primarily a result of flawed private market behaviour, with the world pulled back from the brink by the heroic efforts of various government actors.  The understandable mood of “never again” translates into a bigger role for government – more regulation and more regulated entities.  Governments protect the public from the (mostly unwitting) predations of inadequately regulated private markets, and the too easy ebbs and flows of private capital.  But an alternative story – to which Wallinson’s story contributes – would emphasise the role of government choices in generating the conditions that made severe crises likely in the first place.  For example, the US crisis would never have occurred, on the scale it did, without the sustained government efforts to drive down lending standards and expand credit, all made possible by the role of the extraordinary role that state has long had in the US market for housing finance.  And the two other worst housing collapses of recent years –  Spain and Ireland – would probably never have happened on anything like the scale they did without the decisions of the respective governments to adopt the euro, and hence apply interest rates not set to reflect domestic economic conditions.

No single story is ever the whole explanation of complex phenomena, and the two perspectives in the previous paragraph are deliberately sketched out in slightly caricatured fashion

Of course, John Taylor would add another strand to the “government failure” story, with his emphasis on the Federal Reserve’s departure from the prescriptions of the Taylor rule in the early 2000s.  I don’t find that particular argument very persuasive, and indeed in some respects I think it helps shed light on the Wallinson story.  The US was far from being the only country where monetary policy departed from the prescriptions of a Taylor rule.  For example, Willy Chetwin and I showed a few years ago that New Zealand’s OCR had for some years in the early-mid 2000s been set below what a New Zealand Taylor rule (using the Reserve Bank’s own estimates of the output gap and neutral interest rates) would have suggested.    The US was also far from the only country exposed to foreign capital inflows pursuing yield.  But the US experience of housing loan losses was uniquely bad.  It points to something unique to the United States as being a key part of any explanation.  Statutory mandates to drive lending standards ever lower looks like a pretty compelling element of any successful story of the causes of the crisis.  Fortunately, we’ve had nothing similar in New Zealand…or in Australia, the United Kingdom, or most other countries.  That doesn’t mean we can’t have big sustained falls in nominal house prices here, but it might mean the narrative around the US-centred crisis might not shed much light on vulnerabilities here.