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Taking a Hint from the Twenties

Question: What is the proper role of regulation in these markets?

Vernon Smith:  I don’t think there is anything you can do to prevent bubbles.  I think we’ve had frequent stock market bubbles that have self corrected and the burden of those bubbles and the pain is basically borne by the investors in those markets and you do not have collateral damage to the economy from bubbles in stock markets like you have in bubbles with housing and generally with consumer durables and I think the solution in the housing and the consumer durables markets is the same as the solution that we’ve worked out institutionally in stock markets and that is require these purchases to be reserved, collateralized.  You have to put up a margin, a respectable margin if you’re buying, making a commitment to buy a long lived asset and you can’t be sure that you’re going to be able to maintain your job and maintain your income and meet those payments and the way you protect against that is to require reasonable down payments and also loan amortization.  Now we learned all of this.  We learned all about amortizing loans.  We learned about having 25 or 30% down payments for homes.  We learned that in the 1920s and 1930s because if you go back to the 1920s there were lots of bank loans being made.  The state banks were making loans on real estate that were interest only loans.  They tended to be short term loans, three and four years.  You paid only the interest and then when they came due you rolled them over and that turned out to be part of the difficulties, certainly not all of them.  A lot of them the problems in the twenties were not only credit financing of home sales, but all sorts of consumer durables.  You had for the first time in the twenties the development of buy now pay later for all sorts of durables like furniture and automobiles and that credit binge in the twenties was an important part of the collapse that took place in 1929 and 1930.  And one of the things that you saw in the 1930s was the disappearance of the unamortized housing loan.  If you compare for example 1928 and 1938 mortgage loans by banks.  In 1938 they’re amortized and in 1928 many, half of them were not amortized, so there is an example where we had institutional learning, but somehow that memory faded.  We forgot that lesson in the case of the housing markets and that’s what gave us a recurrence you see of a lot of the same conditions of the 1920s and ’30s.  We’ve seen repeat of that from about 1997 to 2006 was the boom period in the housing market and then the collapse since then.  And you know we have kind of a nice controlled experiment in one of the states.  I don’t think it’s generally realized that Texas law (and this law dates back I think to about 2001 or 2) prohibits lending, making unamortized loans on a home.  They prohibit balloon payments.  There is a provision requiring that whatever the payment and loan stream conditions are the principle has to rise.  That is as you pay of a loan you more and more of the money is going in to reduce the amount of the loan and what is interesting is that when if you look at the Case-Shiller Housing Index and how it blossomed up from 2000 to 2006.  It was rising 75 or 80%.  In Texas prices only rose 30 percent.  And so it’s clear that this Texas law made a substantial difference there and it seems to me those are very reasonable kind of property type regulations in which you say that people don’t have a right to buy homes without putting up some, a reasonable cash down payment and that the loan be amortized.  And so that’s not a heavy handed regulation.  It’s a very reasonable benign type of regulation: give people rights to take action that are consistent with sustainability and stability. 

Question: What implications does this have for the regulatory treatment of commodities markets versus securities markets?

Vernon Smith:  I think you probably can make a case of having just one regulatory agency.  The CFTC was formed probably because it had a rather different political constituency.  It was commodities and commodities futures and markets and that political constituency was in the Midwest, the agricultural states where as the FCC was a much broader and more comprehensive sort of constituency, but with the development of derivatives markets really a lot of the distinction between securities and commodities I think have disappeared.  It’s interesting though that the style of the CFTC and the style of the FCC have been rather different.  The CFTC has always been somewhat more a freewheeling regulatory agency. They’ve not been a heavy handed regulator and it’s particularly interesting that Chairman Born, who was chairman of the CFTC in 1998, her agency issued a concept release in 1998 in which they were proposing to reexamine the exempt from regulation status of the derivatives market and they were not necessarily proposing that there be some sort of heavy handed regulation be introduced.  In fact, they left open the possibility of some sort of self regulation, regulation by the industry.  That was opposed.  Their concept release was opposed by a joint statement that came from the Federal Reserve System, Federal Reserve banks.  That was Greenspan at the time in 1998.  Treasury Secretary Ruben in the Clinton administration, he joined in opposition to that and also the FCC chairman. 

In retrospect, Born is seen now as something of a hero because she wanted to reexamine the question of the exempt status of those instruments and I think actually a fairly simple regulatory change for those derivatives is all that is called for and that is simply require them, derivatives to be listed on exchanges.  If you did that the exchanges then would require them to be collateralized and that is to me the main problem in the derivatives market, particularly that was true in the housing mortgage derivatives market because those are essentially markets where people are making bets on whether a certain class of mortgage backed securities are going to suffer default and the providers of that, the seller of those contracts. You see that’s a form of insurance in the sense the person who buys those contracts sees that as a way of hedging their risk of default, but it’s not insurance if the sellers of those contracts are not required to collateralize the contract and generally those contracts were not required to be collateralized.  This is basically how AIG go into trouble.  They bought a whole lot of these mortgage backed securities contracts and they weren’t collateralized although they agreed that if they lost their triple A rating they would then start collateralizing those contracts.  Well they lost their triple A rating and of course they couldn’t begin to come up with amount of cash it would take to collateralize them.  So as I see it the defect in those markets was the fact that there was no provision that required them to be collateralized and you know if if A’s promise to pay B can’t be performed upon because A has got a contract with C and C has not delivered on his promise to pay A you have a systemic risk problem and that’s the sort of thing that was created in the derivatives market and at every point in the network, the financial network it’s important that every node that the individuals who are making supply commitments collateralize those commitments, so that if prices turn down there is a cushion in there.  There is an inventory cushion to prevent an escalating slide in prices and defaults.  So to me it’s what is needed here is not some kind of heavy handed regulation, but simply an application of principles that we’ve already learned a lot about in other markets. 

Recorded on December 17, 2009

We forgot the lesson of the ‘roaring 20’s’ in the case of the housing markets and that’s what caused a recurrence; you see of a lot of the same conditions of the 1920s and ’30s, says the Nobel Prize winning economist.

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