Why did subprime mortgage borrowers make the choices they did, even when in many cases their decisions made them worse off than they were to begin with? To answer this question we need to take a closer look at how people determine what is most in line with their self-interest — and how they fail.

Self-Interest Can Be Led Astray

We continually draw on the process of detecting patterns and making order from chaos when we are trying to figure out which choices are in line with our self-interest. In order to choose effectively, we ask ourselves — consciously or subconsciously — How does it look? We’re usually pretty accurate, but there are some systematic ways in which our ability to determine what’s true might fail us, which can have dire consequences. Our pattern-detection abilities are just as good at finding apparent patterns in purely random events as they are at finding actual patterns. These tendencies can also lead us astray when the true pattern is more complex than we realize.

We also consult our emotions from the very beginning, asking ourselves, How does it feel? We use the information we collected in the former process as a backdrop for assessing our feelings about options confronting us and their potential outcomes, and we make the choice that we feel will have the most positive consequences. But as with pattern detection, there are some systematic ways in which consulting our emotions can lead to error. It’s easier to feel the present consequences of a choice than its future ones, so we give greater weight to the former. However, decisions based on present desires may not be well suited to our modern world, where the ultimate goal is to be as satisfied with the long term as possible.

Buying Into the Illusion

So what kind of patterns and feelings were people detecting when they looked at the costs and benefits of owning a house?

Owning a home had traditionally been seen as a safe investment for the average person, almost guaranteed not to lose value over time. Indeed, the inflation-adjusted average home price had stayed almost constant at $110,000 (in today’s dollars) between the end of World War II and 1997. At that point a new pattern emerged, with prices nearly doubling to about $200,000 between 1997 and 2006 due to a perfect storm of demand-increasing factors: low interest rates, the creation of new financial products based on mortgage income and aggressive lending practices to name just a few. Many local markets grew even faster, especially those in California, New York and Florida.

Seeing this dramatic and consistent growth convinced people that this was a truth about the world — that prices would continue to rise in the future. A nationwide survey conducted by Fannie Mae in 2004 found that 70 percent of Americans considered buying a home to be a safe investment, nearly double the percentage that considered a 401(k) retirement plan to be a safe investment.

Combined with the more immediate and tangible benefits that purchasing a home offers, real estate began to look like an amazing investment. People buying a home to live in for years to come were afraid that if they didn’t act immediately their dream home would become dramatically more expensive, while speculators saw a golden opportunity to get rich quickly. They rushed to enter the market as quickly as possible, driving prices still higher.

But while the upward trend in housing prices could have been consistent with a pattern of constant increases in the future, or moving toward a new and permanently higher plateau, it could have been equally consistent with another pattern that is more variable and difficult to recognize: boom and bust, or a “bubble.” In a bubble situation people feed off one another’s enthusiasm, pushing prices far higher than the true value of the assets in question. Eventually it becomes clear that they’re overvalued, at which point the bubble pops as everyone rushes to sell their assets.

Our pattern-detection abilities and feelings can serve as a powerful source of information about the subtleties and complexities of the world around us, but once we’ve come to see a particular pattern we subconsciously want it to be right. It feels better to think that we’ve unlocked the mysteries of the universe and of the future, and when the pattern promises wealth or other forms of success, as in the case of the subprime market, it’s even more tempting to believe in.

Sheena Iyengar, the S. T. Lee Professor of Business, is the author of The Art of Choosing (Twelve, March 2010), which was published this month. Watch a video interview with Professor Iyengar about the book.

Photo credit: The Truth About Mortgage

	The shot that saved the High Line: a view of the elevated tracks before restoration.

Robert Hammond, vagabond artist and High Line visionary, begins with a photo: a grass-covered railway, 30 feet above the fray, careens up the west side and disappears into the cityscape, like a strip of Central Park cutting through Gotham. The picture matters because this whole elevated-railway-turned-public-park idea was difficult to visualize back in 2001, but the photo offers a glimpse. Hammond calls it “the shot that saved the High Line.”

Next up is John Alschuler, adjunct professor at Columbia’s Graduate School of Architecture, Planning and Preservation and chairman of Friends of the High Line. The High Line, Alschuler explains, is one and a half miles of elevated railway that extends from the city’s Meatpacking District to Hell’s Kitchen, a corridor whose proximity to river and railyards made it America’s most important manufacturing hub in the mid-1900s. All goods coming to or leaving New York eventually found their way onto the line, so to say that the High Line facilitated New York’s rise to industrial superpower is not hyperbole.

So there’s that. And there’s the photo. The combination of the two made for a compelling case to save the High Line. “We saw the chance to create a world-class urban amenity,” Hammond explains. “one that would appeal to a New Yorker’s sense of history and design and reinvigorate this historically rich but blighted edge of the island.”

Eight years of fundraising, planning and politicking later, that vision has been realized. The High Line, now beautified by glass and grass and public art, has become the unique park promenade that Hammond envisioned back in 2001. Per the plan, a new West Chelsea has taken shape around it.

	Robert Hammond shows the route of the High Line in an aerial view.

The transfer of air rights, a city planning mechanism that helped persuade naysayers and NIMBYs by increasing property values, allowed the neighborhood around the High Line to go vertical. This planning change coincided with the development boom of 2005, and the combined effect has been sudden and striking. The Standard Hotel, Frank Gehry’s IAC headquarters and countless other design-in-mind projects (one resembles plume of locomotive smoke) now stand as symbols of the new West Chelsea — no longer a dodgy enclave of abandoned warehouses, but the preferred address of athletes and actors, Nike and Google.

Of course there is criticism — too expensive, too narrow, too modern. And sure, in the wake the real estate collapse, appreciating these expensive (and mostly empty) towers requires a little suspension of disbelief. But walking the line for the first time on a late summer Saturday, it’s evident that something positive has happened here. While the critics are busy being critical, the rest of New York is enjoying their new park: a family walks their dog, a couple watches the sunset over the Hudson, a singer strums “Mr. Tambourine Man”. Let’s remember: five years ago this was an abandoned, blighted eyesore.

Hammond’s hope for the High Line is simple: he wants it to be a place New Yorkers — not tourists — go to and enjoy. He may get his wish: It certainly won’t photograph as well as Times Square, it won’t inspire people like Top of the Rock or offer the solace of Central Park. But it will be a great place to stroll on a Saturday, to appreciate New York’s past and present and enjoy sunsets and Bob Dylan covers — a great park, 30 feet above the fray.

Photo credits: Joel Sternfeld and Kirill Babikov

“How do we make decisions under uncertainty?” Professor Wei Jiang posed the question to an audience of students last week during orientation. The question not only referred to the lecture’s topic — the financial crisis — but was offered as a framing device for students as they begin core classes in the MBA program this week.

“This will be the most important skill you can develop,” she said.

A new orientation module focused on the financial crisis was created this year to give new students an overview of the causes and issues of the crisis and provide key questions that connect it with upcoming courses in the core. In her lecture, Jiang considered different aspects of the crisis including international policy, behavioral bias, compensation structure, government regulation and risk models.

The module is part of a larger initiative by the School to use the financial crisis as a vehicle to foster integrative thinking in business training. Another element of that initiative is the creation of a new cross-discipline class, which will launch in Spring 2010, on the future of financial services. During the past summer term, former chief legal officer of Lehman Brothers, Thomas Russo, taught a half-term course looking at the crisis.

“Look ahead as well as look around you,” Jiang told students at the end of her lecture. “Think in terms of tradeoffs and equilibrium.”

Photo courtesy of Columbia Business School

Despite the jolt of market optimism after the Dow jumped above 9,000 for the first time since January last month, there are less hopeful economic indicators all around.

In New York City, one of the most apparent is empty storefronts. The New York Times reported that the city’s vacancy rate was 6.5% overall and more than 15% in parts of midtown Manhattan. In a citizen-journalism project, the city’s public radio station WNYC has asked its listeners to add their own indicators (more crowded campgrounds, overgrown highway signage, the height of cargo containers in Port Elizabeth).

Elsewhere, another canary: the Better Business Bureau of Chicago reported a steep increase in complaints about payday loan operators. From March 2007 through March 2008, five complaints were filed. From March 2008 to March 2009 this increased to 30 complaints filed.

In a recent column for Slate, Professor Ray Fisman questioned why people take out these kinds of loans that have an APR in the ballpark of 400 percent. Are they desperate or do they not understand the loan’s terms? He cited research that found that “borrowers who were given a chart explaining the three-month cost of carrying a payday loan were 10 percent less likely to take a loan during subsequent months. Among those who did take additional loans, the total amount borrowed averaged around $195, as compared with $235 for the control group.” In other words, financial literacy is a small factor — but for many borrowers, the need for fast cash is too great to be deterred.

	What unusual economic indicators have you noticed? Please leave a comment.

At the macro level, Professor Paul Glasserman pointed us to the VIX volatility index as an economic indicator. “It is a forward-looking measure of volatility in the stock market,” he said. “High volatility is often accompanied by negative returns. From 2004 through the middle of 2007, the VIX stayed below 20%. In the fall of 2008, it jumped to over 80%. It’s been generally declining since and is currently around 24%. A drop below 20% would be a symbolically important event.”

Some good news however: economic indicators are not necessarily mood indicators. Professor Jonathan Levav directed our attention to the research of Princeton economists Daniel Kahneman and Alan B. Krueger and their research on income and happiness. In a 2006 article in Science, they wrote, “People with above-average income are relatively satisfied with their lives but are barely happier than others in moment-to-moment experience, tend to be more tense, and do not spend more time in particularly enjoyable activities.”

Photo credit: Andrew Dallos

The Obama Administration released a public report (PDF) earlier this week that said only 9 percent of eligible home loans have been modified under the government’s Making Home Affordable program and named the loan-servicing companies they say have not modified any loans.

Is the public outing a fair or effective way to urge more companies to modify loans? Professor Chris Mayer spoke on Marketplace Radio (listen to the story) on August 4 and said a better way would be to work through the investors. He said:

Well I think the idea of sort of a public outing is not my favorite way to conduct government. You know, these are complicated programs and the government hasn’t made it easy to participate all the time. But no, I don’t think it’s fair to call people out. I prefer other methods. … My sort of preferred approach would be to work with investors to get rid of the servicers who are being ineffective at this.

Should the government publically out home lenders that it says isn’t doing enough to help homeowners?

Photo credit: Meghann Marco

This post is part of a special series celebrating the School’s Alumni Forever Week (March 30 through April 2).

Profile
Robert Klein ’04
Vice President, MJC Associates LLC

Tell us about your career path
Prior to business school, I was at Goldman Sachs in Fixed Income Derivatives and Private Wealth Management. Upon graduation I worked at Reckson Associates Realty Corp. When Reckson was acquired by SL Green, I left and helped start a boutique investment bank focused on the real estate sector, MJC Associates LLC, and I have been there ever since. Last year we completed our largest deal, which was $1.7 billion.

Looking back at your CBS experience, what was your aha! moment?
Taking Real Estate Finance with Larry Raiman ’89 in 2003 was where I got my first exposure to real estate finance. He was a phenomenal teacher and I spent a lot of time with him, outside of class, discussing my thoughts on real estate. Leanne Lachman, who is an executive in residence, really helped me shape and define my career goals. Her guidance in conjunction with the rest of my experiences at the School gave me the framework and connections to execute my plan. It’s important to learn about real estate and to know about real estate companies, but it is crucial to have professors and faculty, such as Larry and Leanne, available to help you network.

As a business practitioner, where do you see opportunity this year?
There are a few places for opportunity. In the distressed side of the world, there are an abundance of companies with liquidity issues ranging from the capital structure of the companies all the way down to the performance of individual assets. The opportunity is to creatively match capital and distressed product. There is a lot of phantom capital right now and they key is knowing how to align yourself with real capital.

What advice do you have for MBA or prospective MBA students?
My advice, especially for folks in real estate or looking to get into it: be creative and really put yourself out there and meet as many people as possible. Jobs are few and far between, and because many firms are not using traditional sources of hiring, you have to be creative and figure out a way you can add value to a person or organization. You can’t rely on having an MBA to secure a position in this market. Your networking skills are crucial, and if you opitmize your student experience, it will define and separate you.

Photo courtesy of Robert Klein

The New York Times (and others) reported on Tuesday that Morgan Stanley’s real estate man in Shanghai has come under investigation for giving gifts and cash to government officials in order to get in on choice deals in China, likely in violation of the U.S. Foreign Corrupt Practices Act (FCPA).

The Morgan Stanley head office has taken the view that this was the rogue act of a rogue individual, and an internal investigation revealed that “questionable activity was isolated to a discrete set of real estate transactions in China.” This is an unfortunate — yet all too common — reaction to revelations of corporate misdeeds.

Bribery and corruption are global problems that, at least from the perspective of countries like the U.S., remain safely hidden from view. Garth Peterson was a blue chip banker from a blue chip firm, yet anyone involved in land deals in China surely won't be surprised that he was involved in illicit payments to politicians and bureaucrats.

When evidence of pay-offs or favor-seeking surface in such organizations, many of which have explicit public anti-corruption stances, it is seen as a pathological deviation from the legal conduct of business.

Yet Peterson was most likely a typical banker put in a situation where bribe-paying was very literally the norm. Before its company-wide corruption scandal made global headlines, Siemens was an average company bidding on contracts in corrupt countries — rather than a corporation with a rotten culture.

Labeling individuals like Peterson or companies like Siemens as unprincipled exceptions shoves under the rug the deeper problem: informal rules that dictate global commerce. As long as the conversation focuses on catching deviants, we’ll never have an open dialog on changing the norms that bear much of the responsibility.

There is also the need for those higher up in the chain of command to accept responsibility. Local managers are often given conflicting messages. They’re rewarded first and foremost for making big bucks for the company. (It’s interesting to note that Peterson's monkey business only came to light after China’s real estate market went sour.) Of course, this directive may be accompanied by warnings to stay on the right side of laws like the FCPA and to adhere to a corporate code of conduct, but it’s often with a wink and a nudge. The message: do what you can within the confines of the law to maximize profits.

Yet given legal ambiguity combined with innate human ability to rationalize anything from stealing office pens to Enron-style fraud, it’s not surprising that expediency and the lure of promotion or profits rule the day.

What’s to be done? There are certainly efforts underway to change global business culture. One particularly noteworthy example is the Partnering Against Corruption Initiative (PACI) spearheaded by Mark Pieth and the World Economic Forum. PACI focuses specifically on changing the “cultural equilibrium” of business practice by attracting a large number of CEOs to sign on to a public declaration of personal anti-corruption pledge. Shifting the equilibrium will be a difficult process; there will always be “rogue” corporations that are willing to undercut the honest conduct of business. Yet it’s hard to imagine we'll get very far in affecting change unless we can start with an honest conversation.

This article originally appeared on Forbes.com.

Photo credit: theCarol

“We are great risk of becoming over-dependent on a miracle solution,” Sam Zell cautioned students during his recent presentation at Columbia Business School. Referring to the current economic crisis as the first “Blackberry recession,” Zell warned against instant gratification and said the economic recovery could be slow and gradual.

Professor Lynne Sagalyn introduced Zell, who spoke about the economy and the real estate market on February 17 as part of the Silfen Leadership Series.

Though cautious, Zell did sound a note of optimism when he said that the real estate industry will recover more quickly than pundits suggest, and that equilibrium for the single-family home market could appear as soon as the summer.

“But before you ask where the opportunities are, you have to identify what your capital is worth. The biggest mistake anybody could make is to assume that his capital is worth the same today as it was a year ago or two years ago,” he said. “The reality is that it is worth two, three or four times more than it was as recently as 24 months ago.”

Zell said opportunity could be found in the debt-side of real estate and in geographic areas where demand is growing, citing locations as diverse as China, Brazil, Mexico and Egypt.

“Ultimately, profitability will come from the acquisition of assets at measurable discounts to replacement costs, whether it is in equities, real estate or any other area,” he said.

Photo credit: Leslye Smith

President Obama’s housing plan, which will take effect on March 4, is aimed at two groups of homeowners. The first group simply cannot afford to make their mortgage payments and are in acute danger of foreclosure. The second includes homeowners who are current on their payments but who are unable to refinance in the face of high interest rates due to their homes’ decreased value.

“The nightmare scenario is that this second group of homeowners will all start abandoning their houses,” says Professor Eric Johnson. “But behavioral economics suggests that won’t happen so easily.”

“We need to know one fact: how many people will abandon their houses when that property is underwater. Standard economics makes a clear prediction that when your house is underwater, and you owe more than it’s worth on the market and that amount is more than it costs to move, you will abandon the house and accept a foreclosure.”

“But there are two effects in behavioral economics that suggest that won’t happen so easily,” Johnson continues. “The first is the endowment effect. People tend to value their own house above its market price.” Johnson cites a 1997 study by Senior Vice Dean Chris Mayer and David Genesove of MIT that analyzed the Boston condo market in the early 1990s. The study showed that a homeowner’s equity position determined his or her experience as a seller. Those with a high loan-to-value ratio set a higher reservation price, causing the home to take longer to sell. “Owners don’t want to sell at a loss. They have what we call a loss aversion,” Johnson says.

“Secondly, people weight present outcomes more than long-term benefits. Imagine making a choice between staying where you are and moving somewhere else. That somewhere else might be nice, but what do you have to do to get there? You have to pack up, pay movers and learn a new neighborhood. All those are upfront costs, while the benefits are long-term. People are impatient and weight present costs and benefits more, so they will walk away less often than we might think.”

Photo credit: Eric Hackathorn

Professor Frederic Mishkin, a former member of the Board of Governors of the Federal Reserve System, met with students yesterday in a community forum to present his view of the current financial crisis. Framing his analysis in the historical context of the Great Depression, he said that many elements of the current crisis were “classic” and that they inspired a sense of “déjà vu.”

“The basic issue is that financial markets are the brain of the economy,” Mishkin told the students. “They are key to an economy functioning well because they help allocate capital to productive investments. But when financial systems stop working and they can no longer allocate capital, we see what is happening now.”

“A basic problem in allocating capital is asymmetric information … It’s an agency problem. What happened in this financial crisis, and in financial development, is new financial innovation, which in the long run is a very good thing,” he said. “The innovation was driven by a couple of features, technology and high-speed computers. This allowed you to do two things: cheaply bundle small loans into a security, so there were low transaction costs, and get information on people and their credit worthiness in a quantitative manner.”

“This allowed you to democratize credit and give credit to people who otherwise wouldn’t have gotten it, and then put those loans into a security and sell it off. A lot of people would like to see subprime lending never happen again but that would be a disaster. It is a real danger that regulation could kill off this market because it is something that, if it’s done right — which it easily can be — is a tremendous benefit to the average person who couldn’t access credit before.”

“But the problem is that sometimes you don’t solve all the information problems,” Mishkin continued. “Although there were all these benefits, maybe people didn’t have the right incentives to pay back [the loans] … Incentives were not aligned with those of the holder of the security.”

“We also had a huge flow of liquidity come in; poor countries were providing capital to rich countries, [like China to the United States],” he said. “As a result we had this global savings glut and huge inflows of liquidity. This, combined with the financial innovation, made the system go wild. Also what you see — and this is classic — is that when you have innovation and a burst of liquidity [together], you frequently have an asset bubble. And in this case it was in the real estate market.”

Photo credit: Randen Pederson

The housing market and growing number of foreclosures are placing an enormous strain on American households and the economy. There were more than 2.2 foreclosures started last year and house prices are in the worst decline since the Great Depression. Fixing these problems must be a priority for the next administration.

The government needs to take a two-pronged approach. The first part — stabilizing the housing market — is something I have discussed widely. In a plan developed with Dean Glenn Hubbard, I propose that the government allow new mortgages to be issued at a rate that is 1.6 percent above the rate of a 10-year Treasury bond. That new rate, which may be as low as 4 percent for conforming mortgages, will stabilize the housing market, provide a fiscal stimulus and raise housing demand.

The second part is preventing foreclosures, which I spoke about today in an interview with CNBC (watch video). My Columbia University colleagues Edward Morrison and Tomasz Piskorski and I have outlined a new proposal for reducing foreclosures. We propose a combination of an incentive fee program for service providers and a legislative initiative to modify servicing agreements.

Ours is a new approach that focuses on what has been the most intractable part of the foreclosure problem: the behavior of third-party servicers who manage portfolios of securitized portfolios. Recent research from Thomas Piskorski, Amit Seru and Vikrant Vig shows that third-party servicers opt for foreclosure much more often than banks that service their own loans.

The proposal eliminates the barriers that prevent these third-party servicers from better managing their portfolios. The first step is to create an incentive fee structure to make loan modification rewarding for both servicer and investor. Secondly, temporary legislation must remove explicit barriers for modifying PSAs and should create “litigation safe harbor” that insulates servicers, provided they modify loans in good faith for investors. We calculate that by taking these steps, up to one million foreclosures can be prevented at a modest cost of $10.7 billion to taxpayers.

The way to fund solutions on both these fronts is with TARP expenditures. If the new administration makes this a priority, they can facilitate economic recovery, reduce foreclosures and help struggling homeowners while protecting taxpayers.

As 2009 begins, the economic lessons learned during the financial crisis will quickly be put to the test. Participants in the recent research symposium, “Preventing the Next Financial Crisis: Lessons for a New Framework of Financial Market Stabilization,” which was hosted by the Sanford C. Bernstein & Co. Center for Leadership and Ethics, provided a look at some of the issues and trends that will shape the year ahead:

Monetary policy is still effective, said keynote speaker Professsor Frederic Mishkin. “I think it’s an absolute fallacy that monetary policy isn’t effective during a financial crisis. It’s just plain wrong.”

Bankruptcy should be an option, because it allows for speedy work outs, argued Professor David Skeel of the University of Pennsylvania Law School. “The problem is that if you address one form of moral hazard [with a bailout], you create another. With Bear Sterns the Fed addressed shareholders’ moral hazard, but [in doing so, it] created creditor moral hazard. That is why, I argue, firms like Lehman didn’t do a lot to try and change their balance sheets after the Bear Sterns collapse,” he said.

Regulatory process will undergo a major overhaul in 2009, said Dean Glenn Hubbard. Many panelists agreed that the systemic risk of trillion dollar markets, such as those for credit default swaps, is too great and that such instruments should be traded in regulated clearinghouse exchanges.

The price of homes must be bolstered, said Senior Vice Dean Chris Mayer, who, with Dean Hubbard, has designed a proposal to stabilize the housing market by guaranteeing a 4.5% interest rate for American homeowners. According to Mayer and Hubbard’s calculations, this would allow Americans to refinance their homes, yielding an average monthly savings of $350.

Financial literacy is poor amongst the poor. Data presented by Professor Stephan Meier about financial literacy showed that 30% of people with adjustable rate mortgages do not know that they have them. This percentage is fairly descriptive of all income groups, however Meier said that it is highest among the poorest.

In a December 17 op-ed in the Wall Street Journal, Senior Vice Dean Christopher Mayer and Dean Glenn Hubbard expressed their support of a U.S. Treasury plan to lower mortgage rates for new homebuyers to as low as 4.5%. The Treasury’s plan closely parallels Mayer and Hubbard’s own plan, which they unveiled in October. The op-ed follows Mayer’s presentation about mortgage rates and homeownership at the Bernstein Center research symposium, “Preventing the Next Financial Crisis,” on December 11.

In the op-ed, Mayer and Hubbard demonstrate the strong relationship between housing prices and mortgage rates and how lowering mortgage rates now will likely increase homeownership rates in 2009. They also argue that house prices are already at or below where they should be based on fundamentals (download research paper PDF).

They also address one of the main concerns swirling around the Treasury’s possible plan: its risk to lenders:

Some have argued that lenders should earn more than the average 1.6% spread, to compensate for the fact that housing is a much riskier investment today. We don't think so. Recall that a mortgage can be thought of as a risk-free bond plus two possibilities that increase risk to lenders: default and/or prepayment. Historically, the risk of default adds about 0.25% to the interest rate. The remaining spread of the mortgage rate over the Treasury yield represents the risk of prepayment and underwriting costs. With falling house prices, the risk of default could indeed add 0.75% or more for a newly underwritten and fully documented loan. But 4.5% would be the lowest mortgage rate in more than 30 years — so the additional risk to lenders of prepayment would be almost nil. And low mortgage rates would substantially reduce the risk of further house price declines.

Professor Charles Calomiris, speaking at the Bernstein Center symposium, supported Mayer’s plan, saying, “The incremental costs to the taxpayers are negative. The GSEs that we now own have $5 trillion of mortgage debt, $1.6 trillion is subprime with 10 times the current default rates of the normal remainder in that portfolio. We also have trillions of dollars of FSA mortgages and, of course, [the ones] in the private sector. If you look at expected losses on those subprime pieces, which are somewhere between 20 and 25% right now, that the effects of [Mayer’s] proposal would be to reduce taxpayer’s fiscal costs going forward.”

The Treasury is considering a plan that may lower mortgage rates to as low as 4.5 percent for people buying homes. Chairman of the Federal Reserve Ben Bernanke discussed the proposal on December 4 (read complete transcript). The plan, still in development, resembles a plan developed earlier this year by Senior Vice Dean Chris Mayer and Dean Glenn Hubbard (read more).

Prof. Mayer, interviewed in the New York Times on December 5, urged the government to consider extending the low rates to existing home owners in addition to new buyers.

"This really is the opportunity of a lifetime," [Mr. Mayer] said. "If you ask someone if this is the time to come into the market, I think anyone who would have bought a house in 2007 and was sitting on the sidelines, or who wants to buy this year or would buy in 2010, would want to take advantage of this."

Mr. Mayer said long-term Treasury rates are so low right now that the government could actually make a profit on the cheap loans. The Treasury can sell 10-year bonds right now and pay only 2.7 percent a year, far below the 4.5 percent that it would be charging home buyers.

But he said his own preference was to make the mortgages available to existing homeowners as well as home buyers.

"I think there are additional benefits one could have by extending the program for people who refinance," Mr. Mayer said. "At 4.5 percent, you might be looking at 25 million people who could refinance and the average savings could be $400 to $500 a month."

He also analyzed the plan on NPR’s All Things Considered on December 4 (listen to audio) and discussed how the move could bolster house prices. He said:

"My own research shows that as many as 1.5 million to 2.5 million people could come into the housing market if such a program were in place. That kind of influx of new home buyers pulls a lot of inventory off the market. That then stops the decline in house prices and eventually leads house prices to turn the other direction. That's an enormous first step in preventing foreclosures because the lower house prices go, the more people face pressure to walk away from their house."

 

That diet, at least elements of it, was at the core of a panel discussion with Dean Glenn Hubbard and professors Bruce Greenwald, Pierre Collin-Dufresne and Christopher Mayer.

“We still are in a period of substantial credit stringency,” said Hubbard in his opening remarks. “Financial institutions remain undercapitalized for normal activity.” [In a separate column published on Oct. 3 with Princeton's Alan Blinder, Hubbard suggests expanding the FDIC cap.]

Prof. Greenwald followed with a discussion of monetary policy’s role in the financial crisis with a ‘tale of two decades’. In the 1960s the changes in U.S. money supply were linked to subsequent growth in the nominal GDP. In the 1990s, reforms in monetary policy led to very little movement in the nominal GDP, while the money supply was extremely unstable.

“The real heart of this crisis is that the traditional means for recapitalizing these institutions have gone away,” Greenwald said. “The movement of interest rates down to 2% has had no effect, just as monetary policy has had very little effect for a long time. If you’re going to restabilize the economy, you have to have a direct means to recapitalize the banks.”

Greenwald came out in favor of the Treasury’s bailout plan, saying, “If you don’t want to be Japan in the 1990s, just give [the banks] the money. The return in terms of economic stimulus will far outweigh the cost of any financing they get.”

Prof. Dufresne, speaking next, pointed to the location and foundation — low interest rates, high demand, insufficient models, complex vehicles — of the risks in the 1990s as key factors in the current financial crisis. “This made exposure hard to measure,” he said.

Concurring with Greenwald, Dufresne said the solution to the crisis was in bank recapitalization. (watch video)

Prof. Mayer focused on the housing market’s role in the credit crisis. “As we look at the problem in the U.S.,” he said, “we need to think about how to stop the housing crisis.” Mayer and Dean Hubbard have proposed a much-discussed plan that would allow anyone with a primary residence mortgage to refinance at 5.25% on a 30-year-fixed rate loan. (listen to NPR audio about proposal)

Mayer closed his comments considering the coming year: “We’re going to have to re-create a new lending system in the future.”