Poole Party — No Housing Lessons Learned

William Poole, president of the Federal Reserve Bank of St. Louis, made a lengthy speech on Real Estate in the U.S. Economy. Skipping over the first few pages, let’s turn our attention to a section called “Current Problems in Real Estate and Lessons Learned”:

“Current difficulties afflicting the real estate sector have, to date, been confined to the residential sector; business outlays for structures have been quite strong. Since its peak in 2005:Q4, real residential fixed investment expenditures have declined by 19%. Over the same interval, real business investment in structures has increased by 21%. If you plot these two series on a chart, they would look like scissors: one line going up and one line going down — and their slopes would be quite steep. Indeed, their slopes suggest that the current rates of change are not sustainable. Housing will not continue to fall at double-digit rates, and outlays for business structures will not continue to increase at double-digit rates.”

Poole is quite correct. Outlays for business structures will not continue to increase at double-digit rates. Commercial real estate is extremely overbuilt. Overcapacity is rampant.

“Unfortunately, recent events suggest that housing will remain weak for several more quarters; stabilization may not begin until well into 2008. Probably the most important statistics in this regard are the number of unsold new homes still on the market relative to their current sales rate and the recent trends in house prices…”


“Some potential homebuyers are no doubt delaying purchase because they expect house prices to fall.”

This is a critical point. Consumer psychology is extremely important. The secular bull market in housing reached a pinnacle in summer of 2005 with people standing in line overnight hoping to be one of the lucky ones to buy a Florida condo. It does not get much more insane that that. A massive overbuilding of commercial real estate has occurred, as well. A consumer-led recession will highlight all the commercial malinvestments sooner or later.

“As seen in Figure 8, prices have decelerated sharply nationwide. According to the price index published by the Office of Federal Housing Enterprise Oversight (OFHEO), through the second quarter of 2007, prices are still a bit above year-earlier levels.


“However, another measure of national house prices — the S&P/Case-Shiller price index (SPCSI ) — actually declined 3% in the second quarter from a year earlier. A subset of this measure, indexes based on house prices in the 10 and 20 largest U.S. markets, suggests that prices have declined even more in the third quarter. In July 2007, the 10-city composite has declined 4.5% from 12 months earlier and the 20-city composite has declined about 4%.”

Any index that suggests home prices are up year over year is fatally flawed. On this point even Shiller is a blazing optimist. By excluding enormous declines in new home prices, builder markdowns, and incentives, Shiller has dramatically understated the nature of the declines. The OFHEO data are from Mars.

“Although this episode of financial turmoil is still unfolding, my preliminary judgment is that there are no new lessons. Weak underwriting practices put far too many borrowers into unsuitable mortgages. As borrowers default, they suffer the consequences of foreclosure and loss of whatever equity they had in their homes. It is painful to have to move, especially under such forced circumstances. Investors are suffering heavy losses. There is no new lesson here: Sound mortgage underwriting should always be based on analysis of the borrower’s capacity to repay and not on the assumption that a bad loan can be recovered through foreclosure without loss because of rising property values.

“The Federal Reserve has neither the power nor the desire to bail out bad investments. We do have the responsibility to do what we can to maintain normal financial market processes. What that means, in my view, is that we want to see restoration of active trading in assets of all sorts and in all risk classes. It is for the market to judge whether securities backed by subprime mortgages are worth 20 cents on the dollar, or 50 cents, or 100 cents.”

Poole is correct that the Fed has no power to bail out bad investments (at least not forever). However, it is disingenuous to state it has no desire or willingness to try to do so. Recent Fed actions should be ample proof.

“Although there is a substantial distance to go, restoration of normal spreads and trading activity appears to be under way, and we can be confident that in time the market will straighten out the problems. We do not know, however, how much time will be required for us to be able to say that the current episode is over.

“Thank you. I’d be delighted to take your questions.”

Who’s Responsible?

The most galling thing about Poole’s speech is his attempt to blame the free market for problems entirely created by:

  • The Fed
  • The SEC
  • Political hacks.

The Fed’s Role in the Housing Bubble

It is widely understood that the Greenspan Fed fueled the blowoff top in housing by slashing interest rates to 1%. In a direct challenge to Poole’s statement that “The Federal Reserve has neither the power nor the desire to bail out bad investments,” the Fed did just that. Instead of letting banks suffer for stupid loans to dot-com companies and foreign countries, it bailed out the banks by blowing an even bigger bubble in housing.

However, the Fed’s role in this mess goes far beyond an ill-fated decision to slash rates to 1%. The Fed has had a decade’s long history of keeping rates too low too long, and throwing liquidity at every problem that arises. By purposely punishing savers for the benefit of risk takers, the Fed creates a moral hazard and an expectation of still more bailouts when something goes wrong.

Minyanville Professor Vitaliy Katsenelson spoke about this on Tuesday in “The Cost of a Government Bailout”:

“The largest cost of a government bailout is one that is not readily apparent — the so-called moral hazard, wherein society shields investors from the fallout from their actions. The unintended consequence of a government bailout is that it sets the stage for an even greater housing crisis next time, since it suggests to purchasers that owning a house is a risk-free endeavor. If your home’s price goes up, great. If it goes down, you claim to be a victim, and society compensates you for the risk you’ve taken. With screwy incentives like that, the cost of the next bailout will make today’s housing crisis look like a cakewalk.”

The SEC’s Role in the Housing Bubble

Poole is claiming, “Weak underwriting practices put far too many borrowers into unsuitable mortgages.” That finger is pointing the wrong direction.

The real problem with underwriting is the conflict of interest at rating agencies in conjunction with interest rates policies that encourage speculation. I spoke about that idea in “Time to Break up the Credit Rating Cartel.”

Government sponsorship of rating agencies created the problem. The free market solution is to let Moody’s, Fitch, and the S&P sink or swim by the accuracy of their ratings. Instead, they operate with impunity, like any government-sponsored monopoly.

The Political Hack’s Role in the Housing Bubble

The ownership society, 300-plus housing bills to make housing affordable, the creation of GSEs, tax incentives, etc., all play a role to make housing unaffordable. Government should not promote one means of living over another. It gives an unfair advantage to a select percentage of the population (single-family homebuilders and homeowners, for example) at the expense of renters. Promotion of housing also leads to rising property taxes that become a burden to those on fixed incomes.

The latest insanity comes from Barney Frank, chairman of the House Financial Services Committee, who sponsored a bill creating an Affordable Housing Trust Fund designed to provide affordable housing for low-income families.

No Housing Lessons Learned

  • The Fed has learned nothing
  • The SEC has learned nothing
  • Political hacks have learned nothing.

Poole was wrong when he said, “There is no new lesson here.” He was wrong because he does not even understand what the problem is.

Instead of attempting to figure it out, we see legislation on top of legislation on top of legislation. The legislation onion grows more layers every year. Each layer of legislation masks (at best) or compounds (at worst) the problems of the previous layer. The only way to fix the problem is to scrap our tax laws in entirety, dissolve the Fed, stop promoting housing (and everything else, too), and get government out of our lives.


October 10, 2007