Vermont, Texas, and Subprime Loans

The Wall Street Journal has a story about Vermont and subprime loans:

…For the past five years, as home loans went to even Americans with poor credit and no proof of steady work, Ms. Todd couldn’t get a mortgage in spite of her good credit and low debt. Vermont banks told the self-employed landscaper that her income stream was unreliable. The 32-year-old changed careers, taking a permanent job as a teacher, to boost her chances.

Vermont’s strict mortgage-lending laws largely prevented the state’s residents from signing the types of dubious home loans written in other markets across the country. Its 1990s legislation made mortgage lenders warn customers when their rates were relatively high, and put the brokers who arranged loans on the hook if their customers defaulted. Now, by at least one measure, the state has the lowest foreclosure rate in the U.S…

These tendencies help explain how, in the 1990s, the state moved to rein in mortgage lenders based on just a few instances its chief regulator says raised red flags. According to Vermont’s Department of Banking, Insurance, Securities and Health Care Administration, one broker solicited customers through newspaper classified ads, charging up to $5,000 for referring customers to a lender. Another searched property records for owners’ tax liens, a town clerk reported, searching for what the department believes were people who could be desperate to borrow….

In laws passed between 1996 and 1998, Vermont required lenders to tell consumers when their rates were substantially higher than competitors’, with notices printed on “a colored sheet of paper, chartreuse or passion pink.” And in what officials believe is the first state law of its kind, Vermont declared that mortgage brokers’ fiduciary responsibility was to borrowers, not lenders. This left Vermont brokers partly on the hook for loans gone sour…

Vermonters didn’t see the same sharp rise in home ownership that swept much of America in recent decades, which, despite the bust, buoyed economic growth. And while part of the increase in U.S. home ownership reflected excesses in lending and borrowing, some of it represented real progress in the form of more Americans achieving the cherished goal of getting — and keeping — a home of their own. By 2007, the percentage of owner-occupied households as a whole reached 68.1%, up from 63.9% in 1990, according to U.S. Census data. Vermont started at a higher base but saw ownership rise just 1.1 percentage points in that span, to 73.7%.

Daniel Indiviglio follows up it with an in-depth comparison to Florida, while Tim Duy goes through the article and ends with this fantastic note: “according to the article, the ‘pitfalls’ amount to: Informed consumers, fewer foreclosures, healthier banks, higher rates of homeownership, and virtually no impact on average growth. Those are some ‘pitfalls’ – truly, greater consumer financial protection would spell ruin for us all.” Ha!

Two additional things:

Prepayment Penalties To go back to an old soapbox of mine, it’s worth noting that Vermont has outlawed prepayment penalties. Why is this important? My own thoughts, and the research is finding this as well, is that “lenders designed subprime mortgages as bridge-financing to the borrower over short horizons for mutual benefit from house price appreciation…Subprime mortgages were meant to be rolled over and each time the horizon deliberately kept short to limit the lenderís exposure to high-risk borrowers.” The prepayment penalty is what made these bad-faith loans profitable to the lenders, and with house prices increasing, prepayment penalties allowed lenders to bet directly on this housing appreciation.

To put it a different way, banks, instead of underwriting borrowers, were betting that house prices would increase, and paying consumers to sit in the houses. The fees and prepayment penalties were the payout that made this bet profitable (with that consumer getting what’s left over in housing appreciation). Banks don’t normally bet on house prices – they have exposures, but they are secondary exposures related to recoveries and risks – they bet on consumers. Getting rid of these prepayment penalties keeps them from taking that side bets. It also helps markets actually do their job, by allow borrowers to shop between outfits and products while reducing this transaction cost – and allow the innovation of interest rate risk management to make things a little easier for the consumer.

Texas Like Vermont, Texas has some of the strictest mortgage regulations on the books. No prepayment penalties, no balloon mortgages, etc., and as a result of the Homestead Act of 1839 and subsequent laws strict rules on Home Equity Loans (pdf).

I mentioned earlier in the year, that these consumer protection laws may have played a major role in keeping Texas from having a major housing bubble. I did not know at the time that there was a study at the Dallas Federal Reserve, Why Texas Feels Less Subprime Stress than U.S., that also came to the same conclusion:

Due to the state’s strong predatory lending laws and restrictions on mortgage equity withdrawals, a smaller share of Texas’ subprime loans involve cash-out refinancing, which reduces homeowner equity and makes default more likely when mortgage payments become unaffordable….

State data on subprime mortgage delinquencies suggest that housing prices and local economic factors are still the primary drivers of subprime default rates. Even so, mortgage characteristics also matter—from the incidence of ARMs to the purpose for which the loan was taken out. In general, cash-out refinancing loans are more prone to delinquency than loans for outright purchases.

Recent tightening of credit standards in the mortgage market has put a lid on the growth of subprime and exotic mortgages. Nevertheless, a sharply deteriorating economy, weak home sales and a continued downward trend in housing prices suggest that delinquencies and foreclosures will continue at a high level.

I find it very ironic that places like the AEI are using Texas as the role model for The Way States Should Conduct Themselves in the future, which is by association bootstrap-tugging laissez-faire financial capitalism. The research produced at the Dallas’ Federal Reserve, by economists on the ground, points out the exact opposite – consumer protection is a major reason why Texas isn’t Arizona or California or Florida. Consumer protection allows a baseline of financial safety, a net where the work of building our real economy can take place.

43 responses to “Vermont, Texas, and Subprime Loans

  1. “Ms. Todd couldn’t get a mortgage in spite of her good credit and low debt. …. The 32-year-old changed careers, taking a permanent job as a teacher, to boost her chances.”

    And you think this is a good thing?

    No prepayment penalty fees? If you think that to set up the client so as to be able to collect a prepayment penalty fees was what the banks did a priori you sure got a conspiratorial mind that has gone berserk.

    In Europe for instance, if you finance yourself at a fixed rate, you have to pay a penalty rates for prepayment if rates go down for the simple reason that on the other side of this debtor is an investor who accepted to commit his money at a fix rate and who runs the risk of losing big if rates go up.

    I am all for good regulations but not just for the sake of putting in place regulations. The burden of proof should always be on the regulation not on the market.

  2. I never, in my wildest imagination, considered the possibility that Texas would pass legislation to intefere with a get rich quick scheme. Good job, Texas

  3. Mike,

    You and I have gone round before on the impact of the mortgage regulations in Texas. As I pointed out in April, the regulations you cited apply to a specific type of loan known as a Section 32 loan. Here is the link to that post. http://www.butthenwhat.com/?p=3308.

    I agree with your point that the restrictions in Texas on cash out refis as well as home equity loans probably helped stave off some of the bubble effects but one might also posit that Texans didn’t jump into cashout refinancing because housing prices didn’t appreciate wildly in the state. Simply, they didn’t have the equity to borrow.

    And just to close the circle here, I continue to be puzzled by your antipathy towards prepayment penalties. Once again you and I had an exchange http://www.butthenwhat.com/?p=4783.

    In that post I noted that prepayment penalties tended to be the norm in most of the OECD countries and most of them turned in better performances in their mortgage markets than did we.

    Here was my concluding paragraph.

    Sorry, Mike, but I just don’t see how the facts fit your theory. Heck, prepayment penalties might be in borrowers’ best interest. Think about it. They deliver lower rates, discourage the use of homes as piggy banks and slow down the churning of property. Not all bad.

  4. donthelibertariandemocrat

    For Texas, you also have to consider the relative absence of land use regulations. My own view, also now advocated by Richard Thaler, is to increase the down payment as home prices rise relative to other goods. There should always be a 20% minimum down payment.

    If we want to encourage home ownership for the less fortunate, we should provide their down payment, and be clear that the person has a real shot to pay off the remainder of the loan. However, John Hempton has just posted this interesting view:

    http://brontecapital.blogspot.com/2009/08/modelling-fannie-mae-and-freddie-mac_19.html

    “The losses (even after all losses are booked) come from primarily outside the traditional business of guaranteeing small well-secured and documented mortgages.

    Traditional GSE business (guaranteeing lower value mortgages with reasonable terms on full documentation and with a down-payment) was very effective at raising home-ownership rates whereas modern subprime lending, it seems, just caused a blip in home-ownership rates that corrected with much pain.”

    I simply prefer cash transfers to guarantees.

  5. It is confusing to me how economically literate analyses such as this report of a good wsj article can then suddenly go doolalley on the matter of prepayment penalties.
    Banks in the US lend money on houses at fixed rates for 15 or more years. If they don’t ‘match fund’ those loans with liabilities of equal maturity/duration, then they are “borrowing short and lending long” which as any fule kno was the cause for example of the great thrift crisis of 1989/90 (and of many other similar disasters).
    So in order to be able to lend for a 15 year fixed rate period, they have to also have fixed rate liabilities of 15 years (or equivalent hedges). So what happens if the borrower prepays? Gosh! Those durned 15 year liabilities are still owed by the bank!
    If the bank is not to risk losing a large sum of money, it has to have a hedge against the prepay so as to be able to buy out those 15 year liabilities. The get this hedge through the prepay penalty. If there is no such penalty, the borrower is having their cake and eating it too –and the bank goes bust, as so many thrifts did in 1989/90 (whether from maturity mismatch, or failure to hedge prepayment risk). Now, those thrifts were condemned for taking reckless risks. Yet your post seems to be demanding that banks should now take exactly those risks, and to be calling banks who (entirely appropriately) hedge those risks (through prepayment penalties) ‘predatory’. How clueless is that? Are you really that dumb? –the rest of your post implies that you aren’t, but it’s hard to tell given the weirdness of your claim.
    Look here: consumers can’t have it both ways. They can’t borrow fixed for 15 years and then expect their to be no cost if they prepay. There always is a cost: it’s just a question of who pays that. The individual (that’s capitalism) –or the bank (that’s socialism). I think we all know which works best? THERe’S NO SUCH THING AS A FREE LUNCH –SOMEONE HAS TO PAY THE COST OF THE HEDGE

  6. These are the same reasons why Canada avoided a housing bubble.

  7. I do not see it.

    Please explain why if the consumer pays it is capitalism and if the banks pays it is socialism.

    Just making a statement does not convince anyone.

    Show us why the statement is true.

  8. I feel like I’ve been transported back in time to when all the blame was put on the “subprime crisis.”

    —————-

    A few days back on this blog there was even doubt expressed that consumer protection could have any macroeconomic effect.

  9. Any bank that borrows 15 year [or more] money to support a mortgage is nuts. The duration of a mortgage is much shorter: about 5 years taking into account all the probable cash flows associated with the loan. One of those cash flows is pre-payment risk. So if my bank is matching against the duration of its mortgage portfolio it is taking into account pre-payments already: it shouldn’t need to charge an extra fee on top of its asset and liability strategy.

    Banks would be dumb to match individual loans: isn’t that the whole idea behind a portfolio – to look at assets across a large number of loans and calibrate against expected averages? If so product pricing includes an assessment of the risks involved in running such a portfolio.

    Adding all sorts of fees for specific events such as pre-payment is simply a way to double up on extracting a reward for undertaking that risk. Of course you could unbundle all such pricing and then charge against a menu of events, but then you would have to reduce the raw interest rate too.

    You can’t have it both ways.

    Finally: banks are in the business of intermediation. They borrow short and lend long. It is their biggest source of profit and their biggest risk. All the fancy ‘risk mitigation’ stuff of the past twenty years was supposed to eliminate/manage that risk. What I don’t get is this: banks make profits by taking duration and other risks. If you eliminate/manage those risks away why do you still make a profit. Haven’t you removed your reason for being?

    The fact that banks still make enormous profits after all the hedging and so on tells me either that they failed to eliminate the risk, or that they are doubling up on pricing.

    Which is it? Maybe both?

    What am I missing?

  10. I can’t believe there are people out there that take the time to write blogs and still don’t know this was not a “subprime” problem. Generally speaking it affected mortgages of all types.

    The problem was and is the lose monetary policy of the Fed. All that cheap money is bound to find a place to be spent. You can have all the “consumer protection laws” you want, but you’re still not going to plug all the holes. If it weren’t real estate it would have been something else. How bout turning off the spigot rather than trying to plug all the holes?

    Generally speaking the hardest hit were markets highly speculative (California, Florida) or had a poor underlying local economy(Michigan). The Fed’s lose money is likely to find its way to the most speculative markets. The markets most desirable and/or in limited supply. In general Texas is neither.

    Texas has several things going for it, most of which can be attributed to conservative fiscal policy. No state income tax and pro business tax policy. Texas created more jobs in 2008 than all the other 49 states combined. Texas is a right to work state which makes the labor market dynamic and flexible. Even if you find a union in Texas it is still relatively pro business. The Texas constitution requires a balanced budget each year so draining entitlement programs are few and far between. Texas has a $6.7 billion Rainy Day Fund responsibly put aside in times of boom. The Texas economy is diversified and strong. So Texas is not like Michigan.

    Texas is not like California or Florida because well… there aren’t that many speculative markets. Neither highly desirable or in limited supply.

    I say not highly desirable reluctantly because I’ve enjoyed living here most of my life, save for a 3 year stint in Europe. I’ve been to most highly desirable market in the US and I get it. I do however live in Austin and put it right up there with any place in the World.

    More importantly than the limited desirability is Texas is just huge. You can go to just about any potentially speculative market and have acres of open land within a few miles. Why pay a “bubble price” for a home when you can get a new home a mile down the road. More than anything this kept housing prices sane.

    Texas was both somewhat lucky to come out relatively unscathed due to its sheer size but economically strong mostly due to its small government and hands off economic policy. Texas is really the polar opposite of California. I think there is a lesson to be learned there.

  11. I believe all lessons from Texas boil down to 4 words: “Don’t mess with Texas.”

  12. Ryan: I don’t think there is any claim that the Great Recession is caused by subprime. Clearly the dynamics are much more complex and global (since other countries also experienced the same problems – like Spain and Ireland). But in the US arguably the worst of the mortgage lending excesses occurred in subprime and it made the bubble much worse than it would otherwise have been.

  13. I tend to think the observation of lower growth in home ownership in Vermont may not be useful. The higher overall level of home ownership in Vermont would likely create diminishing returns on growth that at least partial explain the disparity.

    Mike,
    Great Post.

  14. winstongator

    Most of the subprime loans with prepayment penalties were NOT fixed-rate loans. The 2-28, most pernicious, was sold as something you could refi out of, and since home prices always go up, the prepayment penalties would come out of the appraisal and not the borrower’s pocket. Focusing on the interest rate risk inherent in FRMs, while ignoring the reality that was the subprime ARM is either intentionally misleading or completely missing the elephant in the room.

  15. winstongator

    Have you ever talked to anyone who has been involved in a property crash related to oil or who saw the aftermath of the S&L crisis?

  16. I remember having had a mortgage offer that included the penalty free right to prepayment against a very slightly higher interest
    - it was then your bet whether interest would go below 6.25 % or rise – no matter what I would bet I would have my 30 year guarantee lasting the whole mortgage duration – that was 30 years ago though – maybe the Volksbanken are up to scratch now ;-)
    (down-payment was 30 % though which could be fiddled around with for the price of being really short on cash for the next ten years or so unless your career took off of course)

  17. Plugging holes makes it harder and thus creates jobs for clerks – not just on the “regulator-side” but by my guess just as many or more? on the “free-market” side
    … as every one knows who wanted to save taxes by filing a maximised travel expense account

    - I used to call that job like many others my fairy tale telling hour and I swear I always stayed strictly within the law and all the rules and regulations but still made sure my bosses came away with a nice little profit on their expenses

    I know that makes me a traitor to socialism but one has to have one’s professional pride to keep intact also

  18. The Texas laws are consistent with sound underwriting.

    Too many creditors(and the rating agencies) being asleep at the wheel was the primary contributor to the sub prime mess.

  19. So Vermont and Texas demonstrate consumer protection, in mortgage products, is a net benefit to the state economy.

  20. Yes. I think this is a good thing.

    In a world with risk-averse people who really hate banking panics, financial system crises, it sounds like a good deal. To avoid direct costs to taxpayers in the hundreds of billions of dollars (I repeat: hundreds of billions of dollars), this sounds reasonable.

    All in favour, say “Aye!”

  21. “So Vermont and Texas demonstrate consumer protection, in mortgage products, is a net benefit to the state economy.”

    Not at all! If what you want is to minimize the damage in the crisis that might be but if you want to maximize the net gain to the economy you have to measure the whole boom-bust cycle.

    If you just worry about the hangover… you might never go to the party… the important question to answer is … was the party worth the hangover?

  22. Canada did not avoid a housing bubble because it restricted prepayment fees. There’s good analysis of the Canadian situation that’s come out of the IMF this spring and summer, including

    - the Article IV (May 2009) http://www.imf.org/external/pubs/ft/scr/2009/cr09162.pdf

    - “Canadian Residential Mortgage Markets: Boring But Effective?” (June 2009) http://www.imf.org/external/pubs/ft/wp/2009/wp09130.pdf

    - “Why Are Canadian Banks More Resilient?” (July 2009) http://www.imf.org/external/pubs/ft/wp/2009/wp09152.pdf

    Bottom Line:

    Canada had a much smaller housing bubble and much less of a liquidity crisis. There has been no bail out of banks or near-banks. The financial sector, although stressed, was the least affected among the G7.

    A big factor seems to be a much more conservative mortgage market.
    - Less than 3 percent of Canadian mortgages are subprime and less than 30 percent of mortgages are securitized (compared with about 15 percent and 60 percent respectively in the United States prior to the crisis).
    - Mortgages with a loan-to-value ratio of more than 80 percent need to be insured for the whole amount (rather than the portion above 80 percent as in the United States).
    - Mortgages with a loan-to-value ratio of more than 95 percent cannot be underwritten by federally-regulated depository institutions.
    - To qualify for mortgage insurance, mortgage debt service-to-income ratio should usually not exceed 32 percent and total debt service 40 percent of gross household income.
    - Few fixed-rate mortgages have a contract term longer than five years.
    - Mortgage interest in Canada is NOT tax-deductable.
    - Prepayment penalties in Canadian mortgages are the norm.

  23. And Britain’s sub-prime crisis is neatly explained in the video embedded here http://learningfromdogs.com/2009/08/15/sub-prime-crisis/

  24. All caps at the end? Really?

    Yes, to extend winstongator’s point, if I understand some Federal Documents correctly, 98% of fixed rate loans do not have a prepayment penalty; is that socialism? Most subprime loans, with (high) floating rates, do; is that fascism?

    As for compensation for negative convexity risk inherit in financial fixed-rate loans (or callable bonds more generally), I’d say we should be careful about abusing the term “hedge” vis-a-vie prepayment penalties. If I take out a fixed-rate loan, and the interest rate rises, and I prepay it because of exogenous factors (my health, my job, etc.), I believe (it’s been a while) you’ve turned a profit, or regardless the negative convexity issue hasn’t been touched.

    But I still pay the full penalty! This may be semantics, but if I pay the penalty regardless of whether or not you take a hit vis-a-vie convexity, we should call it a fee. And the neat thing about fees is that they can be estimated and sliced up. Why not take the expected fee on a portfolio of loans, transform it in a fixed rate, and add it onto the fixed rate? Isn’t that why we pay all that money to the finance sector, to figure out these things?

    That and pacr already wrote my other follow-up point re: duration matching. Great comments!

  25. Vermont’s restriction on prepayment penalty only applies to Vermont licensed lenders. Much to the annoyance of the State, lenders who fall under federally chartered licenses were exempt from the Vermont restriction. Many subprime lenders had the federal exemption.

    Vermont’s smallness with its population of 600,000 is what kept it civil. Too small for out-of-state lenders to put much emphasis on marketing to Vermonters. In rural areas, the loan sizes were also too small for West Coast lenders to bother with.

    And, the State is so small, that borrowers, Realtors and local lenders have some connection to one another. You do right by your neighbor.

  26. “If you just worry about the hangover… you might never go to the party… the important question to answer is … was the party worth the hangover?”

    I guess it depends who you are. If the partygoers cause billions of dollars in damages that they don’t have to pay for, and kill thousands in DWIs while not dying themselves, the answer would be yes – for those invited to the party.

    Your theory, such as it is, presumes that there is no way to tell beforehand how much harm the party might cause and no costs that can’t be undone.

  27. all that applies to Iceland also and they have only 300.000 but went berserk anyway

    maybe Vermonters pride themselves of swimming against the stream or some other minor quirk that saved them?

  28. that’s not how I understood it – I understand the question was the party worth the hangover as a good question to induce forward looking for remedies while in order to find them you have of course to analyse where the party did all its little wrong turns.

    because isn’t there the dilemma that with only steady-go innovation*) will not get into any market real as well as financial? – so you have to have a certain hyping and there is always the risk that that hyping gets highjacked by criminal reckless good for nothing or takes in inexplicable ways off by itself – but without the hyping there is maybe a stable but also very stale society who is not necessarily more just.

    therefore I think keeping things in check has to be balanced against letting things take a ride – the art is to stop the ride at the right moment (Greenspan claims you can’t), create beforehand conditions which make it impossible for the gamblers to find a wedge (needs quite superhuman skills which I have never seen in almost 50 years of clerking) or just look on and let the thing run its course (the bill for which is usually paid by the “normal” human)

    - now after the bust has happened I think it is right to ask the question was the party worth the hangover or should we put in brakes here and there and maybe over there also to make it harder for the next ride to get out of hand and

    by all means one way or another have a great idea how to ease the pain of the “normal” human

    In case I have expressed myself badly I’ve taken my whole “wisdom” here from keenly observing fashion manias (and participating in some)

    *) I keep reading “new innovation” – ought to be interesting to find out what that is going to be or already is

  29. The mortgage bubble had little if anything to do with banks managing lending risk. Don’t forget that all the mortgages were securitized. Banks simply bundled them up for sale to insurance companies, pension funds, hedge funds. The idea was to create a financial product you could sell at an immediate profit in a low interest environment where pooled capital was desperate for a return. In hindsight it seems ridiculous that anyone bought these CMOs for 105%, but don’t forget they were rated AAA.

    Since securitization is probably here to stay, the net result of increased consumer protection is likely to be higher interest rates on home mortgages. All these bank practices now viewed as predatory also produced the considerately low rates which fueled demand and helped generate rising home values. Homeowners living within their means did quite well for quite a while in this game, but when the music stopped those without chairs came down hard.

    With essentially infinite fiat money bubbles are a fact of life. All that money has to settle somewhere; it jumps from one asset class to another, rewards those invested in the right vehicle at the right time, punishes those who buy at the wrong price. Why didn’t we bail out those who bought Applied Materials at 256 in 2000? The bailout is the problem here, not so much the mortgage bubble.

  30. For the time being the only thing the regulators are looking at is to avoid defaults and that is why they set up capital requirements for banks that are exclusively based on the risk of default of clients as measured by the credit rating agencies… and they even missed on that. But, the purpose of our financial system has to be more than just avoiding a default, for that a mattress might do.

    And so, for years now, I have been arguing that if we absolutely have to keep this Basel method we should at least demand that the minimum capital requirement for the banks be calculated using a matrix with on one axis some better defined risk of default weights and on the other axis “societal purpose” weights. Why should bank finance “riskless” but useless or even dangerous projects for the society and not worthier projects even though they carry more risk?

  31. i think it was old legislation. and several years ago we got rid of the homesteading exemption. i guess it was more luck than any thing else as we hadn’t made all those changes earlier we would have been in the same boat as the others

  32. banks were not the main writers of the mortgages, that was the mortgage companies and brokers, who would write notes knowing they were going to sell them before they could go bad while they were still on the hook for them. our problems were started here, and helped out by the rating agencies selling a rating (if if was from the right company it got aaa without any trouble, or research), and the housing inspectors were too much into needing more sales with real estate to rein over stating prices. securitization has been around a long time, but it was used to assist in creating this mess

  33. no the main reason we didn’t have as big a bubble is we don’t have that high an income level to make bubbles work well. we have some of the same perspective that Florida has (pro business and no income tax), we just have less income to make blow up the bubble, and we sure don’t have any land that has much in the way of high desirability factors

  34. i think that the observations in Vermont certainly refute most claims about consumer protection. while the growth of home ownership was slower, it seems they will be longer lasting (after all they are at 70+%, while the rest of us are falling back to 63%). in this case the slower growth is more reliable. almost sounds like the tortoise and the hare doesn’t it? and the turtle one then too.

  35. “nay”

  36. We’re still working on ways of getting Vermont to borrow from the IMF.

  37. and we sure don’t have any land that has much in the way of high desirability factors

    …or housing for that matter.

  38. Didn’t Texas already have its real estate bubble and crash back in the 80s?

  39. induce Vermonters to start a flirt with the Russians offering an air base or whatever – that their finances are more solid than Icelands wouldn’t matter a bit they would be “saved”

  40. “Vermont’s strict mortgage-lending laws…made mortgage lenders warn customers when their rates were relatively high”

    This reminds me of something I mused about with Nick Lowe in a long conversation in the comments section of his blog with Stephen Gorden, Worthwhile Canadian Initiative (at: http://worthwhile.typepad.com/worthwhile_canadian_initi/2008/12/the-bank-of-canada-should-peg-the-tse-300-revisited.html?cid=143783570#comment-6a00d83451688169e2010536a789dc970c):

    Me: Let me offer, however, a much less radical idea that could be nonetheless effective at decreasing bubbles and busts in asset markets, and that is a warning system, like with cigarettes, based on the current market P/E ratio. Research has shown the market P/E ratio, in its various forms (10 year inflation adjusted, cyclical adjustments, depreciation adjustments, etc.) to be highly correlated with bubbles and busts, and with subsequent risk-adjusted returns, and this makes great sense as investors own the earnings. And, they by and large get those earnings, about half from dividends and half from ownership of real assets purchased with the earnings.

    If brokerages simply were required to issue a prominent warning, verbally and/or in writing, on the dangers of investing in the stock market when the market P/E hit a certain level, say 35, I think, if done right, prominently enough, and promoted well by the government, this could really discourage laypeople from investing in the stock market during strong bubbles.

    I teach one of the largest personal finance courses in the U.S. at the University of Arizona, and am president of one of the largest personal finance education companies, and I can tell you few of my students understood P-E ratios before I taught it, or much about the market at all. I think a good prominent warning system could be very effective.

    It could be color coded, something like white when between 15 and 25, orange when 25 to 35 and red when over 35, with a strong warning of the dangers of investing with a market P/E that high (the exact numbers would depend on which form of the P/E ratio was used). On the other end of the scale, it could be light blue when 7 to 15 and dark blue when under 7; there you would have a warning against selling, and not hanging on, if feasible, for what look to be high long run returns.

    Every purchase or sale would feature the color code prominently on the computer screen, in writing, etc., with appropriate warnings, before the transaction was finally agreed to. In addition, advertising on TV and in print would support the warning system’s awareness and attention. Likewise, I’d like to see a warning given regarding the dangers of not diversifying every time someone purchased an individual stock, or a fund concentrated in just one sector.

    Nick: Your own proposal is more sensible (though not as exciting theoretically ;-) ). Sort of like an official financial tsunami warning!

  41. teach people to use pencil and paper and only the calculation apparatus in their brain before they say yes to embarking on an investment – make them stubbornly insist on that method and that method alone that if it can’t be understood with just these tools they will keep away
    - the seller might loose patience while you do it that way though and dismiss you as a hopeless imbecile because it is in the short cuts which superior minds effortlessly and elegantly navigate that the hitches/risks/pitfalls are conceiled

  42. Yeah, drive by oil prices.

    http://en.wikipedia.org/wiki/File:Oil_Prices_1861_2007.svg

    You see the 80s? That $20/barrel oil bankrupted a lot of people who had developed in the previous ten years.

    The Savings and Loan Crisis began when Texas banks failed after losing money in real estate.

    It’s a good thing that we’ve never seen a nationwide decline in housing prices. Something bad like that might have secondary effects on the stability of banking.

  43. Not a bad idea your warning system… maybe you could outsource it to the Fed. Now that said, even though perhaps the whole market’s average P/E might tell you something the individual P/E does not because 35 could just be pointing a tremendous growth potential, that you would not want to miss out on even if the P/E was 70 while the P/E of 7 could just be indicative of the stock going nowhere.

    What is most important, at the end of the day, is that any investor understands what he is doing, does what seems to be in accordance with his circumstances and keeps some capability to manage when things do not turn out as expected… in other words brokers have to truly care about their clients without isolating them too much from the risk that generates returns. Hard walking? Indeed!

    If you go to http://www.gao.gov/new.items/d03734.pdf you will find “U. S. General Accounting Office: International Financial Crisis … Challenges Remain in IMF’s ability to Anticipate, Prevent, and Resolve Financial Crises.”

    In it you will read such extraordinary things as:

    “During the 1991–2001 forecast periods, 134 recessions occurred in all 87 emerging market countries. We found that the WEO (World Economic Outlook – the IMF report) correctly forecasted only 15, or 11 percent, of those recessions, while predicting an increase in GDP in the other 119 actual recessions.”

    “Our analysis for the 87 emerging countries shows that, for more than 75 percent of the countries, the WEO current account forecasts were less accurate than if the Fund had simply assumed that the next year’s current account would be the same as this year’s. The results are even more dramatic for G7 countries: a forecast of no change was a better predictor than the WEO forecast for six of the seven countries. This demonstrates that, even in stable economies with excellent data, the WEO has done a poor job of forecasting this key crisis anticipation variable.”

    “Internal assessment of the Fund’s EWS (Early Warning System) models shows that they are weak predictors of actual crisis. The models’ most significant limitation is that they have high false-alarm rates. In about 80 percent of the cases where a crisis was predicted over the next 24 months, no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.”

    So let us keep our expectancies of the accurateness of any alarm system low. Anyhow… Good Luck!