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Did the Fed Cause the Housing Bubble?

I was traveling over the weekend and so didn't get a chance to post on Friday about my latest piece in the WSJ, a contribution to an Editorial Page symposium on Alan Greenspan's argument a few weeks ago that the Fed didn't cause the housing bubble.

My argument that the Fed did is in the WSJ, "Low Rates Led to ARMs". It is about halfway down the page.

Some readers will remember that during the fall I posted here the chart that provides the data that I summarize in my Friday column.

In a nutshell, the economic argument is that the substitution by consumers of ARMs for FRMs provides the economic mechanism for Federal Reserve short-term monetary policy to affect housing prices that both Greenspan and John Taylor had not discussed. Greenspan focused on the constancy of the 30-year rate and Taylor focused on the interest rate without providing a mechanism for converting short-term rates into housing prices (which was Greenspan's basic response to Taylor).

Commentor (mail):
It seems pretty clear that the Fed helped create the conditions in which the housing bubble occurred. However, securitization plus credit default swaps was the mechanism under which the big banks were willing to take greater and greater risks, thereby pushing housing prices up. The big banks didn't manage their risks correctly because they believed they were protected from defaults by the likes of AIG. If you want to pick one thing that "caused" the housing bubble, try the securities modernization act.
3.30.2009 9:14am
progressoverpeace (mail):
The Fed contributed to the housing bubble by its refusal to let the US go into anything resembling a recession (which are necessary periods of economic life), but that fault is not solely on the Fed as the American people declared recessions to be, essentially, illegal years ago - throwing out everyone in office if the whiff of a recession comes around.

What really caused the housing bubble was the forced misvaluation of debt-risk by the Federal Government (through the CRA and other methods of coercion) in the sub-prime market which got naturally arbbed through the whole debt market, massively propelled by Fannie and Freddie's charge to move through the market and clean these loans off the sheets of lenders to keep the flow going. Anyone with a brain knows that you can't pervert one section of a market (that is as intimately tied together as the debt market) and have that mispricing quarantined.
3.30.2009 9:19am
Aultimer:
progressoverpeace: if Freddie and Fannie bought up about half of the subprime loans do they get the blame for the other half too?
3.30.2009 10:07am
Floridan:
Fed policies may have been necessary, but they were hardly sufficient to cause the housing housing bubble.
3.30.2009 10:12am
Anderson (mail):
Agreed w/ commenters that there's no *single* cause, but TZ is surely right to point to the Fed as one important cause.

Necessary but not sufficient, as Floridian says; had the Fed been more prudent, the bubble couldn't have assumed its egregious proportions.
3.30.2009 10:15am
progressoverpeace (mail):

Aultimer:

if Freddie and Fannie bought up about half of the subprime loans do they get the blame for the other half too?


Market manipulation (and that's what Fannie and Freddie were doing, along with encouraging the quick growth of this distorted market, especially as they were abusing the "implicit" federal guarantees people associated with them) doesn't require 100% of the market participating. When bubbles start forming (the bubble for lenders, in this case) people will ride them. That is a truism.

People didn't like red-lining, so they mucked everything up and, instead, they'll see all those same areas flourish on stolen money for a little bit and then sink into worse shape than they were before the red-lining was stopped - along with dragging the rest of our economy, and possibly our monetary system, into the abyss.
3.30.2009 10:26am
Brian Macker (mail) (www):
Not only did it cause the housing bubble it also caused the Internet bubble.

The whole point of fractional reserve banking is to borrow short and lend long so I don't know what the mystery is about. Of course governmental price fixing of short term rates will effect long term rates. Duh.
3.30.2009 10:44am
Brian Macker (mail) (www):
BTW, the source of the booms and busts is fractional reserve banking in the first place.
3.30.2009 10:45am
SeaDrive:
Given that some banks got into trouble, and others didn't, I don't see how you can blame the Fed for loans made to people without the resources to repay.
3.30.2009 10:48am
Clayton E. Cramer (mail) (www):
Everyone seems to be missing that the subprime mortgage market expansion was recognized WHEN IT WAS STARTED as likely to lead to this. From the September 30, 1999 New York Times:


In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

The action, which will begin as a pilot program involving 24 banks in 15 markets -- including the New York metropolitan region -- will encourage those banks to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers. These borrowers whose incomes, credit ratings and savings are not good enough to qualify for conventional loans, can only get loans from finance companies that charge much higher interest rates -- anywhere from three to four percentage points higher than conventional loans.

...

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''
3.30.2009 10:58am
Nathan_M (mail):
I find it hard to blame the Fed too much given that there were housing bubbles in most of the western world. It's easy to say in retrospect that the Fed should have deflated the housing bubble earlier but there weren't many commentators calling for that during the bubble and there weren't any other central banks that deflated the bubble in their own country.

No doubt domestic institutions matter on the margins, but if the Fed, Fannie Mae or deregulation are so much to blame why was there also a real estate bubble in Sydney, London, Madrid and Mexico City?
3.30.2009 11:08am
scattergood:
Fraction reserve banking and the Fed helped create a credit bubble. The fact that the excess credit went into the housing market is more the fault of the CRA / Freddie / Fannie etc.

The excess credit had to go somewhere, the Gov't punished those who didn't put the excess credit into higher risk housing and rewarded those who did.

After the subprime mess started, we had quick and fast commodity bubble as excess credit went into that asset class once it became obvious that prices in housing were not sustainable.

So, this wasn't a housing bubble per se, but a credit bubble. Which is why nearly EVERY asset class has gone down in price as the credit bubble deflated. Oil, Housing, Gold, Stocks, Wheat, Corn, Cattle...everything is down in price for their respective peaks. Is anybody saying that the Fed caused the Wheat bubble of 2008? The Wheat futures hit a high of $1396 4/8 on 2/27/08. Today they sit at $505, a 64% decline!
3.30.2009 11:12am
loki13 (mail):

Given that some banks got into trouble, and others didn't, I don't see how you can blame the Fed for loans made to people without the resources to repay.


Yes, I too believe this ideological point while ignoring the evidence of my eyes. When I look at bust cities such as Los Angeles, Orlando, Naples, Miami, Las Vegas et al., what I see are way too many affordable housing units for the poor being foreclosed, and not way too many luxury houses and condos.

What do you believe, the words or your lying eyes?
3.30.2009 11:14am
loki13 (mail):
Just as an aside, I love how the blame is conveniently put on the usual suspects (the poor, the GM workers, too much regulation) as opposed to, I don't know, management, or too little regulation, or, goodness, The Captains of Financial Industry(tm) that we have incentivized to produce short term profits over long-term systemic risk.
3.30.2009 11:17am
George Smith:
It's not necessarily banks that were the source of all of the bad loans. Mortgage companies, big and small, made sub prime residential loans, many at 100% LTV, some with negative amo teaser rates, all ARMs. They did it because they could sell the loans to Fan/Fred, take their commission, and toodle off. F/F bought the loans because they were told to, and because their execs could make tons of money from the sales of the MBS. Institutions, including big banks and insurance companies, bought the MBS because they were "backed" by the US. ARMs reset to market, borrowers can't pay, borrowers have no skin in the game, borrowers walk, dominos begin to fall. Look at your local and regional banks and S&Ls They are not in trouble because their residential mortgage lending was limited to traditional lending criteria. The Fed was one of many causes, but F/F and its Congressional overseers (and lack thereof) was a big one. I've been in real estate lending for 20 years, and the mortgage bankers and brokers I work with, who are all still quite solvent, have been watching this thing unfold for the last six years, and shaking their heads in utter amazement.
3.30.2009 11:34am
SeaDrive:

What do you believe, the words or your lying eyes?


Sorry, but I don't understand your point.

I never said that the buyers who did not qualify according to traditional banking standards were poor. Many, many people with good jobs bought too much house.


BTW, the source of the booms and busts is fractional reserve banking in the first place.


This theory fails to account for the booms and busts of the 19ths century, of which there were many.
3.30.2009 11:46am
Tony Tutins (mail):

Many, many people with good jobs bought too much house.

How is a homebuyer to discern what is "too much house"? He buys what he can afford. First time buyers typically do not understand how much house they can afford, so they rely on the advice of real estate salesmen, mortgage brokers, etc. (Who tell them to ignore the rules of thumb used in a more conservative day.) Constantly increasing home prices provide another spur to get into a house while it's still at least somewhat affordable. (Only a few Cassandras told us that we were in a housing bubble, which made the affordable house of today the "too much house" of next week.) People were encouraged to get in the market and start building equity (house prices always increase over the long term), then refinance to a lower interest rate (no matter how unlikely that seems now).

Even I, conservative with my personal finances, was buffeted with solicitations to refinance my 30 year fixed into a go-go interest-only ARM, which would put $200 spending money in my pocket each month. Those companies are either out of business or really hurting today.
3.30.2009 11:56am
A Law Dawg:
First time buyers typically do not understand how much house they can afford, so they rely on the advice of real estate salesmen, mortgage brokers, etc. (Who tell them to ignore the rules of thumb used in a more conservative day.)


"First time buyers typically do not understand how much car they can afford, so they rely on the advice of car salesmen (who tell them to ignore the rules of thumb Dad told you before you went to buy your first car)."

Why the hell would anyone rely on the advice of the person trying to take your money? That is simply stupidity.

Only a few Cassandras told us that we were in a housing bubble, which made the affordable house of today the "too much house" of next week.


Those Cassandras were all over the place, and if anything weighed against them it was that they made their predictions so early that people accused them of crying wolf. I think the Economist had an article seemingly every week for four years warning about the housing bubble.
3.30.2009 12:03pm
A Law Dawg:
Edit to the above: those Cassandras may have been shouted down as "bubbleheads" but they most certainly existed if you read legitimate sources. Not surprisingly, nobody on "Flip This House!" was going to say the word "bubble," much less admit there was one. My buyer's agent here in metro Atlanta was adamant that there was no housing bubble when I bought my house in 2007. I asked her what she planned to do if the bubble popped in the next 12 months. Her answer: "If the media would stop saying there is a bubble, there wouldn't be one, because there isn't."
3.30.2009 12:10pm
Tony Tutins (mail):

Why the hell would anyone rely on the advice of the person trying to take your money? That is simply stupidity.

Borrowers should be able to assume that rational self-interest would keep lenders from making loans to people who can't pay them back. What happened here? Don't the lenders have the advantage of knowledge and experience over Joe Consumer?

Those Cassandras were all over the place, and if anything weighed against them it was that they made their predictions so early that people accused them of crying wolf. I think the Economist had an article seemingly every week for four years warning about the housing bubble.

Somehow I suspect that the typical homeowner whose house is unaffordable now that his ARM has reset did not subscribe to The Economist.

Were there articles warning about the housing bubble in People Magazine? Was it discussed on Entertainment Tonight?
3.30.2009 12:11pm
A Law Dawg:
Were there articles warning about the housing bubble in People Magazine? Was it discussed on Entertainment Tonight?


This is bad comedy.

Borrowers should be able to assume that rational self-interest would keep lenders from making loans to people who can't pay them back. What happened here? Don't the lenders have the advantage of knowledge and experience over Joe Consumer?


I'm not defending the lenders. But infantilizing the buyers as Red Riding Hoods is either silly or depressing if true.
3.30.2009 12:29pm
ShelbyC:

Were there articles warning about the housing bubble in People Magazine? Was it discussed on Entertainment Tonight?



I see. People are to stupid to manage their finances, so the government should do it for them. People should be immune from the consequences of their actions if those consequences wern't discussed on ET.
3.30.2009 12:30pm
Careless:

Borrowers should be able to assume that rational self-interest would keep lenders from making loans to people who can't pay them back. What happened here? Don't the lenders have the advantage of knowledge and experience over Joe Consumer?

The lenders don't care as long as they can sell the loans at face value. Blame the ratings agencies for being incredibly incompetent.
3.30.2009 1:02pm
Edward Lunny (mail):
" Somehow I suspect that the typical homeowner whose house is unaffordable now that his ARM has reset did not subscribe to The Economist "...Nor, I suspect, to common sense. All of that paperwork that one signs in order to get a mortgage includes information about adjustment periods and rate changes and limits etc etc etc. That paper work doesn't exists for ones entertainment, nor to swab ones buttocks.

"I see. People are to stupid to manage their finances, so the government should do it for them. People should be immune from the consequences of their actions if those consequences wern't discussed on ET " Yes, apparently according to some. To the rest of us, however, If one doesn't have the sense to understand the contract that they signed; perhaps they should not be trusted to roam freely through society. This, to me, is the most agravating part of this fiasco. These people all signed on the dotted line, they all agreed to repay what they borrowed. Yet, all were shocked to find that they could not afford to repay and think that somehow they are entitled to be rescued without any consequence. Quite frankly, pay up, come to an arrangement with your financial institution, or GET OUT ! I am not going to bail you out, I didn't do this to your family ,you did. Stop your whining and take responsibilty for your screw up.
3.30.2009 1:11pm
Tony Tutins (mail):

But infantilizing the buyers as Red Riding Hoods is either silly or depressing if true.

"Infantilizing" Most of how a lawyer earns a living is by exploiting the asymmetry of knowledge between him and his clients. Do you think of your clients as infants?

The borrowers didn't know, and they had no reason to know.
3.30.2009 1:14pm
Aultimer:

loki13
When I look at bust cities such as Los Angeles, Orlando, Naples, Miami, Las Vegas et al., what I see are way too many affordable housing units for the poor being foreclosed, and not way too many luxury houses and condos.

It's no coincidence that non-recourse loans are the norm in the cities you list. The (real) credit crisis isn't the same thing as the (false) foreclosure crisis.
3.30.2009 1:16pm
Tony Tutins (mail):

Stop your whining and take responsibilty for your screw up.

Is that your advice to Elie Wiesel, as well? Surely a Nobel Laureate should have been savvy enough to do some due diligence.
3.30.2009 1:16pm
Ariel:
loki13,

Just as an aside, I love how the blame is conveniently put on the usual suspects (the poor, the GM workers, too much regulation) as opposed to, I don't know, management, or too little regulation, or, goodness, The Captains of Financial Industry(tm) that we have incentivized to produce short term profits over long-term systemic risk.

Just on the point of too little regulation... if there was too little regulation:
- Why did highly regulated countries (most of Europe) suffer as well as less regulated countries (US)?
- What deregulatory changes occurred? The only one is Glass-Steagall (sp?) which passed the Senate with 98 votes to be signed by Clinton. During the Bush years, regulations increased dramatically.
- Why did the head of OTS claim that he had the power and authority to head off the bubble, but, like most people, did not foresee it?

A lot of the bubble was due to the interaction between (1) Basel II regulations (bad regulation - not deregulation) where reserves were required to be based on current asset values; and (2) mark-to-market accounting, which required ongoing asset valuation. Between the two of them, they have the effect of increasing the cyclicality of lending.

Instead of blaming deregulation, the better thing to blame is bad regulation. Maybe our regulators have even less of an idea what to do than our captains of industry.
3.30.2009 1:23pm
A Law Dawg:
"Infantilizing" Most of how a lawyer earns a living is by exploiting the asymmetry of knowledge between him and his clients. Do you think of your clients as infants?


Rule #1 in our firm is to not sell clients on cases they cannot afford. We do not tell clients "this case is going to be super cheap for you to litigate, and when we win it, which we will, you will be richer at the end of the case than before." That is what these lenders did, and the innocent borrowers fell for it; those that thought they were savvy knew the game and played anyway.

It is very common for us, even in this legal environment, to advise potential clients that their case is probably not worth spending money on us to litigate. It is also common for us to tell them that a given case is likely to end up costing more than the potential recovery.
3.30.2009 1:25pm
Commentor (mail):
Fannie and Freddie eased their lending requirements, but by definition, Fannie and Freddie do not buy "sub-prime loans." That cut off is the definition of sub-prime.

Fannie and Freddie was under-capitalized and basically suffered from a crisis of confidence where bond buyers no longer treated their paper as equivalent to treasuries and therefore kept them from being able to refinance. The downfall of Fannie and Freddie is more like a bank failure than a "cause" of the crisis.

To extend the analogy, the downfall of Fannie and Freddie is more similar to the downfall of the commercial banks, who had taken on huge risks through their investment bank arms by purchasing these securities, while thinking they were safe because of their credit default swaps. Congress passing measures to lower Fannie and Freddie's capital requirements are in this sense like Congress passing its limited repeal of Glass-Steagal, allowing commercial and investment banks to live under the same roof, and therefore creating a bank where the proper capitalization level was being improperly gauged based on the huge and unanticipated risks in securitized debt.
3.30.2009 1:28pm
ShelbyC:

Stop your whining and take responsibilty for your screw up.


But whining is probably a more rewarding course of action. Most of these buyers didn't screw up, they took reasonable risks and lost.

Given the rates that house prices were going up, buying a house you couldn't affort was probably a reasonable gamble, depending on when the rates stop:

Upside, make a lot of money

Downside, lose a little and end up not much worse off than you were before.

Now if you can get some sort of bailout on top of that, more power to you.
3.30.2009 2:10pm
Dan Weber (www):
Borrowers should be able to assume that rational self-interest would keep lenders from making loans to people who can't pay them back. What happened here? Don't the lenders have the advantage of knowledge and experience over Joe Consumer?
My advice to people 10 years ago was "never let the bank tell you what you can afford."

Even if you can make the payments, the bank is not the one who is going to decide whether or not the mortgage payment or the life insurance premium gets paid this month. Or compare the mortgage to saving for college. Even if they are right in what you can "afford," that doesn't mean you should sign up.

This isn't anything radical I'm proposing. I think I got it out of Mortgages For Dummies. (It would be interesting to see if the edition published at the height of the bubble took out this warning.)
3.30.2009 2:16pm
A Law Dawg:
the bank is not the one who is going to decide whether or not the mortgage payment or the life insurance premium gets paid this month.


Or decides between the mortgage payment and the outrageous costs of healthcare that are spiraling out of control!!11!1one1! and have been loudly proclaimed as such since [Presidential_Election_X].
3.30.2009 2:20pm
ChrisIowa (mail):

Borrowers should be able to assume that rational self-interest would keep lenders from making loans to people who can't pay them back. What happened here? Don't the lenders have the advantage of knowledge and experience over Joe Consumer?

If the borrower doesn't have the ability to figure out how much house he can afford, is he going to have the knowledge or background to contemplate on the lender's "rational self interest?"
3.30.2009 2:43pm
Curious Passerby (mail):
loki13
When I look at bust cities such as Los Angeles, Orlando, Naples, Miami, Las Vegas et al., what I see are way too many affordable housing units for the poor being foreclosed, and not way too many luxury houses and condos.

It's no coincidence that non-recourse loans are the norm in the cities you list. The (real) credit crisis isn't the same thing as the (false) foreclosure crisis.


Orlando, Naples and Miami are in Florida which allows lenders to get deficiency judgments against the borrowers if the foreclosed house is worth less than the loan balance.
3.30.2009 4:05pm
scattergood:

Fannie and Freddie eased their lending requirements, but by definition, Fannie and Freddie do not buy "sub-prime loans." That cut off is the definition of sub-prime.

Fannie and Freddie was under-capitalized and basically suffered from a crisis of confidence where bond buyers no longer treated their paper as equivalent to treasuries and therefore kept them from being able to refinance. The downfall of Fannie and Freddie is more like a bank failure than a "cause" of the crisis.

To extend the analogy, the downfall of Fannie and Freddie is more similar to the downfall of the commercial banks, who had taken on huge risks through their investment bank arms by purchasing these securities, while thinking they were safe because of their credit default swaps. Congress passing measures to lower Fannie and Freddie's capital requirements are in this sense like Congress passing its limited repeal of Glass-Steagal, allowing commercial and investment banks to live under the same roof, and therefore creating a bank where the proper capitalization level was being improperly gauged based on the huge and unanticipated risks in securitized debt.


You are entitled to your opinions, but not your own set of facts. Freddie and Fannie were intimately involved in the subprime mess. Here is a report from 2002 indicating their level of involvement:


Interestingly, subprime market growth in the 1990s occurred largely without the participation of Fannie Mae and Freddie Mac. The GSEs started showing interest in this market toward the end of the decade and now purchase A-minus mortgages as a regular part of their business. National Mortgage News, a trade publication, estimates their combined market share in 2001 grew by 74 percent, representing about 11.5 percent of all subprime loan originations in that year. Some market analysts estimate that GSEs will soon be purchasing as much as one-half of all subprime originations.

http://www.nhi.org/online/issues/125/goingsubprime.html


The GSE participation in buying and reselling lower quality debt gave that activity the seal of approval. If the LARGEST purchaser and reseller of debt, who was backed by the gov't, didn't have a problem participating in the lower quality mortgage backed debt market, why should anybody else who tried to follow their standards?
3.30.2009 4:21pm
Poor old dirt farmer:
I am not an attorney but I find this website very informative and interesting. Thanks!!!
3.30.2009 4:24pm
Edward Lunny (mail):
" Is that your advice to Elie Wiesel, as well? Surely a Nobel Laureate should have been savvy enough to do some due diligence. "...I'm not aware of any attempt by Mr. Wiesel to place blame or responsibilty on anyone else. He has, I believe, admitted that he was taken in by Mr. Madoff as were many others. The situation, though, is not the same as signing a contract and then pleading ignorance when it comes time to pay. That, pleading ignorance, or ,perhaps, blind stupidity, is the excuse of those whom have chosen to not meet their contracted obligations with respect to their mortgages. Considerably different than being swindled by such as Mr. Madoff.
3.30.2009 5:13pm
keypusher64 (mail):
"Infantilizing" Most of how a lawyer earns a living is by exploiting the asymmetry of knowledge between him and his clients. Do you think of your clients as infants?

This analogy is absurd from the start, because a lawyer-client relationship is quite different from a lender-borrower relationship. I owe my clients loyal and faithful service; the bank that loans me money is not my fiduciary.

Second, "exploit information asymmetries"? What? A lawyer is supposed to explain to his or her clients the consequences of given courses of conduct, as best and as honestly as the lawyer can figure them out. That is what the lawyers I know do; their clients, who are not infants, would not settle for anything less. Of course the lawyer knows things the client doesn't, like the limitations period for breach of contract claims in New York or how to draft a note of issue, but is that "exploiting information asymmetries"? You might as well say the accountant who prepares the client's books exploits asymmetries of accounting information or the man who mows the client's law exploits asymmetries of lawmowing information.

The borrowers didn't know, and they had no reason to know.

A person who borrows several hundred thousand dollars has "no reason to know" whether he can pay it back?

Am I just falling for really obvious trolling?
3.30.2009 5:59pm
ShelbyC:
"exploit information asymmetries"?

Yes, technically a lawer exploits information asymmetries, in the sense that they exploit the fact that they know more about the law than their clients. But lawyers have a fiduciary duty to their clients, which banks don't.
3.30.2009 6:43pm
Tony Tutins (mail):
Interesting article. It's true that Fannie Mae bought about 1/5th of the loans made to borrowers who represented slightly risk (A-) than their standard (A).

Further, loan originators made subprime loans even to prime borrowers, because of the attractiveness of additional fees and higher interest rates.

Ponder this: The lenders knew their borrowers qualified for prime loans, but gave them subprime loans, anyways. This is the asymmetry of knowledge.

The moral, I guess, is that all homebuyers should either have as much savvy as the typical VC reader, or that they should know enough to hire consultants to review any deal they contemplate.

National Mortgage News, a trade publication, estimates their combined market share in 2001 grew by 74 percent, representing about 11.5 percent of all subprime loan originations in that year.

However, A-minus loans account for 50 to 60 percent of the entire subprime market.

Subprime borrowers frequently pay higher points and fees and are saddled with more unfavorable terms and conditions, such as balloon payments, high prepayment penalties, and negative amortization. Lenders say the higher rates and charges reflect the additional costs and risks of lending to borrowers with less than perfect or nonconventional credit. However, research conducted by Freddie Mac suggests that the higher interest rates charged by subprime lenders are in excess of the additional risks these borrowers bear. Thus, increased competition would tend to reduce borrowing costs in the subprime market.
3.30.2009 7:12pm
Ricardo (mail):
Re: fractional reserve banking

It's true that fractional reserve banking (FRB) was the main cause of the crisis. After all, where do most people get mortgages from? From banks with fractional reserves, of course. Without FRB, most ordinary people would never be able to even dream of buying a house of their own. Instead, they would live in their parents' house and take over ownership after their parents die, as many people in other countries do. Without a housing market, you can't have a housing bubble, now can you? Problem solved!
3.30.2009 9:35pm
Moneyrunner43 (www):
Art Cashin is a governor of the NY Stock Exchange and has amazing insight into the way the financial engines of the world work. It is my privilege to read his comments every morning.

Here is his explanation of the financial mess we are working our way through.


With all the finger pointing and acrimonious "us and them" about, we thought it would be helpful to look back and find out how we got swept into the worst financial crisis since the Great Depression. The following is an amalgam of observations by several members of the FoF [Friends of Fermentation] over several evenings of marinating.

As many believe, a driving force in this process was greed. Somewhat perversely, however, the greed was on both sides of the transaction.

Let's set the background. Overall, interest rates had remained low from the mid-nineties on. There were a variety of reasons for this phenomenon. First, was a nearly back to back series of financial shocks. There was the collapse of the Thai Baht followed by the Russian Ruble followed by Long Term Capital Management. At each one, the Fed and other central banks responded by flooding the system with liquidity. And, the crises came so hard upon each other that the banks could not drain the liquidity before having to add more for the next crisis. Then came Y2K. Central banks worried that the public might hoard cash fearing a Y2K collapse of ATMs, bank records, etc. To prepare for the drain that this hoarding might cause, they added yet more liquidity.

Shortly before Y2K actually began, the Fed, realizing there was no hoarding, began hiking rates to sop up all that liquidity. The hikes were a strain on the Dot.com Bubble and it began to collapse. In response, the Fed began to cut again and then, along came 9/11. The concern was that a fear of terrorism could kill the economy. That fear permeated Washington. Recall that when President Bush was asked -- "What can the people do for the country in this crisis?" He simply replied "Go shopping." The message was not lost on Fed. They kept lowering rates. Americans would not be fooled twice, however. They would not rush back to the stock market. They'd put the new liquidity in something "safe" -- something like "real estate."

Central banks didn't feel much pressure to raise rates since inflation was basically dormant. They wondered why such huge liquidity had not sparked rounds of inflation. Mr. Greenspan attributed it to an amazing and unusual growth in "productivity." It was productivity alright -- but it was Chinese productivity. At very low wages, they produced low cost goods which they sold to U.S. consumers, holding down prices and thus inflation. Further, the Chinese recycled the money by buying a swelling pile of U.S. Treasuries -- further holding down yields. So, with no sign of inflation, the Fed kept rates very low, very long.

Now, if you are a pension fund manager these low yields on bonds were causing you problems. Without a better yield, you might be under-funded which might cause you to be unemployed. Seeking better yielding alternatives to Treasuries and corporate bonds, they began to look at those recently new instruments -- mortgage backed securities.

This was the picture the pension managers (and other bond buyers found). The packages were made up of different mortgages, which gave an image of safety through diversification. There was a small bit of subprime in the package to "juice up the yield." The ratings agencies (who got paid by the packagers) pronounced the packages to be AAA.

So, the bond buyers began to buy and, early on, it worked just as planned. Everyone from pension managers to bond arbitrageurs loved them. They loved them so much they asked for more -- and more -- and more. That led the packagers (banks and brokerages) to ask the mortgage writers to get more and more mortgages. That's when things began to fall apart.

In the early years of growing demand for packages, mortgage writers cut rates and cut down payments to sell mortgages. They quickly used up nearly all qualified home buyers while they created a huge housing boom. Yet the demand for the packages grew and grew. (Get me more. I love the yield.) At the same time, Congress was pressing Fannie and Freddie to make mortgages "more available."

The packagers, or syndicators pressed hard for more mortgages to package to meet the demand. The conventional mortgage lenders began to lower standards to expand the target audience (and comply with Congress). The nonconventional lenders threw out almost all standards. Some even began to pay people to apply for mortgages. Some had no income, no job or assets. (The so called Ninja mortgage).

So the greed of the buyers and of packagers fed on each other. A once very viable product became tainted like meat rushed out to meet holiday demand without being fully checked for bacteria. Soon it would bring a fear that would poison the whole system. And, to help grease the skids, FASB 157, the accounting rule to enforce "mark to market" was put in effect November 15, 2007, less than a month after the Dow made its all time high. Talk about ringing a bell at the top.

So let's review how we got here. The Fed held rates artificially low for a very long time. That created an almost insatiable demand for yield which crowded into mortgage CDO's. The demand caused packagers to sharply lower standards to levels well below those used in the computer models that the validity of the packages was based upon. The rating agencies seemed to just rubber stamp the paper.

The fatal flaw in syndication was exposed. Without recourse or look back, the original mortgage lender had no liability. With no "skin in the game", there was no motivation to properly vet the mortgages. The motivation was just the opposite. Move as much paper as you can, book the profits and do it again. Add to all of the above, the imposition of a poorly thought out mark to market rule that would turn a few problems into a massive chain reaction. That's how we got here.
3.30.2009 10:01pm
mariner:
loki13:

Yes, I too believe this ideological point while ignoring the evidence of my eyes. When I look at bust cities such as Los Angeles, Orlando, Naples, Miami, Las Vegas et al., what I see are way too many affordable housing units for the poor being foreclosed, and not way too many luxury houses and condos.

What do you believe, the words or your lying eyes?

Baloney.

Your eyes wouldn't be lying if you'd take off your ideological blinders.

The evidence is irrefutable that loan were made to people without the resources to repay them, and that is the point that was made.

No one but you said those people were poor.
3.31.2009 4:02pm
loki13 (mail):

Baloney.

Your eyes wouldn't be lying if you'd take off your ideological blinders.

The evidence is irrefutable that loan were made to people without the resources to repay them, and that is the point that was made.

No one but you said those people were poor.



People didn't like red-lining, so they mucked everything up and, instead . . .

***or****

Everyone seems to be missing that the subprime mortgage market expansion was recognized WHEN IT WAS STARTED as likely to lead to this. From the September 30, 1999 New York Times:

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.


Indeed.

My "reading between the lines" ability is apparently... different than yours.
3.31.2009 5:20pm
progressoverpeace (mail):
loki13:

Baloney. [ ... ]


People didn't like red-lining, so they mucked everything up and, instead . . .



How about being intellectually honest and including what I posted right before this? I guess I am supposed to apologize for not repeating it in every single one of my posts ... sheesh.

What really caused the housing bubble was the forced misvaluation of debt-risk by the Federal Government (through the CRA and other methods of coercion) in the sub-prime market which got naturally arbbed through the whole debt market, massively propelled by Fannie and Freddie's charge to move through the market and clean these loans off the sheets of lenders to keep the flow going. Anyone with a brain knows that you can't pervert one section of a market (that is as intimately tied together as the debt market) and have that mispricing quarantined.

What that means, for the hard-of-thinking and those who like to selectively cut and paste, is that the pervesion of the requirements for the lower end mortgages had to be propagated through the rest of the mortgage market. If you give someone a 6% mortgage who holds a risk profile requiring an 8% rate, then you have to adjust for those whose risk profile legitimately merits a 6% rate. This works its way throughout the market. The same also happens on the other side of the trade, where the risk analysis of the paper is.

Let me repeat this for you, since you don't seem to understand its importance (or you do, which is why you ignored cutting and pasting it:

Anyone with a brain knows that you can't pervert one section of a market (that is as intimately tied together as the debt market) and have that mispricing quarantined.
4.1.2009 7:59am
loki13 (mail):
progressoverpeace,

So your intellectually honest explanation is that correcting the economically disadvantageous discrimination against the poor and minorities (redlining) caused magical ripples in the debt market that led to all the problems. And this makes so much more sense than a demand-driven explanation (that the markets were craving mortgage-backed securities, so everyone, and their mother, was trying to create more of them by creating more more mortgages- something which is explained ad infinitum in many places).

To boil down-
1. We gave mortgages to the poor (and minorities) who were illegally discriminated against before.
2. Magic Ripples.
3. Profit! Um, no. Crash!

I apologize ffor mischaracterizing your post for implicating any blame upon the poor.
4.1.2009 12:55pm
progressoverpeace (mail):
loki,

Great analysis, there. Forcing lenders to lend to THE POOR, at rates they don't merit, misvalues the debt and perverts the loan requirements. To most thinking people, this would be a moronic notion. But not to you. Just because they're poor doesn't mean that they shouldn't be treated as if they're rich. Huh? Is that how it goes? Brilliant.

"Magical ripples"? You are a genius. Really. Truly. A pure genius.

The demand side was spurred on by the forced mispricing of the risk and the forcing of lenders to create and build this perverted market. Once forced, people finally jumped in with two feet. Big surprise ... to people like you.

Do you actually think with that brain?

But I do like your idea that poor people should be given loans they can't pay back - in fact, your contention that lenders should be forced to lend to such people at insane rates is just peachy. I'm also glad to see that you stand behind such idiocy, even after seeing the effects of it. What would America do without fools like you?
4.1.2009 2:43pm
Pippin:
The Fed facillitated the housing bubble. It printed bank reserves, i.e., artifically inflated the monetary base, which allowed the supply of available credit to multiply through the banking system and the economy as credit to be abused by the banks, homeowners, etc.

These reserves were not the product of increased production in this country, i.e., real weath; they were phony. Hence, the mess we are in.

Here's a chart illustrating the expansion in bank reserves, the result of naked printing by the Federal Reserve for the last 30-some years:
Chart of Bank Reserves

Further, the bubble wasn't limited to real estate. We've had concurrent bubbles in the stock market, commodities, education prices, health care prices, etc.

By the way, bank securitization is a red herring:
Tyler Cowen on Securitization

The fundamental reason is credit inflation stoked by the Fed's phony expansion of bank reserves.
4.1.2009 4:16pm
Dan Weber (www):
The lenders knew their borrowers qualified for prime loans, but gave them subprime loans, anyways

A prime borrower easily becomes a subprime borrower if he tries to borrow beyond his means.

I know that it's the fashion to make sure even complete morons can thrive in society, but home ownership involves certain serious responsibilities. If you can't be bothered to compare rates or read a mortgage documentation, how are you going to decide to do something about that leaky roof? That circuit breaker box making that awful humming sound? The water heater that shakes every time someone takes a shower?
4.2.2009 10:50am

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