A reverse Austrian business cycle theory

Did tight money from the Fed place too high a penalty on deposit funding of mortgages?:

Between 2003 and 2006, the Federal Reserve raised rates by 4.25%. Yet it was precisely during this period that the housing boom accelerated, fueled by rapid growth in mortgage lending. There is deep disagreement about how, or even if, monetary policy impacted the boom. Using heterogeneity in banks’ exposures to the deposits channel of monetary policy, we show that Fed tightening induced a large reduction in banks’ deposit funding, leading them to contract new on-balance-sheet lending for home purchases by 26%. However, an unprecedented expansion in privately-securitized loans, led by nonbanks, largely offset this contraction. Since privately-securitized loans are neither GSE-insured nor deposit-funded, they are run-prone, which made the mortgage market fragile. Consistent with our theory, the re-emergence of privately-securitized mortgages has closely tracked the recent increase in rates.

Here is the full NBER working paper by Itamar Drechsler, Alexi Savov, and Philipp Schnabl.

Comments

This doesn't seem to explain the continued increase in non-bank lending when interest rates were declining in the last decade.

The problem was that in the late 90's congress passed laws that forced Fannie and Freddie to make loans to people who wouldn't have otherwise qualified. AND in the early 2000's congress doubled down and asked them to accelerate the numbers of these loans to inner city unqualified buyers. Simple as that! No mystery. There was of course a cover up of sorts and I suspect that this story is just a continuation of that coverup of the simple truth.

Yep, among other things.

The majority of mortgages were conventional prime rate loans. But market demand consists of all loans, not just prime loans. Normally there would be some sorting and segregating by house quality or neighborhood. But the affordability features of subprime loans attracted prime borrowers. They paid an interest premium on these features. Subprime borrowers bid on houses they couldn't afford, hoping that appreciation would bail them out.

Low tier houses fell the most in price, and this is consistent with your statement. The gubmint pushed people into ownership who never could have passed conventional financing or a rational buy vs rent decision.

Affordable loans didnt, by themselves, cause the crisis. They were part of a grand scheme to promote home ownership.

CRA qualified loans outperformed private-label mortgages in terms of delinquency and loss severity. They also lost market share to the private label issuers between 2003 and 2006.
The CRA is a distortion, but it isn't a notable ingredient in the housing crash.

In this case the cliche is true, the housing/banking crash of 2008-9 is a child with many fathers. The ratings agencies, Fannie and Freddie, the CRA, sure all part of it. But mainly it was wildly overleveraged banks and in the U.S. a really stupid and destructive change to mark-to-market rules in 2007 that had worked for 70 years that turned a rough housing market into a total bonfire.

Every partisan wants to pin it on the other side, the 'bad guys'. But there's no moral high ground on this one, the blame should be understood to be shared by many many forces, and is not a simple 'who's fault' game.

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Heard of Dodd and Frank? Basel?

I would love to see a referee's report from John Taylor.

Me too. He made his thoughts clear on his blog. Had the Fed tightened more, sooner, according to the Taylor Rule, there would have been no crisis.

I'm not sure I buy that completely. Interest rates were clearly not the decisive criteria for buy decisions. As I said in a different post, OMO don't have house prices as a policy target. They are not designed to deflate bubbles.

Yeah... The timeline of this study doesn't appear long enough given the average trend of the FFR prior (quite prior) to 2003.

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Can somebody reboot the TRBot? He seems to be stuck.

Reach for yield?

At the time, the prime rate shot up to 8%, the mortgage rates mainly stable at 6%, and the safe one year rate at 4.5%. Why didn't lenders lend to business at that prime rate safer than mortgages?

Mortgages pegged to the ten year? Bad mistake.

I think this still fits within ABCT, although I'm not familiar with the intricacies of the theory.

Essentially, the Fed took away the punch bowl and banks stopped lending (this fits ABCT). As the Fed was doing this, the rebels heard the party was crazy and showed up late with their own (higher concentrate?) punch bowl. I'm not sure where or if this last part fits with ABCT.

The malinvestment isn't in productive capital but in assets other than productive capital like residential housing. So it's more modified Austrian business cycle theory than reverse. And the cause is . . . . a high level of inequality.

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Let's be clear: the Fed doesn't raise rates in order to pop asset bubbles. It does so based on the unemployment and inflation mandates. If it didnt have the effect of slowing the housing market, it is because they weren't attempting to do so.

Sales and prices continued to climb because of expectations about appreciation. Private label securitization did provide some but not all the funding. Banks also financed growth through brokered deposits and other hot money financing.

Private label securitization did not cause the bubble. It was merely the last man standing in musical chairs buying the largest mortgages from the least creditworthy borrowers at greatest risk of them exercising their implicit put option.

While the GSEs did retreat from securitization somewhat such that private labels made up the majority of securitizations in 2005 and 2006, Fannie and Freddie still ranked #1 and #2 and securitized more than the next several private labels combined. It was their accounting scandals, not prudence, that caused their withdrawal unless someone can show they had foreknowledge that the market was going to collapse.

The bubble wasnt caused at the time of the collapse. That was the explosion. The bubble began much earlier, anywhere from 1996 to 2000. It powered right through the early 2000s recession.

Thanks for sharing this Tyler.

https://www.nytimes.com/2019/03/18/opinion/wall-street-risk-debt.html

One of the best case for strong banking regulation

No, a strong case for removing government incentives for housing.

Did you miss the part about NON-BANK securitizers contributing to the problem? Do you know how much non-bank lenders lend now for houses?

Regulation is almost always a dog chasing its clipped tail.

What caused the deposit shortage? Banks very rarely kept fixed rate loans during those years. They didn't need deposits, just short-term funding for their mortgage operations.

On the other side, banks bought the mortgage operations of the nonbanks or bought their loans and ran them through the securitization department, which security got rated by S&P or others, the rating which was purchased by the bank(seller) of the security.

European and American investment banks (those supervised by SEC) were allowed by Basel II of 2004 to hold AAA to AA rated securities, or anything with a default guarantee issued by an AAA rated entity, like AIG, against only 1.6% in capital, meaning an allowed leverage of 62.5 to 1. How so many seem incapable to connect this with the mortgage boom 2004-2006 and to the 2008 crisis, never stops to amaze me.
https://subprimeregulations.blogspot.com/2016/09/if-ever-allowed-following-would-be-my.html

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