Sunday, August 14, 2011

Anatomy of A Train Wreck: Causes of the Mortgage Meltdown

If you have the time, I highly recommend that you read Professor (of economics at the University of Texas at Dallas) Stan J Liebowitz's research on the causes of the mortgage meltdown. Dr. Liebowitz sites relaxed lending standards, encouraged by the federal government, as a significant factor. The primary culprit for changes in lending standards were not "de-regulation," but a concerted effort by politicians, banks and community activists to expand home ownership. Not surprisingly, degraded lending standards opened the way for the entrance for many speculators to enter the market and further inflate the housing bubble.

One key event was a report published by the Boston Federal Reserve in 1992 calling for private and public sector action to address the "widespread mortgage discrimination against African-Americans and other minorities." Their basic thesis was that discrimination was the primary cause of the higher rate rejection rate that African-Americans mortgage applicants experienced. From this conclusion they recommended the loosening of lending standards, which clearly contributing to the housing crash:

"Even the most determined lending institution will have difficulty cultivating business from minority customers if its underwriting standards contain arbitrary or unreasonable measures of creditworthiness."

"And Special care should be taken to ensure that standards are appropriate to the economic culture of urban, lower–income, and nontraditional consumers."

"Lack of credit history should not be seen as a negative factor. Certain cultures encourage people to “pay as you go” and avoid debt. Willingness to pay debt promptly can be determined through review of utility, rent, telephone, insurance, and medical bill payments...Successful participation in credit counseling or buyer education programs is another way that applicants can demonstrate an ability to manage their debts responsibly."

"Special consideration could be given to applicants with relatively high obligation ratios who have demonstrated an ability to cover high housing expenses in the past. Many lower–income households are accustomed to allocating a large percentage of their income toward rent."

"When considering the credit score, LTV and payment history, we put the greatest weight by far on the last variable…Payment history speaks for itself. To many lower-income homeowners and CRA borrowers, being able to own a home is a near-sacred obligation. A family will do almost anything to meet that monthly mortgage payment."

The report praised Country Wide Mortgages as the paragon for lending virtue, which is ironic, considering that they were one of the first lending firms to collapse because of their looser standards:

 After reviewing the Fed's research, Dr. Leibowitz found glaring statistical errors and structural flaws in the research, among them was the failure of the Fed to factor in pronounced differences in the mean credit score of different groups. When credit scores were factored in, the evidence of discrimination vanished.

One lesson we should gain from his research is the innate hazards of allowing government mandated social, rather than market criteria to determine financial transactions. I believe that we will witness a "school loan meltdown" for similar reasons. Here are some excerpts from his writings:

"Why did the mortgage market melt down so badly? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be? It is the thesis of this chapter that, in an attempt to increase homeownership, particularly by minorities and the less affluent, an attack on underwriting standards was undertaken by virtually every branch of the government since the early 1990s. The decline in mortgage underwriting standards was universally praised as an ‘innovation’ in mortgage lending by regulators, academic specialists, GSEs, and housing activists. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The bubble increased the number of housing speculators with estimates indicating that one quarter of all home sales were speculative sales prior to the bubble bursting. The recent rise in foreclosures is not related to the sub prime/prime distinction since both markets had  similar size increases in foreclosures that occurred at exactly the same time. Instead, the adjustable-rate/fixed-rate distinction is the key to understanding the rise in foreclosures. This is consistent with speculators turning and running when housing prices stopped rising. It is not consistent with the nasty-subprime-lender hypothesis currently considered to be the cause of the mortgage meltdown."

"The increase in home ownership increased the price of housing, helping to create a housing bubble. The bubble brought in a large number of speculators in the form of individuals owning one or two houses in the hope of quickly reselling them at a profit. Estimates are that one quarter of all home sales were speculative sales of this nature."

"In fact, the study was based on horribly mangled data that the authors of the study apparently never bothered to examine. Every later article of which I am aware accepted that the data were badly mangled, even those authored by individuals who ultimately agreed with the conclusions of the Boston Fed study. The authors of the Boston Fed study, however, stuck to their guns even in the face of overwhelming evidence that the data used in their study was riddled with errors. Ex post, this was a wise decision for them, even if a less than honorable one."

"When we attempted to conduct the statistical analysis removing the impact of these obvious data errors we found that the evidence of discrimination vanished. Without discrimination there would be no reason to try to ‘fix’ the mortgage market."

"One man’s innovation can be another man’s poison, in this case a poison that infected the entire industry. What you will not find, if you read the housing literature from 1990 until 2006, is any fear that perhaps these weaker lender standards that every government agency involved with housing tried to advance, that congress tried to advance, that the presidency tried to advance, that the GSEs tried to advance, and with which the penitent banks initially."

In spite of the abundant evidence of all the various successful attempts to relax underwriting standards, almost no one wants to blame those relaxed standards for what has happened. Instead, almost all the blame is focused on subprime lenders who happen to specialize in loans that use relaxed lending standards. Unscrupulous subprime lenders, we are told, are the guilty parties responsible for financial calamity at both the macro level and the personal level. They are financial vampires, sucking the lifeblood from hypnotized mortgage applicants who have signed forms giving away their souls. I refer to this as the subprime boogeyman story.

The bogeyman in the mortgage story is the unethical subprime mortgage broker who seduced unwary applicants out of their hard-earned, sacredly treated assets. The subprime boogeyman charged usurious rates for his mortgages and bamboozled his clients with artificially low teaser rates that allowed them to purchase homes that were unaffordable at realistic interest rates. This character has been pilloried by all manner of politician and pundit. Although a convenient scapegoat, this character does not appear responsible for the main part of the mortgage meltdown. This is not to say that there are not lying and cheating mortgage brokers—there are. But every profession, including economists, has its share of liars and cheaters.
There is an important problem with the hypothesis that evil subprime lenders caused the mortgage meltdown. That problem is the fact that subprime loans did not perform any worse than prime loans. .

The main facts standing in the way of the subprime-boogeyman theory is that adjustable rate prime mortgages had a larger percentage increase in default rates than did the subprime market and that overall there was very little difference between the prime market and the subprime market.

Which brings us back to the question: Why did default rates rise so rapidly for adjustable mortgages but nowhere as quickly for fixed rate mortgages? Higher interest rates seem unlikely to account for more than a small part of the increase in defaults. Declines in house prices, or more precisely, the ending of the price rise should have impacted both fixed rate and adjustable rate mortgages equally, if the population of homeowners was similar for the two types of loans since either group is as likely as the other to be underwater when home
prices fall.

One possibility for the remarkable increase in defaults on adjustable rate mortgages, is that adjustable rate mortgages drew a very different types of home buyer than did fixed rate. mortgages. Fixed rate mortgages, since they charge higher interest rates, make sense for people who plan to stay in their homes for several years and who do not want to risk the possibility of rates increasing. Adjustable rate mortgages, on the other hand, are most attractive for people who intend to stay in a home for only a short period of time if at all. Such buyers get the lower interest rate without the worry about interest rates rising in the future,  since they do not intend to own the home for long enough for the rates to reset.

One type of home purchaser that would be particularly attracted to adjustable rate mortgages is the speculative buyer. These would be people not expecting to stay in their house very long. One sub-type in this genre is flippers, as seen on several television shows. House flippers consist of people who intend to make some alterations to a house and then sell it at a profit. The other type of person looking for a short term gain can be called ATMers. These are individuals or families who like to use the appreciation of a house as a personal.

We are experiencing one of the worst financial panics in the post WWII era. Everyone knows that the increase in mortgage defaults has been the primary driver for these financial difficulties. The mortgages with outrageously lax underwriting standards that have been justifiably ridiculed in the press are not unusual outliers but unfortunately representative of a great many mortgages that have been made in the last few years.

The question that is being asked is the correct question: how did it come about that our financial system allowed such loans to be made, condoned such loans, and even celebrated such loans? The answers that are being given are not yet the correct ones, however. The main answer that is being given, that unscrupulous lenders were taking advantage of poorly informed borrowers, does not fit the evidence nor does it dig deep enough.

Almost completely ignored are the ‘mortgage innovations’ that are largely the responsibility of the federal government. These ‘innovations,’ heralded as such by regulators, politicians, GSEs, and academics are the true culprits responsible for the mortgage meltdown. Without these innovations we would not have seen prime mortgages made with zero downpayments, which is what happens when individuals use a second mortgage to cover the downpayment of the first. Nor would we have seen “liar loans” where the applicant was allowed to make up an income number, unless the applicant was putting up an enormous downpayment, which was the perfectly reasonable historical usage of no-doc loans.

The political housing establishment, by which I mean the federal government and all the agencies involved with regulating housing and mortgages, is proud of its mortgage innovations because they increased homeownership. The housing establishment refuses, however, to take the blame for the flip side of its focus on increasing homeownership—first, the bubble in home prices caused by the lowering of underwriting standards and then the bursting of the bubble with the almost catastrophic consequences to the economy as a whole and the financial difficulties being faced by some of the very homeowners the housing establishment claims to be trying to benefit.

The hypothesis that currently seems to best fit with the evidence suggests that housing speculators were taking out many loans with the hope of a quick and profitable turnover. These housing speculators did not much care about the terms of their mortgages because they didn’t expect to be making payments for very long. But it is clear why they would prefer adjustable rate mortgages. The hypothesis also is consistent with speculators often lying about their income on their loan applications and taking out teaser rates so they would qualify for larger loans, so they could make a bigger bet on housing. Under this hypothesis borrowers are adults, not witless pawns. When the housing bubble stopped growing, according to this hypothesis, these speculators turned and ran. Left holding the mortgage-debt bag are the investors who lent money to these speculators. The size of the mortgage-debt bag was so massive that fear of being left holding it brought the financial system to its knees.

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