Why the housing market imploded

In a recent paper, Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen report (pdf):

This paper presents 12 facts about the mortgage market. The authors argue that the facts refute the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors. Instead, they argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices. The authors then show that neither institutional features of the mortgage market nor financial innovations are any more likely to explain those distorted beliefs than they are to explain the Dutch tulip bubble 400 years ago. Economists should acknowledge the limits of our understanding of asset price bubbles and design policies accordingly.

Scott Sumner summarizes the twelve points here:

Fact 1:  Resets of adjustable rate mortgages did not cause the foreclosure crisis.

Fact 2:  No mortgage was “designed to fail.”

Fact 3:  There was little innovation in mortgage markets in the 2000s.

Fact 4:  Government policy toward the mortgage market did not change much from 1990 to 2005.

Fact 5:  The originate-to-distribute model was not new.

Fact 6:  MBSs, CDOs, and other “complex financial products” had been widely used for decades.

Fact 7:  Mortgage investors had lots of information.

Fact 8:  Investors understood the risks.

Fact 9:  Investors were optimistic about home prices.

Fact 10:  Mortgage market insiders were the biggest losers.

Fact 11:  Mortgage market outsiders were the biggest winners.

Fact 12:  Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in collateralized debt obligations (CDOs) did.

Addendum: There was earlier Boston Globe coverage here.


Vernon Smith and co-researchers such as Dave Porter have long shown how deep is the propensity to speculate and generate bubbles in asset markets, even when there is full knowledge of fundamentals and real payoffs. It is hard to know for sure when a particular market is a bubble, and even as late as 2005 there were serious researchers at places like the NY Fed telling policymakers that housing was not a bubble, even after Shiller's 2nd edn of Irrational Exubrance made it clear that price/rent and price/income ratios had reached wildly unprecedented levels in US housing markets. Needless to say, by then it was too hard to do anything about it.

"serious researchers at places like the NY Fed"

I won't make a joke, but those might be the wrong people to ask. In fact, making them testify to it might make it even worse.

Yes, serious, but in this case mistaken. For those, who want a little more color on how hard it is to call an asset bubble and figure out if expectations are in line with fundamentals, I would recommend the FOMC meeting transcript from June 2005. It includes presentations (starting on page 4) by Board and NY Fed economists on the two sides of the house price issue and then discussion among the FOMC. http://www.federalreserve.gov/monetarypolicy/files/FOMC20050630meeting.pdf

Good find. At the time there were too camps, pro and con that there was a housing bubble. Here is a rogues gallery from the transcript (Reinhart is the husband of Carmen; Lacker is eponymous), with lots of [Laughter].

MR. REINHART. John can correct me if I’m wrong, but I think there is an important element to your question about what is the source of uncertainty. If the source of uncertainty is going to be the evolution of house prices, that basically is uncertainty of a linear type that’s affecting aggregate demand. So you take your best shot and, therefore, set policy accordingly. The other possibility is that you’re not certain how house prices will react as you change your instrument. That becomes multiplier uncertainty; and depending on the structure of the uncertainty in your model, you may either attenuate or not.
VICE CHAIRMAN GEITHNER. My second question is about policy, but not monetary policy. Glenn, in your note, you allude to other instruments if monetary policy doesn’t seem to be the appropriate tool to address a concern about lower value prices. What do we know about the history of the use of the supervisory tool in past periods of concern about real estate bubbles or imprudent lending? Do we have a rich history on the use of those instruments that tells us something about the efficacy or about our foresight in deploying them?
MR. LACKER. It’s called the real bills doctrine.
VICE CHAIRMAN GEITHNER. Since the bills doctrine. [Laughter] MR. RUDEBUSCH. Since you’re going to the British Embassy, I might note that in the United Kingdom they used to allow loan-to-value at origination of 120 percent. You could buy your property under water essentially by 20 percent. One of the recent restrictions they’ve imposed is a limit of 110 percent. So this time around they feel much better in the U.K about where they are with just 110 percent loan-to-value at origination. But the monetary authority there doesn’t have supervisory responsibility—
VICE CHAIRMAN GEITHNER. I meant in our history. In our history, have we used that tool to good or ill effect? Have we used it wisely and with foresight?
CHAIRMAN GREENSPAN. You’re biasing the answer. [Laughter]
MR. FERGUSON. The answer is obviously “yes.” [Laughter]
MR. LACKER. My understanding is that we’ve used it fairly often in the postwar period, in the ’60s, ’70s, and ’80s—in early 1980, for example. My understanding is that it hasn’t worked very well. There have been times when we’ve tried to jawbone the banking system’s allocation of credit.
VICE CHAIRMAN GEITHNER. Is the history one of using it too late, or of using it and its having no effect because there are other ways to get money?

Serious? True. Mistaken? Also true.

But we make an error to stop our analysis there. It is rather obvious that the economists at the Fed, and the entire governance structure of the Fed, have perverse incentives that prevent unbiased analysis. This is not to say they are monsters, or not mostly well-meaning folks who we'd like to live next door to. It is simply to make the point that the Fed, as the maker of the vast majority of US monetary policy is playing on one side of the game: they are insiders. They made the policy. Why would we think that their analysis of the policy, whether "then" in the lead up to the financial crises, or "now" as the post-mortems are going on, would be neutral.

We need to lose the romance of politics. People who take political jobs don't become saints simply because their paycheck comes from the government. They are ordinary people, just like all of us. They pursue the projects which interest them, just like business-folk, entrepreneurs, and yes, even us consumers. So of course, the person who signs their paycheck matters in their analysis, just like it does for business employees and business executives,

Exactly. And did the researchers enter people's minds to discern if they were rational or emotional? this whole mortgage business was racial socialism. Working white people were looted, ravaged, plundered, to satisfy the globalist agenda of giving millions of free houses to non-White invaders so they could multiply rapidly. Watch rascal Bush: http://www.youtube.com/watch?v=kNqQx7sjoS8#t=50s

Why do hostile globalist elite defend Israel as a Jewish ethnostate with Jewish only immigration, but ravage white majority Europe/North America into a multi-ethnic, multi-cultural Gulag with dystopian non-White colonization?

East Asia is 99% yellow. Africa is 90% Black. West Asia is 99% Brown. But 3rd world colonizers, Muslims, Sikhs, Hispanics are aggressively advancing their agenda by annihilating gullible Whites, just as China annihilates Tibet.

Why do gullible Whites cuckold for murderous anti-White elite, who confiscate White people's guns, infiltrate/subvert our banks & espionage agencies, indoctrinate White kids in academia/mass media, plunder White jobs/wages, & butcher White soldiers in bankrupting wars?

"Native" Americans are not native. They invaded from East Asia. Yellow & Brown races committed 10-times more genocide, slavery, imperialism than Whites. Since Old-Testament, Whites have been victims of Jewish/Crypto-Jewish, Turkic, Muslim, N.African imperialism, slavery, genocide.

Gullible Whites should reject subversive anti-White ideologies - libertarianism, feminism, liberalism, & reject hostile slanders of racism/collectivism. Love to all humanity, but White people must organize to advance their families, their fertility, their homelands, their interests. Spread this message. Reading list: goo.gl/iB777 , goo.gl/htyeq , amazon.com/dp/0759672229 , amazon.com/dp/1410792617

racial socialism...hahaha...you are a funny white!

Not on that list:

1) Leverage ratios were insane.
2) Re: "Fact 6," Investors did not understand the contents or risk involved with Synthetic CDOs. Tranching wasn't a new concept, but the way in which things were tranched and retranched ad nauseum, was.

There is a lot not on that list. In fact, I was kind of amazed that with 12 points you would not discuss at all "agency" in bond rating. Hey, they were AAA right? And "rational investors" would dump the whole bucket in an AAA bond.

Good point. I know that money managers have rules w/r/t not being allowed to invest in securities that are rated below a defined level.

It's possible, maybe likely, that a manager would invest in a security they couldn't begin to understand, but was rated AAA.

The way I understand it, Wall Street sharpies reverse-engineered the credit rating companies' process and bamboozled the AAA paper. Still, it was all in the (unread) prospectus and these things were yielding more than other AAA paper (itself a 'hmmm' sign), so there's a bit of caveat emptor on the lazy, greedy, unsophisticated buyers too.

Indeed. But why would anyone invest in anything they didn't understand? (Surely they knew they didn't understand it.) I have been asking this question to many people for many years (since this is, IMO, the biggest problem in financial markets) and have never gotten satisfactory answers beyond the sort of "if anybody knew how clueless I was, I'd lose my job" sort of answers for which the solution, I'd think, is pretty obvious.

I wouldn't call myself a sophisticated investor, nor do I have a multi-million dollar portfolio to manage. That said, I don't go through every prospectus update that shows up in my mailbox (and these things are constantly arriving).

I have no solid idea what terms are changing, or what the managers of the funds and ETFs I'm invested in are buying and selling on a daily basis. Nobody does. Isn't it designed that way?

This is all at the end of the day a shell game driven by lawyers, not a financial market.

And to that point, you have two options in today's world:

1) Stay on the sidelines and (vastly) underperform your peers and watch your savings get ravaged by inflation.
2) Dive into the financial markets and hope you're not left penniless by buried legal disclaimers when the bottom falls out: when the ponzi scheme falls apart, when the bubble pops, when the company's financials reveal fraud and the stock tanks, etc.

There's not of rationality involved.

Doesn't your question reduce to "why would anyone trust a rating?" (Note that ratings are tied-in to US law, with some required to own no lower than AAA, etc.)

"Instead, they argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices."

So, if you assume away the entire reason their decision was irrational (that it depends on ever-increasing home prices), then their decision was rational.

Great work, guys.

I think they agree that that part was irrational, but that they were not tricked by the banks. In fact in the paper they show a prospectus with sensitivities and one of those sensitivities is a 5% drop in house prices and it shows the security losing a ton of money.

It is not that folks did not know what would happen if bottom dropped out of the housing market. It is that they just did not believe that was going to happen.

After all, housing prices did not crash in 1986-87 and banks did not fail from bad mortgage from 1987-1992 proving the bankers learned after 1933 to correctly price all risks in mortgages for over seven decades without ever failing, and things will be even better the more government deregulated.

One of the things we know is that banks who retained mortgages did a better job with lending requirements than banks who sold mortgages. Surely if "no one knode" this split would not be there.

Nobody read the prospectus'. They didn't know what they were buying and selling, simply that the assumption was that tomorrow there would be a liquid market as there was today.

Someone figured out that the really poor stuff was actually on the books of the big investment banks. They couldn't sell it. That was the trash that now the Fed owns.

A rational market theory would predict that if there was such a deep level of incompetence and lack of due diligence that these firms would be wiped out. That is what would have happened in 2008-9 but for $billions from the Treasury and $trillions from the Fed.

It’s weird that the abstract is so out of step with the content of the paper. The abstract says that “borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices”. But if you delve into the paper, specifically the discussion of Fact 12, you’ll find a startling indictment of behavior that should have been identified as irrational at the time, and, the authors imply, could have been with better risk management practices. To me, this is probably the most important part of the paper, but you’ll find no hint of it in the abstract:

“[D]uring the peak of the mortgage boom, mortgage analysts at UBS published reports showing that even a small decline in house prices would lead to losses that would wipe out the BBB-rated securities of subprime deals (Zimmerman 2005). At the same time, UBS was both an issuer of and a major investor in ABS CDOs, which would be nearly worthless if this decline occurred. Why didn’t the mortgage analysts tell their coworkers how sensitive the CDOs would be to a price decline? This question goes to the heart of why the financial crisis occurred. The answer may well involve the information and incentive structures present inside Wall Street firms.”

This very much goes against the “hoocoodanode” attitude of the abstract, and implies room for improvement in risk management.

Tanta knew.

And her accurate list would look very different from what was posted as 'facts'.

The fact that the CDOs would be worthless in a housing price decline was well understood. It was just that a price decline was regarded as highly unlikely.

Wrong, but not irrational.

What was irrational was assigning a "AAA" rating to something that would be worthless in the event of a housing price decline, and the banks acting as though that "AAA" rating had merit, when their own research told them otherwise. Even if you think the chance of a housing price decline is only 1 in a 100, you have no business giving a "AAA" rating to something that will be nearly worthless with 1% probability.

Also, I question the assertion that "The fact that the CDOs would be worthless in a housing price decline was well understood". I'd be interested to see where in the risk disclosure of an ABS CDO it said, "In the event of housing price declines, these securities will be worthless."

Moody's had a 5% national decline as a six sigma event.

They were staffed by idiots.


Prior to 2007, US nationwide house prices have never declined YoY on the nominal basis, at least not since the Great Depression.

But there was/is no structural reason for that to be the case forever. To me, this sounds like this XKCD about election forecasting:


Similarly, negative interest rates on government bonds might have seemed impossible, but here they are:


Who could have predicted a historic bubble would have a historic correction?

Michael Lewis's book _The Big Short_ goes into detail regarding the rating agencies, and he found that most of them just weren't very competent. He discussed how one of the hedge fund managers who was short the mortgage backed securities tried to explain to them why they were wrong and they wouldn't listen. (He wanted some of the rating agencies to downgrade the bad debt as he was taking monthly loses on his position until things finally imploded). The overall impression I was left with was that if you're working for the rating agencies it was because you couldn't get a better job with the firms betting big money on this stuff - so that may explain some of it.

They're thought of the way people in other professions think of government employees in their field.

People seem to forget that we'd had a Housing Bubble in California in the 80's. They also seem to forget the S &L Crisis. Knowing just those two facts gave anyone enough information to avoid being surprised by the events leading up to the Crisis. The only unknowns were the Timing and Severity of the Crisis. Justifying Stupidity is hardly a formula for avoiding Crises in the Future.

To put it another way, False Beliefs sounds too benign.

New York had a not-minor real estate retrenchment in the early- to mid-90s. I would think that more than a handful of these local Wall Street guys would have remembered.

The two other comments make the point, but I'd add these details: Borrowers and investors heard Bernanke announce (early on) that housing prices have never fallen on a national basis and the crisis was contained. Investors were assured that the Gauss Copula algorithm assured the risk was very low due to market diversification. CDO investors were not told of "special selection criteria" secretly imposed by investors on the other side of quite a few deals. Many mortgage brokers (Countrywide, Golden West Financial) certainly did change lending standards and documentation demands. The process of wholesale funding by investment banks to local mortgage operations grew dramatically. Last, but certainly not least, Clayton Holdings executives did (after the crash) testify that if their due diligence showed a loan to be non-qualifying, the peddlers still put the things into MBS. AG Cuomo promised to follow the Clayton information wherever it led. Then he stopped. Then he was governor. CA didn't take it far, either.

There had never been a nationwide fall in prices. And so there never could be, right?

The belief of which caused the problem, of course. People spread out their dollars into an area that "never loses" without bothering to check fundamentals, and so fundamentals could bite them in the ass.

I'm curious whether they think the Fed's low interest rate policy played a role.

Mortgage investors were naive when it came to the extent that average Americans would lie to improve the housing arrangements - whether it was a purchase or cash-out refinance. Everyone seems to ignore how influential HGTV and their clones were in selling granite counter tops, stainless steal appliances, hardwood and marble floors to the masses, and the masses responded by what ever means necessary to get them.

I was a street level insider...saw it with my own eyes.


They were not necessarily naive, but felt it didn't matter. If a mortgagee lies a bit to get a larger mortgage, soon the house will be worth more to make up for any discounting you'd do based on borrower trustworthiness.

Assume continually rising prices, and much that now appears irrational (in our current worldview of fluctuating prices) is actually quite rational.

Rising housing prices crushed stagnant wages - early payment defaults closed warehouse lines of credit, shut down lenders and tightened lending guidelines, which shut out lying borrowers who needed to refi or sell to stay solvent - verifiable income became king and nobody qualified for the bubble prices - housing prices in big bubble areas fell to 2002 levels - exactly where the verifiable income level dictated they should have always been.

Housing prices cannot rise above the level of income of the community - income drives prices - during the bubble, application income was a mirage - borrower's got to the point where they just couldn't inflate their income any more - 100% inflation was very common.

Investor data bases started catching the liars and rejecting their loans - nothing lost if it was a purchaser - refi-ers were dead in the water with no one to bail them out.

There's just so much more there that people just don't want to know or talk about.


Fact 2 is documented to be wrong. Reading their 'evidence' verifies that they didn't take a serious examination of the entire mortgage origination market. It might be better to say that over the course of the entire housing bubble intentional failures were too small or anecdotal a phenomenon to have an effect on the larger economic problem. Towards the end though, some firms were intentionally flooding the market with bad loans then betting against them. Which is to say, the cost of insurance against failure of the mortgages was undercosted to the risks and a tiny percentage of firms intentionally arbitraged that risk.
Kind of like setting your property on fire to get the fire insurance, only in this case they simply gave loans to people who were unlikely to pay it back and bought cheap insurance against that.

I don't know how common the above was, evidently quite rare if this paper is to be believed, but it happened in one such case that the firm stuck in my mind - mostly because of an unusual racial element of the story that made it extra disgusting behavior.

I don't now about the rest of their 'facts' but given they got this one wrong, it's likely the rest of their methodology has errors as well.

I would be grateful if you could refer me to the basis of your opening sentence ("Fact 2 is documented to be wrong").

As I observe below in another comment - replying to Peter Schaeffer - your objection in this regard may just be a matter of language.

To elaborate somewhat: I do not ignore the very great harm done by predatory lending, but it did not in itself cause the 2008 Crisis. What brought that about was well-grounded fears that even the predatory lenders, and those who financed them, had miscalculated the risks and rewards. I would hazard the - yes, cynical - guess that if predatory lending was still (seen as) profitable, the Crisis might never have occurred.

Darn, another example of the problems with the lack of peer review: a report comes out, a blogger reads the abstract, he likes the findings and links to the paper. Then some blog readers take a look at the actual paper and find that it's plain awful.

The abstract is grandiose: "they argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices."

Ah! So these guys found the Holy Grail! Some serious information about people's expectations regarding house prices! Woohoo!

Whoops. Nope. None of that. Fact 9 basically tells us that the evidence behind the grandiose sentence in the abstract is coming from two sources: reports from Lehman Brothers and JP Morgan. In their reports, they assigned low probabilities to crash scenarios. Two sources. No household surveys. Nope. Two reports

But wait, can't we also read in the abstract another grandiose sentence? : "The authors argue that the facts refute
the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors"

I am JP Morgan. I am an insider. I want to sell subprime-linked instruments. I produce reports that place a very low probability that these instruments will become worthless. I make tons of money. Woohoo! And you the best part??? A few years later some guys write a paper saying that I did not do anything immoral because MY OWN REPORT WAS OPTIMISTIC. And their paper makes it to Marginal Revolution!!! Some people on Wall Street must be readings these blogs and laugh their hearts out. Seriously.

I forgot to add: this all makes me very depressed. Very.

Hey, libertarian bubbles don't pay for themselves. Propagandists need to afford expensive DC real estate too.

I sold my house at the peak in 2005. I was very lucky. I thought the housing market was crazy. The reason I thought so was that I knew that first time buyers were priced out of the market. I'm just so dumb turd selling his house and I knew what all these sophisticates didn't. Who are they kidding?

I'm glad to know now that it was common knowledge that the housing market would go up forever.

How stupid.

I guess I could have been a mortgage broker. I've got the smarts for it.

The housing bubble by itself was not enough to cause the financial crisis. It was the the bets Banks placed using credit default swaps that turned a problem into a disaster.

In other words, rational markets are really good at predicting the past. Based on the past year, the high price of housing was rational. A year after the crash in housing prices, the market predicted prices were going to fall. A year after the crash, the market predicted anyone with a job applying for a mortgage was going to lose their job. Two years after the crash, the market predicted anyone applying for a loan will default and be foreclosed on.

After all, markets are rational because everything is rational and we know that prices go up for rational reasons and then go down for rational reasons because everyone making markets rational are rational actors.

Clearly Ponzi and Madoff were rational actors in rational market making. The fact they sold new shares created at no cost does not mean they were no cost because the cost of those shares in a rational market defined their cost.

Rational market theory rejects any connection to production cost of anything..

I published a short story in 2008 in The American Conservative that gives, in fictional form, a broad picture of the street-level factors driving the Housing Bubble in California's exurbs:


Is it just me or does it seem very bizarre Willen asserts that the belief in ever increasing home prices was rationally optimistic when he works for the organization that attempts to keep inflation very low? Or was there a belief at the Fed that price declines elsewhere would offset the rise in housing?

Heh... In other news, those women convicted as witches in Salem in 1692-93 were innocent! After we have found such a convenient whipping boy in the evil banksters, why do some people still insist on confusing us with the so called 'facts'?

Seriously, I would take quibble only with #4: actually, under the Clinton administration, a tax exemption was passed for gain on sale of primary residence. That made homes as an asset class instantly more appealing. This took a few years to percolate through the market, but that's what initiated a housing bubble. Bush administration then conceived of "ownership society", and encouraged lending to lower quality borrowers, enormously inflating the bubble. One-two punch, as they say.

I reviewed this paper a year ago at iSteve:


I liked it, but I pointed out a number of flaws.

Didn't the house prices diverge from the historical norm that had always followed income? A more important question would be if any of these folks, or has anyone asked the ones who saw it coming what they saw?

And all these statements are meaningless unless you factor in scale. What changed that made all these factors nationwide and to a scale that caused such a massive collapse?

Fact 10 - industry insiders lost money
Fact 11 - industry outsiders made money

So the outsiders spotted the problems but the insiders could not. Isn't that pretty much the definition of irrational behavior by the insiders? These "facts" are a joke.

Rationally the insiders would be eating out of dumpsters, along with the economists who wrote this drivel.

Nassim Taleb says that the bonus' paid in 2009 pretty well equalled the amount that the Treasury threw in to keep the whole thing afloat.

I call it the douchebag or dumbass dilemma. Some bankers must have known what was coming and didn't do anything about it. Others just didn't see it coming. Those are the true "rational" explanations for what happened.

But whether they saw it coming is rather beside the point, because knowing you're in a bubble doesn't mean you know when to exit the bubble.

It's true.

Then you are into gambling territory. Fine if that is your livelihood, and that you take the fall or the gains as they come. When equity is the asset that is followed the consequences are that some people lose some money. When debt instruments lose 80% of their value it is far more complicated. It can't be settled quickly because it is a promissory note that is breached, and you are into bankruptcy territory. the crash of 29 was a problem because of the debt used to finance equity purchases. This was a problem because it was all debt, causing cascading failures within the financial industry and government. The market for debt instruments dwarfs the equity market.

Bubbles happen. They get noticed when they are large. They become destructive when they involve debt instruments.

"knowing you’re in a bubble doesn’t mean you know when to exit the bubble"

True. And that would be the "douchebag" option - the bankers knew things were bad and didn't change their business practices.

Yeah nobody thought these new derivatives were like financial weapons of mass destruction.... Its hard to believe this paper gets any serious play. Who's paying people like this to write this tripe? http://seeingthroughdata.com/2012/04/16/frb-blame-collective-self-fulfilling-mania-rather-than-bad-banking/ This was a policy related disaster that didn't happen from 19933 to 1990 because we had better policy. The economics profession is guilty of fraud on the most massive scale of anything in prior history... And yet in perpetuating their own fraud they are often the same people claiming the science behind climate change is suspect.

"borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices."

rephrase as "Given they were completely wrong about facts, they acted rationally". Which situations does this not fit?

or maybe rephrase as "Given that the Nigerian oil minister seemed so nice and polite, it was rational to give him my bank account info and a good-faith deposit".

Scott Sumner or Joseph Goebbels--the BIG lie, twelve in fact.

This is a crock of s _ _ _ and the blogger should be ashamed of himself.

Fact 2: No mortgage was “designed to fail.”

That is simply not true. Back in 2006 I was approached by a poor friend who was negotiating a mortgage and asked to review the terms. The lady owned the house outright (she inherited it from her family) and had no mortgage. However, she did owe back taxes and the home needed some repairs. She was scared that the city (Houston) was going to toss her out (they weren't) and that some of the repairs (electrical work) were urgent (not clear either way).

The lender would only loan a minimum of $55K and the interest rate was outrageous (10%+). There was no way this lady could make the first payment (her income was quite low and she was struggling with cancer).

W\e discussed her situation at considerable length. She was terrified about her back taxes (I told her not to worry which was correct) and seriously considering taking the loan. I tried to dissuade her in various ways to little effect. Finally I said

"If you sign this loan agreement, you will lose your house, your family (including a disabled child) will end up in the street, you will lose everything you have, and it won't take long"

That didn't get much of a reaction either. However, she never took the loan and her uncle helped her out with her tax and repair problems.

Who was the lender? New Century Financial.

This was very clearly a mortgage "designed to fail". Was it the only one? Or one of millions? I think the answer is obvious.

The mortgage transaction of which you give us some details certainly seems very questionable. To describe it as "designed to fail" seems inappropriate, if understandable. It was predatory, but might have "succeeded" - it is simply impossible to say from the details provided.

As I interpret the usage employed by Scott Sumner (and not by any means unique to him), a loan designed to fail would be one which was bound to make a loss. The one which you describe does not - on its face - fit that description.


"As I interpret the usage employed by Scott Sumner (and not by any means unique to him), a loan designed to fail would be one which was bound to make a loss. The one which you describe does not – on its face – fit that description."

A few more details then. The income of the lady in question was only somewhat greater than the required mortgage payment. Given that she had other expenses (including her disabled child), she would have missed the first payment.

The house wasn't in great shape and the location was poor. In foreclosure, it would have never brought enough money to cover the mortgage and the costs of foreclosure process. The lender was doomed to lose money on the transaction (had it been executed). Note that Houston did not have a housing bubble in this period. No rising tide to make bad loans look good. Indeed, in real terms housing in Texas is cheaper than it was decades ago.

I'm amazed how many people seemingly can't understand the point that the paper is trying to make, presumably for reasons of what Tyler would call "mood affiliation" (ie it seems like it might be saying that the finance and housing guys weren't *totally* evil and incompetent, therefore it's obviously propaganda for the enemy that can be refuted with a bit of smug sarcasm).

For those that did miss the point, they weren't saying that the bubble was rational - they were saying that the cause of the bubble was primarily the mistaken assumption that house prices couldn't fall, rather than the various other things that are often blamed for the bubble. Whether they are right or not is another matter, but mocking the authors (or Tyler) for things that they aren't saying makes you look like a blind partisan.

"it might be saying that the finance and housing guys weren’t *totally* evil and incompetent"

No the only way to interpret this is that the bankers were evil OR incompetent. Not both. A mortgage should be a very safe loan. If the borrower doesn't pay you get the house back. To mess that up takes some... ingenuity.

Mortgage failure differs radically by region because housing differs radically. For example Los Angeles prices at the peak of the bubble were 358 % of the start of the bubble but in Dallas they were 142% higher. Mortgage problems in Dallas were minor compared to LA. The Mortgage crisis existed because of overheated local markets not because of greedy bankers. House prices did not increase sharply in Dallas because new housing can be built to match demand. In LA the permitting process prevents new housing from being built in time to meet demand. Housing is miss-diagnosed as a financial failure while it is really over subsidization and restrictions on new construction to meet demand.
The Fed believes that lower interest rates will lead to new construction and economic growth. If that were true prices in LA could not have increased 358%. Lower mortgage rates will lead to more new home construction in Dallas but price inflation in LA.
For example prices in January and February Increased at an annual rate of 22% in the three California cities in the Case Shiller but only 3% in the parts of nation not covered by this index, In the California cities ( LA, San Diego, and San Francisco) house prices average $626 K while outside the index the average price is $118K. The Feds low interest rates have a big impact in overpriced cites where the prices are not sustainable in the long term. Growth in the Case Shiller may be peaking. California cities growth rate was flat in the last three months. The next 2 months will demonstrate if price growth in the expensive markets will stabilize.

While normally a fan of Prof. Sumner, I find it hard to reconcile his "facts" #4,7&8 with developments such as the CFMA in particular. This latter radicalized the financing of mortgage backed bonds in a manner that was unprecedented and was largely invisible to retail mortgage investors. AIG FP, at the heart of the bubble, could not have done what it did, nor would Chuck Prince's bank continued to dance to the music, had this and other "innovations" in regulation not been enacted.

I recall coming across this about a year ago, but to me the crisis isn't about "good guys" or "bad guys" but how the originate-to-distribute model (CDOs and whatnot) increased information asymmetry between loan applicants and those who were supplying the funds. As I recall, Foote et al argues against this by discussing the immense amount of loan information included in CDOs -- but it doesn't talk about the quality of that information.

For example, Keys et al (2010) in "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans" noticed that a FICO score of 620 seemed to be the cutoff of when loans were securitized. However, loans to applicants slightly above 620 performed worse than loans to those slightly below 620, and the only difference was that ones above 620 were being resold as CDOs.

This indicates that the FICO score was being gamed in order to take advantage of the information asymmetry.

Oh, I guess that's still kind of a "good guys vs. bad guys" story. I usually cite Mian & Sufi (2009) "The Consequences of Mortgage Credit Expansion" and a bunch of other work that focusses on securitization itself.

Fact #2 seems fishy to me. While it's possible that in the strict sense of the words, no loan products were *designed* to fail - that no bankers issued loans with the intention of being able to pick up foreclosed houses after the borrowers defaulted, there were some loans out there which seemed like pretty bad setups, and had to have seemed risky at the time.

For example, there were loans available with a very low "teaser rate" often at 1% pa or lower for the first year or two, where qualification was based on the borrower's ability to make the teaser-rate payments, but not the fully-amortizing payments once the loan went to its standard rate (even assuming no increase in interest rates). Even when the rate would go from 1% to 3%, that's a 31% increase in the payments, which few borrowers (especially those who "needed" non-traditional loan products) would be able to absorb, without having to refinance or sell.

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