Why Housing?

Susan Wachter and I have a new paper out, entitled Why Housing?  The paper is a critical review of scholarly theories of the housing bubble.  It focuses on the question of what made housing vulnerable to a bubble and why it has been so hard to resuscitate the market.  

The article also lays out in concise form the theory of the bubble that Susan and I have been propounding for a while namely that the key to understanding the bubble is the shift in the financing channel from Agency securitization to private-label securitization, an asset class rich in information and agency problems.  Our short version of the bubble is that financial intermediaries exploited private-label securitization's information problems to inflate a bubble that produced short-term gains for them through fee-based income.  In other words, this was a man-made bubble, not the product of government affordable housing policy, macroeconomic policy, irrational exuberance, or ineluctable forces of supply and demand.  The abstract is below the break.  

What made housing vulnerable to a bubble?  And why has the housing market been so impervious to attempts at resuscitation? 

This Article critically reviews the theories of the housing bubble. It argues that housing is unusually susceptible to booms and busts because credit conditions affect demand and because the market is incomplete and difficult to short. Housing market distress transmits to the macroeconomy through a balance sheet channel, a construction channel, and a collateral channel. 

Housing is unique as an asset class in that it is both a consumption and investment good.  It is also the largest single consumer asset and debt class.  Because housing is credit-backed and such a large asset class, failure will impact the financial system itself and pull down the economy as a whole. The dual-use of housing, its ubiquity on consumer balance sheets, its highly correlated pricing, and its linkage to the macroeconomy make it a particularly painful type of asset bubble to deflate.

The credit-backed nature of housing is also the key to understanding why there was a bubble.  We argue that the bubble must be understood as stemming from the change in the mortgage financing channel from Agency securitization to private-label securitization (PLS).  This shift enabled financial intermediaries—economic, but not legal agents of borrowers and investors—to exploit the information problems inherent in PLS for their own short-term gain.  In other words, a set of agency problems in financial intermediation was the critical factor in fomenting the housing bubble.

 

Comments

[russ]

Interesting paper. I've been a mortgage banker for the past decade (actually what brought me to this blog was some of the non-sense Ms. Warren was posting back in the day on mortgages).

Regardless, I do agree Wall Streets appetite was the primary driver in that without Wall Street, there would not have been any offerings of mortgages to the public. Wall Street ultimately created the guidelines for the most risky stuff and enable the demand side of the equation to inflate prices (very much like how student loans has enabled tuition inflation).

The one thing though that gets overlooked is the role that fraud played as well. The rising prices created a huge amount of speculation by borrowers. Despite all the crying about foreclosures, initially when the bubble burst, the bulk of those caught up were flippers and speculators attempting to make a quick buck. I saw plenty of people owning 2 and 3 condos, etc. In addition, the lower underwriting guidelines made committing other RE fraud that much easier. It wasn't all old ladies eating cat food initially going into foreclosure.

Of course, all this came crashing down and unfortunately, took a lot of the marginal and subprime homeowner's with them as the equity declined and Alt-A/subprime financing vanished overnight. These borrowers could no longer just refinance themselves out of trouble like they had been in the past so now all they could do was head into foreclosure.

Of course, those borrowers have now affected the typical homeowner by bringing down their values as well and the cylce continues.

A lot of loan officers on the front lines knew the loans were junk, but it isn't our job to develop underwriting guidelines. Most just figured if Lehman wants this loan, that's on them. Not too many people really realized the extent and depth of the bubble though.

I guess we all should have known something was up when bag boys were becoming house flippers.

[AMC]

Perhaps your paper should add "it wasn't my job" to the list of causes. . . .

The collapse of the housing bubble was the catalyst for the subsequent meltdown of the derivatives market and the overall economy grinding to halt.

We basically lost an entire year's worth of GDP in 2008, going from an economy that had too much "hot money" sloshing around, to a severe scarcity of capital.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aZ1kcJ7y3LDM

But hey - for a while there, those yield spread premiums were really good.

[Matthew Bogosian]

russ, on the subject of fraud, you (and hopefully others) may find this interesting:

http://www.econtalk.org/archives/2012/02/william_black_o.html

[Mike Dillon]

"In addition, the lower underwriting guidelines made committing other RE fraud that much easier."

Russ, I think you've got that backwards as well as the horse IN the cart. You point to "fraud" and then to flippers and THEN to lax underwriting standards. Had underwriting been doing IT'S job then more of any *borrower* fraud should have washed out. Of course, none of the lenders had to come up with NINJA loans to begin with. And we'll never really know how much of the borrower fraud was actually LO induced...

You ARE correct, though, in that it wasn't an LO's job to police the market. Their job was to sell the carp "products" that lenders created, not make sure that potential borrowers could afford the loans. Suddenly, I had a flash of Sesame Street with Lefty opening up is coat and asking Ernie, "Would you like to buy a lOOOan? Round and neat..." Of course it costs a hell of a lot more than a nickel. Cue the music. http://www.youtube.com/watch?v=ml6Yqu-spnM

Then again, maybe we're ALL absolved - Erasmus says that the housing bubble was CHINA'S fault - http://finance.yahoo.com/news/china-not-wall-street-caused-102129161.html

To be honest, Russ, I think you could've stopped after "Wall Street ultimately created the guidelines for the most risky stuff and enable the demand side of the equation to inflate prices" and actually left out "without Wall Street, there would not have been any offerings of mortgages to the public." because the housing market was cruising right along making mortgage loans just fine even before Lewie Ranieri securitized his first bundle for Solomon Brothers circa '87.

My personal suspicion is that everything went to hell 15 minutes after that when the first mortgage servicer was born. I'd love to know who/when the first mortgage servicers were within the time line and who created them. I know that concrete aficionado Tom Basmajian created Fairbanks Capital in '89 to service what was coming out of the RTC. And then what happened to convince everyone to start sucking up third party servicers and bringing the operation in-house circa 2005.

[Knute Rife]

I think Heleen Mees is leaving out a few steps. Even if it was Chinese money (a point I'm only granting arguendo), how did it get aggregated and placed in position to lend without securitization, and would the investment houses have lent if they could not have packaged and shipped upstream? I also don't see how she can so readily absolve the investment houses so readily on one hand while writing a piece like this for FP: http://www.foreignpolicy.com/articles/2012/06/12/fed_up

[Adam]

No less than Ben Bernanke has a paper that shows pretty clearly the role of Chinese money in the bubble. Global net savers invested in US treasuries and agency paper, not in private label MBS. But the foreign money moving into Treasury and agency paper displaced US and European investors, who bought AAA-rated private-label MBS. The point Susan Wachter and I make is that it isn't possible to create AAA-rated private-label MBS based on subprime or alt-A mortgages without also creating BBB-rated securities as well. That BBB-rated by-product has to be sold to someone to make the deal economics work. And that someone was primarily CDOs. That's where the story lies.

[Knute Rife]

Yes, I know that foreign money, especially Chinese, came into the US like a tsunami and bought US treasuries. That's how we floated our trade deficit with China. My point was that the money had to come back out of the Treasury somehow, and Mees seems to be arguing that it came out independently of the role of CDOs and all the other plastic fantastics. Also, on the point you and Wachter are making, it didn't help that the AAA ratings were about as solidly rooted as Birnam Wood.

[r fuller]

I am still amazed when lawyers and laymen use non sequiturs sprinkled with platitudes to describe the mortgage (not housing) debacle. One of my favorites comes from the hypocrites that align with the Tea Party. According to them, Fannie and Freddie were at fault and banks were "forced" into making toxic loans because of Community Reinvestment Act and other Democrat legislation. First, most toxic loans were made 2003-2006 when Fannie, Freddie, and HUD were, for the most part, run by Republicans (see Board of Directors). Second, CRA (and other legislation) specifically mention that loans are NOT to be made if they go against "safe and sound" banking practices. Third, CRA is for banks. Most toxic laons were securitized by nonbanks. Fourth, if banks and nonbanks were "forced" into underwriting and securitizing these loans, then they must have been losing a bundle of money in the process. Rarely (if at all) have I heard of someone being "forced" into making a bundle of money.

Irrespective of all the macro influences (China, Bernanke, Greenspan, etc), the "housing" crises was the simple result of lax underwriting (which industry does not disclose) and lax regulation on a huge scale. Full stop. The criminals (gross negligence, at a minimum) are both Democrat and Republican. how many notable convicts? None. How many FTC Section 5 or state UDAP prosecutions? hardly any (if any). Oh, you bought a house in 2006/07 and did not (or rather could not) know massive amounts of mortgage fraud was going on? Tough luck. You deserve to lose the money you may have saved for your kids education. It is the kids of the fraudsters that are our future leaders. Now we see where the "moral hazard" lies.

[mt]

While I am sure the topic you write about was a factor, you have not delved deep enough. You need to understand why there was such insatiable demand from financial institutions for financial products with such obvious risk. The reasons lie in banking regulation mainly. Going back to 86, bank capital regulations have assigned the lowest risk to, and therefore required no capital to support, three things: mortgage-backeds, AAA rated paper and sovereign debt. These rules were common to all developed nations' banks. These did three things: 1) they outsourced what hitherto had been bank examiners' work to the rating agencies (which was perhaps inevitable, once the West shifted completely to fiat currencies and finance capital began to grow enormously); 2) they created the incentive to securitize, because every time an originator securitized, it freed up capital as opposed to the capital the individual loans had required, and the buyer had the same incentive, to hold claims in a securitized form rather than via participation or assignment; you could free; what had been a relatively rare phenomenon was truly turbocharged by bank regulators; 3) they created a situation where the only differentiating factor within this favored class was yield. Thus, they stimulated demand for the highest yielding exdample of each type, which eventually led to subprime mbs which offered greater yield for the same capital weight, and also led to demand for the worst credits among sovereign issuers like Greece, etc.

I commend to your attention the books, Guaranteed to Fail and Engineering the Financial Crisis, to deepen your understanding of this point.

[Adam]

mt--I don't disagree that Basel affected things, but that was a change in 1988, not in 2004. The timing just doesn't work. Susan Wachter and I have looked at the Basel impact in our Commercial Real Estate bubble paper (p.30 et seq). One would expect a greater impact in CMBS than RMBS given the 100% risk weighting of all CRE, but 50% risk weighting of first-lien residential real estate. We don't see much evidence of Basel shaping things in the commercial space, and I've looked at this in unpublished work and found that Basel doesn't seem to play a big role, as it encourages keeping AAA-rate paper, but necessitates finding buyers for the junior tranches, which are punitively risk-weighted.

[r fuller]

OMG - are we still babbling on about excessive risk, capital requirements, Basel, bubble philosophy, and other macro influences. Sounds like a typical Bernanke/Geithner cover up. To quote the paper - "The securitization and CDO desks may well have understood what SHODDY products they were selling, but as Citigroup CEO Charles Prince put it, when the music’s playing you have to keep dancing."

Now, math whizzes, let me ask you. What is the theoretical price of a house that is backed almost in full by a no doc, not fully indexed ARM (ie no due diligence)? Uh, try something close to INFINITY. Now imagine that 20%-25% of the houses sold in "bubble years" fall someplace close to this category. You only needs three "comparable" houses for appraisers to mark the remaining homes in America up to INFINIFTY. The bubble (not the rise) part had little to do with housing fundamentals. The bubble part had to do with purposeful negligence on the part of mortgage insiders. Fair? Undeceptive? you tell me

[factchecker]

I think Adam is right, folks try to blame other factors including lack of a gold standard, and ties
to the other bubbles including the dot com bubble,
but this was different, folks made money off securities backed mortgages which was a reason wall street was doing well with bonuses , exotic books on junk derivatives were common, the idea was always profit in a quick, much in the way balloon
mortgages operate and the theory of the greater fool, there had to be last men standing, housing is different as Adam points out, after all we could have the dot com bubble, commodity bubbles or other stock market bubbles, housing however has involved banks a lot, many folks have mortgages and even if folks could afford to , many still take a mortgage, so banks are involved, if you could not get a traditional loan , securities are involved, compounding the problem is not just no doc or new homes, but home equity loans, you may have paid all cash for that house 20 years ago, but took out a loan far worth what the home is worth, or when you bought the home it was at a low price, real estate bubbles have existed before but not on this scale and not with the securities.

[mt]

Professor,
I take your point about the 86 timeframe, but I'll give you 6 things that happened that help explain the lag.

First, shortly after Basel took effect, the US had a major real estate and banking slump, when the S&L's tanked across the SW and, in the NE, the stock market crash of 87 triggered a slump too. So there were no Basel effects immediately because the industry was otherwise challenged. This slump suppressed the growth in mortgages from 87 to 95. Around 95 you see Clinton and Cisneros launch the National Home Ownership Oolicy and mandate F & F to expand their portfolios and mortgage growth takes off again. MBS follows.

2) there were massive techonological changes affecting finance in the 90s that helped securitization takeoff. Computing power soared, enabling much more efficient portfolio compiling and analysis. Digitization of money. Digitization of applications for credit, led by Fannie and Freddie. Standardization by the rating agencies of documentation. Fiber optic cable replacing the 86 methods of telex and DHL for international transmission of deal docs.

3) Meanwhile, in 86 there were many more non-securitization alternatives for AAA paper - more corporate issuers in the US, Japan etc. As they fell by the wayside, but demand for AAA did not, securitization became the way you filled the gap.

4) You also had, post 86, due to the end of Communism, a massive growth in demand for tradeable financial assets from FIs in Eastern Europe, Russia, and China. China's trade surplus had to be recycled in dollars and that was a major factor not present earlier in our period, just as petrodollars in the 70's caused the collapse of Latin American fiscs c. 1982.

5) briefly, when Clinton balanced the budget, Treasury issuance stagnated and Treasury buyers had to seek for alternatives, mainly F & F but also for other AAA MBS soared.

6) The cost of money plunged in the 00s, but the target returns of holders of financial assets like pension funds, insurers, etc. did not, further driving the quest -- within the safety constraints those institutions are bound by -- for yield and hence for subprime and its like.

It's mutli factorial, but I think there were a lot of things that were going on that came together, like tributaries of a big river, to cause the buildup, and a considerable portion of the cause lies with government policy.

[mt]

Professor,

I commend to your attention the NBER working paper published last month by Carol Bertaut, Laurie Pounder DeMarco, Steven B. Kamin & Ralph W. Tryon (all of whom work for the Board of Governors of the Fed), entitled "ABS Inflows to the US and the Global Mortgage Crisis",
http://www.nber.org/papers/w17350,
which supports some of he points I made in my later comment above.

It was ungated when I downloaded it. For those who don't want to read the whole thing (which is actually quite readable as econ papers go), here is the gist of the abstract:

"We present a more complete picture of how capital flows contributed to the crisis, drawing attention to the sizable inflows from European investors into U.S. private-label asset-backed securities (ABS), including mortgage-backed securities and other structured investment products. By adding to domestic demand for private-label ABS, substantial foreign acquisitions of these securities contributed to the decline in their spreads over Treasury yields."

And my favorite quote:
"the global saving glut countries not only provided financing to the United States
directly through purchases of U.S. assets, but also indirectly through purchases of European
assets that in turn financed purchases of U.S. assets. Moreover, European liabilities to the saving glut countries were primarily in the form of safe assets such as government bonds and bank
deposits, whereas many European claims on the United States were in the form of ABS and other
structured credit instruments that later proved
quite risky. Accordingly, Europeans had
considerable exposure to the subsequent crisis
(as illustrated by the diagram of the “triangular
trade” in financial assets). Ironically, in this
regard Europe was acting as an international
hedge fund, a role that previously had been
attributed to the United States."