by Calculated Risk on 9/23/2011 01:54:00 PM

"[W]hen [bubbles] are underway, [they] are typically enjoyable. As a result, regulatory interventions that temper booms normally are going to be unpopular."

From NY Fed President William Dudley: Financial Stability and Economic Growth. Dudley makes several interesting comments. I've long argued that the primary causes of the housing bubble were rapid innovation in the mortgage market combined with a lack of regulatory oversight.

Here are a few excerpts:

Turning first to the issue of financial booms and busts, empirical observation makes it clear that financial markets are inherently unstable. Throughout history we have seen numerous sizable booms and damaging busts. The notion that financial markets are dynamically unstable is also supported by controlled experiments conducted by behavioral economists.
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Although it is impossible to attribute the instability of financial markets to any one single driving force, recent experience suggests that in many cases innovation plays an important role. ... innovations that initially create real value generate feedback mechanisms that often fuel the development of excessive expectations—a boom that eventually reverses when the basic belief system that sustained it is contradicted by events.

Such innovations can occur in the real economy—consider the Internet—or in the financial sector—think of subprime lending and structured finance products. Although the role of innovation has differed across various booms and busts, some important common elements are evident in many of these episodes.

Early on in the cycle, an innovation can lead to changes in fundamental valuations or the creation of new markets and financial products. Examples of this might include the technology boom that followed the creation of the Internet or the subprime lending and the associated structured finance innovations that supported the housing boom.
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As market participants respond to the innovation, this may cause a surge in business activity. ... This surge in activity drives up profits and prices, which in turn sustains the boom. As part of this process, feedback mechanisms work to reinforce beliefs in the importance and sustainability of the innovation. ... In the case of the subprime lending boom, the provision of credit led to increased demand, which pushed up prices, and rising prices, in turn, held down credit losses. These feedback mechanisms reinforce belief in the sustainability of the boom, often extending the boom far beyond activity levels or valuations justified by how the innovation has changed the “fundamentals.”

The process often comes to an abrupt end, and generally does so when the basic belief system that underpinned the boom is contradicted by events. ... the U.S. housing boom was unsustainable because it was not possible to indefinitely keep relaxing credit underwriting standards to qualify new buyers to stoke demand. It was also unsustainable because the rise in prices often led to a supply response that limited the prospect of further price increases.
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When sudden reversals occur, large costs are imposed on the real economy and the financial system, costs that are not fully internalized by the market participants that may have benefited from the boom.
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[A] critical objective of prudential oversight and regulation should be to enhance the system so that financial transactions of all forms reflect an assessment of risk and return by both the borrower and the lender that is as accurate as possible, recognizing that we live in an inherently uncertain world. This means that our reform efforts should be aimed at strengthening the quality of information and the system of incentives governing risk-taking by both institutions and individuals. And on those occasions when regulators judge that a systematic understatement and mispricing of risk may be occurring, we need to find better and more effective ways to actively lean against those dynamics. This includes using the bully pulpit to point out why a particular boom is likely to prove unsustainable.
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[R]egulation needs to be oriented to establishing standards that will be appropriate throughout the cycle—for both the boom period and the bust. For example, in terms of subprime mortgage underwriting, this would have included enforcing standards with respect to loan valuation, loan-to-value ratios, household income verification, and the quality of loan documentation.
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[N]o matter how effectively we reform the financial system, it seems unlikely that we will ever be able to completely eliminate booms and busts. There will be problems in identifying the boom—distinguishing between what is sustainable and what is unsustainable. There also will be broader and even more subtle obstacles—booms, when they are underway, are typically enjoyable. As a result, regulatory interventions that temper booms normally are going to be unpopular. So in practice even activist regulators may struggle to act early enough and with sufficient force to arrest a boom before it becomes a bubble. This suggests that to make the financial system secure, we are going to have to do much more than just act to temper booms and busts.