On Tuesday, September 16, at a rally at the Colorado School of Mines, Barack Obama criticized John McCain, saying:
Just today, Senator McCain offered up the oldest Washington stunt in the book: you pass the buck to a commission to study the problem. But here’s the thing; this isn’t 9/11. We know how we got into this mess.
It’s one thing to criticize McCain for inaction, but I disagree with Obama’s claim that we know how we got into this mess. In fact, if pushed, I would say I knew a lot more about the causes of 9/11 than I do about the causes of the mortgage crisis.
I just read Robert Shiller‘s excellent book, The Subprime Solution, and he makes a powerful case that the end of the price bubble in residential real estate was the crucial triggering factor.
Indeed, the graph, based on the Case/Shiller U.S. National Home Price Indices, is prima facie evidence of a bubble that expanded and popped:
The dramatic downturn in housing prices was the key trigger — causing an increase in mortgage defaults. But the next step in the meltdown seems to have been the byproduct of 1) high leverage at investment banks and other financial intermediaries and 2) uncertainty over how much of the default risk was held by particular intermediaries.
Assessing a firm’s exposure is complicated by the massively complex web of derivatives and tranches oftentimes unreported in firms’ balance sheets. Firms like Lehman Brothers suddenly had trouble borrowing when lenders had trouble assessing the value of the security they offered. When you’re massively leveraged, just small increases in uncertainty over your asset value can dry up your ability to refinance your debt.
But to my mind, there are still dozens of important unanswered questions.
How much of the crisis was caused by subprime borrowers who made mistakes by borrowing (i.e., would not have borrowed if they had better information)?
Some proportion of the loans had very low down payments and low interest rates for one or two years. It might have been a rational choice for someone to take a chance on homeownership — putting very little money at risk and thinking (correctly): “If housing prices continue to go up, I’ll be able to refinance my house when the two years are up.”
In 2005, Elizabeth Warren gave a paper at Yale’s Legal Theory Workshop, and I called her on a claim in one of her footnotes that down payments for first-time homeowners were minuscule.
I was sure this claim had to be wrong. There is no way banks can loan money with virtually no equity cushion. But guess again.
According to The Washington Post, “four out of 10 first-time buyers used no-money-down mortgages in 2005 and 2006, according to surveys by the National Association of Realtors.” And the median down payment for first-time buyers in those years was just 2 percent.
With so little of their own money at risk, it shouldn’t be a wonder that many borrowers default when housing prices decline. Would you want to keep paying on a $200,000 mortgage when the house is only worth $150,000?
If you want to know why the mortgage system is so fragile, you should look to the drop in home equity — which was occasioned by low down payments and second mortgages that pulled equity out of houses where the owners paid off some of their outstanding principle.
But the problem of high borrower leverage was compounded by the high leverage of many of the firms that ended up holding the mortgage papers. Some investment firms were leveraged 30 to 1 (or more).
Years ago, Shiller called upon Freddie and Fannie to conduct “stress tests” to see whether they could survive a downturn in real estate prices. One of the chiefs had concluded that they could survive a 10 percent downturn in prices, but didn’t think it was plausible that prices would fall more than that.
I like Shiller’s “stress test” idea; but I’m also attracted to the New Orleans levee metaphor: Should our mortgage system’s levees be able to withstand a 20-year flood, or should we design them to withstand a 100-year flood? Levees are not costless. Neither are financial-safety measures.
We also don’t know the extent to which specific terms of subprime loans contributed to the spike in home foreclosures. Some of the loans (particularly those going to minorities) were at high interest rates not justified by the risk of borrower default. Some mortgages were interest-only loans, where the borrowers were not building up additional equity overtime. And many of the loans had teaser rates, which effectively required refinancing after two years.
My tentative take is that the low down payments were more important than any of these other factors as far as adding to systemic risk. Second place would be the effective refinancing risk (because after the house prices started to decline, lenders were not willing to lend $300,000 on a house that was only worth $250,000).
Third place would be the interest-only loans. If the down payments had been higher, interest-only loans would not have been much of a problem at all. There is a systemic benefit with amortizing loans: in a system where people borrow money at different times, there will be different amounts of home equity in the system. But this benefit is dramatically reduced by the ease of taking out second mortgages to pull out any built-up amortized equity.
I’ve done a lot of work on the problem of high borrowing interest rates, and marking up interest rates can exacerbate the probability of default. But while more needs to be known, I believe that this impact is likely to be less than the impact of these other terms. (These inflated rates, however, are a problem in and of themselves — and remain an action item for enlightened regulation.)
But I’m still not sure how many of the defaults are caused because borrowers can’t pay (for example, because of interest resets and the resulting need to refinance), and how many are caused because borrowers are choosing to walk away from mortgages that are seriously underwater.
We also don’t know the answers to parallel questions concerning the lending side. It’s easier to see the possible rationality in the behavior of the loan originators; to the extent that they were flipping the mortgages in the securitization market. But what we still don’t know is why the ultimate buyers were willing to buy.
Was this a failure of Super Crunching? Was it a failure of corporate governance (in that the managers of the buying firms had incentives to unprofitably grow their empires)? Was the failure caused by originator fraud (or the moral hazard of substituting bad-doc loans for what historically had been high-quality loan pools)?
I think it is probably some mixture of all three — with poor corporate-governance incentives particularly explaining the failure of the rating agencies to start downgrading the debt earlier.
Knowing the answers to these causal questions is important if we are going to craft useful policy responses. But that will be the subject of another post — which will more directly focus on Shiller’s subprime solution(s).
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I think that the mortgage bubble popping, while starting the ball rolling, was not the only systemic weakness that has been exposed. So-called “naked” short selling pushed the prices of many of the failed financial companies to the brink even faster than they would have fallen. Much has been written about this at http://www.deepcapture.com . Combined with the looming credit default swapcontracts, complicated derivative contracts and high leverage positions of these companies, it was a house of cards waiting to tumble.
In my circle of friends, colleagues, and family, I only know of people walking away from their mortgage because they are so far underwater that taking a hit on their credit outweighs the negative equity they carry.
In one case, some friends attempted a rehab of a 2400 sqft home and turned it into a disaster. They stopped making payments when they realized they were 50k underwater and facing another 20k in renovations.
IMO any effort to understand this crisis should start with Alan Greenspan and his continual rate cuts, and his will to stop regulation on derivatives.
With the educations that the people at the controls have they should have known better. The question is were they dangerously incompetent or criminally greedy?
Re: comment #3
Amen.
Very nice post, in part because you – without stating so explicitly – demonstrate why individuals would enter into marginal mortgages: incentives like low down payments, teaser rates. In political discourse, the “blame” has focused on the borrowers but they are individuals acting rationally. You do a nice job of showing that these offers were made, that they were shaped by companies and ultimately by what investors on the global market would buy as they chased higher returns.
From an economic perspective, these offerors were acting in their short-term interest, competing for market share against other offerors.
But the offerors depended on the larger capital markets – which they sold into – and those buyers also acted in their immediate short-term interests. If we want to fix blame, not political but economic blame, those responsible for managing money – banks, insurers – have fiduciary obligations of prudence and are subject – supposedly – to regulation designed to focus them on controlling both short- and long-term risk. They absolutely failed.
Take the Icelandic banks because they’re such an easy example. They’re banks. They had a fiduciary obligation to protect their assets but they didn’t because they decided to chase returns, took on unreal leverage and funded projects as though every day would be sunny and warm (in Iceland?). The exact same point can easily be made about AIG: it is an insurer but traded and issued credit default swaps for unbelievable sums without setting aside capital reserves (because setting aside those reserves, in prudence, would have meant not doing those deals).
Thus, from an economic perspective, we have individuals responding rationally to offers that in retrospect were too good to work. We then have offerors – mortgage companies much, much, much more than FDIC regulated banks under the Community Reinvestment Act – maximizing their short term returns, but that often happens in many businesses and when that happens some companies fail. We then have on top of that the buyers, the capital providers, who had both fiduciary and regulatory obligations to act prudently and yet put their short-term profits not only first but at the total expense of significantly more than their worth.
Financial system gone wild. Despite the drop in home values, which caught some still on the escalator, the other part was that most of those no-down loans relied on housing price increases to create equity – the equivalent of a free down payment. But some home”owners” used the new-found equity to increase the mortgage amount and take out cash. (My mailbox runneth over for 10 years with equity finance offers.)
While that was happening, thousands of adjustable mortgages were reaching the reset point (3 years after inception – as in, 2005-06).
On the other end of the pipeline, where the synthetic securities were being created and traded, the hedge funds were doubling down their bets and taking home all the cash being wrung from the bottom of the funnel.
For those in the middle (prudent spenders, investors, fixed rate mortgage holders paying them down, pension funds, bondholders, all also known to the hucksters, shills and carnies as “the marks”), the SEC, the Fed, Fannie, Freddie, Congress, the Whitehouse, all turned their backs while the piranha were in a feeding frenzy – calling it “prosperity that comes from open markets” or some such crap.
Bottom line is that our financial system, left unregulated, is designed to fleece everyone not in on the game. The fat cats just committed the longest and largest legal robbery imaginable – and did it while we (and our protectors) slept (memos from Senators to the Treasury notwithstanding).
But is a government commission the way to go?
Clearly, there will be lots of papers and articles and conferences on this. In this case, the market actually is going to take of it — the academic/finance/economics market, that is.
A government commission is not going to better than that.
It’s easy, it’s a bubble inside a bubble.
A housing bubble inside a mortgage-securitization bubble. Both bubbles are easy to figure out:
I’ve heard people talking about the “victims” of the housing bubble. Regular people who chose to purchase homes and take our mortgages that they couldn’t afford, simply because they were afraid that with the way house prices were going, they “KNEW” they wouldn’t be able to afford a home in the future. Better act now, and refinance or flip in 2 years. Otherwise they’d be priced entirely out of the market soon. So they got sucked into the bubble.
Well, same goes for the securities traders, lenders, and brokers who got sucked into the other bubble, IMHO.
All a bubble is, is people who think they understand the full dynamics of the market, but don’t. They act on what they think is the best information at the time. We can say both groups should know better, but should they? People get in and out of bubbles all along the way. The players at the beginning are not all there at the end.
I believe, for both groups, the profits to be made as the bubble expanded were worth the risks of being there at the end.
Any talk of regulation or reform has to be centered on this concept. We have to make the risks of being on a bubble when it pops real enough that it doesn’t pay to take the chance. I’ve said it before: if high-risk, sophisticated derivative trading can earn you a $50M paycheck or losing your job, wouldn’t plenty of intelligent, rational, informed people go for it?