Arnold Kling  

More Fantasy Testimony

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The Duelling Guarantee... Scratch Beginnings and ...

I am in the process of writing expanded fantasy testimony. Below are what I call "oral remarks." I am also working on some support material that I call "written remarks." My goal in writing this is primarily therapeutic. There is an outside chance that I will get to present some of this on the Hill, although not in a full-fledged hearing.

If you're familiar with my thinking, you may not find much new here. In a way, that makes sense. If my thinking were changing all the time, I would not trust it very much.

I also find myself less interested in linking to what others are saying nowadays. Sometimes, they reinforce what I have to say. More often, they reflect opinions that I am increasingly confident are less informed than mine.

Thank you for the opportunity to provide the first clear, accurate explanation of the way that mortgage securitization produced a financial crisis. I am not a prognosticator. I did not predict this crisis. I am uncertain how best to try to get out of it. My training is as an economist, and my background includes experience at Freddie Mac in the late 1980's and early 1990's developing measures of mortgage credit risk.

When I left the mortgage industry, more than ten years ago, this sort of crisis was unthinkable. In the meantime, a number of developments took place that produced the crisis. It is a phenomenon that I believe I now understand, but only in hindsight.

I reject the two main partisan narratives of this crisis. The Left wants to blame deregulation motivated by free-market ideology. It is true that poorly-conceived regulation was a major factor. However, the blindness of key regulators reflected not ideology but ordinary bureaucratic information loss. The knowledge that existed inside Freddie Mac, Fannie Mae, Treasury, and the Federal Reserve did not flow up to the leaders of those organizations.

The Right wants to blame overly-aggressive lending to minorities and low-quality borrowers, promoted by Congress and regulators. While it is true that many loans were made that should not have been made, the problem was not the color of the borrowers' skins or the content of their credit reports. The problem was low down payments and a large proportion of mortgages for what the industry calls non-owner-occupied homes or investor loans, and what ordinary people would think of as speculators.

The crisis had three main causes. First, securitization got out of hand, approaching three-fourths of total mortgage debt outstanding. Second, housing speculation got out of hand. Third, the gap in executive understanding of financial innovation, what I call the "suits vs. geeks divide," got out of hand.

Cause #1: Securitization

Contrary to popular myth, the growth of securitization did not reflect the genius of Wall Street. Instead, it was both the intended and unintended consequence of regulatory decisions that penalized traditional mortgage lending. Had the competition between securitizers and traditional depository institutions been free and fair, I believe that the securitizers would have lost.

Whatever its theoretical merits, mortgage securitization in practice is a tool for hiding risk and exploiting regulatory loopholes. These loopholes often were pried open by lobbyists. It was an unhealthy triangular trade in which campaign contributions from securitizers were exchanged for Congressional influence of regulations which in turn created profits for the securitizers. I sketch some of this history in my written remarks.

Recently, the main force driving mortgage securitization has been bank capital requirements. These penalize banks for holding loans that they originate themselves. Perversely, the FDIC requires banks to hold less capital against securities backed by low-down-payment mortgages originated by strangers than against high-down-payment mortgages originated by staff under the bank's supervision and control. If the risk-based capital metrics had been tied to the true risk of the underlying assets, then I am confident that banks would have driven Fannie, Freddie, and the private securitizers of Wall Street out of business. Without the distortion of misguided capital requirements, we would have seen old-fashioned loans, originated by old-fashioned prudent underwriting standards, and held in old-fashioned bank portfolios financed by deposits and debt instruments, not by exotic derivatives. Again, this will be explained in more detail in my written remarks.

Cause #2: Speculation

The second main cause was the speculative frenzy in houses. It is my conjecture that roughly 50 percent of troubled mortgages today are loans that were made not to owner-occupants but to speculators. This is a rough estimate--I would rather say that between 30 and 70 percent of troubled loans were made to speculators. I will explain this conjecture in my written remarks. Regardless of the exact figure that prevails, the significant proportion of speculative buyers must be taken into account in devising public policy.

--It is futile to demand that we keep borrowers in their homes when so many borrowers never occupied these homes in the first place.

--It is unfair to ask taxpayers to pay the mortgages of speculators.

--It is unfair to ask mortgage lenders to reduce the interest rate or otherwise modify the loan terms of speculators.

--It is not practical to bail out the housing market "from the bottom up" when so much of the marginal stock of housing is in the hands of speculators.

Cause #3: Suits vs. Geeks

Another factor in the crisis has been executives who misunderstood financial innovations. Financial executives seem to deal with financial innovation in three stages. First comes resistance. Next comes acceptance. Next comes blind faith and hubris. At the latter stage, the financial engineers, who I refer to as "geeks'" sometimes throw up caution flags at the executives, who I refer to as "suits." All too often, the suits run past the caution flags of the geeks.

Charles Duhigg of the New York Times has written two stories, on August 5th and October 5th, respectively, about the executive hubris at Freddie Mac and Fannie Mae. At both companies, the CEO was warned by the firm's own employees about the threat to safety and soundness posed by taking on high-risk loans without adequate capital protection. In both cases, the CEO brushed aside the warnings.

In my written remarks, I will comment further on Freddie Mac, based on my experience with its credit risk culture and contacts with people still at the company. In addition, I will describe how in the private securitization market, the stage of blind faith and hubris was reached with credit scoring as an underwriting tool and with credit defaults swaps as an overall risk management tool.

The suits vs. geeks divide also affects regulators. Ben Bernanke and Henry Paulson are as misinformed about these phenomena as the typical financial CEO. My conjecture would be that much lower down within the Federal Reserve staff and at the Treasury, there are career civil servants who understand the mortgage crisis at least as well as I do. Unlike me, perhaps some of them put together the pieces before it even happened. And yet Mr. Bernanke and Mr. Paulson lack this knowledge. This is not because they personally are defective, but because they are human. Atop an agency such as the Fed or Treasury, the leader sits like an ancient potentate, with advisers underneath him competing for power by manipulating the information he sees.

For a variety of reasons, critical information often fails to make it to the top of large organizations. I call this phenomenon bureaucratic information loss. My guess is that business schools have another name for it. I am sure that there are entire courses dedicated to the treatment of this organizational disease, but there is no cure.

What Next?

I am not a prognosticator. I am not as confident about what I am about to say as about what I have just said.

It appears to me that the Paulson plan, of trying to have the Treasury join the Liar's Poker game of mortgage security trading, is not the answer. Even its proponents seem to be backing away from it, after having bullied, shamed and bribed Congress into passing the ill-conceived plan.

Instead, the solution du jour appears to be bank recapitalization. This may be closer to the right answer, but I think it is worth pausing and thinking a bit before rallying to that banner.

My instinct in this situation is to abandon the things that are broken and instead to reinforce the things that work. In terms of the old saying, when you're in a hole, stop digging.

We are in a hole with respect to mortgage indebtedness. We have too much indebtedness and too little equity. Home ownership is a fine thing, but the emphasis should be on ownership, which means having a reasonable equity stake in the home. People who cannot afford a twenty percent down payment, or even a ten percent down payment, should not be unnaturally encouraged to purchase homes. A housing policy that induces people to save for a down payment rather than subsidizing mortgage indebtedness would lead to a more stable housing market.

We are in a hole with respect to excess housing units relative to households. The slowdown in housing construction is a natural response that should not be resisted. The foreclosure process on houses owned by speculators should be accelerated, not delayed. We need to get to a point where housing units are either deployed profitably as rental units or as economically viable owner-occupied homes. How far prices have to fall to reach that point is not clear, but we should not try to fight the inevitable.

We are in a hole where we have too many lenders doing too little lending. Banks that the FDIC considers undercapitalized need to be separated out from those that are sound. The worst banks need to be shut down. Others, which are neither clearly sound nor clearly insolvent, might be placed in a separate category, where they are able to sustain some operations on the basis of loans from the Federal Reserve but are otherwise restricted in their lending and insulated from being able to damage any healthy banks.

With the marginal banks isolated, the healthy banks perhaps will be able to reconstitute the banking system, including interbank lending and mortgage origination. Capital regulations should be modified in order to encourage sound lending by sound banks. For example, mortgage loans with down payments of at least 20 percent should be assigned a very low risk weight.

Looking further ahead, we need to ask what it is about financial markets that makes them subject to manias and panics. We always know how to prevent the last crisis, but can we ever know how to prevent the next one? Are government institutions the solution, or are they the problem? Taking bureaucratic information loss into account, can regulation ever be relied upon? These are difficult questions. For the most part, the economics profession has not been asking them over the past thirty years. My guess is that over the next thirty years, research priorities will change.



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TRACKBACKS (2 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/969
The author at Anarchy Without Bombs in a related article titled More on the Mortgage Mess writes:
    Arnold Kling, an economist who used to work at Freddie Mac, is developing fantasy testimony that he hopes to deliver to Congress (and might).  Overall, I have found his writings on the topic to be the most informative on the web, and if you want to ge... [Tracked on October 12, 2008 8:14 PM]
The author at Blagnet.net in a related article titled Irresponsible lending and borrowing writes:
    I liked this post by Less Antman and the comments following it, explaining some of the basics of the housing market crisis and its role in the current recession. It is short and simple, but I appreciate that type of post or article in my efforts to lea... [Tracked on October 16, 2008 9:05 AM]
COMMENTS (8 to date)
Karl Lembke writes:

One thing I've been wondering about is to what extent the increase in housing prices may have been the result of the loosening of the standards for home loans. If you cause home loans to be given to a larger population, you have more buyers bidding up the prices of houses.

Would this have been a significant influence on any real estate "bubble"?

TC writes:

Arnold,

I'm a little confused about what you wrote at the end:

Capital regulations should be modified in order to encourage sound lending by sound banks. For example, mortgage loans with down payments of at least 20 percent should be assigned a very low risk weight.

Here it sounds like you are calling for "better regulation" or at least regulations that discourage risk.

Are government institutions the solution, or are they the problem? Taking bureaucratic information loss into account, can regulation ever be relied upon?

Here it sounds like you are endorsing something close to my proposal, which is to have banks choose between being a Low Risk Bank or a High Risk Bank.

Low Risk Banks would be FDIC insured and would have to invest all deposits in short term federal treasuries or cash. High Risk Banks would not be FDIC insured and could invest deposits in all variety of investment vehicles.

Is that something close to what you had in mind when you implied that regulation might not be reliable?

Linda writes:

Home ownership is a fine thing, but the emphasis should be on ownership, which means having a reasonable equity stake in the home. People who cannot afford a twenty percent down payment, or even a ten percent down payment, should not be unnaturally encouraged to purchase homes. A housing policy that induces people to save for a down payment rather than subsidizing mortgage indebtedness would lead to a more stable housing market.

Josh writes:

Your thoughts, as always, seem very sensible. The more I read, the more I feel like the Klingian model of higher education - namely that perhaps too many people are going to college and we would be better off with less - applies to the current financial problem.

Basically, the notion that everyone can somehow get rich simply through the appreciation of asset values (e.g. stocks, homes) etc. is a big reason we have such instability. Most people don't even realize that the stock market (as they conceive of it) is a pyramid scheme - that the only way the average person can make money flipping stocks is to get more and more people into the game. In reality, people should count the money they put into the stock market as gone - into the pockets of the companies they are investing in, or into the pockets of other investors - and then realize that the way to make money in the market is through collection of dividends over the long term [and similarly with houses - that flipping houses is not the reason one should be buying a house].

If more people thought about it in those terms, we would have a lot fewer people getting into these kinds of markets. And in that case, the collateral damage from these kinds of flops would be much less than it is now - a few traders taking known risks would end up with big losses. But the rest of us would just be able to ignore it.

shayne writes:

Arnold:

I generally concur with your conclusions regards 'best lending practices' for the future and the regulatory framework within which that should occur. But I suspect you may be underestimating a third component of the bubble financing. Beyond and possibly of greater magnitude than the unqualified buyers and speculative buyers were the folks that owned a home and refinanced it during the bubble.

In all cases of refinancing a home, the owner is converting equity into cash for use in current consumption. During the bubble, when home prices were being 'bid up', the intrinsic value component of the home was unchanged - instead, the investment value component (current AND far future equity) was being converted to cash for current consumption. In short, all three classes of buyers/borrowers during the peak-price period of the bubble were borrowing against an equity stake that will not be tangible until well into the future.

The story Kucinich loves to tell of the 90 year old Ohio woman who shot herself rather than be evicted from 'her' home is a case in point. From what I've read, her home was fully paid off and she took her FIRST equity loan against it in 1997, and subsequently refinanced it - at increasing market values - several times during the bubble. (To provide a 'happy ending' to the story, Kucinich pressured Fannie/Freddie to 'forgive' her home debt so she can return after she recovers from her gunshot wound. I wonder what her incentives will be to take out yet another equity loan now that the taxpayers have restored her equity.)

I am personally aware of many others who also refinanced (took equity loans) during the bubble and are currently 'under water' with respect to being able to sell to recover. They can make their payments, and are making them, but they will not be 'caught up' in terms of rebuilding their equity for many years to come.

I realize these examples are anecdotal, but I suspect the refinancing/equity loan component is as large or larger than the speculative component you mention. But the result is similar with regard to the lending during the bubble. In all cases, equity/investment value of homes, that would not ordinarily be tangible for many years to come, was converted to cash for current consumption via the lending during the bubble. As others have noted, the debt is massive.

What strikes me as odd is how anyone thinks that by further converting the tangibility of future production into current cash (borrowing - either public or private debt) will resolve this. I believe that's colloquially called, further mortgaging one's future.

rvturnage writes:
Karl Lembke writes:

One thing I've been wondering about is to what extent the increase in housing prices may have been the result of the loosening of the standards for home loans. If you cause home loans to be given to a larger population, you have more buyers bidding up the prices of houses.

Would this have been a significant influence on any real estate "bubble"?

That was a huge influence on creating the bubble. The Independent Institute has a very good paper titled "Anatomy of a Trainwreck" on Governments roll in the loosening of lending standards and how it influenced the current problems.

Jon writes:

I think left out of this is an "agency" problem--managers get immediate payment on the business they bring in. The shareholders pick up the losses later.

The fact is that the damage started in sectors of the mortgage market and firms least influenced by government regulations--private label subprime and subprime loans in the highest cost areas man loans were above the GSE and the FHA limits.

Bill Woolsey writes:

I was just looking at some figures about
mortgages, and I am seeing more like 50%
securitized.

Where does the 80% figure come from?

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