Saturday, March 29, 2008

Gans and Housing

Unfortunately I can't link to Australian Financial Review stories but I thought I'd share this with my few loyal readers. The following was a letter submitted to the AFR Thursday that might I suppose still get a run.

The proposal by Joshua Gans and Christopher Joyce for the creation of an ‘AussieMac’ (“Home loans need an AussieMac” AFR 27 March) is based on the false assumption that mortgage lending is “as safe as houses”. The creation of a AAA rated credit pool to create competition in home lending makes sense if the asset, residential mortgages, really are that secure an investment.

The unfortunate reality is that house prices can be subject to price bubbles like any other asset. Once the bubble goes too far prices will fall, and frequently (or very frequently as now occurring in the US) the owner has negative equity, and the securitised mortgages contain more risk than ever envisioned. The problem with an AussieMac is that it compounds the problem by introducing moral hazard; no one really cares about the quality of the underlying loans if they are using Government guaranteed credit.

The way to stop bubbles is to increase the funding cost to acquire the asset, but in general raising interest rates is a very blunt instrument as it suppresses productive as well as speculative investment. If all housing finance was derived from deposit taking institutions one way to control housing price bubbles would be to reduce the 100% risk weighting given to residential mortgages in calculations of capital adequacy. This is not only effective, but logical, as it reflects the fact that prices now might not match prices in the future.

Securitised mortgages while increasing competition took away the effectiveness of the strategy. A Government backed securitised mortgage market may be worthwhile if it could also include a similar mechanism for dealing with housing price inflation.

Of course I'm jealous that Joshua got an invite to Australia 2020 - but I'm glad he is there, as is John Quiggin. A couple of economists who usually (not always) make sense. Meanwhile poor Malcolm Turnbull and the Liberals are relying on Henry Ergas for their economic advice. I guess he and Malcolm both know how to turn a quid from building and then selling advisory businesses - the search party is still out trying to locate Ergas' other expertise.

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