Coleman, Lacour-Little and Vandell argue that house prices made sense until 2004

The abstract of their new paper:

The cause of the "housing bubble" associated with the sharp rise and then drop in home prices over the period 1998-2008 has been the focus of significant policy and research attention. The dramatic increase in subprime lending during this period has been broadly blamed for these market dynamics. In this paper we empirically investigate the validity of this hypothesis vs. several other alternative explanations. A model of house price dynamics over the period 1998-2006 is specified and estimated using a cross-sectional time-series data base across 20 metropolitan areas over the period 1998-2006. Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE's were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a "bubble" were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the "tail") of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the "dog").

This result is hardly consistent with the charge that the GSEs were the principal source of the problem. It also says something about having a purely private mortgage market.

LA House Prices again

Brad Delong has the Case-Shiller house price index for LA going back to 1987 on his blog today. Nominal house prices are now about double what they were in 1987, for an annualized growth rate of about 3.3 percent. Sounds reasonable to me.

The Fannie/Freddie Conservatorship seems to be working OK

Let' see:

-Interest rates on conforming loans have dropped substantially, helping both homebuyers and sellers in the conforming market. Underwriting standards, though., remain more stringent (good in the long run, perhaps not so good in the short run).

-Senior management got removed without golden parachutes

-Shareholders get largely, but not entirely, wiped out

-The taxpayer, holding 80 percent of the company, gets susbstantial particiation in any upside (which in F&F's case, I think likely).

On net, this looks pretty good. It also looks kind of like Sweden's temporary nationalization of its banking system in 1992, which worked pretty well.

Can't anyone play this game?

A few years back, I reads Robert Caro's Master of the Senate. The thing about the book that most stuck with me was the political genius of Richard Russell. While he was a racist old bastard, he knew how to count votes, and he knew not to showboat in order to get votes. We could use his skills (if not his worst attitudes) right now.

Is Lincoln Forecasting its own Demise?

So I'm watching the Bears-Eagles game, and I see this ad for a Lincoln featuring the David Bowie song, "A Space Oddity," a song that I really like. The idea is that the driver of the Lincoln is just like Major Tom. Of course, in the end, ground control says to Major Tom, "your circuit's dead, there's something wrong."

Note to Self: Always listen to Warren Buffett

During my brief stint at Freddie, an occasional question for discussion at lunch was the company's vulnerabilities. I think it is fair to say that those of us who were worker bees wanted to be sure that the taxpayer would never be on the hook for Freddie Mac debt and/or guarantees.

This was 2002 and 2003, so default risk was not a great worry: the company's underwriting practices at the time were sound, and mortgages were protected either by 20 percent downpayments or mortgage insurance, and property values were still rising, but not yet at a bubble like pace in places like Las Vegas and Florida. As for interest rate risk, the company purchased hedges so that its balance sheet would always have duration of less than a month, and so that duration risk was quite small too--although while hedging duration is pretty straightforward, convexity is more complicated (duration is basically the first derivative in how capital value changes with respect to interest rates; convexity is the second derivative). FWIW, I also thought the people who executed risk management at Freddie were very good at their jobs.

In these discussions, we failed to predict the principal reason the company got into trouble: we had no idea that senior management would recklessly gamble the charter through accounting that was both misleading and (it turned out) incompetent. I have arguments with William Poole, but when he said that management risk was a huge problem with having institutions like Fannie and Freddie, he was right.

But one among us (whose name I will reveal if he/she gives me permission to do so) did predict a major source of the current problem: counterparty risk. For example, Freddie Mac would buy instruments called swaptions, which would give the company the option to swap floating rate debt for fixed rate debt, and vice versa. These swaptions would allow Freddie to manage its balance sheet when interest rates changed in the future. Suppose, for instance, Freddie borrowed long-term in order to finance fixed rate mortgages. Now interest rates fall and borrowers refinance. Swaptions allowed Freddie to trade its expensive fixed rate debt into less expensive floating rate debt to match the lower return on its portfolio (and the converse when interest rates rise). But of course, swaptions would be useless if the institution with which Freddie contracted could not make good on its part of the bargain when interest rates changed.

In 2003, Warren Buffett called derivatives (such as swaptions) weapons of mass financial destruction. Like everyone else, I have long admired Buffett, but I though he got this one wrong. Derivatives allowed institutions to hedge and therefore reduce risk! Or at least, I thought this was the purpose of derivatives.

But of course, investors can also use derivatives to speculate, and when they do so (and particularly when they do so using leverage), derivatives become very dangerous. AIG, for instance, guaranteed against mortgage default. This meant that when defaults rose to levels not seen since the Great Depression, it didn't have enough capital to meet its responsibility to its counterparties. So the counterparties who thought they had hedged their risk found themselves exposed, which in turn ate into their capital position, and so a cascade was on.

Derivatives can be used for good, or for evil. Buffett understands human nature far better than I, and I should always remember that.

A readers asks where to get data about Fannie Mae loan performance

Every month, Fannie Mae (as well as Freddie Mac) puts out a monthly volume summary. The most recent summary, for July, has 90 day loan delinquencies at 1.36 percent. This compares with the Mortgage Bankers Association national delinquency number of 2.35 percent for prime loans, and 17.35 percent for subprime loans for the second quarter of 2008. In case you were wondering, the 90 day loan delinquency number for Freddie was 1.11 percent in August.

The comparisons are not exactly apple-to-apples, but because the MBA data are a little older than the FF data, it is actually likely the case that the GSEs have performed relatively better than the comparison above would suggest.

Full Disclosure

In light of some of my recent posts, I should repeat my disclosure that I worked at Freddie Mac between September 2002 and January 2004. I also own something like 200 shares of stock in the company (if it is important to anyone, I can check the exact amount). Those shares are of course not worth very much right now.

I made many close friends at Freddie, and learned more about mortgages that I could have possibly learned had I never left academia. I also found myself very disappointed with the company in all kinds of ways, which is why I didn't stay very long (although I also didn't stay long because I missed being a professor). I think senior management there has made a series of awful decisions.

Readers may draw their own conclusions about how seriously to take my views in light of this.

Morris Davis writes to me

Morris is currently at Wisconsin-Madison, and was formerly at the Fed.

Why I am opposed to the bailout, by Morris A. Davis

First, I've decided it is bad economics. Suppose the bailout costs 500 billion. Suppose the bailout is effective in avoiding a recession -- The bailout itself costs 3-1/2 percent of GDP. I think you have to go back to 1982, maybe further, to get that kind of contraction in GDP during a recession.

Second, Paulson and Bernanke have proven, repeatedly, they have no idea what is going on. For example, here is a published quote from Bernanke on June 5, 2007, available on the Federal Reserve Board web site: "At this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system." I can find similar quotes from Paulson.

If Bernanke and Paulson have been wrong, every time, why would they be right about the effectiveness or cost of a bailout now.

The reason I have no faith in Bernanke or Paulson is that they have no simple theory to explain what is going on. They know all the bits and details of current events, but they have no simple unifying underlying theory for events.

Third, what assets should be bought in a bailout? Mortgages? How about underperforming stocks? How will the government decide which markets are illiquid and which ones aren't? Forget the adverse selection problem for the moment. Just ask: Why would the government know which class of assets to buy and why?

Fourth and Fifth, the precedent this sets is terrible. This bailout means we have lost faith in free markets to allocate scarce capital to its most productive use. It also tells punishes responsible investors (who did not underwrite or hold high yield junk mortgages) and rewards exp-post the participants in financial markets who took the riskiest bets.

Charles Calomiris and Peter Wallison blame Fannie Mae for the Subprime Mess

Hmmmm. The loan performance on Fannie's book of business is substantially better than the overall mortgage market. And starting in 2002, Fannie Freddie (pink line) lost market share to ABS (light blue line). The data underlying the graph is from the Federal Reserve,

Table 1173. Mortgage Debt Outstanding by Type of Property and Holder.

Could we please stop saying that it was the hybrid feature of Fannie/Freddie that caused them to fail?

I think we have enough failures across enough different types of financial institutions (Investment Banks, Commercial Banks, Thrifts,Insurance Companies and GSEs), and sufficiently (ahem) large rescue packages for them that we can say that the US financial system has very few purely private financial institutions (sorry Lehman Brothers).

Perhaps the new rule going forward is going to have to be that any financial institutions with assets of greater than $X billion will be required to have paid-in capital of greater than Y percent. I have no idea what X and Y should be, but the costs of making X a little too small and Y a little too big are almost surely smaller than the costs of the converse.

Demanding some Accountability is not Partisan Squabbling

The TED Spread (still above 200 bp at this writing) tells me that something must be done quickly to restore investor confidence. But something doesn't have to exclude oversight of the Treasury Secretary or the elimination of golden parachutes for executives whose companies have failed.

How big could a new RTC be to remain comparable to the old RTC?

When the Resolution Trust Corporation was created in 1989, nominal GDP was about 40 percent of what it is currently. That RTC took over about $400 billion in assets. So a current RTC could take over around $ 1 trillion and would be the same relative to the economy as the old RTC.

We did manage to get through the early 90s with a fairly mild recession.

Degrees of Freedom

I am reluctant to weigh in on proposed solutions to the financial crisis, because Ben Bernanke and Henry Paulson are a lot smarter than I and have a lot more information than I. Based on publicly available information, I thought Fannie and Freddie would be OK (and in the end, I think there is still a chance that the conservatorship will actually benefit taxpayers), but it is now clear that public information was not sufficient for making a judgment.

But while Bernanke/Paulson have more information than the rest of us, they have no foundation for calibrating a model to inform them how to move forward. We are completely outside the support of the data. As Charles Manksi describes it so simply and eloquently, because we are in a world of Xs we haven't seen before, we cannot possibly know how to relate those Xs to Ys. And so at the end of the day even our smartest policy makers must rely heavily on judgment. I am not reasurred when I remember that Isaac Newton lost a bunch of money in the South Sea Bubble .

I do think I support the RTC type plan that Paulson is proposing. My worry with it, however, is political more than financial. If we get the wrong sort of people (say those who went to grade school with the Vice-president, or those who were until recently running the interior department) running it in the future, it could produce cronyism and kleptocracy unlike anything we could have before imagined.

Are we at the Bottom in SoCal?

For the second month in a row, Dataquick shows pretty robust sales growth for housing sales in Southern California--along with sharply lower prices. I think this may be a bottom (despite what is going on more generally this week) because:

(1) From a user cost perspective, owning really does look pretty good in many SoCal markets right now, especially for houses that are inexpensive enough to use conforming loans. Mortgage rates are down about 75 basis points on Fannie-Freddie loans since they were placed into conservatorship. People have to live somewhere.

(2) Lots of sales are distressed sales (around 40 percent). This means the prices we are observing are not arms-length transactions, and may be below equilibrium market prices.

(3) While I am wary of anecdotal evidence, I have been getting a lot of anecdotes about bidding wars for modestly priced houses (modestly priced by California standards, anyway).

But there are a number of cautions:

(1) After rising sharply for the past four years, rents in Southern California are stagnant, and perhaps are falling a little bit.

(2) Unemployment has risen sharply in San Bernardino, Riverside, Orange and Los Angeles Counties.

(3) The overall sense of pessimism arising from the financial market crisis could keep buyers from buying.

Altogether this suggests to me that house prices won't be going up a lot anytime soon, they won't be falling much more either.

I should write something about Lehman...

... and I will, but probably not for a few days. There is a lot I need to think through.

I also dropped my younger (by 45 minutes) daughter off at college today. It has been wonderful to see my self-confident, hard-working girls just bubble over with joy while starting out at great universities in great cities. But it has also left me, for the moment, profoundly sad. I am a little surprised at this. Some wisdom does indeed come only through experience.

If not a hybrid, then what?

I kind of liked the hybrid model of mortgage funding. The pure public sector doesn't do that well (FHA underwriting is not all it should be); the pure private sector also doesn't do so well (beyond the subprime mess, there is very little liquidity even in the prime jumbo market right now).

Where I was mistaken was to think 2.5 percent capital was sufficient backing for the GSEs--I thought home mortgages were so safe, that 2.5 percent plus a stress test would be OK. I was wrong. And it is becoming increasingly clear that the GSEs' managements were reckless with the charters, which gives evidence that Robert Van Order's powerful argument that GSE management would never want to screw up a wonderful franchise was also incorrect.

So maybe the correct answer is a hybrid with more capital--say 5 percent. After all, thanks for FDIC and the Federal Home Loan Bank System, Banks are really hybrids too.

The Power of Simplicity

I gave a talk in New York yesterday morning, and then spent the afternoon/evening with my daughter. We were walking down Park Avenue, and caught the two light beams arising from Ground Zero. We both felt our throats catch at the sight.

Megan McArdle doesn't like fixed rate mortgages.

She argues that because house prices are more volatile than interest rates, variable rate mortgages make more sense.

This argument makes no sense. The way to look at the issue is to consider households to be financial intermediaries. Financial intermediaries are most stable when their liabilities and assets have the same duration. Most households have two principal assets--their house, and their human capital. The house has long duration; the duration of jobs is variable. Fixed rate prepayable mortgages can have long duration, and because they have an embedded call option, the duration can be made variable.

Thus a prepayable fixed rate mortgage is a liability that matches well to a house's long duration and the owner's desire to have a free option to move to a new job. It helps stabilize household balance sheets.

Paul Soglin has a blog

He was my mayor for many years. He was a good one, too.