Tuesday, December 9, 2008

Arnold Kling on the housing collapse

In a very wise move, Congress has asked Arnold Kling to testify about the housing crisis and the crater is has left in financial markets. Kling posted his planned remarks on his blog. He has a much more nuanced understanding of the crisis than many of the louder voices out there:

Speaking as a former financial engineer, I have many regrets about the role played by modern financial methods in this crisis. Rather than speak defensively about financial innovation, I want to offer constructive suggestions for public policy going forward.

I emphatically disagree with the extreme partisan narratives for this crisis. To blame the Community Reinvestment Act for what happened is wrong, To blame financial deregulation for what happened is wrong. The narrative I present in my written testimony describes a combination of government failure and market failure.

I want to focus on how both industry executives and regulators were fooled about the risks in the system. In particular, perverse incentives in bank capital requirements encouraged unsound lending practices and promoted excessive securitization.

Kling also offers 4 lessons from the crisis:

1. Capital requirements matter. Details that are easily overlooked by regulators can turn out to cause major distortions.

2. Securitization is not necessary for mortgage lending. On a level regulatory playing field, traditional mortgage lending by depository institutions probably would prevail over securitized lending. Rather than try to revive Freddie Mac and Fannie Mae, I would recommend that Congress encourage a mortgage lending system based on 30-year mortgages originated and held by old-fashioned banks and savings and loans. This would require instructing the regulators of Freddie Mac, Fannie Mae, banks, and savings and loans to all use the same capital standard for mortgages, one that is based on a stress test methodology.

3. Subsidized mortgage credit is an inefficient tool for promoting home ownership. Unless what you want is home buyers who are buried in debt and speculating on house price appreciation, I recommend that Congress not try to create cheap mortgages and instead use other means to encourage home ownership.

4. Recent financial innovations, particularly credit default swaps, have changed our financial system in ways that current policymakers fail to recognize. Bailouts and rescues are counterproductive in today's financial crisis. Within the financial sector, de-leveraging needs to slow down and the process of shutting down failed institutions needs to speed up. Relative to these necessities, handouts from the taxpayers are a hindrance, not a help.

Definitely read the whole thing.

No comments: