May 8, 2012

Foote: 12 reasons why the Mortgage Meltdown wasn't an Inside Job

Economist Christopher Foote of the Boston Fed, who debunked the Freakonomics abortion-cut-crime theory in late 2005 by pointing out that Steven D. Levitt's results stemmed from a couple of dumb mistakes in his programming, and two colleagues have a paper arguing against the mortgage meltdown being, in the words of the Oscar-winning documentary, an Inside Job (or, at least, of misaligned incentives):
Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis 
Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen 
This paper presents 12 facts about the mortgage market. The authors argue that the facts refute the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors. Instead, they argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices. The authors then show that neither institutional features of the mortgage market nor financial innovations are any more likely to explain those  distorted  beliefs than they are to explain the Dutch tulip bubble 400 years ago. Economists should acknowledge the limits of our understanding of asset price bubbles and design policies accordingly.

Foote et al presents 12 "myths" about the mortgage meltdown that they say don't hold up to scrutiny. While I find this to be an excellent framework for thinking about causes of the mortgage disaster, personally, I find some of the myths seems pretty reasonable even after reviewing Foote's graphs. 
For a concrete example, consider the size of required downpayments. Morgenson and Rosner (2011) write that because of the Clinton Administration’s emphasis on homeownership:
[I]n just a few short years, all of the venerable rules governing the relationship between borrower and lender went out the window, starting with the elimination of the requirements that a borrower put down a substantial amount of cash in a property (Morgenson and Rosner 2011, p. 3).
It is true that large downpayments were once required to purchase homes in the United States. It is also true that the federal government was instrumental in reducing required downpayments in an effort to expand homeownership. The problem for the bad government theory is that the timing of government involvement is almost exactly 50 years off. The key event was the Servicemen’s Readjustment Act of 1944, better known as the GI Bill, in which the federal government promised to take a first-loss position equal to 50 percent of the mortgage balance, up to $2,000, on mortgages originated to returning veterans. The limits on the Veteran’s Administration (VA) loans were subsequently and repeatedly raised, while similar guarantees were later added to loans originated through the Federal Housing Administration (FHA). 

Okay, but here's the graph they use to document this assertion, showing Loan to Value percentages in Massachusetts over the years. Notice anything?
Yes, the aqua LTV 100 (i.e., zero down or even cash back) spiked from about 8 percent in 2002 to 24 percent in 2006 at the peak of the bubble.  

Here's a graph from USA Today that I found at Dr. Housing Bubble, showing California's similar spike in zero down home-buying:
The First-Time Buyers (41% in 2006) are especially important because that's mostly where new demand comes from, and incremental demand is much of what drives up prices.

In general, Foote et al frequently argue that because various policies or conditions existed well before the crisis, such as less than 20% downpayments, then loosening downpayments didn't contribute much to the bubble and bust. But, that's overlooking the famous Boiling Frog problem: turning up the heat gradually might not cause a noticeable problem for the frogs in the pot for awhile, but eventually it does. 

Moreover, in the case of lower and lower downpayments, there appears to have been a phase shift when requirements hit zero down. A 3.5% downpayment required for a VA or FHA loan might not sound like much, but cash on the barrel-head scares off the total riff-raff and conmen, plus the government regulations lessened fraud in appraisals and the like. The zero down loans that George W. Bush greenlighted to federal regulators in his October 15, 2002 speech at the White House Conference on Increasing Minority Homeownership were a not insignificant cause of the Bubble.

Still, I would agree with Foote that Tulip Mania-style overoptimism is a big part of the explanation. But where did this over-optimism come from? 

I woud argue that a host of evidence, such as the biggest appreciation and biggest losses happening in the four Sand States of California, Nevada, Arizona, and Florida, that "diversity" played a huge role, especially in the ban on critical thinking about diversity that has been inculcated in the U.S. An immigration bubble preceded and then egged on a housing bubble, and nobody was supposed to say anything bad about it, especially not in internal company documents that could get your firm in trouble for a discrimination lawsuit.

It's really asking a lot of people to tell them over and over that only evil ignorant racist losers notice patterns and then expect them to notice the patterns and respond intelligently.


Whiskey said...

Steve, the greatest problem with the Housing Bubble was the confluence of Bush's program with ... demand for returns in Germany. German Landesbanken and other European institutions loaded up on those junk, subprime mortgages, via derivative tranches, because they were starving for returns. Since there was not much growth in Germany and they were expected to fund all sorts of social programs without taxes being (again) raised after heroic 1990's efforts to spend spend spend to integrate East Germany. Same was true for France, the Netherlands, and the UK to a lesser extent.

All those loans required ultimately, a buyer. The Wing Chaus and the Landesbanken were the buyers, like Bob Citroen of Orange County, wanting to be heroes by earning above market returns. [Which unless you are a crony capitalist like Buffett, is impossible for more than a year or two.]

Foseti said...

"Economists should acknowledge the limits of our understanding of asset price bubbles and design policies accordingly."

I've written a few posts arguing that it's really dumb to have the Federal Reserve - the guys that are responsible for asset price bubble - act as bank regulators as well.

The chances that the people responsible for creating any price bubbles will do anything to "design policies" according to concerns about asset price bubbles is astonishingly small.

Anonymous said...

Whiskey is "Spengler".

Or, at worst, one of Spengler's assistants.

Henry Canaday said...

One problem with the Pure Bubble theory is that all the examples of Pure Bubbles are novel assets or assets being evaluated under novel conditions. U.S. houses are assets with a long pricing history, fairly stable relationships to other series such as incomes and certain logical limits, such as construction costs for new homes. That is why so many people spotted the bubble as it was happening.

[enter username here] said...

The Mesoamerica tractor beam was the indispensable ingredient. If it were just nefarious Chinese & Russian oligarchs would they be targeting Riverside and Clark County, Nev.? The bubble was not qualitatively the same in all locations.

NOTA said...

Instead of a boiling frog, think of a fusebox with a fuse replaced with a penny. You can do that today (if you live in a house old enough to use fuses instead of breakers) and not notice any consequences for years to come. But on the day when you really needed a fuse there instead of a penny, your house burns down.

Similarly, a lot of regulations and customs and bits of cultural advice/wisdom can be very important, but not necessary or important most of the time. Without the combination of an entire industry of mortgage brokers and real estate agents who have lived in a housing boom for years and become dependent on the flow of money coming in, lots of investors looking for safe returns, housing prices reaching levels where normal people mostly couldn't afford a house anywhere they wanted to live on any sensible terms, the post-dot-com-bubble, post-9/11 pumping of money into the economy, all lining up just right, you might go years without ever even noticing that someone replaced a bunch of fuses with pennies because it saved them some money.

slumber_j said...

Not sure I agree here with Steve's comments with regard to diversity-blindness as such. Isn't the problem a more strictly financial one that was incited by the opposite of diversity-blindness?

That is to say, weren't these bad loans encouraged precisely in order to put NAMs in the position of owning homes, regardless of their credit-worthiness?

In other words, I'd say the bubble was the result of explicitly recognizing the relative aggregate financial difficulties of NAMs and then saying that lenders shouldn't pay attention to the problem. That's stupid certainly, but it doesn't entail blindness about the economic status of the minorities in question--rather, the opposite. No? Or do I misconstrue Steve's comment?

Anyway, Whiskey's pretty right about the buyers.

slumber_j said...

By the way, when you go to Slate's 1999 online debate between our genial host and Steve Levitt here: says in the byline "By authors," with a link that sends you straight to 404-Land. How funny.

Luke Lea said...

And don't forget the flood of unspent Chinese dollars that forced down long-term interest rates. That was the fundamental factor behind house price appreciation, which fueled speculation that prices would continue to appreciate.

define: multi-factoral

Luke Lea said...

And don't forget the flood of unspent Chinese dollars that forced down long-term interest rates. That was the fundamental factor behind house price appreciation, which fueled speculation that prices would continue to appreciate.

define: multi-factoral

Luke Lea said...

Correction. Spell: Multifactorial

Anonymous said...

Whiskey is "Spengler".

Or, at worst, one of Spengler's assistants.

No, Whiskey is too ignorant of musical, literary, and financial matters to be Spengler. Whiskey is a self-styled acolyte of Spengler. I doubt the two have ever actually met, though.

Anonymous said...

Comes back to the point made in an earlier thread saying that mass immigration of a low productivity, low wealth producing populace decreases per capita wealth in the USA - and thus tends to lower earnings and thus the ability to buy a house.
The fact is the people that the USA imported en masse in the past few decades were, to put it bluntly, duffers.
Strawberry pickers, floor wipers, baby sitters etc - all competing ferociously with each other to earn a pittance form master, and these people were supposed to be the bedrock of a property owning class on sub-minimum wage.
It's crazy.
If only the authorities had ben harder, tougher and yes, a bit snobbish about who is worthy of being a mortgage holder and who is not.
Sorry, but duffers like dish-washers and gardeners have , never ever been the material house owners are made from. And here we have the irony of the Bush administration screwing down the wages of such people to the irreducible minimum by open immigration and free trade with China, whilst playing 'Lady Bountiful' with them and pretending to play the game of 'let's play house owners' with people who probably can't even write a paragraph in Spanish let alone English.

Torn and Frayed said...

A key point you are missing is that the housing bubble (and dotcom bubble before) was ultimately an attempt to sustain American standards of living in the face of the dual assault of globalization out-sourcing good jobs and mass immigration in-sourcing cheap labor. So as Americans went from working in solid manufacturing jobs to stocking shelves at Home Depot, or as 25$ an hour union carpenters were reduced to doing only side jobs due to the influx of 5$ an hour Mexican labor, they were compensated with “free” money from their rising housing prices that let them go on a consumption boom and buy cheap electronic trinkets from China or do home improvement projects on the back of semi-slave labor from Guatemala. This is why China was recycling Dollars back to the States. They wanted to prime their consumption pump with cheap stimulants. Had the inevitable decline in the American standard of living as a result of globalisation and mass immigration been just allowed to happen immediately, there would have been much more resistance to these policies from the get go.

Allowing the new immigrants to buy houses with nothing down in traditional working class areas also helped increase demand for housing in more posh areas. And as working class people moved up to middle class areas, the same process occurred until almost half the population were demanding to live in McMansions to flee the rising riff raff below them.

But now the party is over and people endlessly debate about it is all Wall Street’s fault or not. The truth is, in a vibrant, productive economy as the US had up until sometime in the 70’s, there is no need for a huge financial sector. The growth of Wall Street and the parasitical Rentier class is just another symptom of the real disease, the cancer of globalisation and mass immigration that is rotting away the standard of living of the working and middle classes. Only when Free Trade is replaced by Fair Trade (trade only with other First World countries, or under strict conditions (minimum wage, environmental standards, etc) with poor countries) and when Mass Immigration is replaced by Selective Immigration (like in Australia or Canada) will the process of restoring the working and middle class standard of living begin.

Conatus said...

The Housing Crisis was caused by mortgage bond buyers telling themselves over and over, their mantra that "Since the depression house prices in the US have never gone down year over year."
And they would not have gone down if they had followed prior FHA downpayment standards, but to encourage minority home ownership the Fed and Clinton and Bush lowered standards. 'One standard for thee and another for me.' In the end it was NINJA mortgages , no-job-and-no-assets mortgages which pushed home ownership higher and created the housing bubble.
So bond buyers were comforted by their mantra and preferred to look away at the declining standards in home loans because that would be racist. No one wanted to question the declining standards because then, like Steve says, they would have a 'your-career-is-over-email' on their hard drive.
In the end, home ownership went up to almost 70% and is now back down to 64% where it was when all this began, only we now have so much debt on the books the idea that money is not real is starting to seep into the public consciousness.
Good luck with the future.

Anonymous said...

Whiskey is a self-styled acolyte of Spengler. I doubt the two have ever actually met, though.

I dunno - it just feels so "Spengler" to me.

I've always had it in the back of my mind that Whiskey was parroting "Spengler", but some of the posts lately are so eerily similar to the "Spengler" corpus that it seems like "Spengler" was at least in the same room at the time they were being typed [maybe leaning over the typist's shoulder, if not actually typing them himself].

Or maybe "Spengler" emails these posts to Whiskey and then Whiskey posts them for him.

Joe Six-Pack said...

One of the most popular theories abou the mortgage crisis was that Fannie Mae and Freddie Mac lending to minorities created the mortgage crisis...

Anonymous said...

Well said, Tom and Frayed.

Carol said...

On the consumer level, I think the resurgent popularity of coffee and mega-caffeine drinks fueled the "optimism." Maybe even meth, for some of these frantic remodeler-flippers.

OK, not totally serious here. But don't let a salesman buy you an espresso while you're trying to decide.

Anonymous said...

I dunno - it just feels so "Spengler" to me.

I can see why people would think that. Whiskey is a dumber, "Game" version of Spengler. I don't doubt that he has emailed Spengler some fan letters, and maybe Spengler deigned once or twice to reply, but I think that's as far as their relationship would ever go. I sure as hell wouldn't want him to represent me or deliver my ideas to the public.

Marc B said...

The author of this piece is wrong. I worked in the mortgage industry throughout the 1990's, and everybody in my office noticed it was overheated in the Denver market as of 1998, as well as in many other boom cities of the era.

Prices were still climbing despite an economy that was cooling off around 1999, when the wheat was being separated from the chafe with the bursting of the dot com bubble. The financial slow down post 9/11 would have been the next natural cool down opportunity, but the housing market was artificially pump primed by the Fed, zealous bankers, and government policies to keep that sector of the economy booming while others stagnated (at the time it looked like it was done on purpose as an offset). By 2004-05, it was extremely apparent how overvalued things were, especially in California, where the median household income was $60,883, while the median home value was $458,500.

Jumbo loans provided to people without jumbo salaries, liar loans, and the loans to minorities under the Community Reinvestment Act were the main reasons for the implosion. What made it more severe was that the can had been kicked so far down the road for so long, that the overvaluation of real estate had become astronomic. In many cities, home prices are back to 1998 levels and people still are not buying. If a mortgage company staffed mostly with college drop-outs could see what was on the horizon seven years earlier, so could the bankers and the government. It was done on purpose.

TGGP said...

Foote's theory seems in keeping with Scott Sumner's story that the Fed just did a surprisingly bad job of managing NGDP expectations in 2008.

Hey, that was actually an interesting comment from Whiskey. If that's what comes from Spengler imitation, I'll settle for it. And I'm someone with a very low opinion of Spengler!

Anonymous said...

The problem isn't just laws/system but mind-set/values.

Long ago, even blacks felt some shame. Today, even many whites feel no shame.

In a shame culture, most people will not take advantage of bankruptcy laws except as a last resort. But in a shameless culture, everyone will take advantage of it.

So, even if the laws and policies didn't change much, the fact is mind-sets did change a great deal. People of a different mind will use the policies different.
In a shame culture, only those who really need it will sign up for foodstamps.
In a shameless culture, everyone will sign up just to get free stuff.