“If price discovery continues to be unattainable in both the subprime, structured CDO and lower quality markets, and if bridges become non-liquefiable, then what we have is a ‘financing’ dilemma. With balance sheets in the dealer communities very heavy and ac-curate pricing a non-starter, the Fed may need to ease to prevent an asset valuation free fall…” – Robert Wolf, Chairman and COO of UBS Americas, July 20071
The signs were there: opaque markets, increasingly risky assets, underpriced risk, overpriced assets, dangerous reliance on short-term financing, low capital, and high leverage. Yet few people noticed, and even fewer did anything to stop it. Among those who stood to profit from the housing bubble, this impulse can be understood. But why did professional economists miss this, if it was in fact predictable?
According to Gerardi, Foote, and Willen (2011), most economists, in the absence of statistical evidence, fell back to The Fundamental Theorem of Asset Pricing. The past half-century of financial economics had been built upon this theorem, which implies that “the evolution of asset prices is, to a first approximation, unpredictable.” Any model that predicts an eventual collapse in housing prices was therefore a violation of market efficiency, and yet the question remains.
The new compilation of economic essays, The American Mortgage System: Crisis and Reform, assembles the views of 30 professional economists to explain market failure, pick up the pieces of a broken economy, and begin anew.[ms-protect-content id=”5662″]
Though the details are hotly debated, the message is unified: To avoid a repeat of the disaster that has rocked the global financial system for the past four years, American housing finance must trans-ition toward greater transparency, better tracking of risky products, standardized products for most borrowers, and fewer incentives for market participants to increase systemic risk in the pursuit of short-term profits. This conclusion derives from an analysis of what the housing bubble was – and what it was not.
It was not the failure of long term efforts to promote sustainable home-ownership and prevent socioeconomic discrimination in mortgage lending. In fact, the U.S. homeownership rate peaked in 2004 around 69 percent. The height of the housing bubble, in 2005 and 2006, coincided with a decline in homeownership (Calem, Nakamura, and Wachter, 2011). The primary drivers of the bubble therefore did not require an increase in homeownership, but rather an increase in leverage through mortgage debt and housing prices.
The Community Reinvestment Act (CRA) existed from 1977 to the mid-1990s without any significant increase in real housing prices. Had it been a driving force in the housing bubble, this crisis would have struck decades earlier. As Willis (2011) shows, economists have had trouble finding a correlation between
CRA lending and increased housing investment. “Of all the subprime loans that were made in 2005 and 2006,” reports Willis, “only 6 percent were extended by CRA-covered lenders…in the communities for which they had a CRA responsibility.” When it did increase lending to low- and moderate-income (LMI) households, the CRA resulted in loans with good performance. According to calculations by Laderman and Reid (2009), “loans made by CRA-regulated institutions in California performed better on average than loans made by institutions that were not covered under the CRA.” Low- to moderate-income communities, disproportionately populated by minorities, were subject to greater inflows of subprime credit during the boom years and outflows during the bust years, and were devastated by the recession. Using independent datasets, Barr, Dokko, and Keys (2011) and Reid and Laderman (2011) find that minority borrowers, especially black households, were more likely to receive riskier, more expensive loans than majority, white households, even after controlling for the households’ age, income, gender, creditworthiness, and default risk. The CRA was put into place to counter this and, in fact, the CRA has been a positive, rather than a negative, influence in LMI com-munities – building, rather than destroying, their wealth in the long run (Riley and Quercia, 2011 and Fisher, Lambie-Hanson, and Willen, 2011).
The other entities that are often implicated are Fannie Mae and Freddie Mac, the “Government-Sponsored Enterprises” (GSEs) that the government took into conservatorship in September 2008 and they clearly did contribute to the meltdown. The original purpose for Fannie Mae, which came well before Freddie Mac, was to purchase mortgages during the Great Depression and stop (or at least slow) the deflationary spiral that plagued asset prices and forced banks into insolvency. At the time, it was a government agency, but it became a private corporation in 1968 – and was soon joined by the competing corporation Freddie Mac. Together, the GSEs purchased long-term, fixed-rate mortgages (FRMs) and, especially after the savings & loan crisis, packaged them into mortgage-backed securities (MBSs) that private investors bought on the secondary market. The crisis had arisen because banks and S&L’s were decapitalized due to rising interest rates, since short-term deposits (with high interest rates) had been used to fund long-term FRMs (with the old, low interest rates). The GSEs resolved this problem by purchasing long-term FRMs, making them the dominant product in the American marketplace for the next six decades. When competing private-label securitizers gave adjustable-rate mortgages (ARMs) and other risky products equal access to secondary markets this stable system eroded (Ellen, Tye, and Willis, 2011). The GSEs had been serving this purpose since the 1970s, making them unlikely culprits for a crisis that struck in 2008. Other countries with severe housing bubbles, like Spain and Ireland, did not have GSEs, implying that some other shared factor drove this global phenomenon. Moreover in the US, a commercial real estate bubble occurred at the same time as the residential real estate bubble.
As private label securitization grew, it took market share away from the GSEs. Nonetheless after 2006, the GSEs did contribute to the crisis through their purchase of Alt-A loans, in particular, (Van Order, 2011) for their investment portfolio and the general collapse in housing prices that affected prime as well as subprime loans.
Nobody was spared, even institutions that avoided the private-label securitizers’ “race to the bottom” (Levitin and Wachter, 2011) through erosion of lending standards. It was this under-regulated, under-informed, under-capitalized, over-leveraged race for short-term profits and secondary market share, fueled by competition and the production of securitized credit, for which lenders held no “skin in the game,” that ac-tually caused the housing bubble, the underlying credit bubble, and the inevitable financial crisis.
Housing finance markets suffer from a severe information failure. Mortgages are complicated products, especially when the market is not dominated by the standard long-term FRM. The only participants who know everything necessary to judge a borrower’s default risk are the borrowers themselves. The originator, however, is able to compile a significant amount of information to estimate the default risk quite accurately, given a simple market and a simple product. But if the originator holds no risk, the assessment of credit and default risk depends upon investors. Once products become increasingly complex, it becomes very difficult for investors to predict default risk, especially when such risk is correlated to the lending of all the interdependent mortgages that are being originated (Engel and Fitzpatrick, 2011).
Securitizers have even less information than originators, and the investors who purchase the final MBSs have the least information of all. If originators are lowering underwriting standards or securitizers are mispricing the assets or their interest rates, these processes are too shrouded for investors to detect misbehavior. Regulators are equally disadvantaged in compiling and computing all the variables involved in all the mortgages being securitized in this massive market. During the housing bubble, these data were not available. Anecdotes in-dicated some of the systemic corruption, but there was no way to quantify the systemic risk (Calem, Nakamura, and Wachter, 2011).
Looking back on the housing bubble, retrospectively, we can say that the mortgage market’s risk was increasing to levels unseen before in American history. Loan terms became creative, predatory, complicated, expensive, and volatile. As private-label securitizers vied for market share, they created new products and lowered their standards to entice borrowers who had been unable to afford loans at earlier, responsible terms. This increase in risk was not accompanied, however, by an increase in mortgage rates. Of course, mortgage rates fell alongside Treasuries when the Federal Reserve lowered rates after the dot-com bubble burst, but even after the Fed increased the federal funds rate, mortgage rates remained low. The spread between mortgage rates and Treasuries
declined, even as the riskiness of mortgage products was increasing exponentially! Originators and securitizers were able to profit from cheap credit. Because originators and securitizers were compensated with fees for the quantity (not the quality) of the products sold, they focused only on short-term profit, not long-term performance (Levitin and Wachter, 2011).
As Kane (2011) and Reinhart (2011) explain, these problems have not been resolved by the Dodd-Frank Act, which Congress passed to prevent a recurrence of the housing bubble and financial crisis. Governments will still have a strong incentive to rescue failing firms if, by not doing so, the entire system is at risk. Even with “skin in the game,” financial institutions still have a strong incentive to focus on short-term profits, and the market continues to be opaque, complex, and heterogeneous. Regulators now have more power to resolve insolvent firms and monitor their actions ex ante but doing so in a timely way is difficult in the absence of information. Dodd-Frank does create an Office of Financial Research, but information must be translated into action, action which will be in question if there is regulator capture (Kane, 2011), unless there is external pressure on regulators to act.
The most important issue left unanswered by Dodd-Frank is the future of the GSEs. Dechario, et al. (2011) propose a cooperative system of private lenders that securitize exclusively long-term FRMs and whose fees are regulated like a utility, thus avoiding races to the bottom by public sector entities. Ellen and Willis (2011) compare this option with the alternatives of full nationalization, full privatization, and a guarantor role for the U.S. Treasury. All solutions, however, are susceptible to the volatility of private market entities’ production of risk. Going forward, with or without dominant public sector entities, increased market transparency and increased accountability, on the part of investors and regulators, will be necessary to prevent future crises.
About the authors
Susan Wachter is Professor of Real Estate and Finance and the Richard B. Worley Professor of Financial Management at The Wharton School, University of Pennsylvania and Co-director of the Penn Institute for Urban Research. Dr. Wachter served as Assistant Secretary at the U.S. Department of Housing and
Urban Development (HUD).
Anthony W. Orlando is a financial researcher and writer based in Los Angeles, CA. Mr. Orlando is a graduate of The Wharton School of the University of Pennsylvania and the London School of Economics.
Marvin Smith is Community Deve-lopment Research Advisor at the Federal Reserve Bank of Philadelphia. Dr. Smith was formerly employed at the Congressional Budget Office and the Brookings Institution, both in Washington, D.C.
1. Quoted in Suskind, R., (2011) Confidence Men: Wall Street, Washington, and the Education of a President. HarperCollins Publishers: New York, NY, p. 22.
i. Barr, Michael S., Jane K. Dokko, and Benjamin J. Keys. “Exploring the Determinants of High-Cost Mortgages to Homeowners in Low- and Moderate-Income Neighborhoods.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
ii. Calem, Paul S., Leonard Nakamura, and Susan M. Wachter. “Implications of the Housing Market Bubble for Sustainable Homeownership.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
iii. Dechario, Toni, Patricia C. Mosser, Joseph Tracy, James Vickery, and Joshua Wright. “A Private Lender Cooperative Model for Residential Mortgage Finance.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
iv. Engel, Kathleen and Thomas J. Fitzpatrick, IV. “A Framework for Consumer Protection in Home Mortgage Lending.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
v. Fisher, Lynn, Lauren Lambie-Hanson, and Paul S. Willen. “A Profile of the Mortgage Crisis in a Low- and Moderate-Income Community.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
vi. Geraldi, Kristopher S. , Christopher L. Foote, and Paul S. Willen. “Reasonable People Did Disagree: Optimism and Pessimism About the U.S. Housing Market Before the Crash.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
vii. Gould Ellen, Ingrid, John Napier Tye, and Mark A. Willis. “The Secondary Market for Housing Finance in the United States: A Brief Overview.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
viii. Gould Ellen, Ingrid and Mark A. Willis. “Improving U.S. Housing Finance Through Reform of Fannie Mae and Freddie Mac.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
ix. Kane, Edward J. “The Expanding Financial Safety Net: The Dodd-Frank Act as an Exercise in Denial and Cover-Up.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
x. Laderman, Elizabeth and Carolina Reid. “CRA Lending During the Subprime Meltdown.” In Revisiting the CRA. Ed. Chakrabarti et al.
xi. Levitin, Adam J. and Susan M. Wachter. “Information Failure and the U.S. Mortgage Crisis.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
xii. Reid, Carolina and Elizabeth Laderman. “Constructive Credit: Revisiting the Performance of Community Reinvestment Act Lending During the Subprime Crisis.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
xiii. Reinhart , Vincent. “The Road Not Taken: Our Failure in Redoing the Financial Architecture.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
xiv. Riley, Sarah F. and Roberto G. Quercia. “Navigating the Housing Downturn and Financial Crisis: Home Appreciation and Equity Accumulation Among Community Reinvestment Homeowners.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
xv. Van Orden, Robert . “Some Thoughts on What to Do with Fannie Mae and Freddie Mac.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.
xvi. Willis, Mark A. “The Community Reinvestment Act: Evaluation Past Performance and Reviewing Options for Reform.” In The American Mortgage System: Crisis and Reform. Ed. Susan M. Wachter and Marvin M. Smith. Philadelphia: University Of Pennsylvania Press, 2011.