The Collapse of 2008 explained simply

Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again is by Peter Wallison, a Washington insider who served on a federal committee investigating the Collapse of 2008 and has now written a 200-page book (inflated to 432 pages by poor editing and redundancies) about why the other committee members were stupid.

Wallison opens by noting that Americans have a rich history of being stupid regarding economics: “During the Depression era, it was widely believed that the extreme level of unemployment was caused by excessive competition. This, it was thought, drove down prices and wages and forced companies out of business, causing the loss of jobs.”

Wallison explains the entire Collapse of 2008 with a few simple facts:

  • starting in the early 1990s the federal government pushed banks and Fannie/Freddie to lend more money to poorer-than-average Americans so that they could buy houses
  • the flood of money on easy terms (0% down, etc.) drove up the price of houses to the point where poorer-than-average Americans could never hope to pay off loans
  • by 2008 half of all mortgages in the U.S. were essentially subprime
  • Fannie/Freddie told everyone that less than 1% of their portfolio was subprime (a lie)
  • when people discovered that the U.S. mortgage market was primarily subprime they panicked
  • mark-to-market accounting rules made banks look great on the way up but exacerbated the panic on the way down

There are some inconsistencies. Wallison blames everything on government meddling with the mortgage market but then he blames part of the collapse on the government refusing to step in and rescue Lehman. Wallison says that Fannie/Freddie were forced to do financially irrational stuff by HUD mandates but doesn’t explain why private sector banks loaded up on ridiculous mortgages too beyond “competition forced them.” Would it actually have been impossible for a mid-size bank to say “We are going to be left behind by Countrywide, Merrill, and Bank of America but that’s okay because the businesses that we understand are profitable.”?

Here are some excerpts:

as housing legislation was moving through Congress in 1992, the House and Senate acted, directing the GSEs [Government-Sponsored Entities (Fannie/Freddie)] to meet a quota of loans to low- and moderate-income borrowers when they acquired mortgages. At first, the low- and moderate-income (LMI) quota was 30 percent: in any year, at least 30 percent of the loans Fannie and Freddie acquired must have been made to LMI borrowers—defined as borrowers at or below the median income in their communities. … In succeeding years, HUD raised the LMI goal in steps to 42 percent in 1997, 50 percent in 2001, and 56 percent in 2008. Congress also required additional “base goals” that encompassed low- and very-low-income borrowers and residents of minority areas described as “underserved.” HUD increased these base goals between 1996 and 2008, and at a faster rate than the LMI goals. Finally, in 2004, HUD added subgoals that provided affordable-housing goals credit only when the loans were used to purchase a home (known as a home purchase mortgage), as distinguished from a refinancing.

As early as 1995, the GSEs were buying mortgages with 3-percent down payments, and by 2000 Fannie and Freddie were accepting loans with zero down payments. At the same time, they were compromising other underwriting standards, such as borrower credit standing and debt-to-income ratios (DTIs), in order to find the NTMs [Non-Traditional Mortgages] they needed to meet the affordable-housing goals.

Because of the gradual deterioration in loan quality after 1992, by 2008 half of all mortgages in the United States—31 million loans—were subprime or Alt-A. Of these 31 million, 76 percent were on the books of government agencies or institutions like the GSEs that were controlled by government policies.

New York Mayor Michael Bloomberg, responding to a question about Occupy Wall Street, stunned observers by exonerating Wall Street: ‘It was not the banks that created the mortgage crisis. It was, plain and simple, Congress who forced everybody to go and give mortgages to people who were on the cusp.”

Wasn’t it the cheap Chinese money that inflated the bubble? Wallison says no, noting that the 1997-2007 bubble was inflating long before interest rates fell: “By the year 2000, before any monetary easing and when the ten-year note was in the 6 percent range, the housing bubble was already larger than any previous bubble. It had grown to that size, in other words, before any Federal Reserve effort to lower interest rates and when flows of funds from abroad were not having a noticeable effect on interest rates. By the year 2003, according to Shiller’s data, the bubble had grown to nearly three times the size of any previous bubble—again, before the Federal Reserve’s policies had pushed short term interest rates into negative territory.”

One of my personal favorite culprits that Wallison minimizes is the repeal of Glass-Steagall: “The repeal of the affiliation provisions, however, had no role in the financial crisis. There is no evidence that any bank or bank holding company (that is, a firm that owns a bank) got into trouble because of an affiliation with a securities firm. The losses that banks and bank holding companies suffered in the financial crisis were the result of what had always been standard banking activity. Even under Glass-Steagall, banks and bank holding companies were permitted to invest in—and thus to buy and sell—mortgages and mortgage-backed securities (MBS), which were regarded by regulators as simply another way for banks to hold loans, a traditional banking asset.”

Wallison notes that an explanation that people want to hear will outlive any debunking:

After the onset of the financial crisis, a widely cited 2008 article in the New York Times by reporter Stephen Labaton incorrectly reported that in 2004 the SEC had loosened the capital requirements for the major investment banks, allowing them to take on much more leverage than had previously been permitted. In reality, what the SEC had done in 2004 was to change the way the net capital of the broker-dealers—the subsidiaries of the investment banks—would be calculated. This had no effect on the capital of the parent companies and no major effect on the required capitalization of the broker-dealers. Nevertheless, the Labaton mistake was then cited in numerous press and other reports as a reason that the large investment banks had increased their leverage before the financial crisis, suffering severe losses as a result. … Later investigations by the Government Accountability Office (GAO) showed that the five major investment banks cited above had not appreciably increased their leverage over its level in 1998, before they had signed up for SEC regulation. … Labaton’s error achieved widespread currency because, as scholar Andrew Lo [MIT professor] has pointed out, it was accepted as true and repeated by many well-known scholars who should have been more skeptical.

How did the ratings agencies fail so spectacularly? Wallison notes that this is a mystery but he says it was not due to the conflict of interest of being paid by issuers: “Why is it that the rating agencies became incompetent or venal when they rated pools of CDOs but not the debt of individual corporate issuers or pools of credit cards or car loans?” He conjectures that the ratings agencies may have failed due to a lack of information: “If it had been known at the time that more than half of all mortgages in the United States were NTMs, that fact alone might have suggested to the rating agencies that the market was far riskier than even the most overheated markets of the past.”

Wasn’t it obvious how bad things were? Not at the time:

Most emblematic of this problem is Ben Bernanke’s statement to Congress in March 2007 that the subprime mortgage problem was “contained” and the lack of alarm about subprime loans that showed so clearly in the transcript of the Federal Reserve’s Open Market Committee only two days before BNP Paribas suspended redemptions in three of its funds. The BNP event, more than any other, seemed to bring to the sudden attention of the financial community the fact that there was a serious problem in the mortgage market. It is certainly unlikely that Bernanke and the Open Market Committee would have been so complacent if they had known—as we know now—that more than half of all mortgages in the U.S. financial system were NTMs, with a high propensity to default when the great housing bubble stopped growing. But market participants were unprepared for the destructiveness of this bubble’s collapse because of a chronic lack of information about the composition of the market. The deficiency of the Federal Reserve’s data was particularly influential.

Accordingly, when the Federal Reserve staff counted up the subprime loans outstanding and provided this data to Bernanke and other members of the Board of Governors or the Open Market Committee, the data grossly understated the number of loans in the financial system that actually met the definition that the Federal Reserve economists had assumed. Instead of 6.7 million, the actual number was probably closer to 18 million, and, including Alt-A loans and loans backing PMBS, at least 31 million. Most of the missing subprime loans were on the balance sheets of Fannie and Freddie, which were hiding the numbers of subprime loans they had acquired to meet the affordable-housing goals.

The mortgage market is studied constantly by thousands of analysts, academics, regulators, traders, and investors. How could all these experts have missed something as important as the actual number of NTMs outstanding? One of the reasons could have been sheer bone-headed ignorance. Nobel Laureate Paul Krugman, for example, informed his New York Times readers on July 14, 2008, that Fannie and Freddie “didn’t do any subprime lending, because they can’t: the definition of a subprime loan is precisely a loan that doesn’t meet the requirement, imposed by law, that Fannie and Freddie buy only mortgages issued to borrowers who made substantial down payments and carefully documented their income.”

How close to right was Krugman? “By 2006, according to a study by the National Association of Realtors, 45 percent of first-time homebuyers and 19 percent of repeat buyers provided no down payment. The median first-time buyer provided a down payment of 2 percent.” Wallison notes that low down payments drive a bubble. A person with $10,000 in savings in the old days could buy a $50,000 home. With a 2 percent down payment, however, the $10,000 would enable signing up for a $500,000 home.

How is it that Fannie and Freddie managed to drag down the rest of the economy? “The competitive effect of what the GSEs were doing should be clear. Imagine how difficult it would be for a lender to require a 20 percent down payment when others were offering no-down-payment loans that were still eligible for the favorable interest rates that the GSEs were offering. As a consequence, the loosening of the GSEs’ underwriting standards spread to the wider market.”

Politics is a big part of the book. Wallison explains how Fannie/Freddie made friends in Congress by promising to assist with affordable housing goals. Regulation of banks and mortgages also enabled the federal government to transfer money from richer Americans to poorer Americans without the transfers showing up in the budget. How? Wallison explains that the Community Reinvestment Act forces banks, if they want to continue to operate, to write mortgages to people from whom they don’t expect repayment. They make up these losses by charging higher mortgage rates to everyone else. How big is this transfer? “The exact size of that contribution is a bit conjectural, however, because the CRA—unlike almost any other government program outside of national security—is kept hidden from scholars, taxpayers, Congress, and even the government agency that is supposed to keep tabs on it. … banks are not even required to disclose the number of their CRA loans to the Federal Reserve, which keeps the records on CRA lending.”

What can one take away from Hidden in Plain Sight? Wallison notes that all of the conditions that led to the Collapse of 2008 are still present. The federal government still pushes to help poor people get mortgages on houses that they can’t afford. As an investor one should therefore be wary of any firm with exposure to this market. The safest course of action would be to invest in other countries. Mortgage defaults did not spike in Canada or most European nations (even Ireland had a default rate only one third that of the U.S.) because those countries did not have a government trying to get everyone into homeownership. Alternatively, invest in a U.S. company that specializes in foreclosures (see “Foreclosure to Home Free, as 5-Year Clock Expires” (nytimes) for a story on how the standard American financial/legal industry can’t move as fast as the law requires and therefore people get mortgage-/rent-free living for five years and then perhaps an altogether free house).

Next book: The Redistribution Recession: How Labor Market Distortions Contracted the Economy (on the question of why didn’t Americans go back to working within a few years after the Collapse).

11 thoughts on “The Collapse of 2008 explained simply

  1. I have a few thoughts about this.

    When the author claims that the housing bubble in the year 2000 was bigger than any previous bubble, does he mean any previous US housing bubble, or any bubble of any kind? And how does he measure the size of the bubble? Some people look at the ratio of house prices to incomes or the ratio of house prices to rents. I live in Arizona, one of the centers of the bubble. From what I recall, the increase in house prices was not particularly rapid in the late 1990s. The value of my house probably doubled between 2003 and 2006.

    Also, the home ownership rate in the US is somewhere around 65%. Most “poorer-than-average” Americans probably rent. In other words, a fairly large majority of mortgages are issued to richer than average Americans. How did efforts to efforts to help poor people have such an effect on the entire housing market?

    You include a quote from Paul Krugman defining a term and then pose the question, “How close to right was Krugman?”. Shouldn’t it be easy to answer that question? Or are definitions of terms controversial?

  2. Vince: Was Krugman right? I thought that the quotes from the book were pretty clear. Krugman stated that Fannie and Freddie had no subprime exposure. In fact, about half of their portfolio was subprime and they both became insolvent until your tax dollars were used to bail them out.

  3. Would it actually have been impossible for a mid-size bank to say “We are going to be left behind by Countrywide, Merrill, and Bank of America but that’s okay because the businesses that we understand are profitable.”?

    Yes, because of the Community Reinvestment Act.

  4. How did efforts to efforts to help poor people have such an effect on the entire housing market?

    Because market pricing is at the margin – if you have a relatively fix supply of housing (in the short run) but you suddenly increase the demand for it, even a few percent, then prices are going to rise significantly.

  5. Philip,
    This has nothing to do with the merits of Wallison’s arguments but I wonder if you had a general opinion of him and his world view before this book.

  6. Actually, the quote you included about subprime is this: “By 2006, according to a study by the National Association of Realtors, 45 percent of first-time homebuyers and 19 percent of repeat buyers provided no down payment. The median first-time buyer provided a down payment of 2 percent.” Did Wallison go on to say that some of those were purchased by Fannie and Freddie?

    Also, Izzie, I don’t think that “pricing is at the margin” answers my question. If demand by poor people increases, one would the prices of houses to go up in poor and near-poor neighborhoods. It’s not at all clear why house prices should then also increase in rich neighborhoods where the house prices are 10 or 20 times higher.

  7. Vince: Could Krugman actually have been wrong? Yes, according to Wallison. As quoted in the original posting: “Most of the missing subprime loans were on the balance sheets of Fannie and Freddie, which were hiding the numbers of subprime loans they had acquired to meet the affordable-housing goals.” Fannie and Freddie were the market leaders in the U.S. The U.S. market was about half subprime. Fannie/Freddie put out misleading statements about how they didn’t have subprime because they didn’t buy mortgages from companies that were specifically in the subprime business. But buried in their SEC filings were the numbers on loans with low down payments, reduced documentation, low FICO scores, etc. So a skeptical person in 2005 could have figured it out or maybe even just someone with common sense looking at all of the crazy offers banks were making.

    [This is not to say that Krugman was alone in being wrong. Anyone who wasn’t desperately trying to short mortgages and short housing, John Paulson-style, was wrong. I’ll include myself in the “wrong” group because, though I suggested in 2006 to a hedge fund manager friend that he short real estate, it didn’t occur to me to try to do it as an individual investor. He actually found the same stuff that Paulson found but rejected it because he thought the fees were too high. I called him up early in 2008 when I read about the collapse of subprime and asked how the idea would have done. He said “It would have been the trade of the century.”]

    Larry: Did I have an opinion of Wallison before reading the book? No. I had not heard of him. My opinion about him after reading the book is that he has some good information but this should have been a 100-page book on how/why the U.S. economy melted down (and may do so again when the next real estate bubble burst because we are now dependent on what would have been called “subprime” in the old days) plus a 100-page appendix on Washington infighting (for those who know/care).

  8. Explained simply, but dubiously. Barry Ritholtz, no bleeding heart, has a very different take in his book on the financial crisis.

  9. I haven’t read the book, only your summary; so if my assumptions are wrong, please correct me.

    There is a lot wrong with this view – it removes the idea that the banks were culpable in any way.

    I believe, if you look into the way the subprime deals were structured and sold to people, you will realize that the banks knew full well that the people taking the mortgage were unlikely to be able to continue paying – however, as long as the mortgage was paid for the first 90 or 120 days, the mortgage broker would be paid his/her full commission.

    And the banks weren’t holding the mortgages either, they were putting them into tranches (not sure if this is the right word) and selling them off to investment funds.

    If you go back and look at the “we pay your mortgage payment for the first 2 payments” sort of deals, and match them up with the timeline that each player in the game needed in order to get paid their commission – you will end up with a very different view.

  10. The problem is that most people close to government and the banking industry try to have the public believe (and quite successfully so) that “no one” could have foreseen all this and no one did. This is not true. There were dozens of brokers and economists that warned, many from before 1999 and the Fed’s reckless financing of the dotcom bubble. When that bubble burst, the Fed tried to “pretend and extend” by flooding the market even further and to make the “camels drink”, the housing financing rules had to be eased. Before that, a credit would normally only be extended to a person who one would be reasonably sure could repay interest and principal. Because, while it is true, that higher interest rates reflect higher risk, there is no interest rate to reflect 100% risk. Yet liar loans, where people were encouraged to invent or overstate revenue or were not asked at all about their revenue streams, were sold to anyone who asked. For a while this worked because rating agencies believed such risked could be insured until everyone began to realize that the insurance premium for a non-repayable loan would have to equally be 100% (“there is no free lunch”). Then everything began to cave in. However, had the “mark-to-market accounting rules” not been introduced that allowed banks to overstate their collateral but had the previous, hundreds-of-years-old “lowest value principle” been upheld, no bank would have been able to “pyramid” these risks and the whole boom would have ended where bank’s capitalization would have ended. So: there were several rules changed (aka broken) at the same time – which makes it difficult to believe this was not done intentionally. Since those who allowed breaking these rules (at the Fed, the SEC and in the legislature) knew why they existed for hundreds of years, ever since modern financing came into being, isn’t it fair to ask if they did actually know they were playing with fire? and that thus all this “no one could have seen it coming” is just to avoid litigation and prosecution? (Or worse – lynching?)

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