by Adam S. Posen, Peterson Institute for International Economics
Op-ed in Welt am Sonntag
April 12, 2007
English version © Peterson Institute, 2007
Few financial developments have the drama of property busts. Accordingly, a great deal of attention is being paid lately to developments in the US real estate market and to the seemingly dangerous fate of residential mortgages there following the recent housing boom. While understandable, this attention is misplaced. Problems in either the so-called sub-prime mortgage market (of loans to borrowers with poor credit histories or limited assets) or the US real estate market more broadly are not going to have a major impact on the US economic outlook.
Why is the substantial decline in new home sales and prices, and the accompanying slowdown in residential construction and related activities, of minimal importance to the overall US economy? This probably seems counterintuitive. After all, the US economy suffered greatly following the regional property busts and savings and loan crisis of the early 1980s, and other countries such as Sweden and Japan had sharp recessions and banking crises following the collapse of their real estate bubbles in the early 1990s. In fact, a substantial share of the episodes of worst economic performance among the advanced economies in the last 150 years has been associated with the financial aftermath of distressed real estate markets. The key words there though—“financial aftermath”—explain the difference for the United States this time.
In general, the far greater share of the performance of economies at the national level can be explained by how they respond to the shocks they face, rather than by what shocks they face. Macroeconomists speak about “transmission mechanisms” built into an economy’s institutions, which either dampen or amplify a given negative impulse to that economy. Oil price shocks, for example, are having much less effect on world economic growth than they did in the 1970s, because our economies’ transmission mechanisms have changed: we use less oil to produce our goods, our businesses are more flexible in adapting to shifts in energy prices, and our general inflation expectations are less likely to move because the price of one good (petrol) goes up. So the same or larger increase in the oil price today causes less disruption than it did in the 1970s.
By the same token, the structure of the US mortgage market has fundamentally changed from what it was during the savings and loan crisis of the 1980s, or even during the last significant US regional real estate crunch in New England in 1990. The form of mortgage lending, how that lending is supervised, and how the risk of delinquent loans are distributed have changed significantly for the better over the last 15 years, and so they dampen the effect of a negative real estate price shock on the US financial system. This is in contrast to the worst episodes in the past, when the US financial system actually amplified the negative effects of real estate distress upon the rest of the economy.
The biggest structural change has been the shift to securitized mortgage lending. Close to 60 percent of residential mortgages in the United States now are not kept on the lenders’ books—upon making the loan, the lender or a larger intermediary bundles these with other loans of similar attributes and sells them to investors in the form of a bond or security. As a result, the mortgage lender gets its cash repaid almost immediately. While the risk from mortgage defaults remain in the system, it avoids collecting on the balance sheets of individual banks where, in past real estate busts, it would erode those banks’ capital. That erosion led in turn to banks cutting back lending in their local region, and foreclosing on more mortgages, in hopes of restoring their own solvency. Such credit contraction would then cause significant cutbacks in investment and employment, causing more mortgages to become delinquent in payments, generating a downward cycle. With securitization, losses on delinquent mortgages no longer have direct effects on bank balance sheets, and so their growth impact is limited.
If securitization led to markedly lesser lending standards in the United States when issuing mortgages, those benefits to economic stability would have been partially offset. In theory, such a decline in lending standards might have happened, because those doing the loan evaluations no longer retained the credit risk and so would be less careful. Yet, in practice, three factors seem to have, if anything, improved mortgage lending standards in the United States on net in recent years. First, the financial investors buying securitized mortgages were at least as tough scrutinizing portfolios of loans as individual bankers. Second, greater automation and standardization limited lending on nonmarket criteria. Third, the large players who held and resold the securitized loans are under better regulatory scrutiny themselves, by the Federal Reserve and other regulators, than the smaller mortgage lenders used to be in the United States by smaller, sometimes state-level or politically captured, supervisors.
Of course, there are still rising numbers of delinquent mortgages, and someone still holds that potential for financial losses. Here, too, though, structural changes have dampened the transmission of such losses when they occur. Rather than regionally based mortgage lenders who have portfolios concentrated in real estate investments in a particular area of the country, the largest holders of mortgages in the United States today are large financial institutions that are diversified across financial assets and regions. In keeping with the classical argument for universal banking that the United States took from Germany when we liberalized cross-state and product limits on bank activities, these lenders have much more diversified and larger portfolios, which can withstand the losses from residential mortgages.
In summary, there will be no large negative impact on growth from the current real estate bust in the United States, though some individual homeowners and communities are suffering. Despite the suspicion being voiced in various quarters on both sides of the Atlantic, sometimes financial innovation is actually stabilizing. In this case, structural change in the US mortgage market has limited the transmission of the real estate shock into the economy as a whole, and it is the transmission of the real estate shock, not the shock itself, that matters.
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