Arnold Kling  

My Views on the Crisis -- A Summary Statement

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First, read Tyler Cowen's post of the same title.

1. Causes

In hindsight, I think that the crisis was caused by
a) creation of the secondary mortgage market (50 percent)
b) low down payment mortgages (30 percent)
c) the "suits vs. geeks" divide (15 percent)
d) other (5 percent)

The more I think about the secondary mortgage market, the less I like it. Any widespread benefits, such as lower mortgage interest rates, are microscopic. On the other hand, several times (not just recently), the market has been used to create or enhance regulatory loopholes that undermined the safety of the financial system as a whole.

My point about low down payment mortgages is not a slam at minority home buyers. It is a statement that widespread home borrowership (where "owners" have little or no equity) is a recipe for volatility in the housing market. If we had kept low down payment lending confined to FHA (the low end of the housing market) and VA (a limited pool of eligible borrowers), I am convinced we would not have had such a big bubble and a big crash. Note, however, that there were property bubbles in other countries, and I do not know how much of a part lower down payments played, if any, in those bubbles.

My point about suits vs. geeks is that too many people did not understand the risk characteristics of these loans. I disagree with James K. Richards, who claims that the risk modelers got it wrong. The risk modelers told Richard Syron of Freddie Mac not to plunge into subprime lending with so little capital. The risk modelers at Goldman kept that firm from making the sorts of mistakes other companies made.

The decline in house prices was not a Black Swan. It was a highly plausible scenario. The problem is that the suits did not grasp the impact that such a decline would have on mortgage securities. The clueless suits include regulators, which explains why the crisis took them by surprise. It also explains why I do not trust them to come up with the best solution.

Decent, upstanding people say that we have to trust Ben Bernanke, Henry Paulson, Barney Frank, and other leaders. The public are considered rubes for not respecting the establishment. In this case, the public happens to be right. The suits are clueless.

2. The Current Risks

The economic ship faces a number of icebergs. Oil markets are taking wealth out of the country. House price declines are taking paper wealth away from ordinary families. On the horizon, there could be an adverse shift in the terms of trade. The number of hours that the average American has to work to earn enough to buy a bottle of French wine, a pair of Italian shoes, or a Chinese-manufactured product could (should?) be much higher than it is today.

In this context, the consolidation in the financial sector is a relatively minor issue. The only policy challenge is to keep banks functioning. There are many ways to do that which do not involve speculating in mortgage securities.

3. Housing markets

Housing markets are very distorted right now, because of low down payment lending and the bubble. Many of the mortgage defaults, at least in the first wave, came not from owner-occupants but from speculators. A rallying cry of "keep borrowers in their homes" is rather empty when a lot of the borrowers never occupied the homes in the first place.

We need housing units to be occupied, at whatever rent or price clears the market. We need owners to be legitimate, meaning people who can afford reasonable down payments and mortgage payments. Getting from here to there is not easy, but I suspect that the more government intervenes, the longer and more painful the process will be.

4. Political economy

I do not think that the private sector is blameless. I do not think that the public sector is blameless. I do think that lobbying and corruption are endemic in the mortgage securities business. We ought to be trying to let that cesspool gradually dry up, rather than throwing taxpayer money into it.

I find it unsettling that Congressional leaders would announce that they have a deal and then fail to pass a bill. It used to be that the definition of having a deal was having the votes to pass legislation. It didn't used to be a form of bluffing.

I find it unsettling that the establishment is promoting fears of another Depression. It used to be that worries about another Depression were confined to obscure books written by crackpots and lunatics. Today, the fear of a Depression is being promoted by the establishment, while those of us who are trying to remain calm and measured are treated as crackpots and lunatics.


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TRACKBACKS (6 to date)
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The author at Risk and Return in a related article titled In Summary writes:
    Tyler Cowen states his basic views on the crisis. My response in italics: 1. Glass-Steagall repeal was not a major cause of the financial crisis, nor was government-induced “minority lending.” I agree on the first, the second charge has so... [Tracked on October 2, 2008 10:52 PM]
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    THE DAILY NEWS How Government Stoked the Mania - Russell Roberts, WSJ A Call To Arms - William Isaac, Forbes.com McCain Defends Bailout Vote - Amie Parnes, The Politico GOP Leaders Face Bailout Pressure - Reid Wilson, RCP The Bailout Grows: Is Washingt... [Tracked on October 3, 2008 10:26 AM]
COMMENTS (9 to date)
dearieme writes:

That's four points. What about points four to seven? There must be more.

Luke Blanshard writes:

What's your view on the role of ARMs? I read an interesting article yesterday that places the bulk of the blame on "teaser rate" mortgages. Obviously these are only as huge a problem as they are when you put little to no money down, but even if you put 20% down on such a mortgage you still might be under water at reset time.

By contrast, it is possible to finance more than 80% responsibly. 4 years ago I put 5% down and got 2 mortgages; now the "second" mortgage is gone and I'm left with what's left of a 30-year fixed-rate mortgage at a great rate.

Hoover writes:

As a European I'm reminded of the Lisbon referendum earlier this year:

"A referendum must have consequences: if one says 'No', one leaves Europe" (Daniel Cohn Bendit)

The establishment gave the Irish repeated warnings of the doom that would follow if they voted no. There were even hints it would lead to war.

And here we are, after the treaty's been rejected in three countries. If we're at war with eachother, I haven't noticed.

liberty writes:

Lots of good points. A few quick questions:

1. Could secondary markets never work, or is there some way that the value of the mortgages could be better carried by those trading, so that they function as primary markets do? Could this have been a policy problem?

2. What about the role of inflationary policy, and artificially low interest rates or excessive lending by the Fed?

3. What are the primary things government SHOULD do (if anything) to alleviate the "crisis" and what should government AVOID doing, in order not to make the "crisis" worse?

You say that "lobbying and corruption are endemic in the mortgage securities business." -- are they endemic to the industry by its very nature, or are there current institutional causes for these things? Clearly, of course, lobbying can only exist if you can lobby for something and expect to get it. Can we not reform government (reduce powers back to their constitutional limits, for example) to reduce this problem?

parviziyi writes:

THE FOLLOWING IS A COPY-AND-PASTE JOB.

As everybody knows, recent increases in mortgage delinquencies are the ultimate precipitator of this "credit crisis". So here are two good links presenting recent and historical delinquency rates:

For delinquencies in prime mortgages and alt-A mortgages (which are intermediate between subprime and prime), see page numbers 29 and 30 at:
http://google.brand.edgar-online.com/EFX_dll/EDGARpro.dll?FetchFilingHtmlSection1?SectionID=6080845-336315-370063&SessionID=gsOoWFEXcwa7Z47

For delinquencies in subprime mortgages see slide #2 at:
http://w4.stern.nyu.edu/salomon/docs/DRP/slides-Van%20Hemert.pdf

This data shows that, for both prime and subprime mortgages, defaults are occurring at an unusual rate only for mortgages originated in 2006 and 2007. Mortgages originated in 2005 and earlier are currently defaulting at a normal, ordinary rate. Originations in 2006 are called "2006 vintage mortgages", and "vintage" refers to refinancings together with the fresh home purchase mortgages originated in the given year.

The mortgage securities market crashed in a very short timeframe in anticipation of extrapolated future defaults that haven't occurred yet. The extrapolation is a reliable extrapolation, as you can see in the above documents.

In sharp contrast, the originating banks who opted to keep their mortgages will be experiencing customer defaults over a longer timeframe, over the upcoming years, which gives them breathing room to shore up their reserves. Shoring up their reserves does reduce the money they'll have available to lend, alright, but today they don't need to lend as much for the simple reason that house prices are lower today. The one offsets the other. This offsetting will continue if house prices fall further. Repeating myself, increasing their reserves doesn't cause a credit crunch. Meanwhile, of course, the originating banks that opted to sell their mortgages to the securities market (and also not buy other mortgage securities) are not exposed to the problem.

Part of the blame for the "crisis" can be ascribed to the originating banks for being too loose with lending, and part goes to the government for making money too loose more generally. But the above data shows that the defaults are not occurring among mortgagees who are still "in the money" on the value of their house, i.e. those that bought in 2005 and earlier. The data also shows that just California, Florida and Arizona account for over 40% of all the defaults in the most recent default data, and those are the particular states where house prices have fallen the most so far (see page number 19 in the first of the above links). The data also shows that the default rates occurring for the 2006-2007 vintage mortgages are greater than historical precedents would predict, but not hugely so. There's well established historical precedent for the phenomenon of borrowers being more willing to walk away from their mortgages when their house is "out of the money". The mortgage securities market should have seen this phenomenon coming. There's another elementary point about delinquencies in a falling market. The great bulk of US home mortgages are only a few years old, due to refinancings. In an average year about half of mortgage originations are refinancings (well over half in the wake of a significant interest rate drop). One of the situations in which mortgagees refinance is where they've somehow run into difficulties paying their mortgage while their house has equity they can borrow against, and so they refinance the mortgage to get money to pay the mortgage. That situation reduces mortgage defaults in a rising market. In the falling market -- bearing in mind that the great bulk of mortgages are only a few years old -- it's not a widely available option.

The mortgage securities industry has collapsed in the wake of a modest and foreseeable fall in house prices. A good prescription now is a severe pruning back of that industry, not a bailout for it. If financial hypoxia starts to reach the real economy due to the mortgage securities problem, it can be relieved through the FDIC (resolving insolvent banks). Hypoxia is unlikely to happen anyway, because of the abundant money being made available by the Fed on easy terms (easy terms does not just mean low interest; see e.g. the "Term Auction Facility"). The Paulson plan is unnecessary. Truly, the Paulson plan would be no more than a taxpayer bailout for the Wall Street companies that overpaid for the 2006-2007 vintage mortgages.

THE ABOVE IS MY VIEW OF THE "CRISIS". A BLIND POINT IN IT IS THE MAGNITUDE OF EXPOSURE OF ORDINARY BANKS TO THE MORTGAGE SECURITIES MARKET MELTDOWN, AS OPPOSED TO THE MAGNITUDE OF THE MORTGAGE DELINQUENCIES PROBLEM. IF ANYBODY CAN DELIVER LINKS TO DATA ABOUT THAT, I'D BE GRATEFUL.

DWG writes:

Luke's point about ARMs appears to be a subset of Arnold's "low-down payment" point. As Luke notes, low down payments exacerbate the risks associated with ARMs.

The bigger problem, as Arnold observed in a post last week, is that lenders appear to have lost sight of the fact that any loan has a "put option" component to it. When this aspect of lending is ignored as it has been, and no disincentives (such as adequate down payments) are required to borrowers to cause them to defer exercise of the "put" or incentives are offered which increase the probability of the "put" being exercised (such as promotional low initial interest rates), a significant element of volatility will be introduced into the market, as we have found out.

I therefore would propose the failure of lenders to properly understand the "put option" nature of a loan as an addition to Arnold's list. In fact, a great part of his points (b) and (c) can be subsumed into this additional point.

Richard writes:

How can you not mention implicit and explict Federal insurance, initially limited to $100K for regular commercial bank deposits, and then implicitly expanding to cover bondholders and derivative counterparties of the shadow/parallel institutions? This growth in insurance, usually with no premia (because the government denied implausibly that it existed) led to truly massive moral hazard and risk taking through mid-2007.

High leverage of implicitly insured shadow-sector entities, combined with subprime/alt-a mortgages and a housing bubble to validate a rational strategy for equity holders and executives (who withdrew profits as bonuses) based on high-risk, high-return investments, which generated astounding profits over the short run. Eventually, with the collapse of the bubble, some of the entities became insolvent -- but their winnings over the prior several years still more then justified the costs they incurred when the the sliver of equity on the balance sheet was wiped out.

Hence, the policy intervention that appears responsible for the crisis was Federal insurance that delinked bank funding from investment risk taking -- and bank owners/execs could gamble with other people's money freely.

The policy dilemma that it seems to me almost no one has come to grips with is this:

1. Bank runs/panics (see Diamond-Dybvig model) appear to require government insurance to avoid.

2. Government insurance leads to moral hazard.

3. Moral hazard leads to absurd risk-taking, and the accumulation of toxic assets.

4. Banking entities fail from inadequate capital and insolvency even when not subject to a classical run as the asset side of their balance sheet collapses.

The usual liberal "solution" is regulation -- but regulation has not been required for hedge funds to do relatively well and present no systemic risk; and regulation did squat to avoid major commercial bank collapses (WaMu, Wachovia, Countrywide etc.), or their role in originating the most unsound mortgages.

So how do we square this circle in the future? CATO has a lot of research and articles on its web site dating back to period immediately after the S&L crisis in the 1980s examining the history and experience with Federal insurance of deposit banks. Since, then, as argued above, the problems caused by this insurance have grown many times worse, suggesting no lessons were learned. (to peruse this literature, do this search on Google: http://www.google.com/search?hl=en&as_q=&as_epq=deposit+insurance&as_oq=&as_eq=&num=10&lr=&as_filetype=&ft=i&as_sitesearch=www.cato.org&as_qdr=all&as_rights=&as_occt=any&cr=&as_nlo=&as_nhi=&safe=images ).

I don't propose an answer (am I a wimp in this forum?), but here are some ideas to explore: (1) private banking insurance with variable premia based on risk; (2) no insurance, but deposits of differnt banks are pooled into mutual fund money-market funds, allowing investor/depositors to diversify risk (but might not deal with significant systemic risk of the kind we're experiencing now).

P.S. I admit to being something of a libertarian, but I'm not an Austrian. I agree with Russ Roberts and others that the CRA and political affordable housing objectives are another Federal intervention that exacerbated the crisis, but IMHO the effects of Federal insurance are more central to the situation we're in today.

Bill Conerly writes:

re the secondary market: what's the alternative?

Depository institutions' most popular deposit maturity is six months, and their longest is 5 years. If they make long-term fixed-rate mortgages, they are at huge risk from rising interest rates. We learned this in savings & loan crisis.

Once upon a time, home mortgages had 30 year amortization but 5 year term; at the end of five years you either refinanced or came up with a huge wad of cash. This protected the bank, but the homeownership opportunity was limited.

There are certainly investors looking for long-term assets: pension funds, university endowments, etc. It seems nearly impossible for them to become primary lenders.

So what is the alternative to a secondary market?

FERGUS O'ROURKE writes:

Is it unfair of me to summarise Dr Kling's view as being that he is in favour of free markets in everything - except when it is the area of activity (mortgage finance) with which he is most familiar ?

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