HT PAREKH FINANCE COLUMN

Delinking Housing Cycles,

Banking Crises, and Recession
Avinash Persaud

The nexus of housing boombusts,

banking crises, and economic
cycles is not unique to the last
crisis and has been increasingly
present in each of the major
banking crises since the break-up
of Bretton Woods in the early
1970s. Housing is a politically
charged issue. A safer housing
market, via planned fiscal
intervention to steady supply,
would do more to make the
financial system safer than all of
the other recent initiatives put
together. Cheaper finance without
cheaper homes only deepens
housing inequality.

ousing booms and busts lie

behind the biggest economic
and financial crises in recent
decades. Between 2006 and 2009, the
Organisation for Economic Co-operation
and Development (OECD) countries that
suffered the largest declines in household spending (Denmark, Ireland, Norway, Portugal, Spain, United Kingdom
or UK, and United States or US) were
those that had the greatest increase in
household debt over the preceding 10
years (Glick and Lansing 2010). Most of
this debt was collateralised on residential homes in one way or another. When
house prices collapsed, the net worth of
these indebted consumers and their
banks followed suit, credit lines were
cut, consumption fell and a fire sale of
assets ensued. Personal consumption
fell by 20% or four times the national
average in the one-fifth of US counties
that suffered the highest decline in
housing net worth during the same
period. The collapse of house prices
deepened the recession, not the other
way around.1
An Old Association

Avinash Persaud (profadpersaud@gmail.com)

is non-resident senior fellow, Peterson Institute
for International Economics, Washington, and
non-executive Chairman, Elara Capital PLC,
London and Mumbai.

10

A nexus of housing boombust, banking

crises, and economic cycles is not unique
to the last crisis or its foremost features
like subprime mortgages or credit derivatives. It has been increasingly present
in each of the major banking crises since
the break-up of Bretton Woods in the
early 1970s. Banking crises triggered by
real estate collapses that were foretold
by a previous boom occurred in the UK
in 1973, Spain in 1977, the US in 1986,
Norway in 1987, Finland and Sweden in
1991 and Japan in 1992. Real estate
booms begetting financial crises are not
unique to advanced economies. Boom
and bust in commercial real estate
played an important role in the Asian

Financial Crisis of 199798, especially

in Thailand, Malaysia, Hong Kong and
Singapore.
Sharp declines in house prices undermine household wealth and bank balance sheets. In response, households
reduce consumption and banks stop
lending. Economic activity drops and
businesses lay off workers. Unemployment rises. This leads to more nonperforming mortgages and weaker
house prices. The essential link between
housing and the economy comes from
foreclosure of non-performing mortgages, fear of foreclosure and also by
the risk-aversion of lenders triggered
by the transformation of their biggest
assets from a seemingly liquid, safe
asset to one that is illiquid and risky.
Both of these links are connected
to mortgages being held by those with
funding that could fly out of the door the
next day.
All assets that are purchased with
overnight deposits, money market funds
or other short-term funding have to be
valued on the basis of the price they will
fetch if sold tomorrow. This is called
marking-to-market. This is not just a
modern legal, regulatory or accounting
requirement but a sensible risk management one. Tomorrow these funders can
ask for their money back and the asset
may have to be sold immediately.
Insured deposits are traditionally sticky,
but internet depositors, money market
funds, and interbank markets are far
less so. If a holder of assets has the
capacity to hold on to them as a result of
long-term funding, it makes sense to
use a more stable, long-term valuation.
But if this capacity does not exist, not
marking-to-market will only be a cause
of speculation over the real solvency of
an institution. That speculation will
further undermine a banks access to
funding.
How Downward Spirals Happen
In the context of a downturn in economic activity, when a mortgage becomes
non-performing, the value of the
asset starts a downward spiral amid
concern for a fire sale of homes, rising

APRIL 9, 2016

vol lI no 15

EPW

Economic & Political Weekly

HT PAREKH FINANCE COLUMN

unemployment, and the deteriorating

saleability of foreclosed and abandoned
homes. In anticipation of that, the best
course of action is to try and recover as
much of the non-performing loan as
soon as possible. This decision is not
substantially altered if the bank had
more capital. It is not in the interests of a
well-capitalised bank to let undercapitalised banks foreclose on nonperforming mortgages first. If asset
prices are falling and funding is drying
up, slower sellers end up reporting
bigger losses than fast sellers. One of
the first tremors of the 2008 financial
crisis was the announcement by HSBC,
in February 2007, one of the bettercapitalised institutions, that it was taking early action in response to a rise in
non-performing mortgages.
Financial crises are often triggered by
assets that were previously considered
safe by regulators, rating agencies, and
investors, turning bad at the same time.
The abrupt overturning of previously
strongly held beliefs about market
value causes a lurch into risk aversion
by banks and others. Bankers in wellcapitalised banks, seeing their less wellcapitalised competitors suffer, turn riskaversion into their brand, making it
more entrenched, not less so. This is
augmented by the use of regulatoryapproved risk models that translate past
volatility into future risk.
Policy responses have been stymied
by the widely held but historically
incorrect view that borrowing short to
lend long is the unchangeable essence
of banking. All that can be done,
according to this view, is to tighten
bank lending requirements, increase
capital, and for central banks to offer
near limitless liquidity. More capital is
required and the more capital the better it is for the safety of banks and taxpayers, but it does not sever the link
between the housing cycle and the
economy as much as many hope. Capital buffers are not used to hang on to
troubled assets. Moreover, the descent
into risk aversion is one of the
reasons why aggressive central bank
lending may keep banks alive but
does not quickly restore lending and
spending.
Economic & Political Weekly

EPW

APRIL 9, 2016

More can be done. The mortgage

dominance of and by banks is in direct
response to the incentives on offer from
bank regulators. It is not the natural
result of technological, market or competitive forces. Todays banking model
follows the regulatory model. Regulators favour, for instance, the securitisation of mortgages with lower capital
requirements allowing banks to outcompete traditional mortgage lenders. It was
not always so. The proportions of mortgages to household debt; of bank mortgages to all mortgages; and of real-estate
lending to total bank lending, are each
dramatically higher than 40 years ago.
There are types of mortgages that
could reduce the sensitivity of the economy to housing cycles. One example is a
mortgage that automatically reschedules interest and principal payments
during an economic recession, forestalling foreclosures and holding up household expenditure. Banks cannot provide
these types of mortgages because doing
so would add to their already dangerous
pro-cyclicality: their liquidity and asset
values rise and fall with the economic
cycle. Institutions that have long-term
liabilities, such as life insurance companies and pension funds are better suited
to doing so because what matters to them
is that their investments pay off in the
long run when life insurance and pensions come due, not that they provide an
income beforehand. They can offer mortgages that provide the flexibility that suits
the homeowner, offsets the economic
cycle and meets their own investment
objectives. They do not because current
and oncoming capital requirements for
insurers make it costly for them to do so.
The solution is for the natural capacity of long-term insurers and pension
funds to spread liquidity risks over time,
and the current inability of banks to do
so, to be better reflected in financial
regulation. The global capital adequacy
requirements for insurance assets recommended by the Financial Stability
Board must be adjusted for the maturity
of the liabilities they are set against. The
Basel Committees Long Term Stable
Funding Ratio for large international
banks, which requires banks to fund
illiquid assets with stable funding, must

vol lI no 15

no longer be delayed and the definition

of liquid assets needs to be narrower.
Provide Homes,
Not Cheap Finance
These steps will reduce the danger of
housing finance but unless we address
housing inequality there will be political
pressure for easy financing that could
reintroduce danger. Housing is a politically charged issue. The authorities
should have an annual target for the
new supply of affordable homes and
employ planning laws, fiscal policy and
direct building to help meet it but they
should refrain from subsidised mortgages. Cheaper finance without cheaper
homes only deepens housing inequality.
By not reflecting liquidity risks in capital requirements, banking and insurance regulators in the advanced economies have conjured up a dangerous system where those without liquidity take
liquidity risks and those with liquidity
fail to do so. Systemic risk committees
were created after the crisis to identify
just these kinds of systemic flaws and
develop joined up responses. Two regulatory steps, one in banking and the
other in insurance, would enable the
financial system to take long-term risks,
like long-term mortgages, more safely.
History suggests that a safer housing
market would do more to make the
financial system safer than all of the
other recent initiatives put together.
Note
1

For an excellent survey of the link between

housing cycles and recession, see House of Debt
by Atif Mian and Amir Sufi, University of
Chicago Press, May 2015.

Reference
Glick, Reuven and Kevin J Lansing (2010): Global
Household Leverage, House Prices and
Consumption, Federal Reserve Bank of San
Francisco Economic Letter, 11 January.

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