Transcript of Question & Answer Session Future Directions in Financial Stability Analysis: Learning from Others, Learning from the Past

Totally ignoring Ian’s warning earlier about seeking simple explicit explanations for events, what’s the simple explicit explanation for that picture in what was it 06 or something? That one yeah, yeah.

Well it was over building beyond the actual requirements of population growth. They had an enormous building boom and if you just looked at the flow of building you wouldn’t have worked it out because you also needed to know how much sort of housing they had, what their income growth was, what their population growth was. But bottom line, there was also a building boom, an enormous building boom as well as, partly enabled by a huge easing in lending standards.

But it’s the suddenness that makes me want to find an explicit clear explanation for it, a Brady explanation. Did anything happen there at …

That was when the spigot …

First started at the end of 03 and they started to finish too long term rates a little bit later, this was their conundrum that Greenspan had and so I was [inaudible].

But essentially that was about when subprime and other mortgage default rates started rising, so basically that building boom had been enabled and that increasing rate of household formation had been enabled by a huge easing in lending standards. And the reason it became so problematic was because they actually managed to build up the oversupply, so you had a kind of an undershoot in housing prices, not just a reversion to where they’d been before.

In his book that he published in the spring Tim Geithner, in his chapter on Leaning against the Wind he makes the following observation: he says that there were economist teams at the New York Fed that were doing various scenarios analysis and they were looking into what would happen if there was a 20 per cent default rate on mortgages. And then they drew the conclusion that this was a containable risk and not something that needed to be of great concern. And pretty much everybody shared that view so a lot of what happened there was a lack of appreciation of how a small loss can escalate into and balloon into a huge crisis. So I was wondering what you take is on that and whether you would like to see more research on that question?

Well essentially stress testing, can we do better with stress testing, absolutely. It’s a very rich and growing field, part of the problem with stress testing is you’re asking a model to say something about a range of data beyond where it’s actually been estimated over, I mean certainly in Australia, have we seen a 25 or 30 per cent fall in housing prices? No we haven’t, we don’t really know and we know that they’re important non-linearities. I have to say Timothy Geithner’s book is another of those things I have not yet had time to read, however (I mean the pile is just getting crazy). There’s so much good stuff coming out, however I think one of my observations about what the US authorities were thinking at the time, is they really were focussed on the subprime piece, and what a lot of people didn’t realise even if you just look at the graph, the same data source, subprime and prime together, but you don’t plot them on the same scale – you give them their own scales – the turning point was exactly the same, and I have to say one of the crowning achievements of my career was the BIS Annual Report of 2007, where I demanded that we put “and other”, when we started talking about you had subprime mortgage defaults, and I said “no subprime and other, you’ve got to put and other, it’s not just subprime”. And it’s there in black and white in the BIS 2007 Annual Report that came out in the June of that year and I’m going to claim that one, because it was me who insisted on those two words were, probably the best thing I’ve ever done. But yeah if you were overly focussed on the subprime market you missed what was actually going on, in fact a lot of what was happening was sort of outside the subprime but also outside the Fanny Freddie piece, it was the Alt-A, the jumbos, the IO loans and yeah people just, they thought it was contained to subprime but it was actually much deeper than that.

After sharing with us your thoughts about the mess in the US. What can you say about the success in countries like Australia and Canada?

I don’t want to sort of get drawn into who’s worked things better, I think another way of thinking about it is actually most countries didn’t have a mortgage meltdown and particularly countries where most of the lending is done by prudentially supervised agencies. You actually do get better … historically you’ve gotten better results and I think that’s certainly part of it. Prudentially supervised banks can still get themselves into trouble but it’s more often to do with commercial real estate and corporate lending than it is mortgages, and I think that’s something a lot of people in recent years have forgotten and it’s something I’m quite worried that people are looking in all the wrong places.

Okay one there, and one there and then we’ll have to stop.

So we were sort of looking at the crisis, but I guess we’ve now had in the North Atlantic at least five years of depression and no end to it, and the chronically depressed economy also seems to raise different problems obviously (a) what to do about it but (b) how that interacts when outstanding debt is a big part of the problem, how all that interacts. Is there anything interesting being done on how you deal with financial stability in a chronically depressed economy?

Well I think my main comment there is it turns out that the old models that everyone teaches at undergraduate school turned out to be a pretty reasonable way of thinking about it and that standard macroeconomic policy has the effects that we learnt about in undergraduate school.

A picture like yours can be more useful than a model or it speaks very well. I saw one recently which compares Australia with other countries, banks in Australia about two thirds of its lending is for property. Where in other countries like Germany, Switzerland it’s only about one third, doesn’t that show an imbalance in Australia about the housing lending takes place?

It’s a common misconception, I think it does tell you how difficult it is to assume that cross country averages tell you something about imbalances. Yes, a lot of the lending that the banking system in Australia does is mortgages and that does mean that merely because of its size – as we said this in the financial system inquiry submission that we made – housing can pose a systemic risk merely because of its size even though it’s not particularly risky, but consider the alternative things that banks could get involved in, and German and Swiss banks were not lending in housing because they were lending to US housing through RMBS, they were lending to shipping companies, they were lending to hedge funds. I think I know which imbalance I’d rather pick.