March 27, 2013
Understanding the housing bubble
A key reason that I was insufficiently worried in 2005 about bad mortgage loans being made at the time was that the people who funded the loans-- most importantly, the packagers and buyers of private-label mortgage-backed securities-- had more motivation and resources to evaluate the risks accurately than I did. That they made an incredibly costly mistake is now indisputable. But the question remains, why?
One interpretation emphasizes misaligned incentives. Money managers earned bonuses while others were left holding the bag. Institutions like Fannie, Freddie, and AIG profited handsomely during the run-up, but the government picked up the tab when things went bad. These kinds of explanations come very naturally to most economists, whose models are usually built on the assumption that economic decision-makers are responding in a rational way to the incentives they face.
But an alternative view is that the key players were simply mistaken as a group, lulled into a misunderstanding of what was going on through social and institutional feedback that sustained a misguided groupthink. This view is hard for many economists to embrace, though there is a good case to be made that this is an important part of the story of what we just went through.
A new research paper by Ing-Haw Cheng, Sahil Raina, and Wei Xiong has come up with an ingenious way to test which of those two explanations best describes what really happened. Quoting from the paper:
We sample a group of securitization investors and issuers from a publicly available list of conference attendees of the 2006 American Securitization Forum, the largest industry conference. These investors and issuers, whom we refer to collectively as securitization agents, comprise vice presidents, senior vice presidents, managing directors, and other non-executives who work at major investment houses and boutique firms. Using the Lexis-Nexis Public Records database, which aggregates information available from public records, such as deed transfers, property tax assessment records, and other public address records, we are able to collect the personal home transaction history of these securitization agents....
Our analysis shows little evidence of securitization agents' awareness of a housing bubble and impending crash in their own home transactions. Securitization agents neither managed to time the market nor exhibited cautiousness in their home transactions. They increased, rather than decreased, their housing exposure during the boom period through second home purchases and swaps into more expensive homes. This difference is not explained by differences in financing terms such as interest rates, or refinancing activity, and is more pronounced in the relatively bubblier Southern California region compared to the New York metro region. Our securitization agents' overall home portfolio performance was significantly worse than that of control groups. Agents working on the sell-side and for firms which had poor stock price performance through the crisis did particularly poorly themselves.
Our analysis presents evidence that is broadly inconsistent with systematic awareness of broad-based problems in housing among mid-level managers in securitized finance based on a revealed beliefs approach. However, a home purchase provides a consumption stream that may not be easily found in the rental market, and thus may reflect a consumption motive in addition to beliefs about the future path of asset prices. Despite this, our analysis can be interpreted as testing for whether agents believed income shocks from their jobs in mortgage securitization were permanent. In particular, it is difficult to rationalize why securitization agents endowed with income risk tied to housing would purchase additional second homes and swap into larger homes in 2005 if they simultaneously anticipated an imminent broad-based collapse in housing markets. We also find little evidence that securitization agents were conservative in the value-to-income ratios of their purchases, and that homes purchased in 2004-2006 were among those most aggressively sold in 2007-2009, relative to both control groups. This suggests that securitization agents overestimated the persistence of their incomes and that any consumption stream in these houses was short-lived.
Another way I sometimes pose this question is as follows. Suppose we gave an individual securitization agent perfect foresight of what was to come, that is, exact knowledge of the current and future path of their personal bonuses, stock options, and career path. If they had this information, would they have made the same decisions as they actually made in 2005-2006? If so, that would be confirmation that the basic problem was one of misaligned incentives.
But the data uncovered by Cheng, Raina, and Xiong suggest that, at least as far as their personal home purchases are concerned, the answer would be no.
Posted by James Hamilton at March 27, 2013 06:03 AMdigg this | reddit
Many other areas of the developed world had housing bubbles and over-extended mortgage lenders in the same period.
What is the point of looking at only one area? What lessons can be drawn?
Posted by: c thomson at March 27, 2013 06:26 AM
This is an interesting study. It suggests that broader macro forces were at work, rather than nefarious manipulation by a specific set of financial agents.
This is also consistent with the expanse of the bubble, which included Iceland and Ireland, two markets which we would think US real estate agents did not influence.
Finally, such bubbles have typical patterns. For example, I seem to recall that securitization of mortgages (CDOs, CMOs, etc.) also occurred before the Great Depression. So did the appearance of blank check companies (SPACs, as they are known in the US today). Excessive liquidity leads to a search for yield, and that in turn leads to ever more exotic instruments parsing risk in increasingly unconventional and poorly understood ways.
Thus, the Cheng et al study would seem to lend indirect support to the Blame It on Beijing theory. Excessive speculation was driven by excessive liquidity, not by the poor ethics of the financial community. This implies the only real safety valve on the economy was the Fed, and they failed to act decisively because rising asset prices were not associated with rising inflation, which would have been the customary trigger for tigher monetary policy.
Posted by: Steven Kopits at March 27, 2013 06:31 AM
Why can't it be both?
Posted by: Andy at March 27, 2013 06:33 AM
Gee, does it make me feel better to think of the financial sector as crooked (based on the evidence of selling structured mortgage-backed vehicles that were expressly designed to be shorted) or just stupidly greedy (based on this research)? Hmmm, that's a tough one. Either way, it makes me very worried that this group wields so much political power that they have been able to shrug off virtually all meaningful re-regulation. The little that has been accomplished on that front is now being walked back by their minions in Congress, including the legislation now progressing that will allow the banks to house derivative activites inside their FDIC-insured subsidiaries.
What could go wrong with that?
Posted by: Bill Meyer at March 27, 2013 06:35 AM
Nate Silver (the 538 Blog guy) addresses this topic in his book. In a nutshell, he thinks that the rating agencies confused risk (which can be quantified) with uncertainty.
Posted by: Jeffrey J. Brown at March 27, 2013 06:49 AM
stupid money plus stupid people shaken not stirred and topped with a large greed olive. yum!
why is any fancy study needed to understand the bubble. econothought does not rule the world. if it did the world would be a dull place.
Posted by: dilbert dogbert at March 27, 2013 07:46 AM
The idea of hedging risk was sound. You insure one person against a certain event. If you spread the risk by doing this with many clients, you're essentially running an insurance firm. If you cancel the risk by insuring someone else with opposite exposure to the same event, you are running a hedge fund. Both insurance firms and hedge funds have to calculate incredibly complex risk. Something as simple as a farm future already involves climate modeling, usually on a global scale.
If you rely on the models long enough and rake in profits, you start believing them, and you put your boffins to work on reducing second, third and fourth order risks. You end up with vast, very heterogenous portfolios that have no risk.
Except that some risk factors are never accounted for. Counterparty risk is the one that underlies the "systemic failure" problem: part of your risk balancing involves working with other institutions, and their demise completely upends your risk profile. But a more basic failure is that neutralizing risk against "normal" changes in the market comes at the cost of much steeper rises in risk when things change more than "normal". The "black swan" event is a bit misleading in that it gives the idea that we're talking about a single big change that upends the models. In reality, a number of correlated changes can destabilize the risk profile of a portfolio. The correlation can be accidental or just not present in the model.
This is also why it was not possible to trade "toxic" assets after the underlying models had been discredited: without industry-wide agreement on the validity of valuation models it was not possible to put a price on them.
Unfortunately, nothing has changed here. We simply can't model reality well enough to avoid these events. Worse, if a company would properly value assets, it would charge more to take on risks, which would put it at a competitive disadvantage. So it's bad to have a better model, at least as long as things are going well.
This means that an unregulated financial system that strives for high efficiency (low transaction costs) will always end up crashing and burning. This isn't a problem per se, as long as it does not take the rest of the economy with it.
Posted by: endorendil at March 27, 2013 08:03 AM
Ahem. I note my comment at July 11, 2005 10:21 PM to http://www.econbrowser.com/archives/2005/07/how_to_talk_to.html
Posted by: Stuart Staniford at March 27, 2013 08:52 AM
Thanks Endorendil for your sage words.
"an unregulated financial system that strives for high efficiency (low transaction costs) will always end up crashing and burning. This isn't a problem per se, as long as it does not take the rest of the economy with it."
In what universe can any financial system crash and burn without taking the rest of the economy with it?
Posted by: MarkS at March 27, 2013 09:00 AM
Positing this as an either misaligned incentives or group think provides a false dichotomy. Human nature being what it is we must admit that incentives affect perceptions.
Upton Sinclair once observed, "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"
Similarly, 'it is easy to get someone to believe something when believing it helps him earn a bonus.'
Posted by: Theo at March 27, 2013 09:37 AM
There is a video online, maybe from PBS, I saw several months ago. One scene followed the front line mortgage analysts as they analyzed thousands of mortages. They talked about waiters and waitresses reporting $400k in income, or some unbelievable number like that. They joked about some of the outrageous claims on the mortgage applications. Their supervisors told them not to take any action. The takeaway was that it was obvious many of the loans would default, but they were processed anyway.
The pressure to produce went all the way up the chain of command. The business model of borrow short, buy every mortgage available and securitize was well known. The incentive for upper management was that the competition was doing the same thing.
It was a game theory problem with a fuzzy time horizon and fuzzy penalty for getting caught. If I break the rules, I earn a bonus and keep my job. If I get caught, so do my peers, so I still perform at my peer level. If I don't bend(break) the rules, I underperform my peers, earn no bonus and get fired.
Which is worse? Getting fired while my peers who break the rules do not get fired. Or, breaking the rules and earn my bonus as long as the industry-wide business model works?
The question was whether or not a law-abiding ethical manager could survive until the business model collapsed or the SEC stepped in.
In hindsight, the best strategy was to break the rules. There were no major penalties for individuals who broke the rules. For the most part, they kept their ill-gotten gains.
Regarding the real estate purchases of securitization agents. They saw real estate booming and had full information of the underlying cause. Why would they think the end-game was near? In other words, did they have the skill to predict a trend reversal in home prices?
It would be interesting to see the average holding period and average amount of exposure for agents vs the benchmark portfolio for real estate holdings. Securities agents may have been treating the home market as a trade rather than a long term investment. The may have built up larger exposures than the group in the benchmark portfolio of real estate.
Posted by: tj at March 27, 2013 09:42 AM
Do the authors address the wealth effect and the fact that these securitizers may have made so much money that the purchase of trophy homes was not a significant investment decision?
How many of the securitizers have lost the homes to foreclosure vs. how many are comfortable today and wouldn't have cared much about dropping property values with perfect foresight?
I agree with Andy: it's both.
Posted by: W.C. Varones at March 27, 2013 09:45 AM
The research of Cheng, Raina, and Xiong cited in the article is very interesting. For me it reaffirms Upton Sinclair's principle that "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!"
Posted by: Cris P at March 27, 2013 10:04 AM
The sampling of individuals might be highly biased (though I haven't read the paper referred to). From my own experience, attending conferences is many times an activity pursued as a perk by agents, often by un-busy and possibly mediocre agents. Perhaps sampling those not in the conference within the same business groups would reveal different behavior. Perhaps the smart people were too busy working to have time for enhancing group-think at a conference.
Posted by: david at March 27, 2013 10:06 AM
As someone that litigated with the funding entities (e.g., Lehman)and saw the internal memos, etc., I have to say that the conclusion in the article is only partly right. These guys -- and it was mostly guys -- knew full well the fraud that was going on in originating and securitizing. They just did not expect to get caught, knew if they were caught that the only punishment likely was they would have to give some money back and thought they were so smart they would see the end coming, if it ever did, long before the rest of the world. By the time the end came, they were in so deep they couldn't unwind and/or had actually bought their own lies.
Posted by: Dan Mulligan at March 27, 2013 10:39 AM
Paper here not behind NBER paywall.
They do consider wealth and income and still find that the agents were oblivious.
... which still doesn't imply that bad incentives are good policy.
Posted by: W.C. Varones at March 27, 2013 10:46 AM
One may suggest going through the chain of execution by climbing up this chain and the conditions precedent for this successful disaster.
Low interest rates, please see the derivatives in each of the main banks books OCC derivatives and the same to be made available in Europe.
Government bonds, please see the retention of bonds by the primary dealers, remember the Fed Boston raiding a bank where hedge funds would receive shelter (Google cannot help).
The new appointed Fed chairman instructing the primary dealers to stop manipulating the bonds markets (Was it C.Harper from Forbes? Google is not responsive to the query).
Dealers from City Bank Frankfurt being expelled for selling Bunds at lunch time with effect of raising yields of the said Bunds.
Fed Boston paper evidencing the inadequate ratings of the mortgage loans.Even after events of default,derivatives of sub prime not looking alike the primary function, the mortgage loans that is. Even when the "primitives" were underwater.
The leverage of Banks and the concentration of risks on a specific sector, being unattended by the supervision bodies.
The public accounts leverages in Europe trespassing the constitutional covenants and the domestic reasoning.
« An equilibrium model of global imbalances and low interest rates »
So well used by many countries exhibiting the same pathology, structural current accounts and balance of payment deficits. They produced assets and they produced higher prices.
Excluding public functions, supervision bodies, and political families from the sets of the suspects is not a fault but a crime.
Posted by: ppcm at March 27, 2013 11:51 AM
I was going to post bits of a discussion I had with some of my supply side friends from 2007 concerning this. Their perception of what was going on is amazing looking back. I have not reread the discussion until today.
As the professor notes, the one considered experts had no idea there was a problem. My friends sold homes and moved into rentals and they sold investment properties and sat on large cash positions.
There are many who did see this coming but most of them learned their economics in the real world rather than in Keynesian classrooms.
Posted by: Ricardo at March 27, 2013 01:01 PM
The housing bubble was a investment decision and one most "keynesian" classrooms saw coming quite noticeably.
The "free market" loves this system. Valuation bubble, bust, bailout, repeat. Been going on since the 80's. This one got a little out of control, but they can do a better job next time..............
Ricardo represents the "ivory tower" problem. He forces his own views of what the market should be, and ignores what the market actually likes.
Posted by: The Rage at March 27, 2013 01:50 PM
Just because some people get burned by a scam doesn't mean they didn't know it was a scam. Look at the Bernie Madoff clients. A lot of his clients thought he was a crook. They just thought he was stealing for them, not from them.
Likewise, a lot of the mortgage players knew they were running a scam. They just thought they were smart enough to get out before it blew up.
I don't think this paper proves anything about participants beliefs. It's the old argument, ala Goldman Sachs, that they lost money on the scam so they didn't do anything wrong. Getting burned isn't proof of no criminal intent.
Posted by: Joseph at March 27, 2013 03:04 PM
As humans I think we are always susceptible to group think or herd mentality and bubbles are just a reflection of human nature.
From what I understand Moodys and S&P were giving these securities AAA ratings when they actually much riskier. If S&P will rate these high risk securities AAA and I'm at Goldman I'm going to try and package and sell as many of these I can. Then if I can get AIG to believe S&P's rating to be valid I'll buy a cheap insurance policy against it.
But why did Moodys and S&P not asses the risk properly and why did so many people blindly trust their opinions? The best answer I could come up with is a combination of ignorance and corruption inside the ratings agencies. Some were probably in on the scam and most were probably just not able enough to rate those securities properly.
So if I am part of the herd and if JP Morgan and Goldman are the leaders and they apparently trust the ratings agencies enough to sell these securities to their customers, then everything must be ok and I'll get in on it too.
Posted by: Matthew Atkinson at March 27, 2013 03:52 PM
I live in SoCal, and I think what's missing from the paper is that the housing crash is a very localized affair that can only be appreciated at the level of zip code data, not county or state-level data. The individuals whose purchases are being analyzed did not buy in the not-so-well-to-do neighborhoods that were worst hit by the crash -- and may well have done so knowingly.
From 2006 to 2010 the authors' data show that these investors only lost 7% on their housing portfolios (Table 7). This would indicate that they used their private information to make relatively wise housing investment choices -- and they certainly did not choose to invest in the neighborhoods where NINJA loans were being given out on the principle that housing prices in these neighborhoods could not fall.
Posted by: Anon at March 27, 2013 04:31 PM
You are still left with most of those loans being liars loans. How could they really beleive those would not go bad?
Posted by: steve at March 27, 2013 06:17 PM
Understanding the housing bubble? this may help
There is in Russia a private investment « house » run by a single man whom went through the hard way as an apprentice of the modern era in investment banking.
Sent to colony or rehabilitation penitentiary for setting up a straightforward pyramidal scheme, where the first subscribers may collect more money than the very last out, he came back from the penitentiary « plein d’usage et de raison » full of practice and reasoning.
He is now launching investment trust funds with garden varieties of pay out but all these funds are properly registered with placing memoranda representations and warranties, due recommendations to the subscribers to seek legal and experts counsels, when not in full understanding of the placing memorandum content. In compliance with the legal requirements, the last time heard of, he was launching an inverted pyramidal fund where the last subscribers out, may collect more money than the first in. One may have to read the full content of the placing memorandum to know whether or not there is an incentive fee for attracting the first subscribers.
Posted by: ppcm at March 27, 2013 09:00 PM
Perhaps the securitization agents knew the stuff they were selling was wormy but assumed it wouldn't matter in the greater scheme of things, because they didn't understand the credit cycle dynamics and might not have known how widespread the worminess was.
Posted by: Tom at March 28, 2013 01:31 AM
Generally, it was people who had some broader understanding of credit cycles who were ahead of the crisis. They were not especially experts in subprime lending, although some of them made themselves such.
Posted by: Tom at March 28, 2013 01:36 AM
As one commentator noted, "both explanations," and possibly more, have validity. Although Ricardo Troll Von Hayek might have missed it, two Keynsians, Dean Baker and Robert Schiller, along with some internal economists in the Federal Reserve, were issuing serious warnings about the Housing Bubble starting in 2002. Market fundamentalists such as Alan Greenspan dismissed their concerns. Further, throughout the financial elite and media there was a belief going all the way to the top of the banks, even banks and mortgage securitizers that knew they were essentially running control frauds, that "U.S. housing prices never fall." And, at least in nominal terms, that certainly was true in the living memory of all the players in the financial markets. Who cares if the loan is a "liar's loan" and that the income is reported is false if the underlying asset will be 25% more valuable in two years? This is where Minsky's work how "Ponzi Finance" stage of a credit boom so accurately described the unfolding of events. In other words, individual and institutional incentives to commit fraud were very strong, particularly locked into a group think belief that the rising asset price would make the fraud irrelevant. Then when the asset price stopped rising, and started to fall, in 2006, it took another 18 months to overcome the "Sinclair Lewis" effect about not understanding facts when your salary depends on that denial.
Posted by: sherparick at March 28, 2013 05:20 AM
Of course, it's quite possible that expensive oil had a negative impact on outlying suburban areas. It's interesting to see how events have unfolded since the following video was released in 2004:
End of Suburbia: Oil depletion and the collapse of the American Dream
Link to trailer:
Link to full video:
So, what happened after the video was released . . .
Global annual crude oil prices (Brent) doubled, from $55 in 2005 to $111 or more in 2011 and 2012.
In response to the post-2005 price signal, total liquids production increased from 84.4 mbpd in 2005 to about 88.9 mbpd in 2012 (EIA).
However, based on the available data, especially the crude oil production statistics compiled by the 12 OPEC countries, it seem likely that there was virtually no increase in global crude oil production since 2005. Crude oil is defined as less than 45 API gravity.
Therefore, virtually all of the post-2005 increase in total liquids production consists of: (1) increased production of liquids--condensate and natural gas liquids--that are derived from natural gas sources and (2) increased production of low net energy biofuels.
Net oil exports are most commonly defined as total petroleum liquids production in an oil exporting country less their domestic liquids consumption, and are calculated in terms of total petroluem liquids. A data base for the 2005 top 33 net exporters, which are defined as Global Net Exports of oil (GNE), show a small decline in net exports from 2005 to 2011 (2012 data not yet available), with the developing countries, led by China, consuming an increasing share of a declining volume of GNE.
Here is the absolutely critical point: If global crude oil supplies are virtually unlimited, why have we almost certainly seen no material increase in global crude oil production since 2005, and why have we seen a measurable post-2005 decline in Global Net Exports of oil, despite a doubling in global annual crude oil prices?
My view is that, using the "Sixth Sense" analogy*, for most Americans our auto centric suburban way of life is dead, but most of us don't know it yet, and we only see what we want to see.
*In the movie, most ghosts don't know they are dead and they only see what they want to see, AKA denial.
Posted by: Jeffrey J. Brown at March 28, 2013 07:16 AM
Krugman called for a housing boom after the dot com bust, and everyone shouted "great !" (except Bill McBride).
There are a lot of criminals out there, and so the subprime lending got engineered, with GS betting on an implosion of this house of cards. It took a long time until collapse, a lot of water under the bridge.
And as long as the banks are not held accountable (say TBTF + bailout), I say : "Play it again Sam !".
Posted by: Johannes at March 28, 2013 07:21 AM
But no worries, we at least have near infinite supplies of cheap natural gas don't we?
There was a hilarious interview on CNBC regarding the natural gas (NG) storage report (shortly after 10:30 Eastern). Storage was down by 95 BCF:
The reporter was talking to an analyst who--a year ago--suggested that we were headed to $1 NG prices, when the price was then around $2. The analyst said that we were still "Well above the 5 year average in storage," (Not true methinks, we are only slightly above five year average), and she put the price ceiling at $4.25.
So, based on prior track record, perhaps we should expect $8 natural gas a year from now, or would it be $16?
Posted by: Jeffrey J. Brown at March 28, 2013 07:56 AM
Yes, a variety of factors and conditions contributed. The largest contributor was a reality. Housing prices had never before declined in the nation as a whole over a sustained period.
I am also interested in an additional question. Why did Paulson and Bernanke consistently underestimate the seriousness of the problem?
Answer - The year 2000 Future Commodities Modernization Act explicitly prohibited Federal Agencies from collecting information on derivatives. No one knew how many insurance contracts had been written by private agencies.
Posted by: ReformerRay at March 28, 2013 08:01 AM
Given the obscene amounts of money those people walked away with after the crash I think the real question is why wouldn't they have blown up the banks.
I mean if you walk away filthy rich in your thirties why would you care? For my money the best reference on this is Frank Partnoy.
Posted by: Noah Campbell at March 28, 2013 08:03 AM
I read the paper and as I read it I found myself asking, "What do economists think happens in business?" That is a real question. I've been in business for some decades.
So for example, we want to build condos or convert some buildings into a higher use. What drives that is the cost of the asset and the end price, with a bunch of stuff in between. Every time, not just in the worst bubble imaginable, someone gets priced out: asset prices rise to the point where people are taking risks that aren't "economic" for others. What drives that "economic" choice is your cost of capital and the amount you can afford to risk, which relates to how much you owe, etc. Every time. And every time the people paying more are professionals. This happens until prices reach the point where the people can't make money unless the thing sits for years or goes through a bankruptcy or two or a forced sale. This is all done by professionals. Sure there are some amateurs but they get eaten regularly.
I don't understand the idea that professionals should know. Is that what economists believe? I'm seriously asking the question. Because this is not how life works.
I looked at the null hypothesis: the "null hypothesis that securitization agents were aware of serious problems and that a large crash was imminent". OK. If they had found that, I would say the market was rigged because the only way that happens is if there is collusion and people are pushing up the market to sell it short. (Or maybe if this is some kind of comic book terrorism to destroy wealth.) I would argue as well that the hypothesis is badly put together: "aware of serious problems" is not related to the second part. The implication is they're testing awareness of the first when it looks pretty clear they're only testing the second. I can list a ton of reasons why "awareness of serious problems" doesn't change behavior. I can not do the same for "oh, oh, look out, here comes a meteor!!!" The paper conflates these two when they're really saying "we find no evidence to support the proposition that people in the field were aware they were about to lose everything because God was going to crap on their heads."
I thought the paper was otherwise well put together but wholly written in the context of academics where understanding of real world behavior is extremely limited.
Posted by: jonathan at March 28, 2013 08:16 AM
Both. As many commentators above have stated, "people will believe easily something they WANT to believe is true"!
In 2007, I commented on several blogs about the coming subprime crisis and potential stock market crash.
The general attitude to these posts was much the same as to the man-made global warming scam - people REFUSE to accept facts. I recall being treated as a "rogue whacko" on several blogs by many. Just as I do today when I point out that data and physics shows man-made global warming is a scam.
Anyway, I made a lot if money by selling all stocks in 2007 and going to cash, buying back in the market in 2009 and buying a foreclosed property in 2011. On the whole people are inanely gullible and feeble minded but our government leadership and regulators should have known better!! I blame them rather than the average joe mortgage underwriter...
Posted by: Jeremy at March 28, 2013 09:04 AM
Part of the housing bubble was a long interest rate bubble, which was engineered by the federal reserve. currently, fed is engineering another extra low interest rate environment, which is boosting the price of 20 trillion fixed income asset. It is not relevant how individuals will manage this risk: the 20 trillion fixed income asset is in the system, and when interest rates go up 3 percentage points, the system will suffer 600 billion mark to market loss. Don't blame a money manager when that happens ... somebody has to take the loss.
Posted by: PS at March 28, 2013 10:53 AM
Yes, the question is why. Substantial incentives existed to prevent the sort of debacle that happened. For example, if you wanted to be in the subprime lending business, funding suppliers and the banks you would sell the loans to required minimum capital requirements before they'd do business with you. That's because if a lender sold a loan to a consolidating bank and there was an early payment default (EPD) or fraud, the lender was required to re-purchase the loan and take the loss. So, the lender had to have sufficient capital to be able to do absorb losses. And, since lenders were responsible, they had strong incentives to exercise good credit judgment in examining loans that brokers brought to them.
When you look at the actual incentive structure that existed in the housing market, I think it's difficult to make the argument that incentives were mis-aligned. To understand what actually happened, a good area to focus on is the 2006 subprime vintage, which ended up defaulting at twice the 2005 vintage, despite the fact external indicators of credit quality such as FICO scores and LTV were similar. EPD accelerated in early 2006, but if you go back and look at the ABS research discussion, no one anticipated that it would turn out like it did by the end of the year. To this day, people are not sure why it did.
One possibility is that lenders invisibly relaxed credit standards, not by changing standard metrics such as FICO scores, but rather by relaxing the due diligence that is not reflected in hard numbers, because they got much more bullish about credit.
But, why did that happen in 2006 and not before? The explanation of mis-aligned incentives doesn't work since incentives were the same. The problem in 2006 was the EPD in the 2/28 hybrid ARM, but that was not a clear before 2006. As I mentioned, when you look at ABS research and investor discussion, no one was aware of the coming problem.
Another possibility is that it was just a mistake pure and simple. Perhaps standard credit scoring models work provided you apply them to the most credit worthy borrowers, who self-select under normal circumstances. But in a housing frenzy, borrowers show up who never would before and the standard credit scoring and credit analysis doesn't work for them. That could explain the surprise in 2006.
I tend to think both explanations have some validity. Evidence for the view that the market got more bullish on credit and may have invisibly relaxed credit standards can be found by looking at default swap spreads in late 2005 through 2006. The Moody's composite single B 5-year spread hovered in the 200 to 300 bps range during that time. This is remarkably low.
To see this, let's take 250 bps as a benchmark and estimate the market's view of the 5-year default rate. The risk neutral default rate is approximately
1- exp(.025*5/.6) = 19%
over 5 years. That's risk neutral and so contains a risk premium. As a back of the envelope, I'll assume that the true market expectation is 2/3 of that value, which gives us a 12.5% 5-year default rate.
Contrast that with the Moody's empirical 5-year cumulative default probability for a single B name, which in 2005 would have been on the order of 32%. The market expectation of defaults over the following 5 years was less than half what had been seen empirically.
That suggests that there was a widespread bullish view on credit, which would have been consistent with a general relaxation of credit standards that would have resulted in the surprising default rates seen in the 2006 and 2007 subprime vintages.
People focus on incentives because they want a villain to blame. But this wasn't about incentives at all.
Posted by: Rick Stryker at March 28, 2013 11:19 AM
Isn't it possible that they did think there was a bubble, but were applying the "bigger fool" theory -- betting that they would be able to sell those homes before the bubble burst?
The fact that they failed to time the market (to sell before the bubble burst) doesn't mean they didn't see a bubble and anticipate that it would burst at some point.
Posted by: Gordon / Brooks at March 28, 2013 01:35 PM
Professor Hamilton wrote:
A key reason that I was insufficiently worried in 2005 about bad mortgage loans being made at the time was that the people who funded the loans-- most importantly, the packagers and buyers of private-label mortgage-backed securities-- had more motivation and resources to evaluate the risks accurately than I did. That they made an incredibly costly mistake is now indisputable. But the question remains, why?
It is interesting that Ing-Haw Cheng, Sahil Raina, and Wei Xiong actually don't answer this question posed by Professor Hamilton. They answer a totally different question, "Did these 'experts' act according to their beliefs?" The answer that was found is that they did. What that tells us is that these 'experts' actually believe their errors in judgment. But a better question is was there a group that did not make their error?
Austrian predictions/Housing bubble
During and after the burst of the Dot-com bubble, numerous economists predicted the 2000s housing bubble that culminated in the Great Recession from 2008 onward.
In 2002, Robert Blumen summed up the effect of the activities of Fannie and Freddie on the housing market as shows the systemic risk and foresaw a coming bailout. Sean Corrigan pointed to the blooming real estate business among all the bankruptcies, and noted that real estate bubbles tend to pop several years after stock market bubbles, and that mortgages may fare much worse compared to stocks... along with their owners. Congressman Ron Paul criticized government involvement in housing, and said that like all artificially created bubbles, the boom in housing prices cannot last forever.
In 2004, Mark Thornton wrote that higher interest rates (indicated by the Fed) "should trigger a reversal in the housing market and expose the fallacies of the new paradigm, including how the housing boom has helped cover up increases in price inflation. Unfortunately, this exposure will hurt homeowners and the larger problem could hit the American taxpayer, who could be forced to bailout the banks and government-sponsored mortgage guarantors who have encouraged irresponsible lending practices." Later on, he spelled out the consequences for the construction industry, unemployment, foreclosures, bankruptcies, bailouts of banks and GSEs, and a long recession.
Stefan Karlsson wrote that the next crisis will be more serious than the mild recession of 2001 one; as it is, in fact, that very same crisis, only postponed.
In 2005, Doug French after observing the mania in Vegas, quipped "condos are the last segment of the housing market to catch fire in a boom and the first to crater in a bust.", and concluded that the bust must be close. Gary North warned against the danger of ARMs (adjustable rate mortgages).
Investor Peter Schiff acquired fame in a series of TV appearances (most in 2006 and 2007), where he opposed a multitude of financial experts and claimed that a bust was to come. He was warning about the speculation, ARMs, houses that couldn't be sold, people walking away from them and coming bailouts for several years before in print.
Anderson, 2001, 2003, 2007; Armentano, 2004; Beale, 2009; Blumen, 2002, 2004, 2005; Corrigan, 2002; Crovelli, 2006; DeCoster, 2003; Duffy, 2005A, 2005B, 2005C, 2005D, 2006, 2007A, 2007B, 2007C, 2007D; Economics of contempt, 2008; Englund, 2004, 2005A, 2005B, 2005C, 2005D, 2006, 2007, 2008; French, 2005; Grant, 2001; Karlsson, 2004; MacKenzie, 2003; Mayer, 2003; Mueller, 2004; Murphy, 2007, 2008; North, 2002, 2005; Paul, 2000, 2002, 2003; Polleit, 2006; Ptak, 2003; Rockwell, 2002, 2008; Rogers, 2005; Schiff, Undated A, Undated B, Undated C, Undated D, 2003A, 2003B, 2003C, 2004A, 2004B, 2005A, 2005B, 2005C, 2005D, 2006A, 2006B, 2006C, 2007A, 2007B; Sennholz, 2002; Shostak, 2003, 2005; Thornton, 2004A, 2004B, 2005A, 2005B, 2005C, 2006, 2007A, 2007B, 2007C, 2007D; Trask, 2003; Wenzel, 2004; See also Woods (2009, p. 188 for further bibliography).
Anderson, William L. 2001. "The Party is Over," February 20
Anderson, William L. 2003. "Recovery or Boomlet?" July 07
Anderson, William L. 2007. "The Party is Over – Again," August 30
Armentano, Dominick. 2004. "Memo to Federal Reserve: Increase Interest Rates Now!"
Beale, Theodore. 2009. "The Return of the Great Depression"
Blumen, Robert. 2002. "Fannie Mae Distorts Markets." Mises Daily, June 17
Blumen, Robert. 2004. "All Real Estate, All the Time". March 8
Blumen, Robert. 2005. "Housing Bubble: Are We There Yet?" May 8
Corrigan, Sean. 2002. "The Trouble with Debt". July 01
Crovelli, Mark R. 2006. "Gold, Inflation, And... Austria?" May 31
De Coster, Karen. 2003. "The House that Greenspan Built: Irrationally Exuberant Wall Street Welfare Parasites and Their Fed-God." September 12
Duffy, Kevin. 2005A "The Super Bowl Indicator," February 5
Duffy, Kevin. 2005B. "Honey, I Shrunk the Net Worth," March 3
Duffy, Kevin. 2005C. "Alan, We Have a Problem," August 2
Duffy, Kevin. 2005D. "Panic Now and Beat the Rush," September 24
Duffy, Kevin. 2006. "Are Mortgage Borrowers Rational?" June 24
Duffy, Kevin. 2007A. "It’s a Mad, Mad, Mad, Mad World," May 22
Duffy, Kevin. 2007B. "For Whom Do the Bells Toll?" Barron’s, June 18
Duffy, Kevin. 2007C. "Financial Markets on Crack," August 22
Duffy, Kevin. 2007D. "Mr. Mozilo Goes to Washington," September 15
Economics of contempt. 2008. "The Unofficial List of Pundits/Experts Who Were Wrong on the Housing Bubble." July 16
Englund, Eric. 2004. "Monetizing Envy and America’s Housing Bubble". July 19
Englund, Eric. 2005A. "Houses Are Consumer Durables, Not Investments," June 8
Englund, Eric. 2005B. "Diminishing Property Rights Will Lead to a Higher Rate of Mortgage Defaults." June 28
Englund, Eric. 2005C. "When the Housing Bubble Bursts, Will President Bush Practice Mugabenomics?" July, 19
Englund, Eric. 2005D. "When Will America's Housing Bubble Burst?" November 4
Englund, Eric. 2006. "The Federal Reserve and Housing: A Cluster of Errors?" April 22
Englund, Eric. 2007. "From Prime to Subprime, America's Home-Mortgage Meltdown Has Just Begun." September 24
Englund, Eric. 2008. "Countrywide Financial Corporation and the Failure of Mortgage Socialism." January 28
French, Doug. 2005. "Condo-mania." July 11
Grant, James. 2001. "Sometimes the Economy Needs a Setback." New York Times. September 9
Karlsson, Stefan. 2004. "America's Unsustainable Boom." November 8
MacKenzie, D.W. 2003. "Doubts about Recovery" October 08
Mayer, Chris. 2003. "The Housing Bubble." The Free Market. Volume 23, Number 8 August
Mueller, Antony P. 2004. "Mr Bailout", September 30
Murphy, Robert P. 2007 "The Fed’s Role in the Housing Bubble." December 28
Murphy, Robert P. 2008. "Did the Fed, or Asian Saving, Cause the Housing Bubble?" November 19
North, Gary. 2002. "How the FED Inflated the Real Estate Bubble by Pushing Down Mortgage Rates: Report As of 2002," Reality Check, March 4
North, Gary. 2005. "Surreal Estate on the San Andreas Fault." November 25, 2005
Paul, Ron. 2000. "A Republic, If You Can Keep It" January 31
Paul, Ron, 2002. "Testimony to U.S. House of Representatives", July 16
Paul, Ron, 2003. "Testimony to U.S. House Financial Services Committee", September 10
Polleit, Thorsten. 2006. "Sowing the Seeds of the Next Crisis." April 25
Ptak, Justin. 2003. "Government Employees, Go Home!" November 12
Rockwell, Llewellyn H, Jr. 2002. "The Marvel That Is Capitalism" April 08
Rockwell, Llewellyn H, Jr. 2008. The Left, the Right, and the State. Auburn, AL: The Mises Institute, 2008
Rogers, Jim. 2005. "Interview with Jim Rogers on the housing bubble." April 22
Schiff, Peter. "Peter Schiff predictions" (video) Undated A.
Schiff, Peter. "Peter Schiff Was Right" (video). Undated B.
Schiff, Peter. "Peter Schiff was right 2006-2007 - CNBC edition" (video). Undated C.
Schiff, Peter. "Peter Schiff Was Right Again " (video). Undated D.
Schiff, Peter. 2003A. Commentary, March
Schiff, Peter. 2003B. Commentary, April
Schiff, Peter. 2003C. Commentary, June
Schiff, Peter. 2004A. Commentary, May
Schiff, Peter. 2004B. Commentary, June
Schiff, Peter. 2005A. Commentary, April
Schiff, Peter. 2005B. Commentary, July
Schiff, Peter. 2005C. Commentary, August
Schiff, Peter. 2005D. Commentary, October
Schiff, Peter. 2006A. Appearance on CNBC, January (video)
Schiff, Peter. 2006B. Speech to the Money Show Conference, February (video)
Schiff, Peter. 2006C. Speech to the Western Regional Mortgage Bankers Conference in Las Vegas November (video, transcript)
Schiff, Peter. 2007A. Crash Proof: How to Profit From the Coming Economic Collapse (1st edition) New York, N.Y.: Wiley, February 2007
Schiff, Peter. 2007B. Appearance on Fox News – January 12 (video)
Sennholz, Hans F. 2002. "The Fed is Culpable." November 11
Shostak, Frank. 2003. "Housing Bubble: Myth or Reality?" March 4
Shostak, Frank. 2005 "Is There a Glut of Saving?" August 4
Thornton, Mark. 2004A. "'Bull' Market?" February 9.
Thornton, Mark. 2004B. "Housing: too good to be true." June 4
Thornton, Mark. 2004C. "A Bull Market in Gold — Technically Speaking", March.
Thornton, Mark. 2005A. "Is the Housing Bubble Popping?" , August.
Thornton, Mark. 2005B. "The Price of Gold: How High Can it Go?", August.
Thornton, Mark. 2006. "The Economics of Housing Bubbles.", June
Thornton, Mark. 2007A. ""We Told You So", March.
Thornton, Mark. 2007B. "Illegal Immigrants and the Housing Bubble", March.
Thornton, Mark. 2007C. "New Record Skyscraper (and depression?) in the making", August
Thornton, Mark. 2007D. "You Heard It Here First", August
Trask, H.A. Scott. 2003. "Reflation in American History." October 31
Wenzel, Robert. 2004. "Government Isn't God: FDIC Sticks Banks With Bad Loans and Sticks Borrowers With Subprime Junk."
Woods, Thomas E. Jr. 2009. Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington D.C.: Regnery Publishing
Posted by: Ricardo at March 29, 2013 12:01 PM
Securities aren't bought, they're sold. If you don't believe this, look no further than the stock market and what it's become.
Posted by: Chicken at March 29, 2013 07:39 PM
I am with Bill Black . . . this study doesn't explain who the genius was that created NINJA loans and why they created those loans.
As was described by that NPR episode of Planet Money . . . I think it was called "The Global Savings Glut" . . . they described how some mortgage broker loaned to a migrant worker who only made 17,000 dollars a year picking strawberries every dollar required to purchase a 750,000 dollar home . . . You think that the smartest guys in the room made this loan and didn't know that it would end badly? It boggles the mind that you think that they did this in good faith!
Posted by: river at March 29, 2013 10:14 PM
Did it ever strike you that this broker made this loan legally and was encouraged to make such loans by the congress and by the regulatory agencies? Also, do you actually believe that this broker would have made such a loan if he had to face the risk and liability?
The government encouraged such loans and then took the risk and put it on taxpayers. The result is that unscrupulous members of the political elite (remember Franklin Raines) took the taxpayers for a ride. The small brokers were insignificant compared to the Fannie and Freddie capos.
Posted by: Ricardo at April 1, 2013 10:37 AM
It's quite simple. In the "good, old days" commercial banks would keep some or all mortgage loans on their books. Recently, the banks sold the loans to investment banks which packaged the loans as MBS. The ratings agencies, being paid fat fees by the packagers, blessed the junk with AAA ratings. The buyers of the MBS relied on the rating agencies and those buyers got screwed.
Posted by: Thomas McGovern at April 1, 2013 10:58 PM
Time to shout out Hanlon's Razor?
Posted by: ellen1910 at April 2, 2013 10:11 AM
What boggles the mind is how Harvard MBAs, Wharton professors, Federal Reserve chairmen, and other types who convene at places like Davos to plan the global future could have believed things would turn out differently. What would make someone think that worthless loans, all mooshed together then sliced thin and sold, would somehow acquire value? Did these people believe in magic? Statists like Paul Krugman and Alan Blinder who failed to see this catastrophe coming are emerging from the woodwork now to explain in retrospect that this implosion was the result of too little regulation—the natural outcome of free-market greed, unguided by the visible hand of Uncle Sam. [Harry]Veryser [in his book IT DIDN'T HAVE TO BE THIS WAY] shows that this diagnosis is pristinely, perfectly wrong, like an autopsy report that blames a lung cancer death on “not enough cigarettes to kill the tumor.”
Posted by: Ricardo at April 4, 2013 08:15 AM
Re: the long list of Austrian predictions.
Also worth going back to read the Economist cover story of March 2002, "the Houses that saved the world".
Not Austrian, and didn't predict anything well, but it shows how well aware even mainstream media were that a housing bubble was likely developing already in early 2002. It lays out how loose central bank policy drove up house prices and prevented a collapse in spending after the bursting of the equity bubble.
The psychologically interesting aspect of a bubble is how it really does lull most everybody into suppressing their doubts.
Posted by: Tom at April 7, 2013 07:12 PM