Housing debt typically is on the short list of key sources of risk in modern financial systems and economies. The reasons are simple: there is plenty of it; it often sits on the balance sheets of leveraged intermediaries, creating a large common exposure; as collateralized debt, its value is sensitive to the fluctuations of housing prices (which are volatile and correlated with the business cycle), resulting in a large undiversifiable risk; and, changes in housing leverage (based on market value) influence the economy through their impact on both household spending and the financial system (see, for example, Mian and Sufi).
In this post, we discuss ways to assess housing risk—that is, the risk that house price declines could result (as they did in the financial crisis) in negative equity for many homeowners. Absent an income shock—say, from illness or job loss—negative equity need not lead to delinquency (let alone default), but it sharply raises that likelihood at the same time that it can depress spending. As it turns out, housing leverage by itself is not a terribly useful leading indicator: it can appear low merely because housing prices are unsustainably high, or high because housing prices are temporarily low. That alone provides a powerful argument for regular stress-testing of housing leverage. And, because housing markets tend to be highly localized—with substantial geographic differences in both the level and the volatility of prices—it is essential that testing be at the local level…. Read More
In his memorable review of 21 books about the 2007-09 financial crisis, Andrew Lo evoked Kurosawa’s classic film, Rashomon, to characterize the remarkable differences between these crisis accounts. Not only were the interpretations in dispute, but the facts were as well: “Even its starting date is unclear. Should we mark its beginning at the crest of the U.S. housing bubble in mid-2006, or with the liquidity crunch in the shadow banking system in late 2007, or with the bankruptcy filing of Lehman Brothers and the ‘breaking of the buck’ by the Reserve Primary Fund in September 2008?”
In our view, the crisis began in earnest 10 years ago this week. On August 9, 2007, BNP Paribas announced that, because their fund managers could not value the assets in three mutual funds, they were suspending redemptions. With a decade’s worth of hindsight, we view this as a propitious moment to review both the precursors and the start of the worst financial crisis since the Great Depression of the 1930s.
But, first things first: What is a financial crisis? In our view, the term refers to a sudden, unanticipated shift from a reasonably healthy equilibrium—characterized by highly liquid financial markets, low risk premia, easily available credit, and low asset price volatility—to a very unhealthy one with precisely the opposite features. We use the term “equilibrium” to reflect a persistent state of financial conditions and note that—as was the case for Humpty Dumpty—it is easy to shift from a good financial state to a bad one, but very difficult to shift back again.... Read More