1. "When it comes to the home mortgage boom and
bust, who was to blame? The borrowers? The lenders? The
government? The financial markets? The answer is yes. All were
responsible." (Thomas Sowell, The Housing Boom and Bust,
2009.) This seems fair.
2. Not explanatory of the problems are "greed"
and "no regulation." Greed is a constant, always with us as part
of human nature. As for "no regulation," the highly regulated
commercial banks and the highly regulated thrifts are deeply
enmired in the swamp of the bust, just as they have been many
times in the past, constant regulation notwithstanding.
3. Economic and financial cycles are natural and
cannot be avoided. The bubble was an exaggerated cycle. Various
government actions contributed to making it worse:
• Fannie Mae and Freddie Mac, a government-sponsored duopoly,
were made into huge points of concentrated vulnerability to
failure, which then indeed failed. They significantly inflated
the housing bubble though their huge entry into high risk
mortgages right at the top of the market -- financed, of course,
with government-guaranteed debt, so that the buyers of their debt
did not have to ask about the soundness of their asset expansion.
(See paragraph on trade deficit and China below.) This risky
strategy was encouraged by politicians and by HUD's "affordable
housing goals."
• The "Greenspan Gamble," which was intentionally to ignite and
feed a housing boom to offset the deflationary effects of the
tech stock crash, succeeded too well. Instead of a mere housing
and mortgage boom, we got the bubble.
• The dominant rating agencies, a government-sponsored duopoly,
were made by regulation into concentrated points of vulnerability
to failure, which then failed, when their high credit ratings of
MBS built from risky mortgages did not include anything
resembling the downside case which became reality.
• Politicians all cheered rising home ownership rates and
"creative" mortgage financing, which simply meant riskier
financing.
4. There was a "logical" very widespread belief
that house prices could not fall on a national basis. "Average
U.S. house prices rarely fall from one year to the next. Bankers,
brokers, appraisers, loan servicers, mortgage investors,
homeowners and the designers and promoters of collateralized debt
obligations all attest to the truth of this assertion… 'History
is definitive,' pronounced the American Banker, 'the
national average price of a home may remain flat for a number of
years, but it doesn't fall.'" (James Grant, Mr. Market
Miscalculates, 2008.)
Mortgage professionals were well aware of many instances of
regional housing and mortgage busts, with falling house prices
and high defaults and losses. But it was thought that this would
not, and perhaps could not, happen on a national average basis.
This firm belief by almost all parties made it possible for the
belief to be false, in the paradoxical way of financial markets.
5. The market and the regulators became enamored
with statistical treatments of risk. But: "The model works until
it doesn't." (Moore's Law of Finance)
Human sources of risk are old-fashioned: short memories, the
inclination to convince ourselves that we are experiencing
"innovation" when what is happening is lowering credit standards,
optimism, speculation which is successful in the early bubble
stages, gullibility, group psychology.
6. "The good times of too high price almost
always engender much fraud. All people are most credulous when
they are most happy." (Walter Bagehot, Lombard Street,
1873.) True then, true now, unfortunately.
7. Highly leveraged financial systems are bound
to have panics and busts from time to time. Increasing leverage
of households was promoted by lenders and the government to
create "affordable loans," with both higher LTV ratios and higher
debt to income ratios. Financial firms were highly leveraged.
Financial engineering produced highly leveraged structures,
including CDOs, SPVs, CDOs-squared. Banks are able to be highly
leveraged because of government deposit insurance, and have
created balance sheets heavily concentrated in real estate risk.
The entire macro economy became more highly leveraged, with
record debt to GDP ratios, the "Big Balance Sheet Economy."
Leverage always feels good when things are going up.
The "Great Moderation," of which the world's central bankers were
so proud, created the conditions in which increased leverage
seemed successful, thereby also creating the conditions for the
bubble and bust. "Stability creates instability." (Epigram of
Hyman P. Minsky's "financial fragility" theory.)
On the way down, needless to say, the leverage is more than
painful.
8. The large and persistent U.S. trade deficit
was financed by a build-up of debt, notably with China, but also
with other countries. An important part of the debt was held in
obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan
Banks, because these were viewed as U.S. government risk (as
indeed they were, as proved by events). But it meant that the
trade deficit was thus directing credit expansion to housing.
Chinese savings became high U.S. house prices.
There seems to be an interesting analogy of the oil boom of the
1970s with consequent LDC ("less developed countries") credit
collapse of the 1980s, to the Chinese export boom and consequent
housing collapse of the 2000s. People were very proud in the
first instance of "petro-dollar recycling," and in the second of
"record home ownership." Consider:
• Oil went from OPEC, which put the proceeds into U.S. banks,
which made loans to LDCs, which later defaulted.
• Goods went from China, which put the proceeds into U.S. debt
securities, which financed mortgage loans, which later defaulted.
9. So-called "fair value" accounting, pushed by
the SEC and its helper, the FASB, made the panic and the bust
worse. So did pressure from both these bodies to constrain the
build-up of the necessary loan loss reserves in good times.
10. "The most common beginning of disaster was a
sense of security." (Velleius Paterculus, History of
Rome, c. 30 AD)
topics:
Financial Crisis, Housing Bubble
