The Lessons from the Housing Market Crisis

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The Lessons from the Housing Market Crisis

• Professor Elias Karakitsos
• eliask_at_guildhall.gg

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Causes of Credit Crisis

• US housing market symptom not cause
• Too much liquidity
• Internet, Housing, Commodities, Shipping, Private
  Equity and US Treasuries
• Liquidity created by
• Bad Financial Engineering (shadow banking)
• Mistakes in monetary policy

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Consequences

• Falling house prices and an inverted yield curve
  turned hefty profits in shadow banking into huge
  losses, spilling over to mother banks
• Widening credit spreads
• Higher cost of borrowing
• Lower credit availability
• Tightening of lending standards

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Consequences and Risks

• K-model predictions
• House prices stabilise in spring 2010 at 40
  lower than peak in mid-2006
• Debtgt 50 (61 to 101) in the upswing, 98-07
• 81 by 2010 (irreversibility)
• Gross wealth Return to pre-bubble level
• lt 50 (144 to 230), 98-05
• Net wealth 82 to 134 in the upswing
• 58 by 2010

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Figure 17 The Housing Market Loop
Income or Interest rate Shock
House prices
Real Residential Investment
Net Real Estate
Gross Real Estate
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Risks to Recovery

• US government and Fed spending, lending
  guaranteeing
• Commitment 12.8 trillion (GDP 14.2)
• Current allocation 4.2 trillion
• Fed balance sheet expansion
• 1.4 trillion to 2.2 or from 6 to 16 of GDP
• Monetary base to more than 100

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Risks to Recovery

• Risks to sustainability of recovery
• Rising default risk premiums, inflation risk
  premiums exchange rate risk premiums
• Issuance of US Treasuries 2.5 trillion in 2009
• Rising long term interest rates
• Printing of money Inflation when economy
  recovers. Dollar depreciation.

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Policy Challenges Inconsistencies

• Inflation or Deflation
• Drain of liquidity (deleverage)
• Acceptance of lower equilibrium asset prices
• Or
• Flood the system with liquidity to restore
  previous levels of asset prices
• But risk creating new bubbles (US Treasuries)
• Break vicious-cycle bank losses-house prices
• 1.3 trillion rising to 3 trillion on 40 fall
  of houses
• Demand for credit as well as supply

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Policies to Avoid Future Crises

• Mild, but not excessive wealth targeting in
  addition to inflation and output gap
• Wealth target corridor around 5-times disposable
  income
• Hike rates when wealth exceeds upper limit and
  lower rates when wealth falls below low limit.

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Advantages of Wealth Targeting

• Avoid moral hazard
• Avoid over-regulation
• Enable good financial engineering
• Deal with the consequences of financial
  engineering
• Avoid policies that appear successful, yet sow
  the seeds for future bubbles (low volatility of
  inflation and large volatility of output)

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