Blame is flying in all directions: mortgage lenders had stopped bothering whether or not borrowers could repay as they were passing the buck to Wall Street anyway; Wall Street firms were using subprime mortgages of any denomination as innocuous stuffing in Collateralized Debt Obligations (CDOs); regulators failed to curb the worst forms of abuse – that were no longer restricted to unregulated mortgage companies but had become rampant in the whole industry; homeowners, driven by greed, couldn’t be bothered with reading their loan contracts before signing them.
I’ve got an alternative explanation: each party was following its own well-conceived best interest in a way that was plainly rational within the existing environment. Think of it: if the value of homes goes up every year by a large amount, it makes perfect sense for some to ask for – and for others to grant – a 125% Loan To Value mortgage. Indeed, with an annual housing price appreciation of 13.7% (as it was at its peak in the spring of 2005) it takes only one year and nine months for the house to be worth 125% of its value at purchase time. The same reasoning applies to Pay Option ARMs with monthly payments lower than the interest accrued, pushing the loan into negative amortization; the more it goes, the more you owe but who cares as the home value shoots up even faster! This doesn’t make a prudent strategy but everyone will tell you – even nowadays – that mortgage is still and by far the cheapest form of consumer credit.
What all parties involved failed to notice was that the circumstances were changing. Every one of the characters in the play had adapted to an environment where price appreciation in residential housing had gained the certainty of a natural law. What escaped everyone was that the housing market requires a constant flow of new recruits to come in at entry level, popping all those ahead of them one notch up. When the bubble was about to burst, lenders became aware of at least that aspect and did all within their power to push the heavy payments as far away into the future as was feasible, promoting rock-bottom teaser rates, Interest Only mortgages and Pay Option ARMs with negative amortization.
Even that could only delay the inevitable: with sufficient stretching the elastic band would pop and aspiring first-time buyers at the FHA and subprime entry level: young couples, immigrants, would be left at the gates. Those who got into buying their home by the skin of their teeth were the first to be washed out when the tide reversed and the price of housing started to drop. As industry insiders noted recently, those late-comers have been so roughed up in the process that it will be a challenge getting them back in once things have settled:
Subprime loans sped up and burned a class of future homeowners, said Frank Nothaft, chief economist for mortgage finance company Freddie Mac. “If they had delayed their initial decision to buy, they would have had a higher likelihood of transitioning,” he said. “Now they’ve had a taste of (homeownership) and are back in the tenant pool — maybe forever.” (…) “We knew that we were borrowing forward by bringing in young people at ages that we had not seen in past years,” said Jay Brinkmann, an economist with the Mortgage Bankers Association. “We can see a decline in terms of future home buyers because we have brought forward a certain cohort of the age.” (1)
The regulators no doubt should have known better: while it is understandably nearly impossible for an individual borrower to hold a comprehensive view of the macro-economic landscape and still difficult to grasp it entirely for financial services like mortgage banks, the Fed, the Office of the Comptroller of the Currency (the OCC is the regulator of federal banks) the Office of Thrift Supervision (the OTS monitors Savings & Loans), Fannie Mae and Freddie Mac employ scores of economists who should have seen coming the widening gap at the first-time buyer entry level. The trouble with economists is that a large number of them don’t believe in financial bubbles altogether; others are disastrously slow at recognizing them even when they get as big as the 2005 housing bubble: it wasn’t before June 2005 that Fed’s Chairman Alan Greenspan admitted he saw “froth” in the housing sector. Remember what the press had to say at the time:
The chairman of the Federal Reserve wanted to make one thing perfectly clear: There is no housing bubble. No sirree. What’s going on in the overheating housing market right now is properly described as “froth.” “There do appear to be, at a minimum, signs of froth in some local markets,” Alan Greenspan said. (2)
How come? Because for a bubble to exist, price has to become “speculative,” meaning that it is higher than the sum of its “fundamentals,” the building blocks of value and therefore the benchmark for price. Unfortunately, ways can be found for decomposing whatever price into some fundamentals that make perfect sense. What’s been lacking in financial theory is an infallible model of price formation that recognizes a bubble when there is one. Fed’s researcher Refet S. Gurkaynak writes:
Can asset price bubbles be detected? (…) despite recent advances, econometric detection of asset price bubbles cannot be achieved with a satisfactory degree of certainty. For each paper that finds evidence of bubbles, there is another one that fits the data equally well without allowing for a bubble. We are still unable to distinguish bubbles from time-varying or regime switching fundamentals, while many small sample econometrics problems of bubble tests remain unresolved. (3)
The inescapable conclusion is that if anyone is to blame for the bubble having popped to some eminent economists’ amazement, it is precisely the economists and them only. A Nobel Prize in economy is awarded every year, how come we’re still unable to tell there is a bubble even when it’s about to pop straight in our face with a mega-bang?
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(1) Patrick Rucker, “Home market took a costly subprime advance,” Reuters, Friday May 4, 2007.
(2) Dana Milbank, “Lawmakers Struggle to See Beneath the ‘Froth’ in Greenspan’s Testimony,” Washington Post, Friday, June 10, 2005.
(3) Refet S. Gurkaynak, Econometric Tests of Asset Price Bubbles : Taking Stock, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.2005-04.