Volume 9, Issue 3 - “The Mortgage Meltdown, the Economy, and Public Policy” edited by Guest Editors Stuart Gabriel and John Quigley

This paper relates the 2006-2008 meltdown in mortgage markets to falling asset prices, excessive psychological reaction to the burst bubble, and new mortgage vehicles incapable of accommodating sudden changes in asset values. A combination of market-based and regulatory innovations are proposed. The paper suggests placing greater reliance on innovative futures markets in real estate, inducing the flow of capital to vehicles having self-regulatory features and cultivating resiliency in the market. The bankruptcy law also might come to include “circuit breaker" delays in finalizing settlements during turbulent market settings. Some of the fundamental premises underlying mortgage finance should also be reconsidered. Stakes in individual residences could be combined with stakes in regional property portfolios. Finally, the paper promotes a system of “continuous workout mortgages" regularly readjusting loan balances to reflect economic conditions. These contracts could provide needed flexibility; they also offer systematic advantages over the various sector-based bailout strategies inherent in current loan-modification proposals.

This paper reports three sets of facts: 1) Declines in housing are very good predictors of oncoming recessions in the U.S.; 2) Housing and consumer durables are the most important components of GDP that are soft prior to the official beginnings of recessions, and these two contribute substantially to weakness during recessions; and 3) The cycles in homes and consumer durables are very close, raising the prospect that a monetary rule that targeted housing would alleviate the cycle in consumer durables as well; this is confirmed in an econometric exercise with rates set to stabilize housing starts.These facts are used to argue in favor of monetary policy that prevents excessive building of homes and cars with preemptive rate increases in the middle of expansions when housing starts are above normal and growing higher. This contrasts with the traditional approach which is to raise rates late in expansions when inflation is apparent, but when the markets for homes and durables are very fragile because of excessive building earlier.

This paper argues that the U.S. mortgage debacle must be analyzed in the broader setting of global real estate markets. Recent U.S. home price growth closely tracked increases in other developed economies. The analysis distinguishes among market regions in terms of supply elasticity and localized transactions-costs. A series of user-cost models are presented which imply that interest rate fluctuations must figure prominently in any explanation of movements in price/rent ratios. National factors such as the expansion of subprime credit must also be accounted for. The paper concludes with policy prescriptions addressing rapid price declines and elevated interest-rate spreads. We argue that the federal government should play a leading role in helping to reduce interest rates on new mortgages and cushion against underwriting losses on the existing balance sheets of lenders.

This paper analyzes the impact of the subprime crisis on urban neighborhoods in Massachusetts. The topic is explored using a dataset that matches race and income information from HMDA data with property-level transaction data from Massachusetts Registry of Deeds offices. With this data, we show that much of the subprime lending in the state was concentrated in urban neighborhoods, and that minority homeownerships created with subprime mortgages have proven exceptionally unstable in the face of rapid price declines. The evidence, in Massachusetts, suggests that subprime lending did not, as is commonly believed, lead to a substantial increase in homeownership by minorities, but instead generated turnover in properties owned by minority residents. Furthermore, we argue that the particularly dire foreclosure situation in urban neighborhoods actually makes it somewhat easier for policymakers to provide remedies.

In recent years, the government has greatly extended its reach into the mortgage markets with the goals of (1) mitigating the deadweight losses associated with mortgage foreclosures, (2) promoting affordable homeownership, and (3) providing low cost mortgage financing. In this paper, we identify three innovations-one in each of these areas-that could be made to the American mortgage market that would help obtain the government's objectives while enhancing financial market stability-particularly if all are done together. These three innovations are: (1) “buy your own mortgage" options, (2) variable maturity mortgages, and (3) creation of a government mortgage bond insurer, with an emphasis on insuring covered bonds as well as GSE debt. The first innovation would allow homebuyers to repurchase their mortgage at the “market value" of their homes when they move, thereby helping society avoid some of the deadweight losses associated with unnecessary foreclosures. The second innovation would provide a mortgage that could promote affordable housing without unduly raising the default risks of low- and moderate-income families. The third innovation would help create a variety of financing options for mortgages in the United States. Moreover, it could be integrated into the current system of mortgage financing, which would include government-sponsored enterprises (GSEs), in a manner that would help the government manage the systemic risks associated with the quasi-government backing of mortgage credit and mortgage insurance. In particular, we propose that the government explicitly insure pre-designated financial instruments used to fund mortgage credit (such as covered bonds and GSE debt) by creating a government-backed insurance fund similar to that currently used for deposits.

The paper offers a framework and a specific proposal for the re-regulation of key components of the U.S. financial system in the aftermath of the subprime mortgage crisis. It begins with a review of those aspects of the subprime crisis that required the large, observed government interventions, namely the feared bankruptcy of individual banks, insurers, and government sponsored enterprises with the potential to create a meltdown of the entire financial system. The paper then develops legislative responses that would make future systemic failures and bailouts of this magnitude highly unlikely. The paper's key analytic device is to distinguish two financial firm activities: (1) risky investment activities (“hedge fund" division) capable of causing firm bankruptcy, and (2) market-making and related activities (“infrastructure" division), the failure of which would have systemic implications. The goal of the proposed regulatory change is to ensure that the infrastructure division is bankruptcy remote and can operate on a stand-alone basis if necessary even when losses from the hedge fund division threaten the holding company's solvency.