Financial and economic cycles are inevitable. But do they have to overshoot into bubbles and crises? Once there has been a bubble, the crisis cannot be avoided, so the essential project is to work on preventing the bubble. To address this at the most fundamental level, we should be working on countercyclical behavior to moderate the upside overexpansion. Specifically for mortgage finance, we should create countercyclical loan-to-value limits. Of course, this is the same thing as countercyclical down payment requirements. Such LTV limits should be transparent, easy to apply and relatively free from political interference.

A bubble involves an insidious self-reinforcing feedback loop between asset prices and increasing debt and leverage. The 21st-century housing bubble presents a perfect example of this perverse interaction. As house prices rise in a housing bubble, more debt and more leverage always seem better. Both borrowers and lenders see their profits and the return on their leveraged equity get bigger. Lots of people are making money as the bubble expands. As long as house prices keep rising, delinquencies, defaults and losses on mortgage loans are all low. This experience makes lenders and investors more confident, just as borrowers become more optimistic. Risk appears contained. Politicians are happy and push for increasing homeownership and credit “access.” At the mortgage-loan level, leverage is measured by the LTV ratio: how big a mortgage are you willing to grant relative to the current market price of the house? But what does the current price really mean if prices have been rapidly inflating on a tide of credit expansion? Lenders should view very skeptically the current price of greatly appreciated houses.