DEBUNKING BLAMING THE BORROWERS

finance-and-the-housing-bubble

EDITOR’S NOTE: These articles and treatises are important for many reasons and you should read them and use them in briefs because they capture the truth of much of what was in process during the mortgage meltdown crisis 2001-present.

But I think the most salient point that screams out here is that the PR about borrowers looking for housing they couldn’t afford or speculators looking for houses to flip is completely debunked in fairly plain language. It doesn’t take an economist to know that when demand is high for a product, the price goes up. It doesn’t take an economist to know that when suppliers have too much inventory, the price goes down.The PR myth is a distraction from the real product being sold — the loan that was used as a commodity amongst the securitization players.

This simply paradigm is very helpful in debunking the PR story that borrowers were largely to blame or even partly to blame for much of the crisis that ensued. If borrowers were the cause, then demand would have increased for loans, pushing the cost of those loans higher. Instead, the cost of the loans went down leaving us with the inescapable conclusion that oversupply was the issue not excess demand.

This manifested in a virtual panic on Wall Street where trillions of dollars worth of “mortgage bonds” were sold only to discover that nobody wanted a loan. I know this because I interviewed Wall Street people who told me their estimates of how much money was received and as yet uncommitted. Remember that contrary to had been believed it is now apparent that the mortgage bonds were sold first and THEN the search for borrowers was launched. Nobody in the securitization chain was ever in the chain of risk.

By 2003 the refi craze was over and people, under ever increasing financial pressure, were in no mood to undertake buying new homes or bigger homes, since their median income was shrinking each month. With no borrowers, that would have meant giving the money back which in turn meant digging into their pockets and coming up with the exorbitant fees they had already removed from the pool of money created by the sales of these “Bonds.””Giving the money back” is not in the Wall Street lexicon.

So they set out to create whatever deceptions they could to create the appearance of conforming loans on electronic spreadsheet and destroying the real documents. (Better to say you lost them, than to be in the position of producing them and showing you lied about them). Employing armies of people with virtually no knowledge or training, many of whom (10,000 in Florida) were convicted felons, they went house to house giving sales pitches that were patently untrue. In order to shed as much money a possible, as quickly as possible, they inflated the alleged appraised value of the homes so they could fund more money and claim the investor’s money had been used as intended.

The problem they now have is the same — the chickens have come home to roost and the barn is gone. Like any Ponzi scheme it could only continue to work if more investors purchased mortgage bonds, and there was an infinite number of people who would take an infinite number of loans. The price of the house was immaterial in point of fact — it was, as any car salesman will tell you, the cost of the payments that was being sold.

Convinced that they were lowering their payments, besieged consumers went for the bait only to discover that they had been tricked into a deal where their payments were not decreased in reality and their liability was assured to keep them in economic slavery for generations. Home prices are tied to median income (see Case Schiller indexes). Under the rosiest (and completely unsupported) projections, median income won’t reach the required level to support any of the appraised values used until at least 2040, even with inflated dollars.

Adam J. Levitin
Georgetown University Law Center

Susan M. Wachter
University of Pennsylvania – The Wharton School – Real Estate Department

August 31, 2010

University of Pennsylvania Institute for Law & Economics Research Paper No. 10-15
Georgetown Public Law Research Paper No. 10-60
Georgetown Law and Economics Research Paper No. 10-16

Finance and the Housing Bubble

with 37 comments

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.

Posted in bubble, Corruption, Eviction, securities fraud |