A Crash Course in Economics

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. 

I'm not the only soul
Who's accused of hit-and-run
Tire tracks all across your back
I can see you had your fun
But darlin' can't you see my signals
Turn from green to red?
And with you I can see a traffic jam
Straight up ahead!
- Jimi Hendrix 

A few years ago, I was driving in San Francisco when someone ran a red light, hitting me in the driver's side. Luckily, we both were uninjured, but this had become such an epidemic throughout the city that the mayor eventually took action.

After proclaiming that "too many people are running red lights," he decided to remove them. Yes, he just took them away!

If you've driven in a downtown area lately, you can imagine trying to treat every intersection as a four-way stop, which would slow movement to a crawl. So it's not hard to predict what happened next: people sped through intersections and accidents continued to rack up.

Given the tremendous number of people showing up in emergency rooms, the mayor decided to proclaim a special "commuters holiday" to "reduce traffic and the risk of injury" from commuting. Unfortunately, after the holiday ended the accidents resumed.

Finally, realizing the issue demanded more attention, the mayor reinstated the traffic light system but set all traffic lights to green so there wouldn't be any confusion from the distracting, blinking lights. As you might imagine, this did not help reduce the number of accidents either.

As I'm sure you've figured out by now, this story is fiction — an allegory for the mortgage market. The following, however, is true.

The mortgage market became overleveraged as both borrowers and lenders ran "red lights" and other warning signs when laying their financial well-being on the line.

The government then expanded (yes, expanded) the role of Fannie Mae and Freddie Mac as well as encouraged private sector lenders to increase their activity through many actions, including dropping interest rates dramatically. Accidents continued, unemployment rose and economic activity fell.

In response, the government turned its attention to 18 percent of the economy by focusing on a prolonged debate of healthcare reform. This is not exactly the same as removing stoplights from a large city, but it does seem to have had the same focus and effect on solving the problem. In any case, accidents continued, employment remained a problem and economic activity remained unstable.

The government also created several programs to help home-buyers who were supporting the housing market. The $8,000 first time home-buyer tax credit (as well as the "cash for clunkers program) smells a lot like the "commuter's holiday" mentioned in the story above.

Once that credit expired, accidents continued, employment remained a problem, and economic activity remained unstable.

Finally, Washington turned their sights toward the original cause of the problems: finance. But instead of zooming in on mortgage finance, where the original accident occurred, they enacted an enormous financial reform bill after purposely leaving mortgage reform out, to be debated another day. Reinstate the traffic lights, but set them to green.

Last week, confirmation that all these efforts were not working came in three forms:

1. Home prices declined by the largest margin since late 2008 when the liquidity crisis reached its zenith. As measured by Zillow.com, there was a 3 percent drop in home values during the first quarter which included a 1.1 percent drop in the month of March alone.
    
2. Fannie Mae asked for another $8.5 billion to cover losses. Though Freddie did not come hat in hand this quarter, the two together have pulled down a total of over $100 billion so far.
    
3. Rent rates are rising. As more people are converted from homeowners to renters, upward pressure heightens on this measure. The Market Tightness Index, which measures vacancies and rents, rose to a record level of 90. Any measure over 50 indicates upward price pressures exist.

Unfortunately, Washington has not received the message. Democrats and Republicans are gearing up to rein in Fannie and Freddie's activities after pushing them into a market-dominating position over the past few years. Now that they account for some 95 percent of new mortgage originations, it seems our government wants them to cut back — before there are other players to take their place and at a time when mortgages are far less than "easy." 

Forcing the players with 95 percent market share to cut back will reduce overall mortgage availability from where it is today. You don't have to read Ayn Rand to understand that. Instead, Washington should be addressing the problems faced by both borrowers and lenders.

Borrowers, in addition to the specter of potential unemployment, are having a difficult time securing a realistic mortgage at a realistic rate and LTV. This is likely directly due to the problems face by lenders.

Lenders face an incredible amount of uncertainty today. From Dodd-Frank implementation to Basil III, no banker today has a full understanding of capital and liquidity requirements they will face in a mere five years. They only know the reins are being pulled.

How can financial institutions be expected to pick up the slack for Fannie and Freddie under these circumstances?

Today, there are many negative forces working against economic activity. From extremely high unemployment to an uncertain inflation outlook, the economy is facing challenges it hasn't seen in a long time.

Lack of clarity in financial regulation is just one of these factors, but it is a factor that is manageable. The more unclear the rules of the road are, the more difficult it is for financial companies to navigate a route that promotes financial safety, profitability and at the same time, serves customers well.