Finance and the Housing Bubble

By James Kwak

Adam Levitin and Susan Wachter have written an excellent paper on the housing bubble with the somewhat immodest title, “Explaining the Housing Bubble” (which has been sitting in my inbox for a month). My main complaint with it is that it’s eighty-one pages long (single-spaced), which is most likely a function of law review traditions; had it been written for economics journals, it could have been one-third the length. I also have some quibbles with the seemingly obligatory paean to the importance of homeownership, which I think is an assumption that deserves to be contested. But overall it presents both a readable overview of the history and the issues, and a core argument I have a lot of sympathy for.

The argument is that the motive force behind the credit bubble was an oversupply of housing finance—in other words, the big, bad, banking industry. Levitin and Wachter’s key evidence is that the price of residential mortgage debt was falling in 2004-06 even as the volume of such debt was rising. As Brad DeLong’s parrot would say, that can only happen if the supply curve is shifting outward, not if the demand curve is shifting outward (which is what would happen if it were all the fault of greedy borrowers who wanted to flip houses).

This oversupply of housing finance happened because of banks’ desire to keep the securitization pipeline flowing after the 2001-03 refinancing wave tapered off. Private mortgage-backed securities were their preferred instrument because they are both complex and heterogeneous: complexity means they are impossible to price based on fundamentals, and heterogeneity means that comparing prices between private MBS is meaningless or misleading. And this was possible because there were no regulatory standards governing the private MBS market. The “market regulation” beloved of Alan Greenspan also didn’t work because, among other things, short pressures were soaked up by synthetic CDOs that were willing to sell CDS protection on MBS at artificially low prices.

A lot of the story will be familiar to financial crisis junkies, but you will probably learn something new (about the difference between the CMBS and RMBS securitizations, for example). And most importantly, with all the misinformation floating around about the causes of the crisis, Levitin and Wachter isolate the importance of our deeply flawed financial system.

83 responses to “Finance and the Housing Bubble

  1. In other words, it wasn’t really a housing bubble, it was a credit bubble?

  2. I’m not about to read 90+ pages written by a couple (wanna-be) lawyers, but is the oversupply argument the end of the road for these two authors? If that’s it, then I think they stopped short. Without Freddie, Fannie, Mannie, Stannie and every other government agency guaranteeing these loans, that excess supply never would have been there. Unless I’m not understanding something, these guarantees (and the flawed social philosophies that justified their existence) are the real force behind the housing bubble.

  3. In April 2004 SEC approved that Investment Banks could leverage themselves according to Basel rules and in June 2004 G10 approved Basel II which allowed banks to leverage 62.5 to 1 if lending or investing to the private sector in operations related to a triple-A rating.

    Do you know what 62.5 to 1 means? It means that if you were making a 1 percent margin on an operation you could earn 62.5 percent on your bank equity… precisely that stuff of which big bonuses and too-big-to-fail banks are made of.

    And so what you really had was a triple-A bubble ordained by the Basel Committee. When is the Basel Committee going to be forced to wear a cone of shame?

  4. Jeff,

    (I didn’t read the paper either)

    I think, in other words I don’t really know this, but it seems that the oversupply of capital is in part a result of excessive inflows of foreign investment, mostly in T-bills but also in the GSEs. Then too, these flows combined with excessive domestic capital formations. So it would also seem that these combined flows needed to be put to work somewhere. So if not in housing, elsewhere, or just a loss via interest paid.

  5. “I also have some quibbles with the seemingly obligatory paean to the importance of homeownership” Kwak raises an issue that is critical going forward. The iconic role of homeownership as the basis of middle class status has outlived its value. One of the consequences of the foreclosure crisis is the transfer of wealth to the already wealthy, stripping those homeowners of whatever equity they have invested and accumulated. However, the over investment in residential construction for purchase (single family detached, townhouses, and condos) has meant a lack of affordable housing available for rent.
    The unwillingness of the authors to question the role of homeownership and its preferential tax treatment misses an important side of the bubble.

  6. Jeff–Fannie, Freeddie and Ginnie all lost significant market share during the housing bubble. The bubble corresponded to the growth of MBS that were NOT guaranteed by the government. So how on earth was this a matter of government guaranteeing supply? The point that (I presume) the paper makes is the bubble was not the result of government involvement in the market, but a vacuum of regulation.

    Also, fwiw, Wachter isn’t a wannabe lawyer. She’s an eminent real estate economist at Wharton. Levintin’s worse than a lawyer—he’s a law professor!

  7. None of the government policies have anything to do with owning a home.

    Only the interest is tax deductible, which promotes owing money on a loan, not owning a home.

    And the favorable tax treatment of capital gains encourages selling the house, not owning it.

    So even if you believe in the benefits of home ownership — which I do, in general — our current policies exist to promote asset bubbles, not ownership.

  8. That site “CreditSlips” is very good, Levitin and his “crew” over there are great. but there ain’t no way I’m readin’ 80 pages. I’ll fast-forward to the CMBS RMBS and any securitization stuff that can give me deeper finance knowledge, but if those two want to wax poetic on bankruptcy laws my eyes are whirling over that portion. I got so many finance papers I’ve downloaded now I won’t have the damned things read between now and Christmas 2012 if I don’t download another one.

  9. What’s your evidence?

  10. I think you know clearly I’m a Democrat by now Nemo, but I did think that first time homebuyer’s tax credit was a load of crap. That and the bail out of GMAC really wore me raw on President Obama. That was my first sign the guy had little clue other than listening to Geithner on economic policy.

    All it did was artificially raise prices and score one for the realtors’ lobby and the realtors’ wallets. How the basturds could subsidize the damned realtors and not do the mortgage modifications would be beyond me if I didn’t know Dick Shelby, Mitch McConnell, and other Republicans were in the bankers’ back pocket.

  11. I’ll read the rest of the paper manana but there is nothing new that wasn’t spoken by mortgage rates during the height of the bubble and the spread between these rates and the discount rate during that time.

    Rent on mortgage money was cheap and dropping, even though short rates were rising. This meant credit demand was unequal to supply. The frantic nature of ‘mortgage mill’ operations – to put every dishwasher and lawn blower operator behind a loan – suggested the same thing.

    Another factor was the ‘marginal utility’ of real estate marketing which made buying ‘investments’ you could live in ‘sure things’.

  12. James, I love reading your work. You’re a smart if not brilliant guy. And I’m sorry to say you are wrong when you put the blame squarely on synthetic CDOs. Synthetic cdos, like any derivative or structured product, just makes it easier and cheaper to go long or short. It’s actually a neutral instrument where one of the two counterparties is long and the other is, by definition, short. The person who is long can hedge out their position by going short but, at the end of the day, someone is net-long and someone is net-short, often multiple players on each side.

    Please prioritize reading Vanity Fair’s article about Merrill’s “blundering herd”. Anyone reasonably smart who worked in structured credit at a big Wall Street bank like Goldman knows that what really happened was a classic principal-agent problem in triple-A super seniors. In 2007, banks ran out of customers who would buy triple-A rated super senior CDO tranches. The structurers (bankers) at some of these banks made the traders buy them all to keep the rest of the CDO engine running. So the only part that was mispriced by the market was the stuff no one would buy except banks that were making lots of fees from them. With the help and cahoots of management, the structurers screwed the traders and risk managers.

    I commend you for reading the long article. But that doesn’t mean you or they get it.

  13. Rich,

    The segments below are from a paper which is here:
    http://scepticalmarketobserver.blogspot.com/2010/01/what-caused-us-housing-bubble.html

    (1) Y=(C+I+G)+XM

    Where Y is the value of domestic output at full employment, (C+I+G) is domestic expenditure, and XM is Net Exports (Exports – Imports). During the Boom, both consumption (C) and government spending (G) increased at a rate greater than domestic income (Y). So, for Investment (I) to increase, from a starting position of full employment, net exports (XM) had to decline by at least as much. That is (holding constant domestic income)

    (2) ΔI+ ΔXM≤ 0

    The bubble required that total domestic expenditure exceed the value of domestic output, which required, in turn, an increase in the trade deficit.

    (this is from the conclusion)
    There is little doubt that increased financial sector leverage –from 20x capital to 30x capital from 2000 – 2007 – contributed to, and resulted from, an underestimation of risk that fueled the frenzy of lending, as did all sorts of other contingent circumstances. But the underlying, indispensable factor driving the low rates and increasing the capital available, appears to have been the massive increase in offshore capital inflows. Bernanke and Paulson were correct to identify the Asian savings glut as the locus causes of the bubble.
    =====================================

    Not sure why you asked for “evidence”, I thought this was widely accepted. Bubbles are not possible without an excess of investment capital.

    As for whether there are significant losses if the foreign inflows remain idle, I don’t know the answer to that, but maybe someone will help out in that regard. Interest payments to foreign creditors may be made ex nihilo at times?

    As for the excessive capital created by expanded leverage ratios, it seems very probable that this had less to do with losses than it did a need to maintain the ever increasing pace of lending and growth. But I suppose that adverse feedback loops could have lead to losses had this pace slowed enough, which of course it eventually did. So whether it be ‘losses’ or ‘gains’ it is all just about increasing the pace always and forever, or until everybody understands that it is just keyboard capital.

  14. PUKE….weh weeeeeh weeeeuuuuuugh!!!! Yuck!! Yick!! Quack!! Barf!!! Where is the Chinese spittoon in here….?? Oh My God…….. does anyone have some mint flavored Listerine, 3 bottles of Gin, and a 3 liter Dr. Pepper??? I need the mint Listerine to get the puke taste out of my mouth and the Gin to get the speculators’ propaganda out of my mind.

    Here is my favorite part:
    “Anyone reasonably smart who worked in structured credit”

    Once again it is only those who stuck the 10 foot dildo with rusted nails protruding out, into our wazoo “Knows what really happened” and the rest of us…. well, we will just never understand these debt instruments. Only the “chosen ones” can understand….. First you join the brotherhood at FINRA by cutting your palm open and sharing blood with a FINRA member in the dark FINRA sanctuary on K Street, then cut off your right pinky with a dull hacksaw to prove loyalty to the American Bankers Association, and lastly be willing to forfeit your first born son to Mammon before a burning alter…. or you will just never have the “IQ required”.

  15. 13 Bankers tells the tale quite succinctly. A pack of ruthless, pathologically greedy predatorclass criminals in the finance sector purchased the socalled government and bruted and pimped a complex PONZI scheme called securitization and created a massive supper bubble based on US real estate fictions and myths and systemic criminal activity. Like any and every PONZI scheme, the nano-second money stopped flowing in from the bottom, – the entire FALSE structure wobbled and collapsed.

    The Fed, the Treasury and our socalled leaders, faced with a real horrorshow collapse of the global financial system chose to print money out of the myst and funnel it into the offshore accounts of the predatorclass criminals and den of vipers and thieves on Wall Street responsible for conjuring, concocting, bruthing, and perpetuating this mess, this criminal enterprise, – this horrorshow.

    Now the predatorclass den of vipers and thieves are allowed to continue the same criminal enterprises, without redress. That lack of or failure to redress the underlying systemic criminal enterprises and activities have heaped insufferable burdens and hardship on America’s poor and middleclass, and thier children.

    If we truly want to right these horrible wrongs, the entire systems, economic and political – must be dismantled and destroyed, – all the operators participant in these criminal activities must be punished as ruthlessly as they punished America’s poor and middleclass, and something new and more law abiding, and more equitable must be born from the rubble and ruin of the current system. If not, – the poor and middleclass Americans and their children are doomed to a future of deprivation, hardship, and oppression.

    In a world where there are no laws, – there are no laws for anyone predatorclass biiiiaaatches!!!

  16. Brett in Manhattan

    “As Brad DeLong’s parrot would say, that can only happen if the supply curve is shifting outward, not if the demand curve is shifting outward (which is what would happen if it were all the fault of greedy borrowers who wanted to flip houses).”

    _________

    “Let the buyer beware” applies to banks, too. They were the ones buying the debt of those greedy borrowers.

    I take a view halfway between Keynes “Animal Spirits” and Mises & Hayek’s credit expansion.

    Those Animal Spirits need an “inciting incident” which was provided by the Fed and the banks via easy money.

  17. Bayard Waterbury

    Tyler, who the heck are you, anyway? There was a scam, cramdown from top to bottom. From the street to the crazed investers. We can start with the Brooksly Born fiasco and Greedspan, et al, and move through to the ratings agencies and murky quant underworld. You top my list of people who just are completely and utterly clueless. If, by some wild chance, you actually possess a diploma is something related to finance or economics, you should sue your school for fraud or just stop holding out your diploma a proof of competence.

  18. Bayard Waterbury

    Jeff, the finger pointing can go on ad infinitum. I accept what you had so say, and I believe that James was simply pointing out how a classic bubble defies economic principles as a baseline, and why. It is really that simple.

  19. Bayard Waterbury

    Yeah, Jeff, Fannie and Freddie bought all of the underlying paper. That’s why their hole is so deep.

  20. Bayard Waterbury

    Actually, after reading the paper, I mostly agree, although, oddly, in 81 pages of paper, the conclusion is still somewhat of an oversimplification. It actually doesn’t get far enough into the weeds, but is great as far as it goes. A full explanation and history of the factors leading to the bubble and causing it would probably take a couple of volumes of 5 to 6 hundred pages. But, they did a nice job and it’s nearly impossible to argue with their conclusions. There is, after all, a reason why the British don’t start truly analyzing history for a hundred years or so. The thing I really hate is that no one is having a conversation now about how to encourage soundness in the housing market. The oligarchs are still hard at work to muddy our thinking on this, sadly.

  21. Garrett Wollman

    Isn’t the crux of the problem the existence of a huge amount of money sloshing around the world looking for ever-higher (paper) returns with ever-lower (paper) risks, the whole process being completely disconnected from anything going on in the real economy? It seems to me that this whole thing started in the late ’90s when the Treasury stopped selling long bonds (hey, great thing that surplus), sending lots of investors into the GSE bonds. Then in the 2001/2002 recession, the Fed drove risk-free rates down even further, with the relocation of the manufacturing sector to China holding retail inflation down much longer than would otherwise be expected, so what’s a fixed-income investor to do? Why not buy into these private securitizations that the rating agencies all say are a sure thing, and pay much better than the (available again) long Treasuries? Then in 2007/08 the housing market is looking iffy, default rates are going up, so let’s all buy crude oil futures instead! (After all, everyone needs oil!) And so the economy gets pushed over the edge.

    Where is all that money sitting now?

  22. http://huffpostfund.org/stories/2010/10/new-tax-man-big-banks-and-hedge-funds

    How is this for irony–primary dealers and their affiliate hedge funds going after the gold heart of America–with funds straigght from the fed window at 0.25%

    The graft just gets more and more blatant.

  23. I found this over at Yves Smith’s blog. Obviously originally from CNBC. I think James has it set so these won’t work, but I’m gonna give it a go here. It will be absolutely awesome if it works. Chris Whalen and Barry Ritholtz, the first part with the middle aged blonde you can probably skip.
    http://plus.cnbc.com/rssvideosearch/action/player/id/1618726207/code/cnbcplayershare

  24. Well, it didn’t quite embed above, but that link works, just press play, 15 seconds commercial, then use the little orange slider at the bottom to go to the 3:30 mark.

  25. During the height of the boom, 2/3rds of all mortgage loans and 3/4ths of sub-prime mortgage loans were non-conforming, meaning that they could not be bought by Fannie and Freddie.* They were underwritten privately. If the banks thought they could rely on the bigger sucker of Fannie and Freddie to buy the bad paper, and this was the cause of the crisis, why did the vast majority of the worst paper get written in such a way that Fannie and Freddie _could not buy it_?

    *http://www.mcclatchydc.com/2008/10/12/53802/private-sector-loans-not-fannie.html

  26. Because the nonconforming mortgages were those where you achieved the highest interest and the higher the interest the more you would make when selling them off by the triple-A rating at lower interests.

    A 30 year $300.000 mortgage at 11% is worth $510.000 if sold at 6% because it achieved a credit rating and would therefore provide those involved in the brokerage an immediate profit of $210.000.

    And the banks could leverage their capital with an AAA rated investment earning 6% 62.5 to 1!

  27. Michael M Thomas

    Of course it was a credit bubble. Duh. For forty years, possibly longer, the US economy has been driven by two basic fuel groups: fossil and credit. The difference is that in housing, the basic financed unit, the house, has a much larger SKU value than, say, the automobile, which up to the bubble was the most expensive item routinely financed at retail. Basically, house and credit purchases became loans with houses and cars inside them. It was the availability of finance to the end-buyer that drove production and distribution.

  28. “The unwillingness of the authors to question the role of homeownership and its preferential tax treatment misses an important side of the bubble.”

    Let’s be straight here. The true issue isn’t home ownership at all—it’s _land ownership_. It’s the land that makes a house valuable. The house itself is capital which depreciates over time. Land is a resource in fixed supply, whose value increases over time.

    The way out is to heavily tax land value.

  29. TonyForesta, if you’re looking for the PONZI scheme that underlies the one you describe, I think it’s our debt-based money system. More about it at http://www.webofdebt.com and http://www.monetary.org.

  30. “The rent is too damn high” according to NY Governor candidate Jim McMillan. Part of the move to home ownership stems from free market apartment costs which compared to most other countries is too damn high and why renters moved to the home ownership market.Also some studies argue that 60 percent of the
    people who qualified for FRM’s got put into ARM’s .But the article is right it was supply side driven. Nomi Prinz argues this point quite well in It Takes A Pillage.

  31. Desi Girl aka SJ...Internship

    Hillarious…” in other words, the big, bad, banking industry…” and your assorted puke.

    Kwak, no wonder you were fired from McKinsey.

    Levitin, Watcher clearly state, “The mortgage finance supply glut occurred because markets failed to price risk correctly due to the complexity and heterogeneity of the private-label mortgage-backed”

    Which means, someone else including Hedge Funds, Foreign Governments, Pension Funds and Mutual funds were supplying financing. NOT BANKS…

    You could have been a apartner in McKinsey by now…but instead you took refuge in school.

  32. The cause of the implosion may not be the subject of general agreement, but there is something that could have ameliorated the crash and could yet help.

    Home mortgages were given special treatment in bankruptcy years ago. The inability to modify a mortgage against one’s principle residence was supposed to assure the integrity of securities backed by mortgages thereby encouraging more money to flow into the market. As we now see that was unnecessary; there were enough gullible buyers of such securities to create a demand that could not be satisfied without massive fraud and the wholesale abandonment of any pretense of underwriting.

    I have never understood how it is to the advantage of the market to prohibit writing down loan to the fair market value of a home and allowing owners to retain their homes. A lender cannot realistically expect to recover more than the value of its collateral in any event. In fact that is the only real purpose and effect of a mortgage.

    The result of prohibiting loan modification is the proliferation of vacant foreclosures growing up in weeds or attracting squatters, driving down the value of the rest of the neighborhood.

    Reform of this punitive restriction would greatly reduce the fallout over bad or missing paperwork and just might make life better for many families.

  33. Desi Girl aka SJ...Internship

    “..PUKE….weh weeeeeh weeeeuuuuuugh!!!! Yuck!! Yick!! Quack!! Barf!!! Where is the Chinese spittoon in here….?? Oh My God…….. does anyone have some mint flavored Listerine, 3 bottles of Gin, and a 3 liter Dr. Pepper??? “””

    Ted K, How is high school today?….that rhymes very nicely.

  34. Sadly, the continued presence of cheap money (money that can be borrowed at a low interest rate) allows purely capitalist ventures into Whatever Makes The Most Money The Fastest. Instead of loaning money to the little guy looking to start a business, there are better returns to be made with less risk by going after things like commodities (more to come, but the gas price spike circa 2005 was a taste of that) and foreclosures. As long as the price of real estate is being guaranteed by the government, it is a great way to make a buck.

  35. And also the markets had no way of knowing, much less measuring, the effects of the bank regulators fooling around with their risk-weighs under the table, in precisely the same way when markets now have no way of knowing what the real market interest rates on public debt would be without that regulatory and odious discrimination that orders banks to have 8 percent in equity when lending to small businesses and entrepreneurs but allows them zero capital when lending to the triple-A rated government.

  36. James,

    Very nice find, and though I cannot plough through all 81 pages on a workday I do find their premise quite plausible. I wouldn’t necessarily say it was the ultimate cause, but I do believe Levitin and Wachter have identified one of the previously overlooked drivers behind the residential real estate bubble. In short there was no single cause, but rather a lethal cocktail of central bank interest rate manipulation, agency failure (CRA), hubris (GSEs and politicians), inept risk management tools and the overall “casino culture” that has corrupted the utility of the capital markets in this country.

  37. “I have never understood how it is to the advantage of the market to prohibit writing down loan to the fair market value of a home and allowing owners to retain their homes. A lender cannot realistically expect to recover more than the value of its collateral in any event. In fact that is the only real purpose and effect of a mortgage.”

    There are separate problems driving that tragedy, Pokey. The mortgage servicers haven’t the incentive to work with borrowers, and banks don’t write down mortgages to fair market value as it would wipe out their equity layer.

  38. My Dad railed on the shortsightedness of the boards of directors of various corporations. Board members tend to only arrive at that position in the twilight of their years, and therefore, with a relatively short remaining number of years in their life expectancy, they plan accordingly, which is to say, they look to maximize profits in the five-years-and-fewer time frame. My Dad made this statement to me in the 80s, as he saw Reagan plotting a course of government deregulation and espousing the virtue of pure capitalism. Now it is, if anything, even more so. Now these same captains of industry seek to get rich on the leading edge of the next bubble.

    Many forces are at work all the time to push many potential bubbles-in-the-making so that they become the weak spot and that is where the aneurism develops. Think of the economy as one big balloon (that we all ride in, lest we revert to hunting and gathering) with a number of weak spots (prone to abuse, lacking sufficient government oversight), and all it takes is Hurricane Katrina to shut down a few Gulf of Mexico oil platforms and, the next thing we know, we’ve got gas selling for $4.58 a gallon.

    But it didn’t happen with the latest drilling moratorium post the 4/20 Deepwater Horizon debacle, so it must take more than just a weak spot as defined by a lack of enforcement or regulatory oversight. It has to take a confluence of events to make it happen, and only the most savvy (imagine that you and I are not worthy of being in on the next big thing, it makes it easier to take) can see it ‘possibly’ coming and then, with influence, help to make it happen, or, really, just get in and get out early on. Let the suckers jumping on the bandwagon get caught in an overexposed position.

    I guess that is the beauty of leverage and interdependence. The entire house of cards can come tumbling down.

    Unless Uncle Sam bails you out, then you can just get up, dust yourself off (defend yourself in the press), and sit tight for the next bubble.

    Commodities may be the next bubble. What else is there? You have what you consume in your day to day life, what it takes to make that all happen. Mostly it takes cheap energy and raw materials and cheap labor.

  39. Maybe this: intellectual property. The new stuff will be so good but soooo expensive. Think Apple products times ten. Maybe the next widget will be too good to not have to have a payment for it. Somebody could make a bundle.

  40. Re: @ Nemo___Yes…Nemo it was indeed a “Coma Induced Credit Bubble” whereas the entities subconsciousness went terribly south – flatlining, thus morphing into the surreal world of perpetual austerity. Google @ Ref: Special Purpose Vehicles (SPV’s) / Special Investment Vehicles (SIV’s) via Tier “3” Tranches (1/2/3) rated by Moody’s Aaa. This goes back to pre-imploding Lehman Brothers – CMO’s / (RACERS) “Restructured Asset Certificates with Enhanced Returns”, again evolving into “Synthetic CDO’s” via naked shorts doing the leg-work of legal proliferation. Google @ Ref: [Lehman Brothers] Credit Dirivatives Primer

  41. Re: @ sophie___So this was the better alternative than letting the “TBTF’s”, fail? How utterly shameful! PS. Thank “GOD” for Huffington Post Investigating Unit to publish this brilliant eye opener.

  42. I have a slightly more nuanced set of reasons for the mortgage finance disaster. These two blog posts lay it out (chapters 4 & 5 of a book I wrote during early 2008, as yet unpublished).

    http://mindonmoney.wordpress.com/2010/04/12/roots-of-the-meltdown/
    http://mindonmoney.wordpress.com/2010/04/12/the-blame-game/

  43. If the supply of mortgage finance funds was the problem, why was the housing bubble confined to only a few regions rather than national?

    California and Florida has intense housing bubbles. Georgia and Texas, not so much.

  44. The reasoning behind the anti-cramdown rule was that appraisers couldn’t be trusted to be as accurate as a true market measure of housing value.

    The reality had more to do with the fact that lenders were benefiting from the sentimental value of the house to the homeowner, as opposed to the amount that they could realize if they foreclosed.

  45. Government chartered agencies were disproportionately doing better quality underwriting than the private sector and came to the game very late and half-heartedly.

    More illuminating is the fact that second mortgages that served as the moral equivalent of private mortgage insurance were much more likely to produce defaults than actual private mortgage insurance. The former was regulated by securities laws, the latter by insurance regulators, and the different perspective on quantifying risk made a big difference. But, tax law favored the former at the critical times.

  46. Even more important than the institutional leverage was the executive and senior trader heads I win, tails you lose compensation structure implicit in a system where stock options and bonuses account for most of compensation. They had no skin in the game and predictably took risk. The tax code encouraged this kind of setup, actually effectively banning large cash salaries and disfavoring stock as opposed to stock option compensation.

  47. Car financing was common before the Great Depression, and had more onereous terms which people tried harder not to default on than other loans. Nothing new there.

    Home loans for most of the value have been common since the 1950s, when federal sponsorship made them popular. Also, nothing new.

    The timing doesn’t match the crisis.

  48. Currently the money seems to be flowing into gold speculation. After that it’s

    Part of the issue is we’ve never deflated any of our bubbles, we’re just pushing the excess credit around under the sheet of the economy. S&L into tech stocks, into housing, into oil, into gold . . . it’s the same money, and same players each time.

    And the admin seems happy to let us ride out a lost decade to do that on the backs of the middle class, rather than punish the banks who are creating, and profiting, off of each of these.

  49. Ritholtz and Chris Whalen on the foreclosure mess on CNBC.

    http://www.cnbc.com/id/15840232?video=1618726207&play=1

    about 2:00 minutes into video

  50. No huge profits=No huge bonuses… it is as easy as that.

  51. Brett in Manhattan

    At one point, Whalen says that B of A has 1.2 trillion of Freddie & Fannie exposure.

    I’m not sure I understand the relationship between the banks and Freddie ‘n Fannie. If the banks sold the mortgages to Freddie and Fannie why is it the banks who take possession of the houses and not the agencies?

  52. Re: @ Brett in Manhattan___It does get confusing…doesn’t it? The Gov’t./Treasury/Fed are all involved simultaneously as they were with “TARP”. Simply said, the GSE’s buy the unknowingly toxic (MBS’s, CMO’s, RMBS’s) mortgage assets that were eligible under their qualfying financial parameters with the Gov’t/Treasury/Fed blessing which ends up on the Fed’s balance sheet through the “TALF”. Google @ Ref: “Term Asset-Backed Securities Loan Facility : Frequently Asked Questions. :-)

    http:www.newyorkfed.org/markets/talf_faq.html

  53. @Brett in Manhattan,

    IIRC, Whalen has said that Fannie and Freddie have $___trillion in MBS’s from Bank of America and other banks. If these “assets” prove to be bad, Whalen says Fannie and Freddie can go back to Bank of America, etc, and require a repurchase. — This might answer your question. — Although, how Fannie and Freddie can require a repurchase is another question.

    See:

    http://www.ustream.tv/recorded/10034228

    @ 1:07 into video

    The event is at the American Enterprise Institute (surely a stamp of conservative approval). Whalen is forecasting that 2008 will be a cakewalk compared to 2011.

  54. rayllove –

    Your analysis is right on here. Krugman and Wells conclude basically the same thing. My own view is that over-leveraging in the banking sector probably did us a favor, by bringing the unsustainable foreign borrowing to a head earlier than otherwise would have happened. Roubini and Brad Setser were waiting for U.S. borrowing to become obviously unmanageable, with consequent severe dollar and global economic crises.

    Those who blame lax U.S. banking regulation or loose monetary policy as the prime culprits need to explain the similar housing bubbles in a number of other countries lacking one or both of these conditions.

  55. hey earle,florida, I rather like the idea of Gnarls Barkley doing a version of “Crazy” on the virtual trading floor at the New York Stock Exchange. Cee-Lo and backup could wear Saville Row suits, or maybe dress up as residential construction workers :)

  56. “Whalen is forecasting that 2008 will be a cakewalk compared to 2011.”

    Gott im Himmel!

  57. Bruce E. Woych

    http://www.alternet.org/story/148454/conservatives_push_absurd_lie_that_wall_street_hustlers_were_innocent_victims_…_of_poor_people?page=entire
    Conservatives Push Absurd Lie that Wall Street Hustlers Were Innocent Victims … of Poor People

    By Joshua Holland, AlterNet

    Deregulation allowed Wall Street to build a house of cards on America’s mortgage industry, but many conservatives live in a parallel universe in which the banks are blameless. READ MORE »

    (2)
    Foreclosure Fraud: Wall Street Cheats the Middle Class Again
    Once again the big Wall Street banks are wreaking havoc with our economy in order to come away with outlandish profits at the expense of poor and middle-class people. READ MORE
    Mike Lux / AlterNet

  58. Oversupply may be an effect, but it’s not a cause. The best cause I’ve found is the super high reward for successful sales pitches. Whenever obstacles appeared and slowed sales, the quants figured out new ways to repackage and sell to meet objections. You know, like you can’t unload the Z so some smart person finds a way to stuff them into CDOs that the clients will still buy, and problem solved, bonus earned.

  59. The question was for Jeff. Sorry for the confusion.

  60. OK, some late night reading observations from Levitin and Wachter, beginning with quotes:

    ” The growth of private-label securitization resulted in the oversupply of underpriced housing finance. As we demonstrate empirically, starting in 2003-2004, risk premiums for housing finance fell and the market expanded even as risk was rapidly rising. This set of circumstances—a decrease in risk-adjusted price coupled by an increase in quantity—can occur only because of an increase in the supply of housing finance that outpaces any increase in demand.”

    Redundant with the monetary policy theory. If the central bank erred on low rates, this is the obvious outcome. Nice insight, but this is not a causation, meerely an amplification on the errant monetary policy.

    “Correcting the informational problems in housing finance is critical for preventing future bubbles. Real estate is an area that is uniquely prone to bubbles because of lack of short pressure. For either markets or regulators to prevent bubbles, real time information about the cost of credit is required, as asset bubbles are built on the shoulders of leverage.”

    There is a solution… but discussing it is beyond the scope of the forum.

    It’s late, and James is right. Back when I was an Editor on Yale Journal on Regulation I whittled down articles like this by 50%.

  61. “California and Florida has intense housing bubbles. Georgia and Texas, not so much.”

    Ohio, really not at all. Still, in Cleveland, we were (and still are) the epicenter of foreclosure fraud. It happened to us LONG before it got to all those snazzy states. And it still is ongoing.

    We do have a pretty good Attorney General in Richard Cordray. He’s been right out front on this.

    Let’s hope he lasts through the next election.

  62. Section 1 is a bit off the mark:

    1) As James Kwok pointed out, the premise behind the social utility of home ownership is spotty.

    2) The S&Ls were not the only fixed-rate residential mortgage underwriters in the 1960s and 1970s; they went bust because of management’s inability to hedge the duration gap between assets and liabilities. Commercial banks offered fixed-rate mortgages, and yet they didn’t tank.

    Therefore the first premise is not properly supported in the Levitin and Wachter paper.

  63. I cannot understand how anyone, when the bank regulators allow the banks to leverage 62.5 to 1 their equity with lousily awarded mortgages to the subprime sector if these could hustle up a triple-A rating, can come to call that de-regulation. It was and is simply incredibly bad regulation.

    When the regulators use a risk-weight of only 20% to reflect those risk-weighted assets on the books it is in fact the regulator that is placing 80% of that exposure off their books.

    Without those regulations the markets would never have allowed the banks to leverage as much. Those “bad” hedge funds, which do not produce losses for taxpayers, have a hard time when leveraging over 10 to 1.

  64. Google @ Ref: Goldman Sachs say fraud charges could be just the beginning, say analysts. (Naked Shorts / Synthetic CDO’s)

    http://www.huffingtonpost.com/2010/04/16/goldman-sachs-fraud-char_n_540934.html

  65. Tyler–that’s actually the argument that the article makes. The CDO market underpriced the sub debt investors and removed the normal limits on market risk appetite.

  66. What an ironic username to pick. Call yourself Tyler Durden, then defend the very establishment he would have been working to bring down.

  67. I had never thought of it like that before for some reason. I think I just threw up a little in my mouth.

    Thanks, Nemo.

  68. “On a long enough timeline the survival rate for everyone drops to zero.”

    Zero Hedge – Submitted by Tyler Durden

    http://www.zerohedge.com/

    “Tyler Durden …. establishes an underground fighting club as radical psychotherapy…The film starring Brad Pitt and Edward Norton acquired a cult following…”

    http://en.wikipedia.org/wiki/Fight_Club

  69. I have some quibbles with the seemingly obligatory paean to the importance of mortgage securitizations, which I think is the practical matter deserving to be contested if one is to [rightly] call into question the importance of home ownership.

  70. The psycho-babble about tranches, structured products, and SPVs is meant to obscure a much simpler reality. Loading up a market with an unlimited number of hedges against a security is gambling, pure and simple. It should have been regulated as such. The toadies working DC for the crooks made sure it never would be. That’s what Godfathers do with their money, they bribe people.

    What about the stuff thrown down onto the gambling table? The house that loaded up the triple-A crap with liar loans, Lehman, was running a criminal enterprise. Bill Black classifies it as control fraud. The individuals controlling the company – giving the orders that others learn to follow if they’re going to work there – are running a racket. They are frauds.

    As for the rest of the Wall Street elite, the options for explaining their behaviour are quite stark. Either they are, as they say in Texas dumber than posts, or they were willing accomplices to the deception.

    Let’s take the first of these. They didn’t bother tracking what was in this trash so they had no idea that the house of cards was going to go in the first gust of foreclosure wind. That’s inexcusable and symptomatic of an almost cretin-like understanding of the volatility inherent in creating millions of such “vehicles”. Has all the computing power really made the smartest-guys-in-the-room that stupid? How many times will we have to save them because they don’t care if they trash the house they live in?

    On the other hand they may have understood perfectly well what they were selling was just rancid junk and that they should get rid of it as fast as they could, all the while touting it’s value. If that’s the case, they were at the scene of the crime riffling through the hit-and-run victim’s wallet. They’re partners in the criminal act and should be treated as such.

    This isn’t about high-powered deal-making, about hedge bets to cover both sides of the street, or about risk management. There is no risk equation for transition to collapse such as happened in these markets. The copula doesn’t work, don’t you know.

    This is either about stupid people who didn’t have the faintest clue about how they were loading up the derivatives market for a collapse, or it’s about conmen (and women) who should be in jail.

  71. William Black goes through much of this in an interview he gave to RealNews a while back. In an appearance on Bill Moyers’ Journal, he was even more succinct. He singled-out Lehman as a criminal enterprise, the one that kick-started the entire liar-loan fiasco. Their structured trash got the ball rolling with the implosion of the derivatives market the eventual end-result.

    Those interested in the autopsy should search out the talks from the Roosevelt Institute symposium titled “Let markets be markets”, where Simon is one of the speakers. The presentations provide nothing short of an education in structured products and the hijacking of the AAA rating for this racket.

    One graph that has stuck with me shows the ridiculous heights this reached. The number of triple-A rated CDOs was, near the end of this fiasco, multiple orders of magnitude greater than anything else in the rating agencies portfolio.

    Just as steroids had the effect of de-valuing baseball record books, muscle-bound financing rendered rating agency evaluations meaningless. No one’s even talked about the impact of that.

  72. earle.florida

    This is a little like a smoking gun if you connect the dots–paulson/bernake told us that we had to save the country with TARP (and all the other acronyms that gave trillions to follow and most recently QE1 and on the table QE2) yet, these sacred institutions are strong arming citizens out of their property–imagine a real US citizen trying to scrape together the overdue $1500 in taxes when they get a letter from Bank of AMerica saying that now they owe S10,500 due to the legal fees that the note holder has incurred…then take this times hundreds of thousands of properties across the country…now, can anyone say that this is saving us verses nationalizing the crooked bankrupt entites, and ending the fed and letting the treasury act as a facility to keep lending flowing and refinance everyones struggle to a 3% loan–that is a 3% profit…instead the cartel borrows for 0.0-0.25% to rape and pillage and plunder all in the name of saving our country?

    We need to demand S604 passage in the Senate and we need to demand all legislators stand to justify their behaviors in passing the revocation of Glass Steagall and all the bills that followed that enabled criminality–many have to answer for the treason that has been committed against all of us.

  73. It is hard to say, but sometimes people pose as other people in the blogosphere–no guarantee this is the beloved Tyler Durden from Zero Hedge…if it is you Tyler, sorry, but I have been out of circulation for a while and can’t tell.

  74. Noteworthy: Of all Wall Streets illusionary magical instruments – “Asset Backed Securities (ABS’s)” & “Collatoralized Debt Obligations (CDO’s)” are the worst of the worse (CMO’s,…CDO’s, CDS’s, MBS’s, ABS’s, R&CMBS’s) with a dinosaur’s bone closet ie.) chuck full of…Alt-A’s, Tier 3’s, Sub-Prime “Liar Loans” the quaint makeup of the “Whore of Babylon” where they once took refuge with pleasure.

  75. OK after further consideration, it is clear to see that this person is a poser–he is not THE TYLER DURDEN of Zero Hedge–Tyler is a truth teller, like James and Simon and in no way would illude to anything that would mislead and this poster is CLEARLY doing that!!!

    Just ignore the poser–there are many bank shills floating around the blogosphere trying to confuse people!!!

  76. Whether or not that is the real “Tyler” Durden of ZeroHedge is a somewhat moot point. You can tell by the charts and things he spouts Durden is a trader/speculator at his core. And the only thing that bothers Durden about HFT and algorithms is when Goldman rapes Durden’s piece of the pie and other traders’ (broker/dealers) piece of the pie, not when Goldman rapes the individual investor or lower on the totem pole 401k holder. Durden has an agenda , no “ifs, ands, or buts”. As long as you keep that clearly in mind the site can be very informative.

  77. Thanks Nemo! I consider myself more informed as a result of reading your post :-)

  78. GW, I’ve got the money you’re referring to. Not sure what market I’m going to destroy next, but I’m shooting for something that will devastate widows and children. You are correct though, as long as I have this massive wealth I will continue to look for opportunities to play markets for huge profits. And why shouldn’t I? It’s my money and this is a free country, right? You’re not some liberal who wants to regulate me are you? Better not be or I’ll plan a tea party event on your front lawn!

    *remove tongue from cheek*

  79. Bruce E. Woych

    TYLERDURDEN: THE UGLY TRUTH IS BEYOND THE DISTORTED FICTION AND PERVERTED INCENTIVES OF YOUR RHETORIC:
    READ THIS AMERICA:
    View this story online at: http://www.alternet.org/story/148577/

    From the Book THE MONSTER: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America – And Spawned a Global Crisis by Michael W. Hudson. Copyright © 2010 by Michael W. Hudson. Reprinted by arrangement with Times Books, an imprint of Henry Holt and Company LLC.

    Michael W.Hudson is a former Wall Street economist AND JOURNALIST. “THE MONSTER: How a Gang of Predatory Lenders and Wall Street Bankers Fleeced America – And Spawned a Global Crisis” (2010, Times Books) © 2010 Times Books All rights reserved.

    View this story online at: http://www.alternet.org/story/148577/

  80. Bruce E. Woych

    AND SEE THIS AS WELL:

    Fix Congress First
    Someday, history will record the craziness in the idea that the most important new political movement in the 21st century (so far)—the Tea Party—was inspired by the rage of a cable news reporter. On February 19, 2009, Rick Santelli of CNBC launched into a rant on the floor of Chicago Mercantile Exchange, about the “losers” who were about to be helped by a meager mortgage relief package just signed into law by President Obama. (That program turned out to be a bust for those it intended to help.) “The government is promoting bad behavior,” Santelli fumed. And he promised a “Chicago Tea Party in July”—a promise which then launched the Tea Party movement.
    There is reason to be angry about the mess our economy is in. But it is crazy—literally crazy—to point to “the losers” as the cause. Instead, we need a Nation that at least understands the source of the disasters that surround us now. Last night, with some friends, I saw the very first great and accessible account of that source: A film narrated by Matt Damon—Inside Job.
    Please see this film. It is an extraordinary documentary about the financial mess. It assigns the blame in a way that we can act upon. It is a story about influence producing insanity—within business, the academy, and most importantly, government. If America saw this story, there would be change. We want to do what we can to get people to at least watch.
    Here’s a list of opening dates for the film. Please take your 1,000 best friends to see it, and then ask your 10,000 best friends to help spread the word.
    It will take more than soundbites from CNBC to bring America to the understanding it needs to Fix Congress First. This film is a fantastic first step.
    —Lawrence Lessig

    Visit the FixCongressFirst blog at FixCongressFirst.org/Blog

  81. Bruce E. Woych

    And consider this extension of the current factual domain:

    http://blogs.alternet.org/speakeasy/2010/10/21/the-elephant-in-the-foreclosure-fraud-room-second-liens/

    The Elephant In The Foreclosure Fraud Room: Second Liens

    Investor lawsuits against mortgage servicers could be legally explosive.

    READ MORE

    Zach Carter / AlterNet

  82. Bruce E. Woych

    Secondary contingencies of the TBT-prosecute banking schema against the “STRESS TEST OF AMERICAN DECENCY AND LIVING STANDARDS” provided by our predator class oligarchy:

    http://blogs.alternet.org/speakeasy/2010/10/21/the-elephant-in-the-foreclosure-fraud-room-second-liens/

    The Elephant In The Foreclosure Fraud Room: Second Liens

    Investor lawsuits against mortgage servicers could be legally explosive.

    READ MORE

    Zach Carter / AlterNet

    And politically suicidal…so it won’t happen!