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How to Prevent the Next Crisis

As this is being written, the financial and economic crisis rages on. While progress has been made in quelling the panic in the financial system, it remains far from normal and the global economic downturn remains intense. The global economy will likely continue to shrink in 2009; the last time that occurred was during World War II. The subprime financial shock thus continues to reverberate.

Policymakers understandably have had little room to consider how to ensure that something like this never happens again. The crisis hit its apex when the Bush presidency was winding down and the Obama presidency was getting off the ground. Both were very short- staffed at a time when an army of policymakers would have had an impossible time keeping up with events. But after the panic subsides and the crisis is quelled—and it will—policymakers must quickly refocus their attention to preventing the next crisis.

What follows is four of the most pressing of my “top ten” list of what I believe needs to be done:

Reinstate the Uptick Rule

The downdraft in stock prices, particularly for financial institutions, has been dizzying. Much lower stock prices for these companies are surely justified, given the near-collapse of the financial system and the subsequent infusion of taxpayer capital, but there is a justifiable (albeit difficult-to-prove) concern that stock prices have been manipulated lower by short-sellers. Short-sellers borrow stock and sell it with the intent of buying back the stock in the future at a lower price. With financial stocks so vulnerable in this crisis, short-sellers often at least implicitly teamed up, borrowing and selling the stock and driving prices ever lower. Rumors—some perhaps true, but many that weren’t—often swirled as financial stocks were barraged by short-selling.

The uptick rule is an attempt to throw a bit of sand into a short-selling frenzy. With this rule, a short seller would be able to sell the stock only at a price above the price at which the immediately preceding sale was effected, or at the last sale price, if it is higher than the last different price. This rule had been in place since the Great Depression, when Joseph Kennedy, the first SEC commissioner instituted it; it was dropped in summer 2007, just about the time financial stock prices began heading south.

Expand Data Collection

A lack of timely and accurate information hobbled policymakers’ ability to respond to the subprime financial shock. Data on mortgage delinquencies and defaults comes from a variety of mostly private sources, making it nearly impossible for regulators or others to see the crisis as it grew. No government agency tracks the number of mortgage foreclosures, for example, and the various private sources of such information are limited in various ways.

A ready mechanism for expanding the government’s data collection already exists under the data-collection efforts required by the Home Mortgage Disclosure Act. HMDA requires most mortgage originators to report some information on all loan applications and approvals. This includes data on the lender, location, income, and ethnicity of the borrower; whether the loan is a first or second lien; whether it is a purchase loan or refinancing; and the loan’s amount and interest rate. More frequent updates and more rapid reporting would help policymakers and lenders spot credit quality problems earlier and allow them to respond better to developing problems.

Reform the Foreclosure Process

The current mortgage foreclosure system is a complex mélange of laws and rules that varies substantially from state to state. The foreclosure process generally entails three steps: first a loan default, no more than six months after the first missed loan payment; then a foreclosure auction; and finally a sale of the property by the bank. The average time between the first and last steps ranges from about 7 months in Virginia to 20 months in New York City.

The federal government streamlined the bankruptcy code in 2005 to make it more uniform across states, and it should do the same for foreclosures. A federal foreclosure system would substantially reduce the cost of the foreclosure process, be more equitable to borrowers and lenders, and allow for the more accurate collection of data and information.

A federal foreclosure process should standardize the time between a mortgage loan default and an auction. One year would be reasonable because that is approximately the median current length of time among states. A year would be sufficient to give borrowers who have hit hard times—perhaps because of unemployment or illness—a meaningful opportunity to work with their lenders and turn things around. It also allows lenders to foreclose within a reasonable time if borrowers are unable or unwilling to meet their obligations.

Invest in Financial Literacy

Americans aren’t as smart about money as we should be. Financial illiteracy was a fundamental cause of the subprime financial shock. Yes, many people knowingly stretched to buy an expensive home with a subprime ARM loan, figuring they could either sell quickly at a profit or refinance before the payment reset hit. But many more barely understood what they were getting into. According to Federal Reserve surveys done before the subprime shock, almost half of lower-income home buyers (mostly subprime) couldn’t describe basic features of their mortgage, such as how their interest rate was determined or whether it was capped. Many trusted their brokers to get them a mortgage they could afford, believing it was the broker’s responsibility to look after their financial interests.

The nation’s general financial illiteracy contributes to a wide range of poor decisions on borrowing, saving, and investing. This might have been less dangerous 10 or 25 years ago, when there were fewer financial products to choose from and it was harder to make a financially catastrophic mistake. But ignorance of the basics is certainly perilous today.

Some of the mortgage options presented to home buyers during the housing boom were mind-numbingly complex and confusing; even an economist adept at manipulating spreadsheets would have had trouble calculating future payments on an interest-only or “option” ARM loan.

It is both bizarre and tragic that American high schools today are more likely to offer students cooking classes than personal finance courses. Such courses should be required—period. A meaningful investment in the financial acumen of young people would pay enormous dividends by reducing the likelihood that future households will take out bad mortgages or not save adequately for retirement.

Excerpted from Financial Shock (Updated Edition): Global Panic and Government Bailouts– How We Got Here and What Must Be Done to Fix It (FT Press, May 2009). Mark Zandi is chief economist and co-founder of Moody’s Economy.com, Inc.

Tags: downturn, economy, financial crisis