A Fixer-Upper for Finance
Published in: Washington University Law Review, vol. 87, no. 6 (2010). The published article can be accessed online at: http://scholarship.law.cornell.edu/facpub/189/.
Three facts bear notice in connection with our current financial troubles. The first is that the First World War, before the Second began, was known as “the Great War.” The second is that the global Depression that struck between those two wars, which for now we can still label “Great,” commenced with the burst of a multiyear real estate price bubble prior to the 1929 stock market crash. The third is that the U.S. accordingly addressed that depression through mutually reinforcing new regimes not only of financial regulation, but also of home mortgage finance – the very reforms that brought us “securitization” and the familiar 30 year, fixed rate mortgage. Our present difficulties, moreover, stem directly from recent departures from that originally bipartisan package of mutually reinforcing mortgage and finance-regulatory innovations. Approaches to today’s financial crisis have been strangely unmindful of the history, innovations, and bipartisanship just mentioned. They have also been inattentive to the well established historical linkage between protracted economic contractions on the one hand, and paired stock and real estate crashes on the other. That is surprising not only because these matters are so salient right now. It is surprising also because the reason for the historical link between real estate slumps and broader economic contractions is not hard to find: For the overwhelming majority of Americans, homes are by far the most valuable assets they own. When their values plummet, wealth, credit, consumer confidence, and spending soon follow. The lesson for today is quite clear: No approach to our present financial crisis that does not address the mortgage crisis at its core can succeed in the long run, or even the short run. This Article prescribes means of addressing our current financial crisis by addressing the mortgage crisis at its core. It targets both the short and the long term. In a manner that is sensitive both to the historical roots and to the still operative etiology of the current crisis, it develops a fully integrated, systematic protocol for treating our present financial ills. The Article first structurally characterizes the nature of credit-fueled asset price bubbles and the financial pathologies to which they give rise. It emphasizes that this structure is compatible both with long-term informational efficiency on the part of asset markets, and with individual rationality on the part of market participants. The challenge presented by asset bubbles, the Article argues, is not individual irrationality or informational inefficiency, but a classic coordination problem. Mistaken assumptions to the contrary account in large measure for our failure to have prevented, and for our ineffectiveness thus far in addressing, the present crisis. Coordination problems require coordinative responses. Absent such responses to credit cycles and financial systems conceived as wholes, piecemeal regulatory measures cannot properly discharge their functions. The Article next shows our current difficulties indeed to have stemmed from a classic credit-fueled asset price bubble first in the stock, then in the housing markets over the decade ending in 2006. This bubble was strikingly reminiscent both of that which preceded the 1928-29 American real estate and stock market crashes and ensuing deflation, and of more recent such stories in Asia. The Article then lays out responsive near-term solutions to the present crisis as thus characterized, followed by longer-term measures that will maintain health both in real estate finance and in the financial system more generally. The key to a short term solution lies in employing those institutions we first put into place to deal with our last great real estate bubble and burst, that of 1928. Those institutions are the Federal Housing Administration and its recently renationalized GSE siblings, Fannie Mae and Freddie Mac. The key to longer term maintenance, the Article then argues, is two-fold. Above all, we must restore the Federal Reserve’s original role as bubble-preventive credit-regulator – what the Article calls “regulation as modulation.” Complementary to this task will be the development of more effective bubble-detection methodologies, which can be developed but, as public goods, are currently underprovided. Likewise complementary to credit modulation will be the extension of familiar disclosure and firewall protections from those older fields of finance where they have been operative since the 1930s, to new fields of finance that have developed more recently in the shadows. Getting finance and the credit-debt cycle right, the Article concludes, will get the business cycle and stable growth right as well. Stop bubbles, and we will stop bursts and deflations alike.