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.