My Views on the Crisis -- A Summary Statement

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

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.

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.

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?

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.

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.

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.

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?

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 ?