More Fantasy Testimony

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.