Scott Sumner  

How deregulation can improve bank safety

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Alan Goldhammer directed me to a very interesting article on the Texas housing market (which avoided the worst of the housing boom and bust):

A cash-out refinance is a mortgage taken out for a higher balance than the one on an existing loan, net of fees. Across the nation, cash-outs became ubiquitous during the mortgage boom, as skyrocketing house prices made it possible for homeowners, even those with bad credit, to use their home equity like an ATM. But not in Texas. There, cash-outs and home-equity loans cannot total more than 80 percent of a home's appraised value. There's a 12-day cooling-off period after an application, during which the borrower can pull out. And when a borrower refinances a mortgage, it's illegal to get even a dollar back. Texas really means it: All these protections, and more, are in the state constitution. The Texas restrictions on mortgage borrowing date from the first days of statehood in 1845, when the constitution banned home loans.

"Delinquency and foreclosure rates are significantly lower in Texas," says Scott Norman of the Texas Mortgage Bankers Association. "The 80 percent loan-to-value limit -- that's the catalyst for a lot of this."

Right after the housing bust I suggested that we ought to discourage loans of more than 80% of a home's appraised value. One way to do this is to have FDIC insurance only apply to banks that refuse to issue mortgages of greater than 80% of the appraised value of a home.

Other institutions are free to make those sorts of loans, and if there is a market for them then presumably the loans will be made. But with my proposal the taxpayer would no longer be exposed to the risk of default on low down payment mortgages. It also reduces the government's role in the economy, by restricting the reach of FDIC.

Some worry that these sorts of restrictions would discourage homebuilding. I doubt it---at least not very much---as Texas has the most vibrant homebuilding industry in the entire country. In 2016 Texas built far more homes than any other state, despite being hit hard by the oil price bust. Although limiting the scope of FDIC would have little impact on homebuilding, it would reduce moral hazard and protect taxpayers.

PS. Here's a FT article on the return of subprime mortgages, now called "nonprime".

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CATEGORIES: Finance , Regulation

COMMENTS (7 to date)
Josh writes:

This sounds like a good idea to me, but it seems more like general reform than "deregulation". In what way is this reducing regulations? It sounds like you are adding restrictions.

Jake writes:

Sounds like good policy to me.

I think a better idea would be to get rid of the FDIC completely and require all demand deposits to be held as cash or treasuries. But that is certainly a more radical approach and thus harder to achieve.

Kevin Erdmann writes:

There were about 40 states that had housing markets that roughly looked like Texas'. I highly doubt you will find any sort of support for the idea that this policy made much difference at all.

And, defaults during the housing boom in Texas were high. Here was the story back then:

"In 2008, more than $300 billion worth of volatile subprime home loans will spike to higher interest rates nationwide, and a torrent of foreclosures will likely follow. In Texas, where subprime mortgages have glutted the housing markets of several cities, the effect may be severe."

"the nation’s top five subprime refinance markets-and seven of the top 10-are all in Texas. If the housing market in those cities crashes, the state’s economy could suffer."

Back then, Texas was subprime central and due for a bust. Foreclosures were high. If you presume that loose credit terms were the cause of the problem, then all these stories make sense, as long as you keep the previous versions of the story down the memory hole. If you don't have that presumption, then there is nothing there. Zero. It seems like something is there because there is such a presumption favoring the credit causation that the facts are highly flexible. Texas can be the center of reckless lending or the paragon of restraint, depending on how the story needs to end. And, who could argue against restraining credit markets? Obviously prudence is better. Right?

If there was any policy that was particularly special about Texas that helped stabilize the market (besides elastic supply) it is Texas' high property taxes.

G writes:

Reducing FDIC coverage wouldn't reduce significantly the moral hazard. FDIC is a measure targeted at citizens not banks, limiting the reach of FDIC isn't going to prevent a bank from selling a risky product (if not directly, then through some partnership). [Side note: a big part of the 2008 crisis was due to banks not having to hold the loans, they were doing the loan, then package a bunch of them in securities and sell them.]

The second issue is that even if the measure was effective, the day a major bank would start failing the government would once again step in.

Antischiff writes:

Dr. Sumner and Kevin Erdmann,

These are old comments from Jeremy Siegel(2010), but thought you might appreciate them if you haven't seen them before.

He defends EMH and rapidly rising housing prices during the last cycle. Particularly insightful are his comments about how rating agencies and banks viewed risk in the real estate market. I imagine you'll disagree with many of his comments at the very end about management of the recovery.

There seems to be a general rule that with a rising expected rate of return on an asset, comes more risk of paper capital losses on that asset if NGDP growth disappoints.

Steve R writes:

[Comment removed. Please consult our comment policies and check your email for explanation.--Econlib Ed.]

Billy Kaubashine writes:

Add NO RECOURSE the highe loan-to-value formula and you get the disaster that happened. Even in states with full recourse, the process of obtaining and enforcing a deficiency judgment was so expensive that it was rarely done and, thus, borrowers behaved as if there was no recourse.

Full recourse causes (at least some) borrowers to self-impose risk management. If you offered people a $1000 loan for the purpose of buying lottery tickets, on terms that actually required them to repay the loan, and with full recourse to their other assets, you probably wouldn't get a lot of takers.

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