It is impossible for me to find any commentary anywhere by anyone on the topic covered by William Lucy. Except my commentary. This makes it difficult to analyze, because I cannot benefit from the insights of others. The most frustrating part about this is that one would at least expect some one to debunk it. If anyone has seen any article discussing this study, I would appreciate it. Several newspapers did put it on their front page. Several real estate associations have also posted articles. But no one has analyzed its implications to my knowledge.

Maybe he and his graduate assistant at the University of Virgina forgot to add something. It would be as if a physicist published an experiment demonstrating that the speed of light can be breached, and no one bothers to even comment on it in passing. Here we are, supposedly, in the midst of the greatest financial crisis since the great depression.  Some academic then discloses that our perception of the crisis has been massively distorted by not understanding the difference between the market value of mortgage securities and the market value of the housing collateral which backs it. Further, the academic declares the decline in the value of the collateral itself (housing) has also been massively exaggerated and extremely localized. And no one comments?

There must be a reason this study is ignored The William Lucy Study. Look at my links to the right under Commentary and Economics. I look at these frequently and another dozen or so. The economists in particular are academics who have tended to also be involved in policy. They all comment on the crisis.  Much is discussed. What is not discussed is "how much was/is the financial system really at risk due to the housing crisis"? The answer to this question impacts our judgment of the actions taken by the Bush and now Obama administrations.

My theory for the study's invisibility is its potential for massive embarrassment for the economics profession and to our regulators. It was released toward the end of February of 2009. If they could debunk it, I am sure they would have. William Lucy is not an economist. He is a 69 year old professor of architecture who has written many books on urban and ex-urban planning. How could an architect figure out something they did not? Because, as Hayek often commented, economists tend to obsess with aggregates, often missing and ignoring the local knowledge which is critical to time and place.

As someone who has studied the specifics of urban and suburban formation, Lucy may have been in a better position to see the obvious, as he was not blinded by "mark to market securities". Regardless, the information contained within the study is there for all to see. If Lucy is even approximately correct, it means the regulators, i.e., Treasury Secretary Paulson, New York Fed president (now Treasury Secretary) Geithner, and Federal Reserve chairman Bernanke were lost in a fog of "mark to market" and never bothered to question what it meant. This lead them to take action which accelerated a panic which could have been mitigated. This is unacceptable.

Since no one else wants to critique Lucy's study, let me put forth one possible criticism. While one can multiply Lucy's estimations of losses by a factor of 4 or 5 and have all my following points still hold, let me state one possible error in his analysis. It is theoretically possible he took averages to calculate losses, even at the local level, when it is the case there should be adverse selection bias as to which mortgages will default. That is, it should be the case that the highest leveraged creditors are the ones most likely to default, where he might have assumed that everyone is equally likely to default. I raise this because I could not determine how this may have effected his numbers. Lucy implicitly raises this very issue when he discusses his methodology and believes he has effectively accounted for this potential phenomenon. So he clearly understands the complexity of the issue. This is all the more reason to be frustrated that there has been no commentary by economists.

This could be why, when I did my analysis last Fall, my number of potential "true losses" was 4 times higher than his. I am not saying he made this error, I am only saying I could not determine it one way or the other. Having said that, this is irrelevant to my conclusions. People like NYU's Roubini created estimates of losses up to $3.5 trillion, which is clearly off the wall. The point is these numbers were knowable then by the regulators. Given that banks had already written off more than $500 billion by last September, they would have already accounted for the high end of the estimation. Mark Zandi of Moody's had come to a similar conclusion last Fall as well. It does not matter if the losses were/are/will be Lucy's $145 billion or mine of $500-$600 billion. These were already accounted for and written off before the bailouts occurred.

SOME KEY OBSERVATIONS BY LUCY

Here are some remarkable statements (highlights are mine):

"National housing price declines and foreclosures have not been as severe as some analyses have indicated, and they are not as important as financial manipulations in bringing on the global recession. Most foreclosures have been concentrated in California, Florida, Nevada, and Arizona, and a modest number of metropolitan counties in other states. In fact, 66 percent of potential housing losses in 2008 and subsequent years may be in California, with another 21 percent in Florida, Nevada, and Arizona, for a total of 87 percent of national declines in these four states"

"California was vulnerable to foreclosures, because the median value of owner-occupied housing in 2007 was 8.3 times median family income, while the 2007 national average was only  3.2, and in 2000 it was lower still at 2.4"

"Potential housing value losses from 2008 foreclosures in 50 states, if values decline to year 2000 levels, were less than one-third of the $350 billion that has been provided to banks and insurance companies to cope with losses in mortgage backed securities"

Lucy did not state this, but the latest OFHEO data shows home prices at just under 50% higher than 2000 levels, nationally. Think about that for a second.

"Housing price corrections in a few states and a modest number of counties and metropolitan areas contributed to a national and international financial crisis. The spatial pattern of these foreclosures has received little attention, even though manipulations by financial institutions broadened localized foreclosure problems into an international financial crisis which has begun a global recession".

"Foreclosure rates were low in most states in 2008. In three-fourths (38) of the 50 states, foreclosure rates were below 0.50 percent (1 in 200). In one-half of the states (25), foreclosure rates were below 0.25 percent (1 in 400). And in 11 states, foreclosure rates were below 0.10 percent (1 in 1,000).The extreme skewing of foreclosure rates has economic, political, business, and public policy implications. The economic implication is that the origins of the foreclosure crisis were geographically limited, even though the financial crisis has spread worldwide"

"Announcements of foreclosure increases during 2007 and 2008 tended to be exaggerated..... National and international financial systems are extremely fragile if they are stressed to the breaking point by a moderate foreclosure rate with foreclosures concentrated in a few states"

Lucy is also critical of the always quoted Case-Shiller index which contributes to the exaggeration. As an index, it is what it is, and is radically misunderstood. It decidedly is not the best measure of house value trends. Foreclosed houses have constituted half the houses in the Case-Shiller index for the "big four" states. It does not measure, apartments, new houses, or condominiums. Since 7 of 20 of its measured areas are in the high foreclosure states, they are overstating national housing declines. The Case-Shiller index is a "capital weighted repeat sales index". These kinds of indexes can be viewed as "trend biased". Other points by Lucy are:

"One benefit of foreclosures concentrated in a few states is that price declines are rapidly reducing the house value to income imbalances that fed the foreclosure crisis. Housing in these high price markets is becoming more affordable. The National Association of Realtors compiles an existing single family affordability index that includes median prices and median family income. It showed a 2007 affordability index value of 111.8 followed by an average January through September 2008 index value of 127.9, a considerable improvement.  If maintained, the 2008 affordability index would show housing affordable to more families than in any year since 2003".

Lucy's study is far more academically precise than what I wrote during September and October. But a large percent of these same points were made by me in these three essays; California Dreamin?; Where is Cool Hand Luke When You Need Him?; and And the Darkest Hour is Just Before Dawn. I raise this because it means anyone with an internet connection could have seen this last summer. It is remarkably irresponsible that these issues have not been stressed, as they are at the core of the failure of Paulson's and Geithner's policies.

SO, WHERE HAVE THESE LOSSES COME FROM?

So if housing prices drop to levels in 2000, which are currently 50% higher than in 2000, Lucy estimates actual realized losses will be about $145 billion. Since housing prices have not declined to these levels, why have the bank's stated losses been so high?  Lucy believes it comes from mispricing mortgage backed securities. Some more quotes from the Lucy study follow:

"The absence of a market blocked the federal government from establishing a value for many MBSs backed by delinquent and foreclosed mortgages. But an estimate of the cost of buying these mortgages, if they can be separated from MBSs, is possible. Data in this study for housing values relative to family income can be used. Or, as an alternative, housing values relative to household income could be used."

Lucy's insight is that the creation of large quantities of mortgage backed securities limited the ability of mortgage servicers to renegotiate mortgage terms. This, of course, was well known and commented on. Think of these securities as the equivalent of a mine field. 99% of the field is clear, but every once in a while someone steps on a mine and they are gone. No one in their right mind will, therefore, enter the mine field. Unless, of course, they are accompanied by a minesweeper. The government's role was to be that minesweeper. Lucy states that the data was there for all to see. So why didn't they see it? I have already said why in this and other essays. For a refresher the opening paragraph of Anatomy of a Bailout will suffice. Some more Lucy quotes follow:

"If all the listed foreclosures and preforeclosures became repossessions, then these value reductions would cost $95 billion in California, $10 billion in Florida, $5 billion in Nevada, and $4 billion in Arizona, a total of $114 billion....{even} this estimate overstates the crisis dimension of foreclosures."

"An extreme perspective on pricing mortgage-backed toxic assets can be acquired by projecting 2008 foreclosure losses if housing prices decline to year 2000 ratios of housing values to family income. In all 50 states, the decline to year 2000 house values would be about $145 billion, with 87 percent in four states—California $95 billion (66 percent), Florida $18 billion (13 percent), Nevada $6.5 billion (5 percent), and Arizona $5.5 billion (4 percent)."

"A problem faced by lenders has been the so-called “mark to market” accounting rule. This rule requires lenders to value assets at current market prices. While seemingly reasonable, this rule over-values property assets during the “bubble” period of inflated expectations during housing price increases. Mark to market undervalues properties if the market for them erodes or disappears when housing prices fall.  Banks then limit loans to retain enough capital to meet regulatory requirements for reserves relative to liabilities."

ECONOMICS PERCEPTION BIAS

One immediately can tell that Lucy is not an economist by reading the above paragraph. Mark to market is to most economists what the Pope's infallibility is to Catholics. It is both faithfully believed and misunderstood. Nothing creates more cognitive dissonance in an economist's mind than questioning the legitimacy or meaning of mark to market. To declare that mark to market accounting might actually give out wrong signals is just very difficult for them to accept. Yet anyone who thinks about it realizes it is just an approximation of value, no more intrinsically valid or "true" than other approximations. This does not lead down the road to nihilism. It leads down the road to recognition that judgment is always particular to time and place, regardless of valuation method. We all know calculating the value of a particular mortgage backed security is difficult in times of crisis. But this is exactly what regulators should have known.

Ironically, Lucy also has a simple solution which I did not and still do not support. Yet, his straight forward approach is refreshing. He does not get twisted up in "angels on a head of a pin" issues like "moral hazard". He says:

"If the U.S. Treasury purchased the MBSs at a discount, it might not lose any money on the MBSs in the short-run and might make some profit later. The discount would not need to be large for most MBSs, since most of them are performing above 90 percent of payments due. And the U.S. Treasury does not need to satisfy regulators that it is valuing the MBS assets by "marking them to market".”

"Banks and other lenders have claimed losses on their balance sheets far in excess of the actual reduction in value of the houses on which mortgages have been foreclosed. Moreover, the recorded losses are greater than the house value declines that would occur if the foreclosed properties declined in value to year 2000 levels. It is possible that price reductions to year 2000 levels will occur. But such large price declines can occur as a result of deep and prolonged recession, not because of an excess of supply occasioned by the foreclosures themselves which add to the backlog of houses for sale."

Alright, enough already. You get the point. He also says the bubble was caused by Government policies pushed by the Clinton and Bush administrations to increase home ownership in America from 65% to 70%. This was the ultimate cause in his opinion. This makes way more sense to me than money supply and interest rate policy gobbledygook critiques of Greenspan and Bernanke.

CONCLUSION

What does one conclude? Was this an excusable mistake by Paulson and Geithner back in September when they sought to bailout AIG (really Goldman)? Absolutely not. In fact, relative to the 7 previous crises that were faced by Greenspan, this was by far the easiest to understand. This was a travesty. This was easily explainable to the public and investors, but it was not. Why? We know why. Goldman Sachs faced "mark to market" extinction. As I have previously said, "{Paulson, Geithner, and Bernanke's} confusion in understanding the approximation which is mark to market accounting, their failure to understand a financial market "squeeze", their failure to not compare mortgage values to actual housing values in the real housing market, their crony identification with the very firms they were regulating, their failure to realize that derivatives are a "cash zero sum" transaction, and their inability to be calm under fire and rise above the cacophony of screaming Wall Streeters", is what turned a controllable crisis into an uncontrollable one. 

It also means when the dust settles, we all will realize we have been had. A fake crisis cannot last forever. We have not lasted as a species for a few hundred thousand years to have that happen to us. This crisis, at least in the financial sector, may already be over--although it was largely a mirage from the outset. Remember the photo shopped pictures of Obama as FDR on the cover of Time Magazine? Remember Rahm Emmanuel's brazen comment on Meet the Press about a crisis being an opportunity to pass legislation that otherwise could not be passed? They have manufactured a crisis of historic proportions. Who benefits from this crisis mongering? Not the people who have lost their jobs because of it. Not the shareholders of financial institutions who lost 75% of their investment. Who are the smiley faces around town? Obama/Pelosi/Reid seem pretty happy these days, don't they?