Aug042015

Fear of housing debt is healthy and rational

People should fear the consequences of being trapped underwater with an expensive mortgage on a cheap house.

excessive_debtDuring the housing bubble, nobody feared debt. When people believe real estate prices can only go up, then they see no risk in buying because they believe they can sell the property for enough to pay the debt. This peace of mind is rational as long as everyone disbelieves the reality that house prices can go down.

The housing bust ended the delusional complacency regarding mortgage debt. Millions of people discovered very painfully that house prices can go down, and they can end up owing more than they could possible repay absent recovery in house prices. With this pleasant delusion shattered, what emerges is the far more rational fear of the consequences of excessive mortgage debt.

I pity those people who bought at the peak because they endured the consequences of excessive mortgage debt often through no fault of their own. I don’t pity those people who refinanced at the peak and put themselves in a bad position through their foolish and irresponsible choices. Both groups of people endured the harsh consequences of excessive mortgage debt, and everyone should be mindful of the terrible price these people paid for their decisions. Fear of debt is both healthy and rational.

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Economics Housing Bust Legacy? Too Much Fear of Debt

By Noah Smith 19 Jul 27, 2015

After the great American housing bubble blew up in 2008, taking the financial system and the economy with it, there was an often-bitter debate about the underlying causes. Why had housing prices been driven to unsustainable heights in the first place?

There really isn’t much to debate about here. The only mechanism capable of inflating house prices to unsustainable heights is toxic financing terms, particularly negative amortization. It wasn’t qualifying unstable subprime borrowers that was the problem; the real problem was giving unstable loans to everyone, prime and subprime alike.

Were Americans borrowing to overconsume, or were they just trying to make a quick buck? The answer matters because it will guide future policy.

In California, they were trying to do both.

WhereDidAllTheHELOCGo

One hypothesis — let’s call it the debt hypothesis — was that homeowners chose to take on too much housing debt, and that this debt allowed prices to rise above reasonable levels. A duo of well-known economists, Princeton University’s Atif Mian and the University of Chicago’s Amir Sufi, have advanced this idea in a magisterial recent book, “House of Debt.” The debt hypothesis is appealing both to many conservatives (who think government policy encouraged overborrowing), and to many liberals (who think that the unscrupulous finance industry tricked borrowers into piling on too much debt).

I like this hypothesis too — because it’s the truth.

Why would Americans take out so much debt? Perhaps they were trying to replace their declining incomes. Median household income in the U.S. peaked in 1999. People probably have consumption benchmarks — no one wants to be less well-off than their parents. Also, income inequality in the U.S. climbed substantially during the late 20th century, and people may have a desire to spend more when they see their richer neighbors spending more. This explanation has been advanced by some heavy hitters, such as former University of Chicago economist Raghuram Rajan, now governor of India’s central bank.

People took on so much debt because lenders were offering them free money. People saw no reason not to take on too much debt because the debt was made cheap by low teaser rates and negative amortization terms, and everyone believed house prices would always rise enough to pay off the debt.

California_Kool_Aid

The alternative hypothesis is that the housing bubble was simply a classic speculative asset bubble, in which people knowingly overpaid for houses because they expected other people to come along and pay even higher prices. This explanation — let’s call it the bubble hypothesis – says that the housing bubble wasn’t fundamentally different from the late-1990s tech bubble, or any other bubble throughout history. This suggests that the inherent instability of financial markets, not the borrowing decisions of homeowners, was to blame.

This thesis is also true. The psychology of the housing bubble was classic bubble behavior, but none of this would have come to pass had lenders not enabled the foolish behavior of borrowers everywhere.

This debate seems arcane, but it matters a lot for public policy. If household debt is a destabilizing force in the economy, maybe the government should act to limit the amount that people can borrow.

Obviously, I am an advocate of this. People can only borrow so much before they can’t earn enough to make payments and they become insolvent. Lenders during the 00s made millions of borrowers insolvent, and the recession caused by lender’s foolishness made millions more insolvent.humpty-dumpty_bailout

The problem of borrower insolvency was not caused by the recession for most people. Lenders made millions of borrowers insolvent before the recession, and the credit crunch that resulted from cutting off these insolvent borrowers caused the recession that hurt the remainder.

But if the housing bubble was just a normal asset bubble, then such distortionary measures are likely to hurt more than they help.

So which is right?

This is a false dichotomy. They are both right to some degree, but the excessive debt hypothesis is what policymakers should respond to.

Economists have come up with evidence both for and against the debt hypothesis. In 2011, a group of economists from the Federal Reserve Bank of New York found that much of the increase in mortgage origination in the bubble years went to people who owned multiple properties, many of them house flippers who were speculating on price increases, rather than people buying homes to live in or hold as rental properties. That solidly supports the idea that speculation, not debt, was the culprit.

The speculation was the result of excessive debt, not the cause. People speculated because lenders enabled them to do so. Clearly, there was a lot of foolish speculation during the housing bubble, but we have less speculation today, not because people are any wiser, but because lenders aren’t enabling it.dont_come_crying

But Mian and Sufi offer evidence in the other direction. They show that in areas where income grew less during the mid-2000s, mortgage credit went up more. In other words, it looks like people were using debt to make up for falling incomes, giving support to the debt hypothesis. Lower income meant more debt, and a bigger housing bubble.

In January, however, opponents of the debt hypothesis released a rebuttal to Mian and Sufi. Economists Manuel Adelino, Antoinette Schoar and Felipe Severino show that when you look at individuals rather than zip codes, the pattern reverses — people whose incomes grew more also borrowed more during the boom. Even more crucially, it was middle- and high-income borrowers who were more likely to default after the bubble burst. So if we restrict our attention to only the loans that went bad — the loans that, in a perfect world, shouldn’t have been made in the first place — we see that debt wasn’t a substitute for income.

This is not right. After documenting more than 1,000 HELOC abuse cases in Irvine alone, I can confidently say that much of the foolish borrowing during the housing bubble was about supplementing income.

… the evidence seems conclusive that there was a lot more at work in the housing bubble than a surplus of lending to lower-income Americans.

Yes, there was a lot more going on than that. Lenders created a couple of trillion dollars in surplus lending to all Americans, many of whom spent it and stimulated the economy with their Ponzi wealth.

So what is the upshot for policy? We should think twice about having the government restrict the flow of lending.

The government should restrict the flow of lending because lenders obviously aren’t capable of making good decisions on their own.

BailoutCartoon

Although there are definitely cases in which lending is done in a fraudulent or predatory manner, which we should try to prevent, there is great danger in the idea that debt itself is a toxin that wreaks havoc on the economy.

No, there is not. (See: Signatory debt is bad; asset-backed debt is good)

The long asset booms of the ’80s, ’90s, and 2000s made us complacent about debt, but the bursting of the housing bubble has made us too suspicious of it. We need to find a happy medium.

Dog-Poohing-on-Credit-CardsNo, we don’t. Signatory debt is slavery. Signatory debt is money given to a borrower simply based on the borrower’s promise to repay. It has nothing to do with an asset, and if the borrower chooses not to repay, recovering signatory debt can be very difficult because it is not backed by tangible collateral.

Signatory debt provides no useful purpose. It provides a short-term economic boost as demand is pulled forward, but once it is consumed, money that would ordinarily have been spent by the borrower on consumer goods is instead diverted to the lender for debt service. It’s only when signatory debt is expanding that the economy is stimulated. The expansion of signatory debt is a Ponzi scheme.

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