--Lawrence H. Summers is the Charles W. Eliot University
Professor at Harvard and former U.S. treasury secretary. He
speaks and consults widely on economic and financial issues.
The opinions expressed here are his own.
By Lawrence H. Summers
Oct 23 The central irony of financial crisis is
that while it is caused by too much confidence, too much
borrowing and lending and too much spending, it can only be
resolved with more confidence, more borrowing and lending, and
Most policy failures in the United States stem from a
failure to appreciate this truism and therefore to take steps
that would have been productive pre-crisis but are
counterproductive now, with the economy severely constrained by
lack of confidence and demand.
Thus even as the gap between the economy's production and
its capacity increases and is projected to increase further,
fiscal policy turns contractionary, financial regulation turns
towards a focus on discouraging risk taking, and monetary
policy is constrained by concerns about excess liquidity.
Most significantly, the nation's housing policies
especially with regard to Fannie Mae and Freddie Mac --
institutions whose very purpose is to mitigate cyclicality in
housing and who today dominate the mortgage market -- have
become a textbook case of disastrous and procyclical policy.
Annual construction of new single family homes has
plummeted from the 1.7 million range in the middle of the last
decade to the 450,000 range at present. With housing starts
averaging well over a million during the 1990s, the shortfall
in housing construction now projected dwarfs the excess of
construction during the bubble period and is the largest single
component of the shortfall in GDP.
Losses on owner-occupied housing have reduced consumers'
wealth by more than $7 trillion over the last 5 years, and
uncertainty about the future value of their homes, as well as
the inability to refinance at reasonable rates, deters
household outlays on durable goods.
The continuing weakness of the housing sector is a major
source of risk for major U.S. financial institutions, raising
significantly the costs of the loans they offer.
In retrospect, it obviously would have been better if
financial institutions and those involved in regulating
them--especially the FHFA--recognized that house prices can go
down as well as up; if more rigor had been applied in providing
credit; if the GSEs had been more careful in monitoring those
originating and servicing loans; and if all those involved had
been more vigilant about fraudulent behavior.
The question now is what should be done to address the
housing market, given the drag it represents on the national
economy. With virtually all mortgages in the United States
provided by the Federal government or guaranteed by the GSEs,
this is inevitably a matter of government policy.
Unfortunately, for the last several years, policy has been
preoccupied with backward-looking attempts to address the
consequences of past errors in mortgage extension by addressing
homeowners on a case-by-case basis, and decisions regarding the
GSEs have been left to their conservator FHFA which has taken a
narrow view of the public interest. FHFA has not acted on its
conservatorship mandate to insure that the GSEs act to
stabilize the nation's housing market, and taken no account of
the reality that the narrow financial interest of the GSEs
depends on a national housing recovery.
Instead of focusing on the stabilization of the housing
market, its focus has been on reversing its previous policies
heedless of changes in the environment, and in treating
mortgage finance as a morality play involving homeowners,
financial institutions and banks rather than an important
component of national economic policy.
A better approach would involve a number of changes in
First, and perhaps most fundamentally, credit standards for
those seeking to buy homes are too high and rigorous in America
today. This reduces demand for houses, lowers prices and
increases foreclosures, leading to further tightening of credit
standards and a vicious growth-destroying cycle. Publicly
available statistics suggest that the characteristics of the
average applicant in 2004 would make an applicant among the
most risky today. Of course the pattern should be opposite,
given that the odds of a further 35 percent decline in house
prices are much lower than they were at past bubble
Second, as President Obama stressed in presenting his jobs
bill, there is no reason why those who are current on GSE
guaranteed mortgages should not be able to take advantage of
lower rates. From the point of view of the guarantor as
distinct from the mortgage holder, lower rates are all to the
good since they reduce the risk of default. Yet, at least until
now the GSEs have made refinancings very difficult by insisting
on significant fees and by requiring that any new refinancier
take on all the liability for errors in underwriting the
original mortgage, at a cost to American households of tens of
billions a year.
Third, stabilizing the housing market will require doing
something about the large and growing inventory of foreclosed
properties. The same property sold in a foreclosure sale nets
about 30 percent less than if sold in the ordinary way and the
knowledge that that there is a huge overhang of foreclosed
properties deters home purchases. Aggressive efforts by the
GSEs to finance mass sales of foreclosed properties to those
prepared to rent them out could benefit both potential renters
and the housing market.
Fourth, there is the issue of preventing foreclosures which
was the initial focus of housing policy efforts. The truth is
that it is far from clear what the right way forward is. While
the Obama administration HAMP effort has been widely criticized
for overly restrictive eligibility criteria, the reality is
that a large fraction of those receiving assistance have
ultimately been unable to meet even their reduced obligations.
This suggests that the task of helping homeowners without
either damaging the financial system or simply delaying
inevitable outcomes is more difficult than is often supposed.
Surely there is a strong case for experimentation with
principal reduction strategies at the local level. The GSEs
should be required to drop their current posture of opposition
to experimentation and move on a more constructive posture.
Fifth, there were clearly substantial abuses by major
financial institutions and most everyone in the mortgage
industry during the bubble period. Just compensation to the
victims is a legitimate objective of public policy. But
allowing negotiation over the past to be the dominant thrust of
present policy creates overhangs of uncertainty that impose
huge costs on the financial system and inhibits current
lending. It is equally in the interests of bank shareholders
and the housing market that a rapid resolution of disputes be
achieved. The FHFA should be striving to bring the current
period of uncertainty to a rapid conclusion.
While the GSEs are by far the most important actors in the
mortgage space (and hence the FHFA that serves as their
conservator is the most important player in housing policy),
there are others who can make a constructive difference. Bank
regulators could facilitate inevitable restructuring of
underwater mortgages by requiring banks to treat second
mortgages and home equity loans in realistic ways.
The Fed could support demand and the housing market by
again expanding purchases of mortgage backed securities.
With constructive approaches by independent regulators, far
better policies could be in place six months from now. The
anticipation of a change to supportive policies could change
the tone of the market even sooner. There is nothing else on
the feasible political horizon that can make as a large a
difference in driving American economic recovery.