Wykład V.L.Smith

8/2/2019 Wykad V.L.Smith

1/20

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

1


2/20

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?

2


3/20

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


4/20

4

Recession Starts,

Q4, 2007S

GDP

S

H


5/20

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.

5


6/20

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


7/20

7

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.


8/20

Monetary

Ease

8


9/20

Housing bubble also fueled by a large inflow of foreign investment, aconsequence of the US trade deficit.

9


10/20

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


11/20

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.

11


12/20

Impact on the poor? The Cheaper the House the worse the bubble;

and in crash, the greater the impact on bank losses

12


13/20

13

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.


14/20

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


15/20

The Federal Reserve, Mortgage Bubble and Crash

15

IFED

ACTIONS

II


16/20

16

Parallels with the Great Depression: Mortgage Funds Declined beforethe 1929 Stock Market Crash, and 1931 banking crisis

Bank Panic/Failures


17/20

Depression: Housing expenditure boom, 1922-26; collapse 1927-33;Decline impacts consumer spending, investment, and economy,

1929-33.

Depression

Starts, 1929


18/20

Housing Expenditures, percent GDP, 1920-2010

18

Shaded Areas: U. S. Recessions


19/20

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.


20/20

20

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

Documents

Wykład V.L.Smith