Unsafe Lending Logic

Yesterday's prepared remarks and Q&A by Alan Greenspan before the House Finance Committee were widely reported by various news agencies and blogs - some excellent commentary and a complete list of links can be found in this post on Mark Thoma's blog.

The big story, if there was one, was the reiteration that it is not the job of the Federal Reserve to influence asset prices through monetary or regulatory policy - stocks five years ago, housing today, and whatever asset class inflates next. As has been heard many times before, asset price bubbles are difficult to identify before they have popped, and it is possible that "pricking" a suspected asset bubble may result in more damage than would be caused by the bursting of the bubble.

In a written response (pdf) to questions posed by Rep. Jim Saxton (R., N.J.), chairman of the Joint Economic Committee of Congress, it was explained this way:

Bank regulatory policies are neither designed nor used to influence asset prices in particular sectors of the economy. Rather, their purpose is to ensure adequate bank risk management and thereby strengthen the safety and soundness of individual banking firms, foster a resilient banking system and protect FDIC-insured deposits.
...
The regulatory system is not designed to influence or control asset bubbles, but rather to ensure that bubbles, should they develop, do not lead to unsafe lending practices.

Is anyone else perplexed by this logic? If a bubble develops, it is the job of the Fed to ensure that unsafe lending practices do not follow...

As this relates to the recent guidelines about home equity lending, this implies that to ensure the stability of the banking system, if a housing bubble exists, then it is the Fed's job to ensure that unsafe loans are not made as a result of the housing bubble. In other words it is OK for someone to pay $600,000 for that California home that would have fetched $300,000 four years ago, but if the guy who has been living next door during those four years wants to borrow against his equity, then we have to be careful.

We pause to note the minor point that were it not for the existence of the housing bubble, very few home equity loans would have been made in recent years - safe, unsafe, or otherwise. But, that point aside, the more relevant oddity here is that these unsafe home equity loans bear a striking resemblance to the presumably safe loans that begat the housing bubble - interest only, no documentation, high debt to value ratios, etc.

In response to a subsequent question, this is offered:

As I indicated in my testimony, there does not appear to be a "bubble" in home prices for the nation as a whole, but there are signs of "froth" in some local markets where home prices seem to have risen to unsustainable levels. It is not clear whether lending practices have contributed to these local conditions. After all, the mortgage market is national in scope, while rapid price increases have been in particular areas.

How can it not be clear that lending practices have contributed to the local conditions? Interest-only loans in California, no doc loans, size of first time homebuyer down payment, pick your favorite statistic - when only 10 percent of the population can afford to buy the median price home using conventional lending standards and prices continue to rise, it's a pretty safe bet that lending practices are involved.

And, that last statement - can the logic get any more twisted?

Stated another way, if lending practices were responsible for the rapid rise in real estate prices, we'd have housing bubbles in 100% of the country instead of just 60% of the country, as reported earlier this week by Merrill Lynch.

That sounds like unsafe lending logic!