As the author of The Great Housing Bubble, I am an authority on the housing bubble. As someone who has written daily about the myriad of circumstances and consequences of the bubble, I have examined this phenomenon from every conceivable perspective. One of the great features of blogging is the constant exposure to other points of view on these issues. If there is something I miss, a reader usually points it out. The astute observations have greatly increased my understanding of these issues. For all these reasons, I would compare my understanding of the housing bubble with anyone, and from what I read coming from the economists at the federal reserve, they are still years behind what the readers of this blog already understand.
The federal reserve paper below that is the focus of today’s post is a major leap forward for the federal reserve’s understanding of the housing bubble. The authors conclude the bubble was a financial mania based on the erroneous beliefs of market participants. This is a huge step forward. The paper dispels many of the popular myths surrounding the housing bubble, but they also discount some of its basic truths. In the end, they reveal they have no idea why market participants lost their minds, and thereby erroneously conclude nothing can be done to prevent housing bubbles. As a result of their failure to understand the causal mechanism, they propose policies to mitigate the impact of bubble rather than to try to prevent them. This is very wrong and very dangerous. The result of this ignorance will likely be another housing bubble.
The weakness of this study is its failure to provide a causal mechanism for the bubble. Economists tend to break down into two camps, those that understand large-scale issues, and those that understand the impact of individual incentives: the macro and the micro. This schism in economics is a hindrance to understanding the housing bubble. The reason participants in the housing bubble lost their minds is because they had individual incentive to do so.
Borrowers and buyers saw the opportunity for unlimited wealth and spending power (please see: Desire for mortgage equity withdrawal inflated the housing bubble). Investors saw an opportunity for relatively high yields with little risk. Lenders and loan originators saw opportunity for large fees, and realtors went along for the free ride as they always do. Everyone was making money, even the parties taking on the risk through credit default swaps. Underlying it all was a steadfast belief house prices cannot go down — a delusion reinforced by 60 years of steadily rising house prices. Since no parties to the transaction perceived any risk, and since everyone was profiting from the transactions, the individual incentives were bound to spark demand.
The federal reserve paper fails to understand the incentives of the parties as outlined above. With a huge demand for real estate from everyone concerned, the only thing preventing a bubble was the checks and balances in the system. These include appraisals, underwriting, and government regulation. Each of these was systematically dismantled by the relentless push of high demand. A body of regulations are required to prevent the incentives in the system from removing the barriers in the system that prevent housing bubbles from forming.
For example, when appraisers were made independent, a valuable restraint was put into the system. If appraisers are paid to provide an impartial estimation of value rather than being pressured to “hit the number,” they will function as a natural restraint against exuberant market participants. As another example, in Texas, mortgage equity withdrawal cannot exceed 80% of the value of the property. This effectively shuts down the housing ATM and kills the incentive of buyers and borrowers to overpay for HELOC booty because the free money was not forthcoming. Texas did not participate in the housing bubble for this reason. And as an example of the federal reserve’s failure, the lack of regulations on credit default swaps caused a dramatic mis-pricing of risk which gave investors a false sense of security on their investment. It wasn’t just that investors didn’t think prices could go down, they believed they had insurance against loss if they did. Each of the above examples demonstrate where regulations impact the individual incentives, and changing those incentives would change the behaviors of the participants in a way that lessens the likelihood of a future housing bubble.
In the end, the biggest barrier the federal reserve will have in preventing another housing bubble will come from its own member banks. Preventing a housing bubble ultimately means limiting lending. Housing bubble are inflated with air provided by lenders. This paper draws erroneous conclusions largely because the authors don’t want to rock the boat and propose any solution which would inhibit lending. Unfortunately, inhibiting lending is exactly what’s required to prevent another housing bubble.
What if the conventional wisdom about the mortgage crisis is all wrong?
That’s the implication of a new paper from economists at the Federal Reserve Banks of Atlanta and Boston that’s bound to spark debate because, if their premises are correct, it sharply undercuts the justification for much of the new regulation that’s been erected over the past two years.
Three economists, Christopher Foote, Kristopher Gerardi, and Paul Willen, present two narratives of the financial crisis in trying to answer why so many people made so many dumb decisions.
The first view is that the financial crisis was an “inside job” where various industry players, from the mortgage lenders to mortgage traders, took advantage of unsophisticated rubes, from homeowners to mortgage investors.
This isn’t as much a coherent theory as it is a politically expedient argument used by both sides for supporting different agendas. The political left uses this as a justification for its pandering to loan owners. The political right uses this theory as a reason to shut down the GSEs. Both use sides use half-truths to further their agenda as all politicians do.
They largely discard that view for a second one—the “bubble theory” where delusional attitudes about home prices, not distorted incentives, fueled poor decision making.
No one doubts that mortgage credit expanded, the authors concede, or that many borrowers received loans that they wouldn’t normally have qualified for. “The only question is why the credit expansion took place,” they write. Securitization, for example, didn’t by itself cause the crisis, but instead channeled money “with ruthless efficiency” that “may have allowed speculation on a scale that would have been impossible to sustain” in the past.
The paper is correct in identifying a rapid credit expansion fueled by excessive optimism as the reason house prices went up; however, they utter fail to identify the individual incentives that created the excessive optimism, and therefore they fail to craft useful policy proposals to change those incentives.
The entire paper is worth reading, but here’s a synopsis of the “12 facts” that help shape their view:
Fact 1: Resets of adjustable-rate mortgages did not cause the foreclosure crisis. The authors find that the 84% of these borrowers who went into foreclosure were making the same payment when they first defaulted as when they took out their loan. The conclusion: adjustable-rate loans performed worse than fixed-rate loans because they attracted less creditworthy borrowers, “not because of something inherent in the ARM contract itself.”
This is half true. ARM resets did not cause problems. They would have, but they didn’t get the chance. First, many borrowers couldn’t afford the teaser rates, so they were doomed to implode even before the reset. Second, falling interest rates made the payment shock much less for many borrowers. The real problem was going to be when the loans recast to fully amortizing loans, but since so few survived to see the payments recast, this ended up not being a problem. In other words, what would have been a problem failed to become one because even more serious problems intervened first. It’s like Lee Harvey Oswald being shot on his way to trial. He was doomed at trial, but he was killed before he even got there.
Fact 2: No mortgage was “designed to fail.” Instead, the products weren’t designed to sustain a drastic decline in home prices.
This is dangerously stupid. Option ARMs can only succeed in a market where prices appreciate faster than the debt accumulates. This is a Ponzi loan, and it should be recognized as such. Both interest-only and negative amortization loans are designed to fail, not by choice, but by the fact they have embedded within them the necessity of increasing prices to sustain the Ponzi scheme.
Fact 3: There was little innovation in mortgage markets in the 2000s. Loans that required reduced documentation (what became known as the “liar’s loan”) or that had negative amortization (the “pick-a-payment” loan) had been around in the 1980s and 1990s. Instead, what happened during the last decade was that these niche products became mainstream.
Fact 4: Government policy toward the mortgage market did not change much from 1990 to 2005. Low down payment loans were introduced by the government…in the 1940s. “It is impossible to find any government housing initiative in recent years that is remotely comparable” to the expansion of government’s expansion in the post-World War II period, the authors write.
This is true, and it’s one of the reasons the political right’s arguments against the GSEs are disingenuous bullshit. Personally, I believe the GSEs should go away, but not for the reasons given by the political right.
Fact 5: The originate-to-distribute model was not new. Secondary mortgage markets, where investors bought loans from originators, had been around since the 1970s. And before that, mortgage companies had sold their loans to insurance companies.
The mechanism that delivered capital to the housing bubble was not the culprit. We need a secondary mortgage market to ensure the nationwide flow of capital where it is needed.
Fact 6: MBS, CDOs, and other “complex financial products” had been widely used for decades. “The idea that the boom in securitization was some exogenous event that sparked the housing boom receives no support from the institutional history of the American mortgage market,” the authors write, though the types of collateral backing those products certainly did change.
CDOs themselves were not the problem. The mis-pricing of risk and thereby the mis-pricing of these assets was the problem. Captured ratings agencies and unregulated credit default swaps were a big part of the problem here.
Fact 7: Mortgage investors had lots of information. Of course, investors may simply have paid less attention to this information because many securities received triple-A ratings. (Some may take issue with this point due to the level of fraud that surprised many of the most well-informed market analysts).
Fact 8: Investors understood the risks. Some mortgage analysts had published “remarkably accurate predictions about losses” if home prices turned down. The bigger question, the authors raise, is that “given how badly these loans were expected to perform, why did investors buy them?”
Investors did have good information, and they did understand the theoretical risk, but they had no concept of the actual risk they took on. Rating agency rubber stamps, and a faith in ever-increasing prices caused them to ignore the risks as a very low probability event.
Fact 9: Investors were optimistic about house prices. This helps answer the aforementioned question.
Everyone was overly optimistic about house prices. This was the central problem of the housing bubble.
Fact 10: Mortgage market insiders were the biggest losers. The firms that were the most involved in the market and which retained the most risk on their balance sheet, either via whole loans (option adjustable-rate mortgages at Wachovia) or securitized loans (at Bear Stearns), fared the worst.
Only stupid mortgage market insiders retained risk. Most cashed out and took their fees. Anthony Mozilo comes to mind.
Fact 11: Mortgage market outsiders were the biggest winners. The “big shorts” such as John Paulson and Michael Burry were relative newcomers to the mortgage market. Their insight about a housing bubble and “not any fact about credit, the origination process, or moral hazard” led them to make their winning bets.
Fact 12: Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in collateralized debt obligations (CDOs) did.
This is an unimportant semantic distinction. Everyone who bought mortgage bonds had poorer returns than they anticipated. How much poorer depended on the degree of leverage and the priority of returns.
So what are the implications of these 12 facts? In sum, the housing-finance universe of the future—for both banks and borrowers—should be prepared to withstand greater home-price volatility.
This is their dangerously ignorant conclusion. They are throwing their hands up and saying we can’t prevent bubbles. Nothing could be further from the truth. Many common sense policies could change the incentives in a way to prevent the market participants from either wanting or allowing a new bubble to form. In surrendering when regulators should be fighting practically ensures future housing bubbles. That makes me angry because as a taxpayer, I will undoubtedly be on the hook to pay for the next one.
Does this mean regulators spooning out the wrong medicine? Possibly. “Unfortunately,” the authors write, “none of the new mortgage disclosure forms proposed by regulators includes the critical piece of information that borrowers need to know: There is a chance that the house they are buying will soon be worth substantially less than the outstanding balance on the mortgage.”
Disclosures wouldn’t matter anyway. I told people not to buy homes for nearly five years, and gave detailed explanations of why, and most still didn’t believe me. Any routine disclosure will be routinely ignored by a borrower who believes their house prices will go up and they will get unlimited HELOC spending money.
The only way to prevent future housing bubbles is to change the incentives of the parties. Right now, not just do we lack the political will to do the right things, this federal reserve paper clearly demonstrates policymakers don’t have the requisite understanding to prevent housing bubbles even if they wanted to.
Half a million reasons to overpay for real estate
Personally, I don’t see what is so difficult to understand about how individual buyer’s incentives drove people to pay any price for real estate. Perhaps the concept of mortgage equity withdrawal is too abstract. Readers of this blog have seen documented cases day after day of people like today’s former owners who put $20,000 into a property and got to take $500,000 out. No other investment offers such a lucrative payout. Plus, the loan owner get’s to live in a nice house too. It’s the best of both worlds. As long as the ability to get so much for so little exists, people will have a strong incentive to inflate housing bubbles.
- The former owners of today’s featured property paid $195,000 on 12/20/1993. They used a $175,00 first mortgage and a $20,000 down payment.
- On 6/9/1999 they got their first taste of HELOC booty with a $50,000 bank gift. It must have been well received.
- On 10/6/1999, a scant 4 months later, they went to the housing ATM for another $83,800.
- On 6/29/2001 they obtained a $142,115 HELOC.
- On 7/11/2003 they obtained a $300,000 first mortgage.
- On 10/31/2003 they opened a $99,000 HELOC.
- On 1/3/2005 they obtained a $250,000 HELOC.
- On 8/11/2006 they refinanced with a $570,000 first mortgage.
- On 8/27/2007 they got a $108,100 HELOC.
- Total mortgage debt was $678,100.
- Total mortgage equity withdrawal was $503,100.
- They quit paying in mid 2009 and got to squat for over two years.
This isn’t rocket science. Look at how these people lived. The desire to turn $20,000 into $500,000 is what fueled the housing bubble.
Lake Forest Overview
Median home price is $345,000. Based on a rental parity value of $488,000, this market is under valued.
Monthly payment affordability has been improving over the last 5 month(s). Momentum suggests improving affordability.
Resale prices on a $/SF basis increased to $221/SF to $223/SF.
Resale prices have been falling for 12 month(s). Price momentum suggests falling prices over the next three months.
Median rental rates declined $16 last month from $2,066 to $2,050.
Rents have been rising for 12 month(s). Price momentum suggests rising rents over the next three months.
Market rating = 9
$500,000 …….. Asking Price
$195,000 ………. Purchase Price
8/2/1993 ………. Purchase Date
$305,000 ………. Gross Gain (Loss)
($15,600) ………… Commissions and Costs at 8%
$289,400 ………. Net Gain (Loss)
156.4% ………. Gross Percent Change
148.4% ………. Net Percent Change
5.1% ………… Annual Appreciation
Cost of Home Ownership
$500,000 …….. Asking Price
$17,500 ………… 3.5% Down FHA Financing
3.80% …………. Mortgage Interest Rate
30 ……………… Number of Years
$482,500 …….. Mortgage
$136,936 ………. Income Requirement
$2,248 ………… Monthly Mortgage Payment
$433 ………… Property Tax at 1.04%
$158 ………… Mello Roos & Special Taxes
$125 ………… Homeowners Insurance at 0.3%
$503 ………… Private Mortgage Insurance
$70 ………… Homeowners Association Fees
$3,538 ………. Monthly Cash Outlays
($343) ………. Tax Savings
($720) ………. Equity Hidden in Payment
$22 ………….. Lost Income to Down Payment
$83 ………….. Maintenance and Replacement Reserves
$2,579 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$6,500 ………… Furnishing and Move In at 1% + $1,500
$6,500 ………… Closing Costs at 1% + $1,500
$4,825 ………… Interest Points
$17,500 ………… Down Payment
$35,325 ………. Total Cash Costs
$39,500 ………. Emergency Cash Reserves
$74,825 ………. Total Savings Needed
This property is available for sale via the MLS.
Please contact Shevy Akason, #01836707
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