Housing ; Monetary policy ; Housing - Prices

James D. Hamilton

English

Research Papers in Economics

415
Governor Mishkin has done a nice job of categorizing the various 
channels by which the consequences of monetary policy might be 
transmitted to the economy. I’d like to take a step back and reflect 
on what are the instruments of monetary policy, the transmission of 
whose effects we’re discussing.
The instrument of monetary policy that we tend to think of first 
is the time path of short-term interest rates. It’s natural to start there 
because it’s easy to quantify exactly what the Fed is doing.
But another instrument of monetary policy that I think needs 
to be discussed involves regulation and supervision of the financial 
system. This is inherently a messier question. It’s harder to quantify 
the effects, and many of the issues I’m going to be raising today may 
be outside the current regulatory authority of the Federal Reserve 
itself. Indeed, one way you can view the history of our financial 
system is that a certain type of problem becomes recognized, we 
develop regulations to deal with it, and then new parallel institutions 
evolve, outside that regulatory framework, where the same kind of 
problem arises in a new setting.
Commentary:   
Housing and the Monetary 
Transmission Mechanism
James D. Hamilton416  James D. Hamilton
Although the regulatory question is messier to address, I think 
we’d all agree there have been periods historically where it played 
a key role in determining the course of events. The most recent 
experience might be the 1980s, for which you all know the story.1 As 
a result of a series of bad luck and bad decisions, a significant number 
of U.S. banks and savings and loans at the time ended up with a 
position of negative net equity. But that did not prevent them from 
being able to borrow large sums at favorable rates, thanks to deposit 
insurance. The decision problem for an entity in that situation has 
a clear solution  —with the lower part of the distribution truncated, 
you want to maximize the variance of the investments you fund with 
that borrowing. That recklessness in lending was a factor aggravating 
both the boom and the subsequent bust of that episode. Fortunately, 
through a combination of good luck and good policies, we were able 
to correct the resulting mess in a way that avoided the more severe 
problems that some of us were anticipating at the time.
Why do I suggest that there might be something similar going on 
in the current environment? I’m basically very puzzled by the terms 
of some of the mortgage loans that we’ve seen offered over the last 
few years  —for example, mortgages with no down payment, negative 
amortization, no investigation or documentation of the borrowers’ 
ability to repay, and loans to households who had demonstrated 
problems managing simple credit card debt.
The concern that I think we should be having about the current 
situation arises from the same economic principles as a classic bank 
run and potentially applies to any institution whose assets have a 
longer maturity than its liabilities. The problem arises when the losses 
on the institution’s assets exceed its net equity. Short-term creditors 
then all have an incentive to be the first one to get their money out. 
If the creditors are unsure which institutions are solvent and which 
are not, the result of their collective actions may be to force some 
otherwise sound institutions to liquidate their assets at unfavorable 
terms, causing an otherwise solvent institution to become insolvent.
In the traditional story, the institution we were talking about was 
a bank, its long-term assets were loans, and its short-term liabilities 
were deposits. In the current situation, the institution could be a Commentary  417
bank  or  investment  fund,  the  assets  could  be  mortgage-backed 
securities or their derivatives, and the short-term credit could be 
commercial paper. The names and the players may have changed, 
but the economic principles are exactly the same. How much of a 
worry this might be depends on the size of specific potential losses for 
Institution X relative to its net equity and the volume of short-term 
loans that could potentially be disrupted as a result.
This  is  not  just  a  theoretical  possibility.  My  understanding 
is that this is exactly what happened to Germany’s IKB Deutsche 
Industriebank on August 9 to set off the tumult in global short-term 
capital markets.2
Governor Mishkin discusses the potential role of real estate prices 
in the monetary transmission mechanism. I am seeing that not as an 
issue in its own right, but instead as a symptom and a propagation 
mechanism of the broader problem. It is a symptom in the sense 
that, if loans were extended to people who shouldn’t have received 
them, real estate prices would have been bid up higher than they 
should have been. And it is a propagation mechanism in the sense 
that, as long as house prices continued to rise, all sins were forgiven. 
Even a completely fraudulent loan would not go into default when 
there’s sufficient price appreciation, since the perpetrator is better off 
repaying the loan in order to enjoy the capital gain.
The problem is that, as this process gets undone, both effects 
operate in reverse. A credit crunch means that some people who 
should get loans don’t receive them, depressing real estate prices, and 
as prices fall, some loans will become delinquent that otherwise might 
not. If such fundamentals are indeed contributing factors on the way 
up and the way down, the magnitude of the resulting decline in real 
estate prices, and their implications for default rates, could be much 
bigger than the reassuring numbers Mishkin invites us to remember 
based on the historical variability of these series. What worries me 
in particular is, if we see this much in the way of delinquencies and 
short-term credit concerns in the current economic environment, 
in which gross domestic product (GDP) has still been growing and 
house price declines are quite modest, what can we expect with a full-
blown recession and, say, a 20% decline in average real estate values?418  James D. Hamilton
Now, the question that all this leads me to ask is why  —why did 
all this happen? Why were loans offered at such terms? I’m not sure 
that I have all the answers, but I am sure that this is the right question. 
And if you reject my answers, I hope it’s because you have even better 
answers, and not because you dismiss the question.
It seems the basic facts highlighted in Green and Wachter’s paper 
yesterday might be a good place to begin. Since 1990, U.S. nominal 
GDP  has  increased  about  80%  (logarithmically).  Outstanding 
mortgage  debt  grew  50%  more  than  this,  raising  the  debt/GDP 
ratio from about 0.5 to 0.8. Mortgage-backed securities guaranteed 
by Fannie and Freddie grew 75% faster than GDP, while mortgages 
held outright by the two government-sponsored enterprises (GSEs) 
increased 150% more than GDP. The share of all mortgages held 
outright by Fannie and Freddie grew from 4.7% in 1990 to 12.9% 
in 2006, which includes $170 billion in subprime AAA-rated private 
label securities. The fraction had been as high as 20.5% in 2002.3 It 
is hard to escape the inference that expansion of the role of the GSEs 
may have had something to do with the expansion of mortgage debt.
This acquisition of mortgages was enabled by issuance of debt by 
the GSEs, which currently amounts to about $1.5 trillion. Investors 
were willing to lend this money to Fannie and Freddie at terms 
more favorable than are available to other private companies, despite 
the fact that the net equity of the enterprises  —about $70 billion 
last year—represents only 5% of their debt and only 1.5% of their 
combined debt plus mortgage guarantees. If I knew why investors 
were so willing to lend to the GSEs at such favorable terms, I think 
we’d have at least part of the answer to the puzzle.
And I think the obvious answer is that investors were happy to 
lend to the GSEs because they thought that, despite the absence of 
explicit government guarantees, in practice the government would 
never allow them to default. And which part of the government is 
supposed to ensure this, exactly? The Federal Reserve comes to mind. 
I’m thinking that there exists a time path for short-term interest rates 
that would guarantee a degree of real estate inflation such that the 
GSEs would not default. The creditors may have reasoned, “The Fed 
would never allow aggregate conditions to come to a point where Commentary  419
Fannie or Freddie actually default.” And the Fed says, “Oh, yes, we 
would.” And the market says, “Oh, no, you wouldn’t.”
It’s a game of chicken. And one thing that’s very clear to me is 
that this is not a game that the Fed wants to play because the risk-
takers are holding the ace card, which is the fact that, truth be told, 
the Fed does not want to see the GSEs default. None of us do. That 
would be an event with significant macroeconomic externalities that 
the Fed is very much committed to avoid.
While I think that preserving the solvency of the GSEs is a 
legitimate goal for policy, it is equally clear to me that the correct 
instrument with which to achieve this goal is not the manipulation of 
short-term interest rates, but instead, stronger regulatory supervision 
of  the  type  sought  by  the  Office  of  Federal  Housing  Enterprise 
Oversight  (OFHEO)  Director  James  Lockhart,  specifically, 
controlling the rate of growth of the GSEs’ assets and liabilities, and 
making sure the net equity is sufficient to ensure that it’s the owners, 
and not the rest of us, who are absorbing any risks. So here’s my key 
recommendation  —any insitution that is deemed to be “too big to 
fail” should be subject to capital controls that assure an adequate net 
equity cushion.
While  I  think  the  answer  to  our  question  may  begin  here,  it 
certainly doesn’t end there, since the more problematic mortgages have 
all been funded outside the GSEs. Moreover, the growth of mortgages 
held outright by the GSEs has stabilized since 2005, and we simply saw 
privately issued mortgage-backed securities jump in to take their place, 
with their share of U.S. mortgages spiking from 8.6% in 2003 to 17.4% 
in 2005. One might argue that the buyers of these private securities 
may have made a similar calculation, insofar as the same aggregate 
conditions that keep Fannie and Freddie afloat would perhaps also be 
enough to keep their noses above water. Or perhaps Professor Shiller is 
right, that psychologically each investor deluded himself into thinking 
it must be OK because he saw everybody else doing the same thing. 
Or maybe they were more rationally thinking, “The Fed wouldn’t let 
us all go down, would it?” And the Fed says, “Oh, yes, we would.” And 
once again, regulation, not selecting an optimal value for the fed funds 
target, has to be the way you want to play that game.420  James D. Hamilton
If these bad loans were all a big miscalculation, perhaps that 
is  something  the  Fed  might  consider  addressing  as  a  regulatory 
problem  as  well. The  flow  of  accurate  information  is  absolutely 
vital for properly functioning capital markets. I have found myself 
frustrated, in looking through the annual reports of some of the 
corporations and funds involved in this phenomena, at just how 
difficult it is to get a clear picture of exactly where the exposures are. 
I think the accounting profession has let us down here, which you 
might describe as a kind of networking equilibrium problem. But if 
the Federal Reserve were to develop and insist on certain standards 
of accounting transparency for its member institutions, that might 
help to be a stimulus to get much more useful public documentation 
for everybody.
It  also  might  be  useful  to  revisit  whether  Fed  regulations 
themselves may be contributing to this misinformation. Frame and 
White (2007) report that U.S. depository institutions face a 4% 
capital-to-assets requirement for mortgages held outright but only a 
1.6% requirement for AA-rated mortgage-backed securities, which 
seems to me to reflect the (in my opinion, mistaken) assumption 
that cross-sectional heterogeneity is currently the principal source of 
risk for mortgage repayment. Perhaps it’s also awkward for the Fed 
to declare that agency debt is riskier than Treasury debt and yet treat 
the two as equivalent for so many purposes.
Of  course  I  grant  the  traditional  argument  that  regulation 
necessarily involves some loss of efficiency. But to that my answer is, 
It’s worth a bit of inefficiency if it enables us to avoid a full-fledged 
financial crisis. I’d also point out that, if our problems do indeed 
materially  worsen,  the  political  calls  for  regulation  will  become 
impossible to resist, and much of the cures recommended by the 
politicians would create dreadful new problems of their own—that 
too is part of the historical pattern we’ve seen repeated many times. 
For this reason, I think it would be wise for the Federal Reserve 
to be clear on exactly what changes in regulatory authority could 
help prevent a replay of these developments and preposition itself as 
an advocate to get these implemented now. Such steps will also be Commentary  421
necessary, I think, to restore confidence in the system, if the situation 
indeed worsens from here.
Now, I should also emphasize that understanding how we got 
into  this  situation  is  a  different  question  from  how  we  get  out. 
Tighter capital controls by themselves right now would surely make 
the matter worse, and allowing an expansion of the GSE liabilities 
may be as good a short-term fix as anybody has. But I do not think 
we should do so without seeing clearly the nature of the underlying 
problem and certainly cannot think that by itself expansion of GSE 
liabilities represents any kind of long-run solution.
Finally, in closing, suppose that I’m wrong about all of this. 
Suppose  that  the  developments  I’ve  been  talking  about  —the 
appearence of loan originators in every strip mall, anxious to lend 
to  anyone,  and  other  parties  just  as  anxious  to  buy  those  loans 
up—suppose that it is all a response to the traditional monetary 
instrument, the manipulation of the short-term interest rate. After 
all, a 1% short-term rate, 6% 30-year mortgage rate, and 13% house 
price appreciation, such as we saw in 2004, is plenty of incentive to 
borrow and repay. I used to believe that this was sufficient to account 
for all that we were seeing, and many of you perhaps still think that 
way. But if it were the case that all these institutional changes are just 
a response to interest rates, it means that the lags in the monetary 
transmission process are substantially longer than many of us had 
supposed. If people were still buying houses in 2006 as a result of 
institutions that sprung up from the conditions in 2004, it means that 
if we thought in 2004 that overstimulation could easily be corrected 
by bringing rates back up, then we would have been wrong. And 
likewise, suppose you believe that the pain we’re seeing now, and may 
continue to see for a matter of years, until the new loan originators all 
go out of business and recent buyers are forced out of their homes, is 
simply a response to a monetary tightening that ended a year ago. If 
so, then if we think today that, if things get really bad, we can always 
fix things by rapidly bringing interest rates back down—well, then, 
once again, we’d be wrong.422  James D. Hamilton
Endnotes
1See for example Kane (1989) and Keeley (1990). 
2Wall Street Journal, August 10, 2007, p. A1. 
3Sources: Office of Federal Housing Enterprise Oversight, Enterprise Share of 
Residential Mortgage Debt Outstanding: 1990–2007Q1, and Lockhart (2007). 
References 
Frame, W. Scott, and Lawrence J. White. 2007. “Charter Value, Risk-Taking 
Incentives,  and  Emerging  Competition  for  Fannie  Mae  and  Freddie  Mac,” 
Journal of Money, Credit, and Banking, 39, pp. 83-103.
Green, Richard K., and Susan M. Wachter. 2007. “The Housing Finance Revolution.” 
Kane, Edward J. 1989. The S&L Insurance Mess: How Did It Happen? (Washington: 
Urban Institute Press).
Keeley, Michael C. 1990. “Deposit Insurance, Risk, and Market Power in Banking,” 
American Economic Review, 80, pp. 1183-1200.
Lockhart, James A. III. 2007. “Housing, Subprime, and GSE Reform: Where Are 
We Headed?”
Shiller,  Robert  J.  2007.  “Understanding  Recent  Trends  in  House  Prices  and 
Homeownership.”

Charter Value, Risk-Taking Incentives, and Emerging Competition for Fannie Mae and Freddie Mac,”

Housing, Subprime, and GSE Reform: Where Are We Headed?” Shiller,

The Housing Finance Revolution.”

Housing and the monetary transmission mechanism: commentary

http://www.kansascityfed.org/Publicat/Sympos/2007/PDF/Hamilton_0415.pdf

Housing and the monetary transmission mechanism: commentary

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics