Housing Booms and Busts

photo by Alex Brogan

Patricia McCoy and Susan Wachter have posted Why Cyclicality Matter to Access to Mortgage Credit to SSRN. The paper is now particularly relevant because of President Trump’s plan to roll back Dodd-Frank’s regulation of the financial markets, including the mortgage market. While McCoy and Wachter do not claim that Dodd-Frank solves the problem of cyclicality in the mortgage market, they do highlight how it reduces some of the worst excesses in that market. They make a persuasive case that more work needs to be done to reduce mortgage market cyclicality.

The abstract reads,

Virtually no attention has been paid to the problem of cyclicality in debates over access to mortgage credit, despite its importance as a driver of tight credit. Housing markets are prone to booms accompanied by bubbles in mortgage credit in which lenders cut underwriting standards, leading to elevated loan defaults. During downturns, these cycles artificially impede access to mortgage credit for underserved communities. During upswings, these cycles make homeownership unnecessarily precarious for many who attain it. This volatility exacerbates wealth and income disparities by ethnicity and race.

The boom-bust cycle must be addressed in order to assure healthy and sustainable access to credit for creditworthy borrowers. While the inherent cyclicality of the housing finance market cannot be fully eliminated, it can be mitigated to some extent. Mitigation is possible because housing market cycles are financed by and fueled by debt. Policymakers have begun to develop a suite of countercyclical tools to help iron out the peaks and troughs of the residential mortgage market. In this article, we discuss why access to credit is intrinsically linked to cyclicality and canvass possible techniques to modulate the extremes in those cycles.

McCoy and Wachter’s conclusions are worth heeding:

If homeownership is to attain solid footing, mitigating the cyclicality in the housing finance system will be imperative. That will require rooting out procyclical practices and requirements that fuel booms and busts. In their place, countercyclical measures must be instituted to modulate the highs and lows in the lending cycle. In the process, the goal is not to maximize homeownership per se; rather, it is to ensure that residential mortgages are made on safe and affordable terms.

*     *     *

Taming procyclicality in industry practices in housing finance is much farther behind and will require significantly more work. There is no easy fix for the procyclical effect of mortgage appraisals because appraisals are based on neighboring comparables. Similarly, procyclicality will require serious attention if the private-label securitization market returns. While the Dodd-Frank Act made modest reforms designed at curbing inflation of credit ratings, the issuer-pays system that drives grade inflation remains in place. Similarly, underpricing the risk of MBS and CDS will continue to be a problem in the absence of an effective short-selling mechanism and the effective identification of market-wide leverage. (34-35)

McCoy and Wachter offer a thoughtful overview of the risks that mortgage market cyclicality poses, but I am not optimistic that it will get a hearing in today’s Washington.  Maybe it will after the next bust.

Countercyclical Regulation of Housing Finance

Pat McCoy has posted Countercyclical Regulation and Its Challenges to SSRN. The abstract reads,

Following the 2008 financial crisis, countercyclical regulation emerged as one of the most promising breakthroughs in years to halting destructive cycles of booms and busts. This new approach to systemic risk posits that financial regulation should clamp down during economic expansions and ease during economic slumps in order to make financial firms more resilient and to prick asset bubbles before they burst. If countercyclical regulation is to succeed, however, then policymakers must confront the institutional and legal challenges to that success. This Article examines five major challenges to robust countercyclical regulation – data gaps, early response systems, regulatory inertia, industry capture, and arbitrage – and discusses a variety of techniques to defuse those challenges.

Readers of this blog will be particularly interested in the section titled “Sectoral Regulatory Tools.” (34 et seq.) This section gives an overview of countercyclical tools that can be employed in the housing finance sector:  loan-to value limits; debt-to-income limits; and ability-to-repay rules. McCoy ends this section by noting,

The importance of the ability-to-repay rule and the CFPB’s exclusive role in promulgating that rule has another, very different ramification. It is a mistake to ignore the role of market conduct supervisors such as the CFPB in countercyclical regulation. The centrality of consumer financial protection in ensuring sensible loan underwriting standards – particularly for home mortgages – underscores the vital role that market conduct regulators such as the CFPB will play in the federal government’s efforts to prevent future, catastrophic real estate bubbles. (44)

While this seems like an obvious point to me — sensible consumer protection acts as a brake on financial speculation — many, many academics who study financial regulation disagree. If this article gets some of those academics to reconsider their position, it will make a real contribution to the post-crisis financial literature.

Foreclosure Prevention: The Real McCoy

Patricia McCoy has posted Barriers to Foreclosure Prevention During the Financial Crisis (also on SSRN). In the early 2000s, Pat was one of the first legal scholars to identify predatory behaviors in the secondary mortgage market. These behaviors resulted in homeowners being saddled with expensive loans that they had trouble paying off. As many unaffordable mortgages work themselves through the system, Pat has now turned her attention to the other end of the life cycle of many an abusive mortgage — foreclosure.

The article opens,

Since housing prices fell nationwide in 2007, triggering the financial crisis, the U.S. housing market has struggled to dispose of the huge ensuing inventory of foreclosed homes. In January 2013, 1.47 million homes were listed for sale. Another 2.3 million homes that were not yet on the market—the so-called “shadow inventory”—were in foreclosure, held as real estate owned or encumbered by seriously delinquent loans. Discouragingly, the size of the shadow inventory has not changed significantly since January 2009.

Reducing the shadow inventory is key to stabilizing home prices. One way to trim it is to accelerate the sale of foreclosed homes, thereby increasing the outflow on the back-end. Another way is to prevent homes from entering the shadow inventory to begin with, through loss mitigation methods designed to keep struggling borrowers in their homes. Not all distressed borrowers can avoid losing their homes, but in appropriate cases—where modifications can increase investors’ return compared to foreclosure and the borrowers can afford the new payments—loan modifications can be a winning proposition for all. (725)

The article then evaluates the various theories that are meant to explain the barriers to the loan modification and determines “that servicer compensation together with the high cost of loan workouts, accounting standards, and junior liens are the biggest impediments to efficient levels of loan modifications.” (726) It identifies “three pressing reasons to care about what the real barriers to foreclosure prevention are. First, foreclosures that could have been avoided inflict enormous, needless losses on borrowers, investors, and society at large. Second, overcoming artificial barriers to foreclosure prevention will result in loan modifications with higher rates of success. Finally, knowing what to fix is necessary to identify the right policy solution.” (726)

It seems to me that the federal government dealt with foreclosures much more effectively in the Great Depression, with the creation of the Home Owners’ Loan Corporation. In our crisis, we have muddled through and have failed to systematically deal with the foreclosure crisis. McCoy’s article does a real service in identifying what we have done wrong this time around. No doubt, we will have another foreclosure crisis at some point in our future. It is worth our while to identify the impediments to effective foreclosure prevention strategies so we can act more effectively when the time comes.