Suppose Bankers Had Modeled A Severe Home Price Collapse During The Bubble

Suppose bankers did model a 40 percent home price decline. The banks would realize that repackaging and securitizing mortgages was too risky to do. They would also realize that a regular mortgage was also too risky because the collateral, the house, could lose 40 percent of its value. As a cushion, they would want another 10 percent on top and require every house buyer in the US to put 50 percent down to buy a house. Plus, if they did not package and sell the loans, the banks would quickly run out of funds to lend. Not only would subprime and Alt-A loans stop, all mortgage lending would just about come to a halt.

What happens then? No homebuyers. No construction industry. Almost no one can sell a home. Home prices collapse to levels below or the same as current levels. People panic, become afraid and angry at the banks for their irresponsible lack of lending and high down payment requirement. People save a lot of money (to buy a home, out of fear about the economy) instead of spending it. Recession and maybe a depression happen.

Extreme risk aversion is bad for the economy. Banks make loans and take risks. If banks do not take risk, they do not make loans. If you want banks to avoid risk, that means borrowers have to reduce their riskiness by putting up more cash and collateral or not taking out loans and increasing their indebtedness.

If banks do not sell the loans, they quickly run out of cash to lend.

I think we were in a damn if I do, damn if I do not situation with housing.

What we needed was (1) a way for the banks to slightly increase their risk avoidance (no very high loan to value mortgages, no teaser rates, no bad credit or inability to repay mortgages) and (2) for the government to simultaneous lower house price appreciation, lower demand for mortgages and lower demand for new or different homes. Lowering housing demand would have to be done without creating fear and anxiety in the consumer about the future and without creating high unemployment and a recession. I think if the government or the Fed tried to do (2), they ran a real risk of creating a slow economy and a recession similar to our current plight.

I do not think there was an easy way. There were no gentle ways. Once the housing ball started rolling and home prices appreciated dramatically, stopping housing would hurt the consumer and the economy and send it into a recession.

I posted an almost identical comment as the above to Megan McCardle's piece on The Atlantic website, "Jamie Dimon Says They Didn't Model Massive House Price Collapse."