Bernanke's "Market Failure"


Federal Reserve Chair Ben Bernanke gave a big speech on the financial crisis today, in which he identified the roots of the problem as carefree home lending by bubble-fattened financial institutions to owners who couldn't really afford their own houses:

[T]he current housing crisis is the culmination of a large boom and bust in house prices and residential construction that began earlier in this decade.  Home sales and single-family housing starts held unusually steady through the 2001 recession and then rose dramatically over the subsequent four years.  National indexes of home prices accelerated significantly over that period, with prices in some metropolitan areas more than doubling over the first half of the decade.  One unfortunate consequence of the rapid increases in house prices was that providers of mortgage credit came to view their loans as well-secured by the rising values of their collateral and thus paid less attention to borrowers' ability to repay. However, no real or financial asset can provide an above-normal market return indefinitely, and houses are no exception.  When home-price appreciation began to slow in many areas, the consequences of weak underwriting, such as little or no documentation and low required down payments, became apparent.  Delinquency rates for subprime mortgages–especially those with adjustable interest rates–began to climb steeply around the middle of 2006.  When house prices were rising, higher-risk borrowers who were struggling to make their payments could refinance into more-affordable mortgages.  But refinancing became increasingly difficult as many of these households found that they had accumulated little, if any, housing equity.  Moreover, lenders tightened standards on higher-risk mortgages as secondary markets for those loans ceased to function.

So, how to deal with this mess? Provide more home lending by bubble-chastened financial institutions to owners who really can't afford their own houses!

At the macro level, the Federal Reserve has taken a number of steps, beginning with the easing of monetary policy.  To the extent that more accommodative monetary policies make credit conditions easier and incomes higher than they otherwise would have been, they support the housing market. […]

The Federal Reserve supported the actions by the Federal Housing Finance Agency (FHFA) and the Treasury to put the housing-related government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, into conservatorship, thereby stabilizing a critical source of mortgage credit.  The Federal Reserve has also recently announced that it will purchase up to $100 billion of the debt issued by Fannie Mae, Freddie Mac, and the Federal Home Loan Banks and up to $500 billion in mortgage-backed securities issued by the GSEs. […]

Yet another promising proposal for foreclosure prevention would have the government purchase delinquent or at-risk mortgages in bulk and then refinance them into the H4H or another FHA program.

Bernanke's logic is that housing prices just affect the economy too damned much, and so need to be artificially propped up for the economy to rebound. I don't agree with that, partly because I think the long-term consquences will create new destructive bubbles, but I did find Bernanke's description of "market failure" more interesting than most:

[A]necdotal evidence suggests that some foreclosures are continuing to occur even in cases in which the narrow economic interests of the lender would appear to be better served through modification of the mortgage.  This apparent market failure owes in part to the widespread practice of securitizing mortgages, which typically results in their being put into the hands of third-party servicers rather than those of a single owner or lender.  The rules under which servicers operate do not always provide them with clear guidance or the appropriate incentives to undertake economically sensible modifications.  The problem is exacerbated because some modifications may benefit some tranches of the securities more than others, raising the risk of investor lawsuits.  More generally, the sheer volume of delinquent loans has overwhelmed the capacity of many servicers, including portfolio lenders, to undertake effective modifications.

Whole Bernanke speech here. Tim Cavanaugh on Henry Paulson's definition of "market failure" here.