WORD ON THE STREET: Let's turn back the clock for a moment to the second half of 2006. At that time, firms and people around the world held a wide array of financial assets that were ultimately backed by U.S. residential land. (Think, for example, of mortgage-backed securities or any asset backed by mortgage-backed securities.)
They viewed those assets as being largely free of risk. Investors may have understood that a fall in the value of U.S. land would impose large losses on them. However, they put low odds on such a decline taking place. Rather, they seemed to believe that U.S. land prices would continue to rise at a steady clip.
By the second half of 2007, that belief began to unravel in the face of incoming data. People were beginning to learn the hard way that U.S. land was a risky investment – the only question was how risky. The uncertainty about the answer to this question planted the seeds for a global financial panic.
What do I mean by the term "financial panic"?
Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted, present-value sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds – either by borrowing or by selling assets – to pay its current costs. In a well-functioning financial market, solvent firms are typically liquid, because they are able to borrow against their future profits.
In contrast, in a financial panic, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, and even highly solvent firms may become illiquid.
During the mid-2000s, many forms of collateral around the world were either implicitly or explicitly backed by U.S. residential land. As I've described, beginning in mid-2007, it started to become clear that this asset had more risk than financial markets had originally appreciated. It was not clear, though, how much more risk was involved. As a result, financial markets became increasingly uncertain about how to evaluate assets backed by U.S. land. That uncertainty translated into uncertainty about the ultimate solvency of institutions holding those assets – and the ultimate solvency of any of those institutions' creditors.
As investors became more concerned about the quality of mortgage loans, the secondary market for private-label mortgage-backed securities nearly disappeared. As a result, about 90% of mortgages originated over the past two years were guaranteed by government-controlled entities such as Freddie Mac, Fannie Mae, the Federal Housing Administration or the Department of Veterans' Affairs. Investors are willing to purchase mortgages and mortgage-backed securities from these agencies mainly because they have faith that the federal government stands behind those instruments.
This heavy reliance on government guarantees is not a sound long-term strategy. Over time, our country needs a mortgage market that returns to greater reliance on private risk-taking and private risk assessment, along with the enhanced regulatory oversight that is already in place. And, in fact, discussions are currently taking place on suitable options for bringing more private capital back into the mortgage market.
Even more generally, I believe that as a country, we need to take this opportunity to rethink many aspects of our public policy programs in the context of housing finance. Homeownership has long been part of the American Dream, in no little part because homeowners have invested not just in their houses, but in their communities.
But through the mortgage interest tax deduction and other programs, we are encouraging people to buy homes by taking on debt – and sometimes large amounts of debt. If we truly want to encourage homeownership, we should contemplate programs that provide incentives for individuals to save and become equity holders in their homes – and, by extension, in their communities.
We have come through a very difficult recession, caused in no little part by the large fall in residential housing prices that took place after 2006. I believe that the size of this shock meant that this recession was going to be a painful and challenging one, regardless of the policy response. Certainly, the Fed has played, and will continue to play, multiple roles in promoting sound, affordable and accessible housing finance. In our most prominent role as makers of U.S. monetary policy, the Fed is committed to keeping inflation under control, which helps make traditional mortgages more affordable.
The Fed also has a key role in overseeing many of the recent financial reforms aimed at preventing the excessive risk-taking that contributed to soaring home prices, imprudent lending and, ultimately, the housing bust. Our safety and soundness and macro-prudential supervisors will be leaders in applying new regulatory approaches for banks and others.
Narayana Kocherlakota is president of the Federal Reserve Bank of Minneapolis. This article was adapted from a speech Kocherlakota gave before the Minnesota Emerging Markets Homeownership Initiative Workshop on April 5. His complete speech can be accessed on the Minneapolis Fed's website.
