I haven’t posted as much as usual over the last three weeks and I wanted to let you know what I’ve been up to. I’ve been working on a longish essay, something on the order of 10,000–20,000 words on the financial crisis. It may end up being a book in a later incarnation.
I’m looking at two issues:
Why did prices rise so dramatically between 1995 and 2003?
Without this price rise, the subprime market never takes off in 2004-2006. There would have been no NINJA loans, no loans for 103% of the value of the house, no second houses with zero down, no 80/20 loans and so on.
The second question is why did the investment banks use so much leverage? Why did Bear Stearns put it itself in a position where a 3% drop in asset values made them insolvent? And why did firms lend to Bear Stearns under those conditions?
The standard answers to both of those questions are that people got into a speculative frenzy, ignored the possibility that prices could ever fall, were greedy, overconfident, myopic etc.
Could be.
But I don’t think so. What I have been doing is looking for evidence that might explain these two phenomena without resorting to animal spirits, social contagion and stupidity. Yes, there were all three of these things along the way. But I don’t think they were the driving force.
I hope to have the essay done in late August or early September. Between now and then I’ll be finishing it up and taking some time off. So I won’t be doing much blogging until the end of August. We’ll also be sprucing up the site in the meanwhile and hope to make it both a little more aesthetic and useful. Looking forward to reconnecting in a few weeks.
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Russ, have you seen Bruce Yandle’s application of his “Baptists and Bootleggers” model to the housing/financial meltdown?
http://www.thefreemanonline.org/featured/bootleggers-baptists-and-bailed-out-bankers/
One thing that is important when looking at the sub prime crisis is the spread between short term and long term interest rates——AS A PERCENTAGE OF THE SHORT TERM RATE——-. The nominal spread was never extreemly high, but as rates fell the percentage of percentage spread got to about 100% if memory serves me. This was a powerful incentive to borrow short term, even when long term rates were historically low. Since many people were borrowing short term, the short term rate determined housing prices. This forced more risk averse people who would normally go with 30 year loans to decide between not owning a home or jumping on the short term band wagon because high prices meant they could not affort the long term rate anymore.
Russ,
Don’t forget that people also thought we were in a new paradigm. Analyst report after analyst report was published during the period of tightening credit spreads proclaiming a new, tighter, normal for credit spreads.
Maybe 100% was too high. I think it was more like 50%. This doesn’t change the analysis though because 50% is still huge.
Another thing to consider. As rates fall, the proportion of your house payment that is interest falls compared to the proportion that is principal. At 7% a 30 year loan is almost all interest. At 4% a loan that amortized at 30 years has a much less interest but the same principal. As prices go up and rates go down, this principle payment goes up but the interest doesn’t. Thus, we have a powerful incentive to create interst only loans.
I hope it includes something about China purchasing of Government debt and driving interest rates down in the process of trying to keep the value of their dollar low in relation to ours. I believe that, and the yen carry trade are overlooked as culprits for our liquidity glut from a few years ago. Way too much cheap money was chasing way too many projects for all of them to be quality investments.
Since China has to get dollars from somewhere to by US Treasuries, do you ultimately blame the trade deficit? And if that, then do you ultimately blame…I don’t know, Bretton-Woods?
I don’t blame China or the trade deficit. When China trades with us they have to do something with the dollars. I would suggest that they don’t NEED to buy US Treasuries, they could also buy US dollars but what they do with the money is ultimately their choice. The fact that the bought dollars suited their purposes, I don’t expect that they considered what was best for the US when they made their choice just like we don’t consider what is best for China when we make choices. But their choice and the choice of millions of Japanese had an impact for certain. Just like the choices of millions of others world wide to buy real estate with those cheap currencies and interest rates had an impact. It’s not good or bad necessarily, its just history now.
US Products, Crap, I hate when I write these things while taking phone calls. China can buy US products if they want, not necessarily US treasuries.
Russ-
I hope you contemplate the “compared to what?” options that the average investor faced beginning in 2000. Enron, Worldcom, Adelphia and a handful of other companies were revealed to have engaged in massive frauds. This (as well as the Internet bubble bursting) was a severe blow to what had been years of a growing popular love affair with stock investing. Many people swore off the stock market as a rigged and dangerous affair. THen in the wake of 9/11, the Fed dropped interest rates so low as to render fixed income and other savings vehicles barely worth investors time. Beyond stocks and bonds there is really only one other alternative asset class for average investors – real estate. Thus the mania for real estate was fueled by a lack of acceptable alternatives.
Plus people somehow thought because real estate was something “tangible” that it couldn’t be as rife with fraud like stocks. They were wrong.
None of the bank models took into consideration a scenario where national real estate market headed down. Real Estate ups and downs have usually been regional, not national events. Uh-oh. Although, if you’re observing that we’re in the midst of a national upswing in house prices, one wonders why it’s suddenly impossible that these house prices can also go down at the same time.
National upswing in prices?
http://news.google.com/news?um=1&ned=us&hl=en&q=rising+real+estate+prices
Gives nothing, are you sure about that? How are prices in Manhattan?
I meant during the housing boom.
Excellent. I hope you turn it into a book to compliment Sowell’s excellent THE HOUSING BOOM AND BUST and Wood’s inadequate MELTDOWN.
I so look forward to reading it!.
I have no idea why the banks did it, but I live in silicon valley and I was told by dozens upon dozens of people that this area was special and housing never lost value ever, and continued to believe that no matter how loudly I laughed when they said that.
Silvermine,
That is what I heard most of my adult life, invest in real estate it never loses its value. In the last 25 years or more it seems that this was a constant drumroll from advertisements. Fortunately I never bought into it.
But, that still doesn’t explain in my mind why so many people who could not afford to make the payments still applied and were approved for loans.
Sure it does. Given what you never bought into, but many others did, the borrowers could afford it, especially with the low cost ARMs. Flip in two years, or take the savings for refinancing in two years. Easy money, easy house. And it worked for some.
For the banks, there was the CRA stick, the Fannie/Freddie carrot, and the mountains of cash from the Fed. I don’t know if bankers bought into the idea that home prices would always rise, but with those other factors, they didn’t really have to.
The threshold for approval has everything to do with risk of loan nonrepayment. Economic and political conditions made the risk either seem low, or irrelevant.
I understand the mechanism, that is not the problem in my mind. Plus, only a few were into the buy, flip, profit mode, most did not have the courage to risk nor the ambition to do.
Most were just people who intended to live in the house they bought. These are the ones I don’t understand, the ones who knew full well that there would come a time in the probable near future when they would have to default unless they won a mega millions lottery, and they still did it. That, in MHO makes them moral degenerates, like any common thief.
Looking forward to the essay, and to your return.
Great news, looking forward to reading it. Since you’ve probably done quite a bit of reading, I hope you’ll include a guide to what you’ve found to be the most useful writings so far.
It was also the mortgage originators who used massive leverage.
The Orange Country Register wrote about one mortgage originator that was leveraged 41-1. That’s not a typo.
The companies went bankrupt — but everyone involved walked away with millions …
I submit my review of the financial crisis. It references sources like the WSJ and some comments from blog reading. Possibly you will find it useful as a somewhat organized reference to the articles.
The theme is that the government’s ability to issue guarantees is an unlimited, off-budget, extremely dangerous power. Implicit guarantees were granted to Fannie Mae and Freddie Mac (among other institutions) who used them to command massive capital resources. Used unwisely, this triggered the financial crisis.
This guarantee business has got to stop.
We Guarantee It – Government Caused the Economic Crisis
http://easyopinions.blogspot.com/2008/10/we-guarantee-it.html
“off-budget”
I haven’t read your link yet, but what do you think the specific repurcussions of being off-budget are?
To Vingvista,
“Off budget” literally means not in the accounting of the US. People can make their own estimates, but it remains an outside opinion, not the official determination of the government.
For example, an estimate for the unfunded liability of the Medicare program for treating our ageing population is $30 to $40 trillion (US Debt Clock). The government doesn’t take that seriously because it is not in the budget. The Medicare program is not a legal promise, but merely a policy, so the government doesn’t include this as an offical obligation of the US.
The current national debt is $11.6 trillion, and GDP is $13 trillion.
Fannie Mae and Freddie Mac borrowed $5.4 trillion on the private bond market at a time when the official US debt was $5.5 trillion. This was off-budget, not included in the US debt, because FanFred were officially private companies, despite being sponsored, controlled, privileged, and regulated by Congress. The bond markets and ratings agencies rated FanFred debt almost the same as US debt, recognizing the reality that Congress was implicitly guaranteeing that debt. Congress would never let FanFred default on its debt because the story would get out about Congress’s involvement, in a very public way.
I speculate that many of the bailouts were motivated by paying off the lenders to the bailees, debt that was implicitly guaranteed by Congressional handshake.
Guarantees by Congress are always considered “costless”, because regulation is supposed to keep the guaranteed banks and institutions from doing anything risky. Then, Congress pushes or allows those organizations to do risky things. The 1980′s Savings and Loan crisis was a direct result of guaranteeing the depositors to the S&L’s while allowing the S&L’s to expand their lending beyond residential housing. This is parallel to our current situation.
>>The standard answers to both of those questions are that people got into a speculative frenzy, ignored the possibility that prices could ever fall, were greedy, overconfident, myopic etc.<<
Until I read your essay (assuming I find it persuasive like I do with most of your views) I will continue to believe that this was exactly the case. Combined with preferable tax treatments on housing, public policies legislated in favor of risky borrowers, very low short-term interest rates from 2001 through 2007 (and the ARMs they spurred), and the implicit guarantee the federal governments had with the GSEs, I think that what you just cited on overconfidence/speculation is exactly it.
“Combined with preferable tax treatments on housing, public policies legislated in favor of risky borrowers, very low short-term interest rates from 2001 through 2007 (and the ARMs they spurred), and the implicit guarantee the federal governments had with the GSEs”
It sounds to me like you are describing a rational consumer response to politically-engineered economic circumstances, rather than an irrational frenzy.
I think the whole animal spirits literature – not the “animal spirits” black box of Keynes particularly, but the more analytic work of people like Minsky and Shiller – gets a bad reputation when it’s dismissed as “irrational frenzy”. Overconfidence, speculative bubbles, and animal spirits aren’t “irrational” – and I think most responsible people don’t claim they’re irrational (although Shiller uses the word, so it does get confusing). They’re just a rational response to limited information, limited information processing capabilities, emotion, and adherence to rules of thumb.
Yeah, it does sound like a bit of a contadiction. And the engineered ‘game’ was going along great until the interest rates began to rise and the ARMs started to reset. That hurt the people that got into homes that they really could not afford once the interest rates normalized.
Also, until this happened, many with home loans and non-ARM mortgages were using their home price’s appreciation to suck equity out for their additional spending money. However, that seemigly perpetual party ended after the ARMs folks walked away from their obligations, leaving many forclosures on the market and causing price depreciation for the first time in a long time. Without the home price appreciation — and the additional spending money — the party ended!
Where all this is irrational is the thinking by my a great many people that the party was never going to end. With the benefit of hindsight, it seemed like a no-brainer; that more people should have seen this coming. In fact, Greenspan warned of the asset bubble in housing and even made threats that it had to be popped. Sometimes ‘the crowd’ does unwise long-term things even as they are rationally responding to the incentives they face. Naturally, though, in today’s society here in the USA, the government feels somewhat guilty for the boom/bust incentives they laid out so they chose unburden two groups for the natural consequences that played out: those that walked away from their obligations and those ‘market players’ that over-leveraged themselves believing that the housing prices would always keep appreciating.
You could make a connection to the ongoing steroids “scandal” in MLB.
1. We’re finding out in retrospect that more players were involved than we might have imagined. Bernie Madoff didn’t bring down the financial system. Nor did a small collection of rogue traders.
2. Players like Manny and Big Poppy likely used them because they were effective. Michael Lewis has already made that case for credit default swaps. Complicated but useful.
I’m sure there are plenty more ways to make the analogy. To me, the stories feel about the same. Lots of outrage, little understanding.
This is one of the most interesting takes I’ve read on the 1995-present credit bubble (it was written in mid-2006):
http://www.itulip.com/forums/showthread.php?t=292
The author’s thesis is that in the mid-90s the fed significantly relaxed reserve requirements (in fact 0% for transactions less than $6.6m (think mortgages)). The side effect was that the fed’s monetary policy became ineffective since reserve requirements are the lever which allows interest rates to influence the money supply. Thus we see a massive expansion of M3, and a fed powerless to stop it.
“fed powerless to stop it”
That is quite interesting. Both Greenspan and Bernanke have denied Fed culpability for the reason that the Fed was unable to increase interest rates from the 1% level.
I look forward to reading it Russ. So far Sowell’s has been the best commentary on it that I’ve read.
You should get Sowell on EconTalk, and talk more about the Housing Boom after you finish your piece.
As for why the housing bubble happened, I think Randal O’Toole’s explanation is best:
http://www.cato-at-liberty.org/2008/09/22/blame-urban-planning/
Cato will be publishing a full policy study about this soon, although I bet if you asked him, he might send you an early review copy…
I think it makes more sense to assume that there was a sudden widespread coordinated change in human nature.
In your essay do you make any considerations to a”Veblen Good” or in other words a Forward Sloping Demand Curve. ..ie People buying a good or commodity not for consumption or because the price is a rational price but because they have an expectation about future prices. this effect doesn’t shift the demand curve outward, it actually caused the demand curve to become forward sloping. Unfortunately when the curve is forward sloping it ends up working in reverse as well’ when prices go back down the curve. Hence a recession in prices. I think Robert Shiller had a good point when he said that even skeptics of a price begin to disregard their own judgement because they feel everyone else simply couldnt be wrong.
best of luck Dr. Roberts
Thanks for the update Russ. I was beginning to think that you had wore yourself out. Looking forward to your essay and/or book. Take care. Steve G.
Will the essay be published here?
Russ-
Very exciting! What role do “global imbalances” and East Asian savings rates have to play in your analysis? While Greenspan’s expansionary policy I think certainly played a role, I’ve had a tought time figuring out how that interacted with global imbalances. I think we’ve seen great cases that both are significant, but I haven’t heard really good arguments for how to allot explanatory power between the two. Although your post seems to focus on firm and household behavior, so perhaps you don’t touch on that as much. Looking forward to it!
Russ,
Have you seen the special issue of Critical Review just out on the causes of the financial crisis? Jeff Friedman has an interesting introductory essay entitled “A Crisis of Politics, Not Economics.”
He posted on that about a week ago.
Dr. Roberts,
I am a comparative political economy guy – not totally Rat. Choice Institutionalist but sympathetic. To me it is strange for all those on the left to say that institutions can solve so many of these problems, and then for them to deny that those same institutions can cause problems. I makes my head spin.
Could Neoclassical myopia to institutions reinforce the myopia of behavioral economics? This is the key question for me. Both ignore institutions and it doesn’t serve them well.
Hope to read the new book.
Cheers,
If I may be so bold, I still like my explanation, “How Did the Mortgage Mess Happen” at http://businomics.typepad.com/businomics_blog/2008/05/why-did-the-m-4.html
Almost every analysis of this looks only at the demand side. When you do that, you come up with explanations like principal-agent problems leading to mispriced risk, poor financial regulation leading to regulatory arbitrage, interest rates held too low for too long, and so on. But the supply side is also important. In jurisdictions where the supply response was not artificially constrained by zoning laws, there was not much of a bubble, and prices have not fallen drastically. This should not be forgotten. It takes a lot of bad laws to create this big of a mess.
Perhaps the banks funded speculators….No they wouldn’t…would they???
The supply guy is on to something. Hazlett says holding rates artificially low encourages speculative activities.
It seems other people are also resistant to abandon rationality concerning this crisis:
http://www.telegraph.co.uk/finance/comment/6001161/Dont-look-for-the-irrational-in-the-credit-crisis-we-do-stuff-for-a-reason.html
By the way, why was my previous post in this thread eliminated?