Unpacking the sub-prime train wreck

On this analysis two major factors in the train wreck were the regulations that pushed lenders to water down prudent criteria for lending and the flight of speculators from the housing market when prices ceased to rise. A nuance in this analysis is to point out that it was not JUST the sub-primes that collapsed because the second factor (speculator-flight) applied across the board.

Why did the mortgage market melt down so badly? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be?

This report concludes that, in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs, and housing activists universally praised the decline in mortgage-underwriting standards as an innovation in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The price bubble, along with relaxed lending standards, allowed speculators to purchase homes without putting their own money at risk.

The recent rise in foreclosures is not related empirically to the distinction between subprime and prime loans since both sustained the same percentage increase of foreclosures and at the same time. Nor is it consistent with the nasty subprime lender hypothesis currently considered to be the cause of the mortgage meltdown. Instead, the important factor is the distinction between adjustable-rate and fixed-rate mortgages. This evidence is consistent with speculators turning and running when housing prices stopped rising.

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Patrick
13 years ago

To actually understand how ‘sub-prime’ mortgages worked and how they caused such contagion without reading five books, I suggest reading this paper by John Gorton.

Regulation was undeniably a cause, but how significant I am still not sure. Obliviousness seems to have played a major role.

NPOV
NPOV
13 years ago

So if “prime” mortgages have been defaulting at the same rate as subprime mortgages, why is everyone calling it the “subprime crisis”?

Rafe did you read the WSJ article I posted a while back outlining the multiple pressures on lenders to lower lending standards? It wasn’t *just* politicans trying to increase home ownership, though it was certainly a factor.

Patrick
13 years ago

Yes, from what I can see in terms of evidence NPOV is right – there was not a specific fulcrum but rather a tragic concentration of stupid thinking from academics, charities, politicians, the general public and everyone else about ‘turning the engine of profit to socially responsible ends’ and making both profit and communities and whatever else stupid ideas people could come up with. The right is just as responsible for perverting the intrinsically Calvinist idea of the ownership society into some kind of hippy fantasy whereas ownership superceded actual responsibility, rather than being a result of it. It is worth considering, and I was partly guilty of ignoring this at the time as well, that the theoretical social benefits of the ownership society would ordinarily be produced by mere rental if you had people of the right temperament.

In aid of all that good feeling, people invented sub-prime mortgages, which, as the paper I linked to sets out quite clearly, were nothing like ordinary mortgages. Barely even analogous in fact. But it seems that, much as today we use the word mortgage to describe a common charge but still attach the connotations of the true mortgage, the use of the word mortgage (ie adjustable-rate mortgages, residential mortgage-backed bonds, etc) simply obliviated investors in the securitised product as to what they were actually buying into.

And ultimately, they created a perverse incentive for people not actually suited to home ownership to do so, and then to ‘extract the equity’, typically, unfortunately, for consumption of consumables.

Best take on it all so far (Chris Lloyd probably won’t laugh) is this one.

NPOV
NPOV
13 years ago

From my limited understanding of the history of the period, it does seem that Thatcher had some success in boosting home ownership, primarily through allowing residents in public housing to purchase it privately. I think there’s something to be said for this – if governments can provide public housing to feel the immediate need of shelter, but then offer citizens the chance at ownership once they’ve reached the point that it becomes a worthwhile goal (I suppose, “at the point that ownership becomes a “responsible” choice), it seems like a win-win to me.

Of course, the issue is now that the U.S. has more housing than it needs…so perhaps part of a solution could be for the government to buy up a portion of that housing to be added to the public housing stock, whereby residents then the option of purchase at a later date. I don’t think this is appropriate for the the McMansions built around the outskirts of major cities, but presumably a worthwhile fraction of the foreclosed but currently unsaleable properties are of suitable location/size/cost for use as public housing.

Patrick
13 years ago

I think the virtue of the Thatcher plan was that it remained ordinary home ownership with the risks and benefits associated with that.

‘Ownership’ pursuant to a sub-prime mortgage was categorically not ownership in a meaningful sense, it was participation in a financial product. It was really like a two or three year lease with at the end options for mortgagee to either refinance (if property values had gone up) or default (if values had gone down). Since Mortgagor actually controlled the choice of refinance, it was really like a put option (default) for mortgagee and a call option (accept finance) for mortgagor.

Nothing to with ownership, really.

melaleuca
melaleuca
13 years ago

That’s a disappointing effort at unpacking the subprime train wreck, Rafe. How about discussing all the major factors in the crisis and evaluating how they fit together rather than constructing a caricatured version of what happened in order that you may cling to your libertarian fantasies.

Ken Parish
Admin
13 years ago

There’s no doubt that the government and regulatory pressure in the US for banks etc to advance housing lending to the poor was a significant factor in the equation leading to the current world crisis. However, if you drill down deeper, there’s a sense in which this push itself was a consequence/symptom of the sort of libertarian “private is grouse, public is evil” mania/obsession which Rafe exemplifies.

Instead of persisting with a conventional system of publicly funded housing for the poor/disadvantaged (preferably with a sensible, sustainable scheme to encourage public housing tenants who could afford it to purchase their homes – a la Thatcher etc), the Americans decided that they could magically find a way to square the circle and allow the private sector to lend to (riskier) poor borrowers without either exposing itself to unacceptable risk or imposing a risk premium on the interest rate that priced the loans out of the reach of the poor borrowers they were designed to attract/service. It turns out that it only worked:

(a) as long as housing prices continued to rise and the market believed that this happy state would continue; and
(b) by creating complex financing structures that obscured the risk and made it effectively impossible for anyone to find out who actually bore the risks of default.

Sub-prime loans were (so I now gather) priced at higher than normal interest rates in their early years, but still rates the borrowers could (mostly) manage (although even that seems not to have been the case sometimes), with refinancing taking place after 3 or 4 years at a (lower?) rate after the borrower’s accumulated equity became available as security for the refinance. It’s a neat idea as long as housing prices keep rising, but only if the market could work out and price risk, which became impossible the way these debts were packaged and resold. Government regulation certainly encouraged lenders to advance housing loans to poor/risky borrowers, but didn’t encourage them to structure the system in such a way that risk became impossible to assess or price. However, even if the system had been designed (voluntarily or by regulatory coercion) to be more transparent, it would still have been a house of cards waiting to collapse as soon as there was a downturn in housing prices (which was always inevitable). Moreover, I strongly suspect that, if the system had been more transparent so that the risk profile of subprime lenders could be accurately assessed and priced by the broader finance market, then the risk premium the subprime lenders would have borne would from the outset have meant that the interest rates they could have offered could not have been afforded by any but a tiny proportion of the least risky poor borrowers.

In other words, the whole concept was nonsense from the beginning. The only feasible ways to provide housing to the vast majority of the poor who can’t borrow on the ordinary open market is either by conventional publicly funded housing or by a government-funded or guaranteed scheme to make housing loans available to these “subprime” borrowers. I don’t believe there is any way to construct a sustainable system whereby the private sector can meet the housing needs of the poor to any significant extent without some form of extensive public funding or guarantee. To imagine otherwise was one of the more bizarre fantasies of the neoliberal and libertarian right, for which we’re all now paying.

D W Griffiths
13 years ago

In Rafe’s defence, he starts his post by saying “On this analysis …”. He’s reporting Leibowitz fairly straight.

That said, I am sceptical of very simple explanations of what has just happened. At the least, people should be cautioned by the sight of so many commentators from left and right explaining how the collapse validates their long-held theories about the world – especially when most of them have paid little attention to the last 70 years of thinking about financial system collapses.

To be fair, Leibowitz is not a dilettante media opinionator but a serious analyst. I am nevertheless unconvinced by his analysis, in part because no-one can show that anti-discrimination legislation influenced enough lending to make it more than a minor driver of the housing bubble. The quantities just don’t work.

The Gorton paper is terrific – not least for the disclaimer at the bottom of its first page.

pedro
pedro
13 years ago

No question than that there is a lot more than last night’s carrot in the financial pool of vomit, but that does not make analysis of the government role any less instructive.

I have not seen specific numbers about CRA contributions to the US housing mess, but obviously any significant contribution gets the bubble close to bursting. I expect it would not be possible to quantify because who could even know how to record those statistics. How many banks have a ledger column for loans they would not have made but for CRA?

NPOV, even if prime loans are defaulting, it is a subprime crisis because the subprime loan are a significant feeder to the bubble and the bursting of the bubble will then affect prime loans too.

conrad
conrad
13 years ago

I might be ignorant on this, but surely these explanations might explain some of the US position, but not the global one. For example, I don’t see how any of those factors explain why places like Iceland are now broke. Did someone tell their banks to buy poor quality loan products to subsidize lower social class Americans? I doubt it. The same is true for all the other countries whose banks purchased this stuff, which is many. Perhaps excluding the Asian countries, they had no pressure to enter this mess, but they did.

Given this, it seems to me that potentially impossible things to regulate wern’t regulated and that was combined with a lot of people who were simply greedy and careless.

Patrick
13 years ago

Ken, almost, but wtf

one of the more bizarre fantasies of the neoliberal and libertarian right

???

This was a confluence of left right and every monkey inbetween all being happy at such a magical outcome. Barney Frank is hardly ‘libertarian right’ is he? What about Clinton? I’m not (for once) saying the left are to blame, but putting this on the right is pretty preposterous as well.

Your analysis is pretty spot-on, in particular this part:

Moreover, I strongly suspect that, if the system had been more transparent so that the risk profile of subprime lenders could be accurately assessed and priced by the broader finance market, then the risk premium the subprime lenders would have borne would from the outset have meant that the interest rates they could have offered could not have been afforded by any but a tiny proportion of the least risky poor borrowers.

And therein lay the rub. Securitisation properly done might have been a means of mitigating the risk sufficiently, but then again maybe not.

It seems to me that one of the biggest flaws was letting borrowers ‘extract the equity’ for consumption as opposed to a more conventional mortgage (unfortunately one which would have had to feature the unsupportable interest rates Ken describes) in which increases in equity generally reduce the LVR (which in turn reduces the propensity to default).

Patrick
13 years ago

Conrad, I think that the essential problem, and I’m by far an expert, is that banks hold so many tiers of synthetics based fundamentally on sub-primes, ie based on US house values, that no bank anywhere now trusts the collateral that other banks typically put up against overnight swaps and other short-term finance, so there is no short-term finance, which raises serious issues about the solvency of many banks.

It is also more complicated than that but I believe that is the gist of the contagion problem, with the other part being that as assets (ie those based on sub-prime) lose value, other capital needs to be re-allocated to support the positions basded on those assets, which means it is no longer available for eg swapping Krona to support someone else’s carry-trading.

NPOV
NPOV
13 years ago

Of course Iceland has only recently undergone fairly significant deregulatioon of the banking and finance industry, and pundits were describing the massive benefits of this as recently as November last year:

http://business.timesonline.co.uk/tol/business/markets/europe/article2963336.ece

So I hate to say it, but it really doesn’t surprise me that Iceland has been hit especially hard.

Ken Parish
Admin
13 years ago

As Patrick points out, I’m being a little unfair to single out the neoliberals etc for blame, given that arguably the single largest contributor to kicking off the subprime mortgage phenomenon was Bill Clinton (although Clinton was more of a marshmallow neoliberal than an economic lefty and was also a libertarian at least in his personal habits). The point I was trying to make, however inelegantly, was that the genesis of this now self-evidently suicidal phenomenon lay in considerable part in the neoliberal compulsive suspicion of government action and quasi-religious conviction that private sector activity is always to be preferred, even in areas that have generally and for good reason been regarded as natural preserves of government.

conrad
conrad
13 years ago

That’s very humourous NPOV. I guess the average citizen in Iceland at least has an advantage over others in that given their heritage and the fact that there are only 200,000 people, at least they can probably lynch some of those responsible.

Patrick
13 years ago

a libertarian at least in his personal habits

lol.

But you have essentially restated the thesis in more elaborate terms – surely some blame rests with people who thought that it would be cool for really poor/disadvantaged people to own their own homes? And surely some of those people were a little bit on the left?

trs80
13 years ago

NPOV: The Guardian recently had a good article on right-to-buy and how it’s not the bee’s knees.

Ken Parish
Admin
13 years ago

“And surely some of those people were a little bit on the left?”

I’m sure they were “Third Way” exponents like Clinton, Blair, Keating etc, because it’s a political philosophy that aspires to calculatedly achieving social ends through capitalist market means. I don’t regard this as “left” in any meaningful sense, just as I don’t see myself as “left” in any meaningful sense (the above description simplistically describes my own orientation as well, but I prefer to self-label as a slightly wet classical liberal). No-one that I would label as “left” would embrace any such idea as sub-prime mortgage markets substituting for public housing. However, if I’d dreamed up some idea like inducing the market to construct a scheme to fund borrowers who the market until then wouldn’t advance money to at any price (for very good reasons), I would hope I would have been a little more discriminating and less credulous about the scheme the market then developed.

NPOV
NPOV
13 years ago

trs80 – thanks for that article. It does seem like there have been and still are serious issues with way the program has been implemented (especially the requirement that councils use money raised from selling properties for paying off debt instead of building new housing), but the benefits from it still stand out.
I was pretty surprised that as much as 42% of Britons lived in council housing in the 70’s. Hard to imagine even as much as 5% of Americans being prepared to live in public housing (the one figure I could find suggested as few as 1.3 million households, which is probably about 1%).

rog
rog
13 years ago

Comparing private with public sector is to ignore the bleeding obvious – that Govt monetary policy was enacted by central banks and the Fed used the printing press to fulfill govt policy and it was from this policy that spawned the others like Freddie and Fannie.

rog
rog
13 years ago

Here is Bernanke

The second bulwark against deflation in the United States, and the one that will be the focus of my remarks today, is the Federal Reserve System itself. The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief.

…What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

Francis Xavier Holden
13 years ago

Ken @7 – I’d always thought the sub-prime loans were an initial 2 year or so interest holiday or low interest then higher rates kicked in- and thats what precipitated the crisis for many individuals – for those on limited income higher valuations didn’t mean much. But maybe I’m wrong. Perhaps it was a bit of both sorts of schemes.

I think South Australia used to have a type of Right to Buy scheme and initially the $ earnt went back into rental housing to keep up the stock. But at some stage they stoped using teh $ to build public housing and the stock decreased.

NPOV
NPOV
13 years ago

Rafe, I certainly agree there was a “manifest role of government failure in this episode”…but it was more through allowing deregulation to reach extreme measures than through any sort of mandates on lending institutions to lend to those who couldn’t afford to borrow. The problem with Fannie Mae seemed to be that not only were they being pressured by politicians, investors and other lenders to lower their standards in order to capture more and more market share, but there was nobody doing the job of ensuring that lenders in general were lending sensibly. So it was much a failure of lack of adequate government intervention as of ill-thought-out policy.

Not sure if I’ve posted this link previously, but it gives a good overview of the various pressures Fannie Mae faced:

http://www.nytimes.com/2008/10/05/business/05fannie.html?em=&pagewanted=all

rog
rog
13 years ago

Fannie Mae was a relic of the New Deal and the New Deal has been found to have prolonged the depression

NPOV
NPOV
13 years ago

Rafe, I’d argue it’s exactly the job of government regulators to think about that. But for various reason those regulators weren’t doing their job.

rjm456
rjm456
13 years ago

Rafe

This meme has been pretty thougrally debunked. There is a general explanation here http://www.mcclatchydc.com/251/story/53802.html

Short version:

1. CRA is 30 years old and does not affect prudential standards, it’s just a scoring system that looks at whether lenders are using credit standards to judge borrowers or prejudicial criteria such as “they live in a black neighbourhood”

2. CRA applies only to deposit takers (banks and thrifts) as deposits are only guaranteed by the FDIC if the institution complies with CRA – bad CRA score, no deposit guarantee. That’s how it works.

3. The lenders who wrote the vast majority of sub-prime (brokers etc such as CountryWide) did *not* take deposits. Therefore they not only didn’t give two hoots about CRA, there was no reason for them to bother at all as they weren’t required to

4. The default rate for CRA compliant lenders is *lower* than for the non-CRA variety (eg CountryWide et al). So whatever caused the widespread increase in mortgage default it wasn’t lending to the feckless and undeserving urban poor (aka ‘blacks’)

5. Freddie and Fannie only got into subprime in mid 2007 as a result of an attempt to rescue the market *after* the catastrophe was well underway, and didn’t have a significant share of it.

6. The failure of lenders (guarantors really) like Freddie and Fannie had a lot more to do with complex derivatives (and apparently more than a little fraud) than sub-prime lending

The whole story is bogus.

Patrick
13 years ago

UM, NPOV, massive deregulation and failure of regulation are hard words to squeeze out of any of this. Fannie and Freddie were overseen by an entire agency with 65 staff and a $200m pa budget. That agency recently wrote a massive volume discussing how, under its friggin aegis, those entities perpetrated one of the biggest accounting frauds in history. The unsurprising conclusion: everyone was to blame, except themselves (the, er, overseers).

And banking regulation is incredibly complex and volumnious in general.

It is appropriate to speak of regulatory arbitrage, since that indeed was the root of the problem. It is doubtlessly also appropriate to speak of poor regulation or of regulatory failure. But to blame deregulation is to give free rein to ideological fantasies in complete denial of any reality. It is like the socialists on uni (I am back this week, and the little A4 posters haven’t changed!), forever announcing: ‘How socialism can solve [insert last week’s event here]?’ and ‘system in crisis, is capitalism to blame and is there a socialist way out?’.

NPOV
NPOV
13 years ago

Of course the regulators are partly to blame, I don’t think I ever implied they weren’t.

As for the extent to which “deregulation” was to blame, I think I’ve already posted quite enough articles backing that position up. And given governments from virtually every nation involved in the crisis have agreed to strengthen regulation in response, by your logic, they are all living in “complete denial of reality”.

Patrick
13 years ago

rjm456, points 1-3 are reasonable enough, if perhaps a little short of whole picture, but points 4-6 are well short of the whole picture, although point 6 gets back on track about complex derivatives (including, although you probably didn’t realise it, sub-prime mortgages themselves).

I don’t know what fraud has contributed, at this stage, either – do you have any specific examples?

Tel_
Tel_
13 years ago

The only feasible ways to provide housing to the vast majority of the poor who cant borrow on the ordinary open market is either by conventional publicly funded housing or by a government-funded or guaranteed scheme to make housing loans available to these subprime borrowers.

I would argue that building very small houses might be the answer, and concentrate on the use of economical materials (neither of which happened in this case, maybe someone would like a crack at explaining why).

Im sure they were Third Way exponents like Clinton, Blair, Keating etc, because its a political philosophy that aspires to calculatedly achieving social ends through capitalist market means. I dont regard this as left in any meaningful sense, just as I dont see myself as left in any meaningful sense (the above description simplistically describes my own orientation as well, but I prefer to self-label as a slightly wet classical liberal).

If you look at early American libertarian theory, they did see the free market as achieving social ends, or at very least not stuffing up any worse than existing systems (and the monarchs and churches of Europe had consistently demonstrated that centralised power reliably leaves the poor stacked in filthy slums while slurping the wealth into itself to produce massive palaces and cathedrals). They also saw liberty as a social end in itself, how much freedom should you be willing to sacrifice for comfort? The trouble with the “Third Way” was that the leaders decided that they were going to instruct the free market as to what they decided was an appropriate social end (different fishkettle).

As I’ve said elsewhere, I do believe in libertarian principles, I also believe that the government should provide some basic safety-net provisions at the very bottom end of the market. Also, direct non-monetary charity is the most efficient for government to provide — if they think the poor should have houses, then build houses, not complicated financial schemes. But never forget the bigger picture — government houses built for the poor, should be houses fit for the poor, and give the free market plenty of scope working on bigger and better houses for those who are not poor.

NPOV
NPOV
13 years ago

“The trouble with the Third Way was that the leaders decided that they were going to instruct the free market as to what they decided was an appropriate social end (different fishkettle).”

And why is that “the trouble”? If they do a bad job of it, voters chuck ’em out and demand new leadership. On that basis, a fair amount of the blame should actually fall on American voters for consistently choosing such obvious bad leaders.

Patrick
13 years ago

I wonder if you have thought about what an average response to that last proposition might be, NPOV.

NPOV
NPOV
13 years ago

I wouldn’t make such a proposition in a forum where “average responses” are likely :-)

I will say though that there’s not a great deal of benefit to be gained from blaming almost every citizen, as it does nothing help assist determining what can be done to improve things in the future. So I suppose it would be more helpful to blame, say, the education system, or even the prevalence of fundamentalist religion, etc. – areas that could in principle be improved by a government actually concerned about its citizens’ ability to participate in a working democracy.