الدروس غير المستفادة من أزمة الإسكان

Two very different narratives attempt to explain the massive housing boom and subsequent crash. The first is a tale of corruption by the profit motive. In this story banks, investors, and homeowners dazzled by the golden opportunities in the housing market threw caution to the wind and leveraged up. The second narrative is a tale of corruption in the name of compassion. Government officials, government sponsored enterprises (GSEs), and willing bankers sought to expand home ownership to those who failed to meet traditional sound lending standards.

Before we consider the evidence for each narrative, let’s remember that the housing boom took place in the context of a massive expansion of credit, primarily by the Federal Reserve. The Fed’s role in the expansion and contraction of aggregate credit is the major cause of the modern business cycle. However, changes in the tax code, accounting rules, and financial engineering created incentives that helped to concentrate credit in the housing sector. Still, why were so many people blind to the risks?

In their recent book Reckless Endangerment, Gretchen Morgenson and Joshua Rosner argue that the culprit was reckless greed. They give us a morality tale on a grand scale. Corruption reaches the heads of finance and the highest levels of both parties. Indeed, an economic libertarian could easily enjoy the portrayals of crony capitalists and their political backers. The villains could have been lifted right off the pages of Ayn Rand’s Atlas Shrugged. “Pull peddlers” looked for government regulation to avoid the rigors of competition, while government directives pushed financial institutions to originate an ever-increasing volume of high-risk mortgages. All along the political leaders preached the gospel of mortgages for the masses—let income be no obstacle.

Why were so many people blind to the risks?

Alas, Morgenson’s story is more prosaic than Rand’s. James Johnson, Fannie Mae’s CEO in the 1990s, loosens lending standards—to profit personally. He battles Congress to protect Fannie’s special privileges—to profit personally. He corrupts everyone in his way, from congressmen, to regulators, to community advocate groups, academics, and mortgage bankers—need one wonder why? Everyone is on the take—even Barney Frank and ACORN! She even mentions Johnson’s impeccable progressive credentials to dramatize the corrupting power of the profit motive. Her solution: better regulation.

In “Altruism: The Moral Root of the Financial Crisis,” Richard M. Salsman reaches a very different conclusion. In his analysis, advocates of government intervention appealed to the principle of “sacrificing oneself for the needs of others.” Government expanded access to low-cost mortgages in the 1990s so that the “needy and undeserving” could finance home purchases because the free market demanded too high a risk premium. Congress, the Fed, and regulators pushed the industry to fight “discrimination.”

“Altruism-driven politicians and bureaucrats” writes Salsman, “demanded that long-recognized credit standards be ignored or jettisoned in order to adhere to a standard of need over greed.” He gives us a litany of governmental policies. The Federal Reserve Bank, in Closing the Gap: A Guide to Equal Opportunity Lending, “derides as ‘arbitrary and unreasonable’ such traditional credit standards as a 20 percent down payment.” The Clinton administration pushed Fannie Mae and Freddie Mac to “debase their underwriting standards” to help the disadvantaged. President Bush, continuing the policy of easy access to credit, declared that corporations have “a responsibility to work to make America a compassionate place.”

Reckless greed or reckless compassion: which motive led to the debasing of lending standards? Before we attempt to answer this question we need to briefly review the basics of housing finance.

During the lending process, bankers need to establish two essential facts: the trustworthiness of the borrower and the value of the collateral. The first is a behavioral factor—will the borrower repay? The lender verifies the borrower’s credit-worthiness and makes sure the borrower has some skin in the game, i.e., a down payment. But if the borrower does default, the collateral must be adequate to cover the loan. Here, too, a down payment plays an important role as a cushion to reduce potential losses.

Reckless greed or reckless compassion: which motive led to the debasing of lending standards?

As housing prices increased, the traditional 20 percent down payment became a hardship, especially for young families with modest incomes. A $500,000 home in a New York City suburb requires a $100,000 down payment. Not many people can save that amount, especially while renting. In both government and industry, the standard down payment came under pressure. Was it really needed? What are the risks of a lower down payment—or no down payment at all? How much more interest should one demand from a borrower to compensate for that risk?

Let’s remember that credit card debt has no collateral behind it. To compensate for this risk, high interest rates—often as high as 18 percent—are imposed on the borrower. A mortgage with no down payment is still less risky than credit card debt. But how risky? Those of us who created prepayment and default models grappled with this question in an attempt to ascertain the loss probabilities for the securities we priced. When the market collapsed in 2007, these models failed drastically.

In the post-war period, falling home prices were rare. From 1945 to 2006, nominal home prices never fell on the national level, at least not significantly. Some argue that there was a drop of 1 percent in 1963 and 1990; there were regional drops such as in California in the early 1990s. But a 25-30 percent drop in the national average just wasn’t part of the historical record. Consequently, models used to price mortgage portfolios under-weighted scenarios with large price declines.

All subsequent economic valuations can be attributed to this miscalculation. Originators failed to secure an adequate down payment or charge an adequate interest rate because of the historically modest losses during the half century of housing price appreciation. Private and government mortgage insurers made a similar miscalculation and failed to charge enough to insure potential losses. Wall Street and the rating agencies failed to adequately develop their default models for a scenario they considered highly improbable, which led to a bumper crop of improperly structured and rated securities. Investors, speculators, and banks, using leverage to purchase structured securities, underestimated the risk that borrowers would default en masse, which they did when housing prices tanked.

As industry analysis noted, home prices clearly could not continue to expand at a rate far in excess of incomes or the general inflation level. In the absence of sound macro-economics, most analysts either expected that there would be a soft landing or assumed that the gains made during the boom would compensate for the losses during the lean years. Many professionals, it turns out, are not much different than the average investor: they don’t time the market, they stay in it.

Salsman’s analysis falls short by assuming that self-professed altruism was an abandonment of the pursuit of profit.

In late 2006, monthly mortgage data showed an increase in home owner delinquencies, particularly in subprime mortgages. Goldman Sachs, as Morgenson notes, shorted the market while it continued to sell high-risk mortgage bonds to investors. However, highly ranked analysts at J.P. Morgan and UBS were publicly advising their clients to get out of the market. At the hedge fund where I was employed, we were alarmed by the data and acted accordingly. Obviously, so did other investors, as 2007 brought a general collapse of the subprime market.

Those left holding the bag lost $1 trillion in aggregate. Interestingly enough, it wasn’t the unregulated hedge funds that bore the brunt of the financial collapse. It was domestic and foreign banks and the GSEs: Fannie and Freddie. Why? Was it reckless greed or reckless compassion? Did the profit motive blind and corrupt investors, mortgage originators, and Fannie Mae? Or did egalitarian government regulators push the industry to expand the market to unqualified borrowers?

Both Morgenson and Salsman, while capturing an important aspect of the industry’s failure, create a distorted picture by attempting to shoe-horn the problem into too narrow a category. Morgenson’s view, that the profit motive corrupts, is too simplistic. It fails to acknowledge that industry participants believed in their products and were passionate about providing services to an under-served segment of the market. It fails to explain why the profit motive, which has fueled two hundred years of mankind’s most stunning material advancement, should now be a problem.

Salsman’s analysis falls short by assuming that self-professed altruism was an abandonment of the pursuit of profit when, in fact, industry participants were convinced that they could handle the new lending standards and make a profit. They were convinced that they could safely fund the massive expansion of housing credit. That they were wrong is not proof in and of itself that they were willing to sacrifice profits for altruistic ideals. That government started the ball rolling doesn’t fully explain why the industry took the ball and ran with it.

Salsman’s analysis doesn’t do justice to Rand’s critique of altruism. His use of the word is closer to common use than to Rand’s notion of sacrificing one person to benefit another. With every call for altruistic sacrifice there is someone collecting the sacrifices. The victim and predator are two sides of the altruistic coin. In Rand’s fiction, crony capitalists seek the unearned as they preach subservience to the collective good. In her non-fiction, she condemned crony capitalists as “pull peddlers” who seek government advantage and subsidies that are rationalized as good for the nation’s economy and its weakest members. In a corrupt, regulated market economy, seeking government advantage replaces market discipline with disastrous results.

Banks “got religion” while the federal government’s bordello is still going strong.

Morgenson isn’t completely wrong. There was reckless greed, and if it was not a cunning exploitation of government advantage, it was certainly the lack of diligence that one expects in a regulated economy. Salsman is dead on right that government’s involvement, sanctioned by do-good slogans, paved the way for the disintegration of an industry and the subsequent collapse of the economy. Both fail to describe the challenge of modeling prepayment and default behavior. As a result, their narratives degenerate into one-dimensional caricatures.

To fully describe the history of the bubble and collapse requires a book that hasn’t been written. In the brief analysis of this presentation we can, however, resolve the question of what is fundamental and what is derivative. In economics, one doesn’t have the option of doing a controlled experiment. However, circumstance has provided us with an unusual situation. Since the housing market crash of 2007, private lenders have severely tightened credit—virtually suspending all lending that is maintained on the banks’ balance sheets. Banks and investors now understand the risks and realities of falling housing prices.

As the banks have pulled back, government has expanded its mortgage underwriting. Government agencies readily lend up to $729,000 for a single family home. The FHA still allows down payments as low as 3.5 percent instead of the traditional 20 percent. Given that national housing prices fell over 4 percent in the last year, it isn’t long before a home owner is underwater. Now that the nationalized GSEs are as integral a part of the government as the FHA, it seems unlikely that they are continuing their risky lending practices out of reckless greed.  That leaves reckless compassion.

Banks “got religion” while the federal government’s bordello is still going strong. The FHA, the government’s subprime underwriter, accounts for one-third of all mortgages for home purchases, with Fannie and Freddie insuring most of the rest. The Treasury and Fed hold over $1 trillion of mortgages. The government is doing what the market refuses to do: investing in risky mortgages at below-market interest rates.

With their inadequate down payments, FHA loans are structurally as risky as private sub-prime debt. But defenders of the FHA argue that the historical default rate proves the risk of FHA loans is manageable without requiring a bailout. Of course a similar historical argument was made by private sub-prime lenders prior to the housing collapse. Structurally the loans are the same—a 3.5 percent down payment is a 3.5 percent down payment. The FHA loans for the most part weren’t stressed because of their geographical diversity. The private sub-prime loans were heavily concentrated in California and other bubble states. [i]

As the housing crisis expands nationwide, increased stress is putting strain on all underwater properties. One-fifth of FHA loans made in 2007 and 2008 (when private lenders retreated from the market) are defaulting. And default rates are greater for the prior two years of origination. An estimated two-thirds of all defaults are the result of government agencies or regulations imposed on private lenders. [ii]

The Wall Street Journal reports that the FHA capital reserves are just 0.24 percent—far less than the 2.0 percent federal law requires the agency to maintain. If it were a semi-private institution, as Fannie Mae was, it would require a federal bailout. Given that the FHA “now backs nearly one-third of all new single-family mortgages” often with inadequate down payments, where’s the outcry?

Sound mortgage finance demands higher compensation for the risk of low or negative equity. In government-dominated mortgage finance we see the opposite happening. On Oct. 24, 2011, President Obama announced that the White House would bypass Congress and institute new rules to make it easier to refinance a mortgage. [iii] By executive order , he will loosen underwriting standards “removing the current 125 percent [loan to value] ceiling for fixed-rate mortgages backed by Fannie Mae and Freddie Mac.” [iv]

Thus, the interesting question now isn’t why so many—from the humble homeowner to the head of the Federal Reserve—were blind to the risks of a hyper-expanding housing market before the bust. The interesting question is why, given what we now know, does the government still push risky finance? The continuation of governmental reckless lending after the for-profit institutions have left the market suggests that reckless compassion, not reckless greed, is the root cause.

Attacking private and public officials is easy with 20-20 hindsight. More than one critic has called for criminal prosecutions, with Morgenson, for example, arguing that the risks were so obvious that there was no excuse for the behavior. Why, then, do the same policies continue in the public sphere? If it was obvious then (and it was obvious only to a few), it is surely obvious now!

Government is not and has never been capable of making wise and prudent economic decisions. It isn’t a question of finding the “right regulators” or “selfless public servants.” It’s inherent in the nature of the beast. The very same policies that are condemned when undertaken by private institutions are readily accepted when justified in the name of “helping the unfortunate” or on the premise that “it will be good for everyone.” Both altruism and collectivism enable the acceptance of failed policies that would otherwise be subjected to rigorous scrutiny.

In private economic activity we weigh concrete costs against measurable benefits. But who can truly know what “helps the needy” when it comes to people we’ll never meet? And who can aggregate the costs and benefits of policies that “help the economy” and are “good for everyone?” Such sentiments exempt proposals from critical examination after at most a perfunctory analysis. Most people assume such noble sentiments can’t lead to harm; and critics are summarily dismissed as mean-spirited. Rosner struggled for a decade to warn of the long-term risk and harm to everyone including the intended beneficiaries, but his sober economic analysis was swept aside by the “compassionate” advocates of “affordable housing for the masses.”

Of course there is a secret hope of being among the beneficiaries of collective plunder. This motivation is best hidden behind vague notions of the collective good. [v] John McCain, during the 2008 election, proposed a $300 billion plan to buy underwater mortgages and thus relieve the homeowner of negative equity while supporting housing prices. This brazen attempt to buy votes insulted the dignity of the middle-class voter. President Obama would later propose subsidies for underwater homeowners repackaged as stimulus for the economic recovery. The rhetoric of compassion and collective welfare is an essential element in the corruption—both moral and epistemological—of the middle class.

What will happen when the Fed and Treasury no longer pin mortgage rates at low levels? If this is the key to housing affordability, what happens when mortgage rates rise from 4 percent to 6 percent and payments increase 25 percent? If prices resume their fall, how does a 4-10 percent down payment protect the investor or the taxpayer? More generally, how does diverting credit from business investment to home ownership help to create sustainable employment? A factory or office is a capital investment that is built to enable continued employment; a home is built for consumption. These questions are rarely discussed let alone answered because the evasion of reality and the suspension of rational thought are hallmarks of what I’ve called reckless compassion.

The same monetary regulators who failed to see the damage of excess credit prior to the crash are still at the helm. The same congressional leaders who pushed the partially empowered regulators to expand reckless lending have now created a vastly greater iron-clad regulatory structure that will ensure that no business can avoid these discredited regulations. Systematic failure is more certain that ever before.

Apparently we’ve learned little from the financial crisis. That would require rational, reality-based principles. Paternalistic government exists to save people from such effort. Why is anyone surprised at the result?

[i]            Thomas Sowell, The Housing Boom and Bust (New York: Basic Books, 2009)

[ii]            Peter J. Wallison, “Barney Frank, Predatory Lender,” Wall Street Journal, October 15, 2009, View article

[iii]           “What Housing Risk?” Wall Street Journal, November 29 2011, View article

[iv]           Federal Housing Finance Agency, “FHFA, Fannie Mae and Freddie Mac Announce HARP Changes to Reach More Borrowers,” October 24, 2011, View article

[v]           Sowell also covers this topic in his chapter titled “The Rhetoric of Housing.”

James Kourlas is a retired analyst in the investment banking and hedge fund industries, where he specialized in mortgage prepayment and default models. He had previously worked as a physicist and engineer.