Why Sub-Prime Lenders Didn’t Cause the Housing Crash (2015)

One thing I think is important not to lose sight of: the institutions went bust, but the people at the top who made the decisions that led to the problem all received and retained compensation in amounts that anyone hanging out here would consider "set for life." Tens of millions of dollars.

To cite but one example: http://www.foxnews.com/story/2008/09/26/wamu-gives-new-ceo-m...

I agree, the article is highly misleading because it leaves this out and tries to take the lenders off the hook.

>Nobody was predicting a Great Recession.

But Econ 101 says there will always be a recession at some point. Once prices started skyrocketing far above the historically-sustainable levels, the lenders knew they were going to crash at some point, and so they should have cut back on lending.

They didn't because they had used securitization to lay their risk off on suckers around the world. And that in turn made the recession far worse than it would have been otherwise.

Professor Ferreira seems to be ignorant of the banking mechanisms involved. There is a direct link between sub-prime loan underwriting and prime loan underwriting:

1. Mortgage loans are packaged by retail banks into blocks of loans. These banks need to be able to sell them on to Wall Street investors if the retail banks are to continue to writing more mortgages without breaking their limits.

2. In a block of loans, it is not known who will default, so using a special financial contract (a CDO) an investor can 'buy the first 10 defaulting loans', say, in the block. In return they get a fat coupon, and of course, they pray no-one does default. These risky loan-block 'slices' (or 'tranches') are called subprime.

3. What remains in the block are less risky slices, called prime.

4. It's easy to get investors to buy the prime debt, because it's almost risk free money, especially to institutional players. So limit to lending had always been 'who wants to buy the shit at the bottom', the subprime debt.

5. Ratings agencies colluded with banks to mislead investors about the riskiness of the subprime tranches. They marked the debt as AAA when it should have been far lower. Investors across the world trusted the ratings agencies, so these AAA securities with fat coupons flew off the shelves into funds that were managed by semi-corrupt custodians who were getting paid short-term bonuses. Banks in Iceland, Germany, Greece, etc.

6. Because the hardest to shift debt was no longer hard to shift, the mortgage lenders sought more people to write mortgages for, and they lowered their lending standards across the board. Whether they lent to high credit scoring individuals or not, they impaired their own lending standards by leveraging people beyond their means. This leverage is why the housing bubble's bursting caused such a country-wide crisis.

7. The Professor seems to think subprime lending refers to lending between the bank and the low credit grade home buyers. However, when we say the housing crisis was caused by sub-prime lenders, we are talking about the institutional players who defrauded investors about the riskiness of these subprime CDO tranches, since this was the root cause of excessive lending to all levels of home buyer.

I disagree. You can underwrite and sell a mortgage-based security today. In fact, it's a rather active sector of the market https://www.wsj.com/articles/mortgage-backed-securities-mark...

But they're not necessarily going to receive a AAA credit rating. Which means they will be eschewed by pension funds, sovereign wealth funds and anything systemic. The worst of the worst will get the junk rating and will vie for their little corner of the market, competing for speculative money with oil fracking companies, emerging market bonds and other similarly-priced risky debt.

The investment-grade rating is what opened the big money floodgates.

It's important to point it out because media blamed "poor people taking out loans they can not afford". This message shifted the blame away from the real problem.

> Banks were basically shifting risk off of themselves.

FDIC means that banks are not held responsible for losing depositor money, and depositors no longer pay attention to how risky the bank's financial practices are.

It says all the loans were unsafe - that the housing price dropped so much making a distinction between prime and subprime loans was semantic. Your thesis might still be true if the market wouldn't have collapsed without subprime loans driving it higher, but that's not the mood I remember. We would have overshot anyway I believe.

what makes the whole article junk?

A lot of speculators were indeed left 'holding the bag', as it were, when the credit game collapsed and there were no more greater fools to sell to. But the reason there were no more such fools is that the lenders had scraped the bottom of the barrel, and there was no one left to lend to. There's no question that credit standards were loosened across the board, and it was possible for almost anyone to get a loan. For a while, foreclosure rates were low as long as it was possible to refi or sell your way out of a problem. Another thing that happened was a lot of people borrowed against rising equity and spent the money as if it were free cash, and found out the hard way later that it wasn't. And that's before we even get into the effects of fraud--underwriting fraud, appraisal fraud, fraudulent bond ratings, forged paper trails, and on and on. The bubble floated on an ocean of fraud. It was an unrestrained orgy of greed and criminality on every level.

I agree - especially this part of Dodson's comment:

"When sub-prime borrowers began to default in droves and the value of the private label MBS tumbled, investors also pulled away from the conventional MBS market as well, even though these borrowers continued to make their payments. However, with a short period the domino effect of defaulting mortgagors spread and then began the recession."

I've always viewed the housing crash as the result of the bottom falling out of the housing market. I don't know how common it is now, but in the early 2000s, it was very common for people to view homeownership as some sort of magic escalator to riches - one would buy a home, then basically be guaranteed to resell it for significantly more later, and the gains would be used to buy a more expensive home.

I went to a free "how to buy your first home" presentation around 2002, and this was exactly the model recommended by the people giving the presentation - people who worked in the home loan and real-estate field. Basically "buy the most expensive house you can possibly afford now, because you'll be making more money in a few years and what you think is an expensive monthly payment now will seem like nothing. Then you can resell your home and buy something even fancier."

Obviously, this depends upon a constant influx at the bottom of the "escalator", which is unsustainable because it's a pyramid scheme. The collapse of that pyramid is exactly what happened, IMO, and it wouldn't have been possible without the sub-prime lending.

An interesting note from his comment:

"By 2006 many property markets across the U.S. were destined for a serious correction. Property prices had become unsustainable in an environment of stagnant household incomes, employment insecurity, diminished household savings and a heavy reliance on credit card debt to meet everyday expenses. Interest rates would have had to fall to near zero to keep the bubble from bursting."

Lo and behold, our interest rates are basically zero... Sounds like the bubble hasn't quite burst yet.

> the banks didn't worry about the risk because they trusted the government would help them out

This is euphemistic for the banks stealing money from taxpayers through crony capitalism.

It's been almost 10 years already. That is decently long compared to bubbles of years passed. We average about one per decade.

I think it makes sense. Lenders have a never ending impetus from Wall St to grow revenue and profit.

When all of the rich and moneyed people (13.5m people in the USA are millionaires) have already taken on loans, who do you go to next?

It becomes a cycle of just digging deeper and deeper into the question of "how do we sell this large capital asset to someone who barely has the ability to pay it back in the next 30 years".

Eventually, small economic cracks (sub prime defaults) lead to medium economic cracks (minor layoffs) which eventually, if the hysteria is massive enough, lead to massive economic cracks (major layoffs, shutting down business arms, pull backs in investment)

Eventually the govt is expected by market actors to become a lender of last resort, the dust settles, assets are repo'd, and over time...

... the cycle begins anew.

So, keep an eye out for the cracks that may be forming right now. Soon there will be another Lehman, another Enron, another Oil Crisis, another speculative bubble bursting due to credit on credit on credit on credit.

I suspect not, at least not in terms of a mortgage loan/housing bubble collapse. What is more worrying is a seeming disconnect between the stock market and the rest of the economy. The "middle class that sees a market that’s stable, that had jobs for the past five, six years" has been shrinking for many decades.

It won't be a repeat. You could argue that there are massive imbalances in the economy, but certainly they'll unleash a different kind of economic mayhem if they go awry. Also, I doubt that it's soon, and I don't think Ferreira was arguing that.

Indeed. The economy could have easily dealt with a few banks failing---if the central banks would have kept nGDP up.

Australia, and even more Israel, barely noticed the Great Depression. Britain also did much better than American and the Euro area, thanks to a competent reaction by the Bank of England.

Maybe ratings agencies would do their job and refuse to rate things they can't see into if they were actually competition in the ratings sector, instead of a monopoly by the three ratings agencies, enshrined into law with regulations.

Much of the ratings sector is for all intents and purposes impossible for any outside firm to compete in, because of government regulations that are supposed to ensure high quality ratings. As it happens, the ratings agencies have some of the highest profit margins in the market, which is a classic sign of lack of competition, and rent-seeking.

At the end of the day most of the theories aren't exclusive. It takes a lot of people to create a global economic disaster.

The article just states the flippers were "those with credit scores in the middle and top of the credit score distribution", not necessarily wealthy.

A wealthy flipper, e.g. a value-add REIT, would not generate as much debt in the first place (as they can just utilize their own bank account) and would be less likely to default en masse since they have spare cash and can wait out the downturn in the markets.

Not likely. The Toronto housing market saw its laws changed at the end of April. The market has lost some confidence because of that, but it is likely to only be temporary. Once buyer confidence is restored, it will be business as usual.

Vancouver's market also "crashed" in mid-2016[1] after their new – similar to Ontario's – laws came into effect. Six months later, after buyer confidence came back, an all-time record high was set.

[1] http://creastats.crea.ca/vanc/images/vanc_chart05_xhi-res.pn...

Agreed, and not much more needs to be said about it.