One take on role of subprime mortgages in financial crisis

[JohnStOnge]

Actually I wanted to respond to a thread I saw eariler that started with a citation by a guy downplaying the role of subprime mortgages in the financial crisis. I wanted to do some research before I responded. Now I can't find it. Anyway, this is one example of what I found:

http://www.sba.oakland.edu/Files/news/F ... Crisis.pdf" onclick="window.open(this.href);return false;

On one hand, the author wrote:

"Many blame defaulting mortgages for the current financial crisis, but this massive tragedy is only a component and symptom of the deeper problem."

However, he did identify the subprime mortgage thing as a catalyst and provided fhe following discussion on page 9:

"In fact, default losses on subprime mortgages began to exceed expected default losses in 2007. One of the reasons for the rise in mortgage defaults was the increase in interest rates charged on the loans that had been set at introductory teaser rates which were contractually raised to market levels after the introductory period (ranging between 1 and 5 years) expired. The resulting foreclosures brought an excess supply of homes onto the market that caused residential real estate prices to fall, contributing to further mortgage defaults. As the market value of mortgages fell, the viability of many banks and other financial institutions was called into question, resulting in a wholesale bank run that required the Federal Reserve to bailout the system with several hundred billion dollars in liquidity in the summer of 2007.

As investors began to perceive that defaults could spread beyond mortgages, the systematic risk premiums began to rise across all debt instruments, resulting in a fall in debt prices across the board. Systematically falling debt prices led to further increases in perceived systematic risk and further increases in systematic risk premiums in a cycle that brought us to the 2008 financial crisis."

I haven't read the whole thing word for word but in scanning I'm thinking the central nugget of his take is that there was over reliance on risk models at the expense of reliance on human judgment. Hits home with me because as much as I love playing with statistical models I do think people view them as reality when they're not unless they were developed based on data generated through controlled experiments; and I have a hard time thinking of instances in which that has been the case with respect to models that are used to make decisions in the real world. You just can't start thinking of them as necessarily representing reality. They are nice tools but they ALWAYS have to be taken with grains of salt along with constant mindfullness with respect to the possibility of really severe error.

[89Hen]

Actually I wanted to respond to a thread I saw eariler that started with a citation by a guy downplaying the role of subprime mortgages in the financial crisis.

"In fact, default losses on subprime mortgages began to exceed expected default losses in 2007. One of the reasons for the rise in mortgage defaults was the increase in interest rates charged on the loans that had been set at introductory teaser rates which were contractually raised to market levels after the introductory period (ranging between 1 and 5 years) expired. The resulting foreclosures brought an excess supply of homes onto the market that caused residential real estate prices to fall, contributing to further mortgage defaults."

I haven't read the whole thing word for word but in scanning I'm thinking the central nugget of his take is that there was over reliance on risk models at the expense of reliance on human judgment.

It may have been me that you were responding to. My problem is that some people like to pin the entire mess on subprime. Others like to pin the entire mess on banks in general. Other still like to pin it on the Gov that pushed homeownership over sound lending principles. I'm in the camp that there's plenty of blame to go around and it was no one event or one group of people that held more than maybe 30% of the blame. Banks, loan officers, builders, realtors, home buyers, home owners, Fannie/Freddie, Barney Frank, Clinton admin, Bush admin.... so many people share in the blame.

As for the parts you highlight, I do have a problem with that too. Foreclosures helped speed up the decline in prices, but the decline in prices is what also led to MANY of the foreclosures. People aren't going to walk away from mortgages if they still have equity in the home. There are plenty of foreclosures on people who have fixed rate mortgages. They want to move and are upside down on the house and are tossing the keys to the bank. That has nothing to do with their mortgage.

[89Hen]

Oh, and on the last part about human judgement... POOR human judgement was the real culprit, not that there was no human judgement. When I make a loan, it is up to me to ensure the reasonability that the borrowers can repay the loan. I am an agent for my bank.

There were tons of loan products that were misused by loan officers and home buyers. Interest only, stated income, short term ARM's, etc... It's like the addage that guns don't kill people. Same thing here. It wasn't the products by themselves, it was the misuse of them. I can give you plenty of examples where an interest only, stated income ARM was the perfect product for the right person. Problem is, loan officers don't get paid if they don't make loans. People got in the business because it was easy and fast. I can tell you, it's not like that now. It was a feeding frenzy 8-10 years ago. Now, it's the other extreme.

[kalm]

I'm pretty much in 89's camp on this one. The subprime issue is a big one, but it alone wouldn't have caused a world wide financial crisis that is still going on today. It probably would have sorted itself out like the S&L crisis back when government actually prosecuted the bad guys.

If there was one single cause for all of this it was the human nature of greed. Of course that flies in the face of the libertarian notion of rational self interest creating a utopic market free of government intervention so I realize that notion might be a bitter pill to swallow.

This is from the "No Rolling Stone" thread I started in 89's honor. You should check it out:

The Second Great Bank Depression has spawned so many lies, it's hard to keep track of which is the biggest. Possibly the most irksome class of lies, usually spouted by Wall Street hacks and conservative pundits, is that we're all victims to a bunch of poor people who bought McMansions, or at least homes they had no business living in. If that was really what this crisis was all about, we could have solved it much more cheaply in a couple of days in late 2008, by simply providing borrowers with additional capital to reduce their loan principals. It would have cost about 3 percent of what the entire bailout wound up costing, with comparatively similar risk.

Just as great oaks from little acorns grow, so, too, can a Second Great Bank Depression from a tiny loan grow. But so you know, it wasn't the tiny loan's fault. It was everyone and everything that piled on top. That's how a small loan in Stockton, California, can be linked to a worldwide economic collapse all the way to Iceland, through a plethora of shady financial techniques and overzealous sales pitches.

Here are some numbers for you. There were approximately $1.4 trillion worth of subprime loans outstanding in the United States by the end of 2007. By May 2009, there were foreclosure filings against approximately 5.1 million properties. If it was only the subprime market's fault, 1.4 trillion would have covered the entire problem, right?

Yet the Federal Reserve, the Treasury, and the FDIC forked out more than $13 trillion to fix the "housing correction," as Hank Paulson steadfastly referred to the Second Great Bank Depression as late as November 20, 2008, while he was treasury secretary. With that money, the government could have bought up every residential mortgage in the country — there were about $11.9 trillion worth at the end of December 2008 — and still have had a trillion left over to buy homes for every single American who couldn't afford them, and pay their health care to boot.

But there was much more to it than that: Wall Street was engaged in a very dangerous practice called leverage. Leverage is when you borrow a lot of money in order to place a big bet. It makes the payoff that much bigger. You may not be able to cover the bet if you're wrong — you may even have to put down a bit of collateral in order to place that bet — but that doesn't matter when you're sure you're going to win. It is a high-risk, high-reward way to make money, as long as you're not wrong. Or as long as you make the rules. Or as long as the government has your back.
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http://www.alternet.org/economy/142944/" onclick="window.open(this.href);return false; ... own?page=1

[89Hen]

I'm pretty much in 89's camp on this one.

I'm not so sure about that. You posted the article again that puts 90+% of the blame on Wall Street and the Federal Gov (which you believe is completely controlled by WS).

[JohnStOnge]

This is from the "No Rolling Stone" thread I started in 89's honor.

Yes that is the thread I was looking for. To me the author does not really make her point. She has her opinions, but I don't think she really demonstrated the that it would have happened without the Community Reinvestment Act of 1977 and government interference with lenders' decisions on who they will and will not issue loans to as well as pressure to lend to certain groups. Or you could call it, in some instances, encouraging lenders to lend to members certain groups that they might not otherwise lend to.

As for cause: I don't know why she made such a big deal about the total liability for all subprime loans being a small percentage of the bailout. It looks to me like she agrees with the basic point of the paper I linked; which is that the subprime loan problem was a catalyst. It's kind of like if there is a big pile of brush and I put a match to it. Then there's a big fire that causes all sorts of problems. Sure, I could say that the brush pile being there was the real cause. I could say that if I hadn't lit the match then sooner or later lightning would have hit it or something anyway. The potential for a big fire was created by the existence of the brush fire.

But me lighting the match was a direct cause of that particular brush fire.

My belief continues to be that the egalitarian impulse to "equalize" things was a factor in the financial crisis of 2008. We can never know if I'm right or not because we go back and see what would happen if government would've left lenders alone and never implemented something like the Community Reinvestment Act. And we can't see if she was right about the possible effects of the legislation attempted through the Predatory Lending Consumer Protection Act because it didn't pass.

I continue to believe that if lenders hadn't lent (sp?) money to "subprime" candidates...if that's the posture they would have adopted...egalitarians would have been all over them.

[GannonFan]

I'm pretty much in 89's camp on this one.

I'm not so sure about that. You posted the article again that puts 90+% of the blame on Wall Street and the Federal Gov (which you believe is completely controlled by WS).

Agree with 89 here (both his original point and the point that while you say you agree with him you basically pin the vast majority of the blame on Wall St).

Greed at all levels, and unrational greed at that (as Gordon Gecko said, Greed is good, but only when well thought out and planned - stupid greed is still stupid no matter which way you cut it), is what got us where we are. Plenty of people all around share the blame in that.

[kalm]

This is from the "No Rolling Stone" thread I started in 89's honor.

Yes that is the thread I was looking for. To me the author does not really make her point. She has her opinions, but I don't think she really demonstrated the that it would have happened without the Community Reinvestment Act of 1977 and government interference with lenders' decisions on who they will and will not issue loans to as well as pressure to lend to certain groups. Or you could call it, in some instances, encouraging lenders to lend to members certain groups that they might not otherwise lend to.

As for cause: I don't know why she made such a big deal about the total liability for all subprime loans being a small percentage of the bailout. It looks to me like she agrees with the basic point of the paper I linked; which is that the subprime loan problem was a catalyst. It's kind of like if there is a big pile of brush and I put a match to it. Then there's a big fire that causes all sorts of problems. Sure, I could say that the brush pile being there was the real cause. I could say that if I hadn't lit the match then sooner or later lightning would have hit it or something anyway. The potential for a big fire was created by the existence of the brush fire.

But me lighting the match was a direct cause of that particular brush fire.

My belief continues to be that the egalitarian impulse to "equalize" things was a factor in the financial crisis of 2008. We can never know if I'm right or not because we go back and see what would happen if government would've left lenders alone and never implemented something like the Community Reinvestment Act. And we can't see if she was right about the possible effects of the legislation attempted through the Predatory Lending Consumer Protection Act because it didn't pass.

I continue to believe that if lenders hadn't lent (sp?) money to "subprime" candidates...if that's the posture they would have adopted...egalitarians would have been all over them.

Forests fires are a part of the natural cycle. In fact, they are even beneficial to a certain degree. In my neck of the woods, the Ponderosa Pine tree is fairly fire resistant, adapted to frequent and relatively small brush fires that burn back the undergrowth but leave the established trees still standing. The worst fires occur in forests that have a high density of underbrush due to previous fires not being allowed to run there course and/or years of heavy moisture in the preceding winter/spring. To reduce the fuel load, crews at nearby Turnbull National Wildlife Refuge will occasionally start prescribed burns to limit the danger of a fire getting out of hand.

[kalm]

I'm not so sure about that. You posted the article again that puts 90+% of the blame on Wall Street and the Federal Gov (which you believe is completely controlled by WS).

Agree with 89 here (both his original point and the point that while you say you agree with him you basically pin the vast majority of the blame on Wall St).

Greed at all levels, and unrational greed at that (as Gordon Gecko said, Greed is good, but only when well thought out and planned - stupid greed is still stupid no matter which way you cut it), is what got us where we are. Plenty of people all around share the blame in that.

I didn't assign a percentage to how guilty WS is. What's important is for people to recognize that blaming the crisis exclusively on greedy poor folk, egalitarianism, and one side or the other is a gross oversimplification (see Bush's ownership society and predatory lending). Prins article is a good one highlighting the history of how we got here and her WS and GS background make her a highly credible source. That's why I posted it.

[kalm]

Here's another WS insider describing the causes.

They all suffer cognitive dissonance — the intellectual crisis that occurs when a failed belief system or philosophy is confronted with proof of its implausibility.

And what about those facts? To be clear, no single issue was the cause. Our economy is a complex and intricate system. What caused the crisis? Look:

●Fed Chair Alan Greenspan dropped rates to 1 percent — levels not seen for half a century — and kept them there for an unprecedentedly long period. This caused a spiral in anything priced in dollars (i.e., oil, gold) or credit (i.e., housing) or liquidity driven (i.e., stocks).

●Low rates meant asset managers could no longer get decent yields from municipal bonds or Treasurys. Instead, they turned to high-yield mortgage-backed securities. Nearly all of them failed to do adequate due diligence before buying them, did not understand these instruments or the risk involved. They violated one of the most important rules of investing: Know what you own.

●Fund managers made this error because they relied on the credit ratings agencies — Moody’s, S&P and Fitch. They had placed an AAA rating on these junk securities, claiming they were as safe as U.S. Treasurys.

4 Derivatives had become a uniquely unregulated financial instrument. They are exempt from all oversight, counter-party disclosure, exchange listing requirements, state insurance supervision and, most important, reserve requirements. This allowed AIG to write $3 trillion in derivatives while reserving precisely zero dollars against future claims.

5 The Securities and Exchange Commission changed the leverage rules for just five Wall Street banks in 2004. The “Bear Stearns exemption” replaced the 1977 net capitalization rule’s 12-to-1 leverage limit. In its place, it allowed unlimited leverage for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. These banks ramped leverage to 20-, 30-, even 40-to-1. Extreme leverage leaves very little room for error.

6Wall Street’s compensation system was skewed toward short-term performance. It gives traders lots of upside and none of the downside. This creates incentives to take excessive risks.

7 The demand for higher-yielding paper led Wall Street to begin bundling mortgages. The highest yielding were subprime mortgages. This market was dominated by non-bank originators exempt from most regulations. The Fed could have supervised them, but Greenspan did not.

8 These mortgage originators’ lend-to-sell-to-securitizers model had them holding mortgages for a very short period. This allowed them to get creative with underwriting standards, abdicating traditional lending metrics such as income, credit rating, debt-service history and loan-to-value.

9 “Innovative” mortgage products were developed to reach more subprime borrowers. These include 2/28 adjustable-rate mortgages, interest-only loans, piggy-bank mortgages (simultaneous underlying mortgage and home-equity lines) and the notorious negative amortization loans (borrower’s indebtedness goes up each month). These mortgages defaulted in vastly disproportionate numbers to traditional 30-year fixed mortgages.

●To keep up with these newfangled originators, traditional banks developed automated underwriting systems. The software was gamed by employees paid on loan volume, not quality.

●Glass-Steagall legislation, which kept Wall Street and Main Street banks walled off from each other, was repealed in 1998. This allowed FDIC-insured banks, whose deposits were guaranteed by the government, to engage in highly risky business. It also allowed the banks to bulk up, becoming bigger, more complex and unwieldy.

●Many states had anti-predatory lending laws on their books (along with lower defaults and foreclosure rates). In 2004, the Office of the Comptroller of the Currency federally preempted state laws regulating mortgage credit and national banks. Following this change, national lenders sold increasingly risky loan products in those states. Shortly after, their default and foreclosure rates skyrocketed.

The previous Big Lie — the discredited belief that free markets require no adult supervision — is the reason people have created a new false narrative.


Barry Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture.

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