A fixer-upper for finance.

• Author: Hockett, Robert

Table of Contents I. INTRODUCTION: REAL ESTATE, RECESSION, AND KEEPING THE GREAT DEPRESSION "GREAT" II. THIS OLD HOUSE'S CRACKED FOUNDATIONS: WHERE WE ARE AND HOW WE GOT HERE A. Bubbles Happen: Of Beautiful Babies, Ponzi Processes, and Minsky Moments 1. Beautiful Babies: Underlying Assets, Overlying Valuations 2. Ponzi Processes: There Need Be No Ponzi 3. Minsky Moments: What Goes Up Must Come Down the Same Pathway B. Bubbles Just Happened: Of Easy Credit, New Mortgage Products, House-Flipping, Foreclosure, and Global Contagion 1. The "Greenspan Put": New Techs, New Stocks, New Eras, New Money 2. Flip That House: When Houses No Longer Are Homes 3. Foreclosure and Global Contagion: That Huge Sucking Sound C. What Next? III. The Foundations as First Laid: Where We Were and How We Got There IV. home restoration: triage and longer-term maintenance A. Still-Life of and for the Present Moment B. Home Repair: Triage for the Near Term 1. Fannie and Freddie: First Clean Up the Secondary Market 2. FHA: Restore Order to the Primary Market C. Home Maintenance: Care for the Long Term 1. Regulation as Modulation: The Fed and Bubble Preemption 2. Portfolio Regulation by Reference to Underlying Assets 3. Derivative and Hedge Fund Disclosure 4. A Glass-Steagall for Auditors, Rating Agencies, and Regulators 5. Originator Liability V. Conclusion: The House as Restored I. INTRODUCTION: REAL ESTATE, RECESSION, AND KEEPING THE GREAT DEPRESSION "GREAT"

Unnerving though it is to recall them right now, three facts bear noting in connection with our present financial troubles. The first is that the First World War, before the Second commenced, was popularly known as "the Great War." The second is that the 1930s-era global Depression we can still thankfully call "Great" began with the burst of a multiyear asset price bubble in the American real estate, then stock markets. (1) The third is that we addressed this depression most effectively by developing what, at the time, were remarkably innovative, mutually reinforcing new systems of mortgage finance and financial regulation. (2) Both the Hoover and Roosevelt Administrations designed these systems to operate in tandem. (3) Together they brought us not only those familiar forms of bank and securities regulation still largely operative today and well recognized to be products of their era, but also securitization and the familiar thirty-year, fixed-rate mortgage--curiously less widely recognized today to stem from that era. (4)

Some or all of these observations might come as news to nonexperts. In the received telling, the tale of the 1930s depression places the stock market crash of october 1929 center stage, with a nod perhaps given the bank runs of 1932 and Roosevelt's "bank holiday" of March 1933. (5) Real estate and mortgage finance seldom find their way into the story at all. At best they receive rare passing mention--along with flappers, jazz, and raccoon coats--as token emblems of those excesses routinely catalogued under the heady rubric of "The Roaring 20s." (6)

But emphasis on the role of real estate finance in the 1930s depression will not surprise many financial historians or central bankers. It is a virtual commonplace among these that the worst, most protracted economic slumps--including most recently those in Japan and the rest of East Asia--typically emerge from conjoined stock and real estate crashes. (7) Why might that be? The principal reason is right under our noses: Homes are, in most developed economies, by far the most valuable assets most people own and borrow against; (8) when they plummet in value or are lost in foreclosure, personal wealth, credit, purchasing power, and consumer confidence rapidly follow. (9) Stock and bond portfolios, as most citizens' distantly second most valuable asset holdings, simply amplify the waves generated by real estate fluctuation. (10) Scarce wonder, then, that the Hoover and Roosevelt Administrations addressed our last, "Great" depression through a package of mutually complementary mortgage-finance and finance-regulatory reforms. (11)

Against this well-established historical backdrop, it was perplexing, in late 2008 and much of 2009, to find the principal national and global responses to our recent financial woes boasting every stratagem but that of forthrightly arresting our real estate crash and attendant foreclosure crisis. (12) Real estate seemed to be taken by most for a mere side show or sadly peripheral "human interest story"--something like the 1930s-era bread lines or steinbeck novels--rather than central to our broader national and transnational financial turmoil. In consequence, our governments seemed to be fiddling, with no discernible melody, while a great city burned: the city of Hoover--and Roosevelt-designed mortgage finance and financial regulation, which made the United States, in large part, a nation of homeowners and stockholders. (13)

What, then, have we been doing? Congress and the White House first agreed on a stopgap financial "bailout" plan early in October 2008. (14) The so-called "Troubled Asset Relief Plan" (TARP; the Plan) was remarkable in several respects. As a fiscal matter, the Plan's sheer size--over $700 billion, with no assurance that this would be all--was unprecedented in both real and nominal terms. (15) As a legal matter, the sheer breadth of barely reviewable discretion that the TARP afforded Treasury pressed hard against constitutional limits on executive branch authority. (16) Lawyers seemed widely agreed that the original, three-page version of the TARP delegated authority far in excess of constitutional limits. (17) The amended, 400-page version--at least "as applied" to the crisis--did not fare much better. For at least as striking as the TARP's fiscal scale and delegated executive scope was the remarkably restless, if not capricious, character of actions taken under the Plan after enactment.

Secretary Paulson originally pitched the TARP in September 2008 as a proposed "buy-up" of mortgage-backed securities (MBSs), said to be clogging the credit markets. (18) That, we shall see, was a worthwhile aim--but it was quickly abandoned. Paulson next began speaking, in mid-October of 2008, of "buying-in" to troubled financial institutions by purchasing nonvoting shares in them. (19) Paulson held that the equity injection strategy would render lendable funds more quickly available to lenders, restoring liquidity to credit markets more expeditiously than the original buy-up plan. (20) By early November, Treasury reported that the buy-in plan would entirely supplant the earlier buy-up plan. (21)

In mid-November, however, Treasury announced it would enter the short-term debt markets as well, once again "buying-up" rather than just "buying-in." (22) Then, near the end of November, the plan changed again. Now Treasury would resume purchasing "toxic" assets, but more kinds than MBSs. (23) Finally, in December 2008, talk turned toward employing TARP moneys to tide over automakers as well, a course of action that, by early 2009, had begun to be taken. (24) And so things have more or less continued to the present, even since a new Treasury's taking of the reins to spend from the final installment of TARP funds, and subsequently to recoup many of those funds from their original recipients.

Throughout all of these pivots and changes of direction, a few voices softer than Treasury's were offering proposals that targeted the proximate cause of our present financial distress. (25) That, as suggested a moment ago, is our recently corrupted system of home mortgage finance. In particular, it is the ongoing foreclosure crisis afflicting our post-bubble real estate markets. (26) With time and continued tumult, these proposals--which are much better focused as a financial matter, and less constitutionally troubling as a legal matter than TARP was thought by many to be--have come gradually to be more widely heard. (27) Now, even President Obama, Federal Reserve (Fed) Chair Bernanke, and Treasury Secretary Geithner pay at least lip service to the need of a bottom to falling mortgage markets--and to spend some of the original and since-recovered TARP moneys to do so. (28)

It is very good news that now, more are looking to stemming foreclosures as means of addressing our wider financial crisis. (29) However badly needed the transfusion supplied by the first stages of TARP might have been to keep the "patients" (our banks and other financial institutions) alive on the table, the fact is that these patients--and the Treasury--can be expected to continue to "bleed" until we at last stanch the flow, and the threat, of foreclosures still facing us. The only real question is how best to do that. The question of how to end our financial crisis, in short, boils down in significant part to the question of how to end our mortgage crisis--and to prevent a recurrence.

This Article aims to address those two questions head on, just as the late Hoover and Roosevelt Administrations did--as a package. It supplies an integrated set of short-term and longer-term answers, rooted in careful structural and historical diagnosis of our present ills.

The Article proceeds as follows. Part II first elaborates the aforementioned diagnosis. In particular, it shows that we are indeed coming off of a causally interconnected pair of tech stock and real estate bubbles. The real estate bubble in particular was one which, notwithstanding the assurances of former Fed Chairman Greenspan to the contrary, could be seen in the making even as it was inflating--hence, could have been stopped. (30) Like other bubbles, moreover, this one's growth was compatible with market efficiency and individual rationality. Indeed, in the presence of historically low and, at times, even negative real interest rates maintained by the Fed, the bubble was practically guaranteed by those forms of market efficiency and individual rationality. Widespread...