More thoughts on the Subprime Crisis

Here’s a response to this morning's Marotta post on the causes of the subprime crisis as well as some of the comments on the post.  It's from an investment professional at a global financial services firm and frequent FMF reader. 

"If you continue to not agree with the explanation, then please, counter his arguments, or provide an explanation of your own."

Post wasn't addressed to me, but I'll gladly take the bait.  I'll start with the explanation of my own.  In short form, my explanation is that greed of prospective homeowners and greed of large lenders collided, creating an environment where both believed they could be rewarded for their behavior despite the fact that it led to the current situation.

From the borrowers' perspective this is simple.  Buy a house nicer than you can afford by using an ARM to make artificially lower payments in the short term, continually refinance as long as prices go up, turn in the keys when prices go down and your ability to refi goes down with them.

From the lender's perspective, here's how greed explains the situation without having to resort to any particular ideology:

(1)  Many issuers are not the same people as the ones who end up "holding the bag".  Several mortgage lenders are still in great shape because of their business model -- put subprime borrowers into mortgages, securitize the mortgage pools and sell them, receive a fee annually for servicing the mortgages (i.e. collecting the mortgage payments and distributing them to the securities holders).  Comparisons of average subprime collateral characteristics prove that this led to the crisis.  Lenders such as CIT group who issued loans with the intent of keeping those loans (as opposed to selling them in a securitization) tend to have issued subprime mortgages with lower average loan-to-value ratios, higher average FICO scores, and lower rates of delinquency and fraud.  Meanwhile, lenders who securitized large quantities of loans and thus were not the ultimate risk-takers in the transaction issued loans to lower FICO borrowers at higher LTV ratios, and those loans have performed significantly worse.

(2)  Greed drives financial markets.  Lending money to subprime borrowers in 2007 was no more insane to buying the IPO of a tiny unprofitable web-based tech company in 1998, or buying an S&L bond in the 80s, or buying stocks on leverage in 1929.  The longer a particular class of securities continues strong performance without any reminders of the risks inherent in the investment, the more demand the investment community has for that class.  People now understand that tech was a "bubble", prehaps because retail investors -- individuals -- were heavily involved and lost a lot of money by providing capital to companies incapable of providing a return on that capital.  However, prehaps because the investors who provided capital to subprime mortgage borrowers were institutional rather than individual for the most part, there is apparently a thought that they were "too smart" to actually issue those loans.  Newsflash, institutions lost alot of money in the tech bubble too.  They are far from infallible, and actually have driven most of the asset price bubbles in recent global history, including subprime, tech, Japan, S&Ls and what may be the next bubbles in commodities and/or emerging markets.

To counter Mr. Marotta's arguments:

(1)  There is no link between the CRA and subprime -- The CRA was enacted in 1977, but the subprime lending that caused the current crisis exploded a full 25 years later.  Even from Clinton's 1994 revisions, the explosion in volume of subprime lending did not take place until 8 or 9 years later. Clinton's goal for home ownership, according to Mr. Marotta, was met in 2000.  Subprime crisis has to do with loans issued in 2006 and 2007 for the most part.  In late 2004, Bush announced plans to sharply weaken CRA regulations, but subprime lending grew by leaps and bounds in 2006 and 2007 relative to 2002 and 2003. Again, why don't the timelines agree? 

(2)  CRA doesn't even apply to most subprime loans.  Less than 25% of subprime loans were made by institutions fully governed by CRA – most were made by independent mortgage companies fully outside CRA’s jurisdiction. Furthermore, lenders subject to the CRA have engaged in dangerous lending less frequently than other lenders.  Janet Yellen, president of the San Francisco Fed, said that independent mortgage companies NOT COVERED BY THE CRA made high priced loans at more than TWICE the rate of banks and thrifts.

(3)  If the CRA was really to blame, then wouldn't the lenders have raised he** by now about how the government forced them to lose money?  Why is the rhetoric around Barney Frank's FHA proposal centering around the phrase "government bailout of irresponsible lending" without even a squeak of protest from the allegedly irresponsible lenders?  Answer for yourself.

(4)  A house is not a liability.  A mortgage is a liability, a house is an asset.  Accounting 101.  A home can be an excellent asset if you do what FMF has done and pay off your mortgage as rapidly as possible.  You no longer make mortgage payments or pay rent -- if you find yourself unemployed, nobody can take your home from you.  FMF could share links on the topic of why home ownership is generally a good financial idea. (See Why It’s Smarter to Buy than Rent as an example -- though what's happened the past two years may change the numbers a bit.)

(5)  Mr. Marotta decries the fact that "nobody listens to economists", implying that economists generally think that this government regulation caused the subprime crisis.  Untrue.  For example, the economists who wrote the NYT Best Selling book "Freakonomics", as well as their colleague Itzhak Ben-David, blame the same thing that I do -- securitizations driving lack of due diligence by lenders.

So do University of Chicago economists Benjamin Keys, Tonmoy Mukherjee, Amit Seru, and Vikrant Vig (PDF).

Economists Carmen Reinhart and Kenneth Rogoff note that the causes of the subprime crisis are extremely similar to 18 earlier post-war banking crises in industrialized countries.  Note that those crises and countries didn't have Bill Clinton or the CRA to blame.

The list goes on.  The economic consensus today was that the incentives system was broken – the people responsible for doing the due diligence on an individual mortgage loan (the lender/originator) was typically not the same person who was taking the economic risk if the loan ended up going bad.  The real blame rests in the fact that markets are not happy risk-free things that merrily chug along at equilibrium returns every year.  Markets have *risk*.  Market participants cycle between extremes of fear and extremes of greed like a pendulum.  The subprime environment of 2006, like the internet-startup environment of 1998, is gone for now and unlikely to return in our generation, because investors have learned more about the true measure of the risks involved in these investments.  But the best explanation for those two bubbles, as well as the many other investment bubbles in history, is that for many years a certain class of investments provided strong returns and caused investors to fall asleep at the wheel, ignoring the underlying risks of an investment because those risks had not come to fruition for years.  When the risks became realities, investors found themselves full to the gills with overexposure to those risks, and wondered how they could have been so stupid to begin with.

Misc Sources:

Prepared testimony on The Community Reinvestment Act (PDF)

Did Liberals Cause the Subprime Crisis?

Comments

[Pete]

Thank you. I knew that half of what Marotta said was full of s**t but i didn't know which half.

[Kirk]

Great post and you hit the main two culprits. However, I think the rating agencies are getting off light. Had they actually done their job these CDOs and other toxic products would not have gotten the AAA rating. With more realistic and much lower ratings, the investment banks would not have been motivated to create these products as there would have been fewer buyers.

Of course, the Alan Greenspan fed holds a great deal of blame. And, I would say the Bernanke Fed isn't helping. You can't solve a problem created by artificially low rates by lowering rates to artificially low levels.

[Christopher Smith]

A minor factual correction: The loans involved in the subprime crisis were *not* issued in 2006 and 2007--they *reset* in 2006 and 2007 (and continuing), raising payments and tipping some homeowners into default.

[Rick]

Really, you can't blame just one or two groups of people for the subprime crisis. It was a combination of many problems all intersecting at once that caused a massive blowout in the financial system.

The author of this post is correct that *part* of the problem lies with the fact that originators of mortgages were not the same ones responsible when people didn't pay the bill. Part of the problem is people too greedy and irresponsible for taking out mortgages they new they couldn't afford. Part of the problem was the lending being too greedy and writing these mortgages, assuming that house prices would perpetually increase.

And part of the problem, as Mr. Marotta pointed out, is excessive government interference. In this case, I believe the most egregrious case of government interference is the Fed, a quasi-government regulatory agency, that kept interest rates artifically cheap. Having the price of money too cheap created an excessive demand for this money, and thus drove up the price of the things this money was used to purchase -- in this case, houses.

If the Fed kept rates at a more esensible level, then the extent of the subprime problem would not be nearly as great.

In short, it's really some of everyone's fault, and you can't just blame one group of people and call the other groups "victims".

[tom]

Thanks, FMF... that was my comment asking for a counter explanation. I was sold on Marotta's argument at first, now that's not the case.

Though I do have one question that Christopher Smith brought up... did you mean to say reset as opposed to issued? That makes a big difference in the timelines. If they were issued in 2006-2007, most likely they are just now reseting.

Also, I think the best explanation of all for the sub prime crisis is here:

http://gregmankiw.blogspot.com/2008/03/subprime-primer.html

[Sarah]

Right, and let's not forget two other things:

(1) The ratings agencies--those responsible for classing the securities as investment-grade or not--are paid in large part by the very people they rate. Guess how that's worked out?

(2) Lenders pushed people who weren't "subprime worthy" into subprime loans (say, ignoring assets that might have pushed them up into alt-A territory) because they had incentives to do so (e.g., bigger fees on subprime originations than on alt-A). Unsurprisingly, these were unsophisticated purchasers and those loans did badly...but at a lower interest rate, maybe not.

People like to rant about the greedy house-buyers, but we're talking about a bunch of incredibly sophisticated forces lining up to bring enormous pressure on people who didn't really know that much to try to rip them off, basically. Pray you're never the target of such a high-powered con scheme, people--and until you've survived one, maybe you shouldn't be patting yourself on the back about how much more clever and prudent you are.

(No, I didn't buy a house during the boom.)

[Lord]

Thanks for your response but the garbage Marotta spews is best left ignored. It only encourages more.

[tom]

@Sarah,

Regarding your #2... those people who were "conned" made the choice to buy a house even though they did not have the assets or income to do so, they knew it and the lenders knew it. All the pressure in the world can be stopped by just walking away. I am patting myself on the back for being more clever and prudent. I was a renter looking to buy at the peak of these "con schemes" and I didn't fall for their crap. Why can't it all just come down to plain ignorance? If you cannot get a mortgage loan at your local credit union or bank, what makes you think that you can handle one from the sleazy broker down the street? It's time these people and Congress take some responsibility for their own mistakes.

[Sarah]

Okay, Tom, keep on telling yourself that it could never happen to you, only to the Bad, Lazy, Greedy People. A lot of PF people seem to need to think that to get themselves through the night.

[Jake]

"The loans involved in the subprime crisis were *not* issued in 2006 and 2007--they *reset* in 2006 and 2007 (and continuing), raising payments and tipping some homeowners into default."

While there were definitely some subprime loans issued in 2004 and 2005 that reset in 2006 and 2007, the volume of subprime loans issued in 2006 and 2007 (and thus reseting in 2008/09/10) is a couple times greater than the volume of subprime loans that reset in the past two years! In addition, the "ABX" index, an index that tracks the performance of subprime loans issued in a certain 6 month period, shows that loans issued in late 2005/early 2006 have performed much better than loans issued in late 2006 and early 2007, and that loans issued in late 2007 are expected to do even worse over their lifetimes.

[tom]

@Sarah,

I can tell you, with 100% certainty, it won't happen to me. Before I sign up for anything, I have to do my research and understand what I'm signing. It is the borrowers responsibility to understand the terms and conditions. If they don't understand, then they need to learn. They can go to their local library and access the internet for free. I don't buy this predatory lending garbage, because no matter how much pressure they put on you to sign up, you can always walk away. If the deal is too good to be true, it usually is. The same goes for these "high-powered con schemes".

[mikeb]

THANK YOU!

Wow, I was catching up on my RSS feeds and got angrier at the one-sided crap from that previous post. I am in the top 95% of individual income, and I was offered a ridiculous mortgage when I bought my current home less than 2 years ago. That has nothing to do with a minority or an increase in ownership. They were greedy, they wanted to get my money, not let the next guy have it.

Thankfully I put 20% down, so now that I'm down about 25% on the house, I really am only 5% under water. The 20% was bubble money from the previous house, so I have lost about 5% out of pocket. I am not concerned about recouping that in the next few years, so I'll be fine.

They were willing to give me a 100% mortgage that I could not have realistically afforded. I was utterly amazed that I was approved for it.

I have plenty of friends who are in financial trouble with their homes because they weren't as conservative as I was, and none of them match any of the minority, lower class, or first time home owners that the article speaks to.

Something tells me he bleeds right-wing nut.

[Independent George]

I'm uncomfortable with ascribing moral judgements to a fundamentally economic problem. Yes, borrowers/lenders were greedy, imprudent, and manic, but were they any more so than in previous bubbles?

1. Like all bubbles, the real estate market didn't start out as one. MBS trading and subprime lending did in fact become more efficient in the late 90s, and for a brief while, they were underpriced. The problem is that commodities rarely stay underpriced for long, and once the first few people made money off of it, the traders did what they always do: they followed the herd right over the cliff.

2. There's nothing inherently corrupt about selling mortgages. In fact, by making a morgage more liquid, for a while, it helped consumers by lowering rates. It's easy to see fraud when lenders sell what turned out to be non-performing loans, except that the same lenders were also buying those same loans from other banks. The lenders thought they were being prudent by diversifying into different markets. Unfortunately for them, diversification by industry is as important as diversification by geography, so when the markets collapsed nationwide, it didn't matter how 'spread out' their holdings were; they all tanked at the same time. Absent evidence to the contrary, I can't help but conclude the lenders weren't conning anyone; they all suffered from the same collective hallucination. Not that it makes a difference in the end, but this goes back to my original point of ascribing moral judgements to economic problems.

[David John Marotta]

The author (who is the author???) writes, "Mr. Marotta decries the fact that "nobody listens to economists", implying that economists generally think that this government regulation caused the subprime crisis. Untrue. For example, the economists who wrote the NYT Best Selling book "Freakonomics", as well as their colleague Itzhak Ben-David, blame the same thing that I do -- securitizations driving lack of due diligence by lenders."

Even if we grant that the creation of structured investment vehicles (SIVs) of mortgages is one the primary cause of the subprime meltdown instead of the CRA, this is a false dichotomy. The CRA changes of 1995 is what allowed the securitization of CRA loans containing subprime mortgages:

Community Reinvestment Act (Changes of 1995):
The 1995 revisions were credited with helping to substantially increase the amount of loans to small businesses and to low- and moderate-income borrowers for home loans. Part of the increase in the latter type of lending was no doubt due to increased efficiency in the secondary market for mortgage loans. The revisions allowed the securitization of CRA loans containing subprime mortgages. The first public securitization of CRA loans started in 1997.

It is still the case that the CRA purposefully weakened lending standards and then provided a way for those incentivised to weaken lending standards to avoid continuing to hold their liabilities.

David John Marotta