Back in June, 2007, we wrote a column about the research of Itzhak Ben-David, a Ph.D. candidate in finance at the University of Chicago (who has since accepted an assistant professor position at the Ohio State University). He had been studying the cash-back transaction — a real-estate sleight of hand in which cash-poor buyers received an unrecorded cash rebate from the seller in order to qualify for a loan.
This would result in the buyer sometimes borrowing 100 percent (or more) of the house’s value. That means that borrowers who were subprime to start with are taking on even more debt, creating a loan that’s just waiting to blow up.
Here’s my question: If an academic researcher like Ben-David knew as much as he did for as long as he did — while we wrote the article last summer, he’d been working on this research for a long time — why were so many people, including smart people at sophisticated institutions, caught off-guard by the subprime developments?
Take a look at a few key paragraphs of the article and tell me how much clearer the warnings could have been, and how lax the safeguards were:
[Ben-David] found that a small group of real estate agents were repeatedly involved, in particular when the seller was himself an agent or when there was no second agent in the deal. Ben-David also found that the suspect transactions were more likely to occur when the lending bank, rather than keeping the mortgage, bundled it up with thousands of others and sold them off as mortgage-backed securities. This suggests that the issuing banks treat suspect mortgages with roughly the same care as you might treat a rental car, knowing that you aren’t responsible for its long-term outcome once it is out of your possession.
At first glance, these cash-back transactions, while illegal, might seem a victim-less crime. After all, the seller gets his house sold and the buyer gets to move in with his family. The real estate agent, the mortgage broker, the attorney, and the appraiser are all paid their commissions or fees. Even the bank that made the loan comes out ahead, since it earned its fees on the transaction before passing along the mortgage to investors.
But Ben-David argues that there are at least two potential losers. The first is the honest buyer who won’t take a cash-back offer and therefore can’t buy a house — all while the illegal cash-back transactions are artificially driving up home prices in his neighborhood.
The second loser is the investor who bought the mortgage-backed securities. If a house purchased with a cash-back transaction goes into foreclosure, it is soon discovered that the home is worth less than the value of the loan. This, plainly, is not good for the shareholders of such assets. While people who hate rich people may get a thrill from the idea of wealthy shareholders being swindled by a bunch of small-time mortgage hustlers, keep in mind that mortgage-backed securities are the sort of conservative investment widely held by pensioners and other regular folks.
and 
. You can also watch it on 
This is a great question: “If an academic researcher like Ben-David knew as much as he did for as long as he did – while we wrote the article last summer, he’d been working on this research for a long time – why were so many people, including smart people at sophisticated institutions, caught off-guard by the subprime developments?”
The answer to it is fairly simple: “Of course they knew it all along, it was all part of their plan!” The whole idea behind these lending practices was to get more money into the housing market — i.e. by allowing more people to buy, people who hadn’t qualified as buyers previously — so as to raise the value of real estate beyond its (then) saturation point.
In other words, the market used these subprime borrowers to create (artificially) a housing bubble.
For them to have heeded the advice of “prophets” like Ben-David and stop these practices, would have removed these added funds from entering the housing market, and that would have caused the bubble either to deflate or break, which they couldn’t allow to happen.
In short … too many people were making too much money on this artificial bubble, to do anything to stop it. As usual, it was all about the money.
Until the banks rethink their incentive structures for their securities traders and IB guys, we’re going to keep having these problems.
If I get my annual bonus based on performance, and the sky’s the limit, you bet I’m going to go after questionable investments. They’re not going to dock me for losses, but they’ll stuff me full for huge earnings. The worst they can do is fire me, and I’ll take my millions and go open a restaurant.
I don’t think the banks will do this on their own. I’m a conservative and not a fan of regulation, but this may be a place where we need it. Maybe the SEC should step in and say you can’t keep making it so lucrative for traders to buy into these sorts of questionable securities. Especially if the Fed is going to bail the banks out when they blow up.
I’ve got no sympathy for investors in CDO’s….they violated the first rule of investing, which is never to invest in anything you do not understand.
I’ve also got very little sympathy for the people who took out these loans…they were greedy and trying to live above their means by buying more house than they could actually afford.
The people I do feel sorry for are all those who have lost their jobs because other people were greedy and/or stupid.
But that’s what you get when you underinvest in education to the point that most people graduate from high school and many gradaute from college while being financially illiterate.
A course in personal finance should be mandatory for a HS diploma!
They were not caught off-guard by it. Their rewards simply exceeded the risks. Individual bonuses and compensation earned will not be returned. They were right.
There’s a lot more to the subprimes mess than just the cash-back scheme.
Some people long before June 2007 who made the prediction about the subprime mess, like David Melcher and his hedge fund Balestra Capital.
They placed their bearish bets and are making a killing (http://www.finalternatives.com/node/2162).
As others have pointed out, the IBGYBG philosophy (I’ll be gone, you’ll be gone (wihtour bonuses)) has as much to do with it as anything.
If Ben-David is so smart he should have sold financials short like Balestra did.
mfw13 -
You seem to be missing the point that this practice fraudulently increases the market price, which affects far more than just the individual buyer and sellers for whom you hold so little sympathy.
This means that even people who COULD afford the fraudulently inflated prices end up paying more to the realtors, mortgage brokers, and lenders in commissions, discount points, and interest payments. They lose investment income on the money they use for their down payment. They probably won’t default, but the industry vultures still get to feed, gluttonously, for all the years those mortgages remain in effect. Then, assuming the owners eventually sell, they get hit again because the market will (most likely) by that time have lost the fraudulent inflation.
Focusing on the “greedy and stupid” buyers who bought more than they could afford is like focusing on the soapy film of a bubble, alone, and ignoring all the air inside it.
As to the “how could this happen” question posed in the blog post… I concur with Mark @4 above. Of course they knew full well what was happening, when it was happening.
I don’t think anyone was “caught off guard”. I think everyone saw it coming. It’s just that each player chose to respond differently. Many buried their heads & hoped for the best – which works about half the time on Wall Street (my estimate, of course). But many people in the industry tried to do something about it. Example: I was in the subprime mortgage business for 14 years. The company that I worked for, Accredited Home Lenders, was considered the most conservative & cautious lenders. This caused us to lose a great deal of business to the lenders who had more agressive lending guidelines, looser ethical standards & even lower interest rates. AHL’s president & CEO stated in January 2006 that market was in trouble & due for a correction. Even as guidelines got easier & rates got lower, AHL began tightening it’s standards & raising it’s rates in order to be better prepared for the fallout.
Thanks for this post. Cleared up a lot of holes in what I read in the papers and flew a bit over my head