A Fixer-Upper for Finance

Abstract

Three facts bear notice in connection with our current financial troubles. The first is that First World War, before Second began, was known as the Great War. The second is that global Depression that struck between those two wars, which for now we can still label Great, commenced with burst of a multiyear real estate price bubble prior to 1929 stock market crash. The third is that U.S. accordingly addressed that depression through mutually reinforcing new regimes not only of financial regulation, but also of home mortgage finance - very reforms that brought us securitization and familiar 30 year, fixed rate mortgage. Our present difficulties, moreover, stem directly from recent departures from that originally bipartisan package of mutually reinforcing mortgage and finance-regulatory innovations. Approaches to today's financial crisis have been strangely unmindful of history, innovations, and bipartisanship just mentioned. They have also been inattentive to well established historical linkage between protracted economic contractions on one hand, and paired stock and real estate crashes on other. That is surprising not only because these matters are so salient right now. It is surprising also because reason for historical link between real estate slumps and broader economic contractions is not hard to find: For overwhelming majority of Americans, homes are by far most valuable assets they own. When their values plummet, wealth, credit, consumer confidence, and spending soon follow. The lesson for today is quite clear: No approach to our present financial crisis that does not address mortgage crisis at its core can succeed in long run, or even short run. This Article prescribes means of addressing our current financial crisis by addressing mortgage crisis at its core. It targets both short and long term. In a manner that is sensitive both to historical roots and to still operative etiology of current crisis, it develops a fully integrated, systematic protocol for treating our present financial ills. The Article first structurally characterizes nature of credit-fueled asset price bubbles and financial pathologies to which they give rise. It emphasizes that this structure is compatible both with long-term informational efficiency on part of asset markets, and with individual rationality on part of market participants. The challenge presented by asset bubbles, Article argues, is not individual irrationality or informational inefficiency, but a classic coordination problem. Mistaken assumptions to contrary account in large measure for our failure to have prevented, and for our ineffectiveness thus far in addressing, present crisis. Coordination problems require coordinative responses. Absent such responses to credit cycles and financial systems conceived as wholes, piecemeal regulatory measures cannot properly discharge their functions. The Article next shows our current difficulties indeed to have stemmed from a classic credit-fueled asset price bubble first in stock, then in housing markets over decade ending in 2006. This bubble was strikingly reminiscent both of that which preceded 1928-29 American real estate and stock market crashes and ensuing deflation, and of more recent such stories in Asia. The Article then lays out responsive near-term solutions to present crisis as thus characterized, followed by longer-term measures that will maintain health both in real estate finance and in financial system more generally. The key to a short term solution lies in employing those institutions we first put into place to deal with our last great real estate bubble and burst, that of 1928. Those institutions are Federal Housing Administration and its recently renationalized GSE siblings, Fannie Mae and Freddie Mac. The key to longer term maintenance, Article then argues, is two-fold. Above all, we must restore Federal Reserve's original role as bubble-preventive credit-regulator - what Article calls regulation as modulation. Complementary to this task will be development of more effective bubble-detection methodologies, which can be developed but, as public goods, are currently underprovided. Likewise complementary to credit modulation will be extension of familiar disclosure and firewall protections from those older fields of finance where they have been operative since 1930s, to new fields of finance that have developed more recently in shadows. Getting finance and credit-debt cycle right, Article concludes, will get business cycle and stable growth right as well. Stop bubbles, and we will stop bursts and deflations alike.