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12/23/2007

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GAAS

Professor Becker,

Could I suggest the topic of "frivolous lawsuits" for a future posting. It would be very interesting to hear Judge Posner and you blog about this...

Thanks

Jack

It's something of a "surprise" to me that "the vast majority of economists" would have missed the signs of the mortgage crisis. Others, have mentioned the warning signs of, zero down, "stated income" loans, 103% loans and home equity loans of even higher percentages of value.

Perhaps economists might have been the first to notice the anomaly of the fantastic gains in housing prices too. For example in areas such as Las Vegas or AZ were land shortages aren't much of an excuse, why should home prices out-pace inflation so much?

Perhaps there are no warning signs available to economists, but surely some should have picked up on thousands of "investors" flying into LV, FL or some other "hot" market and posting checks for $1,000 for a house yet to be built and flipping it for ten percent or more of "profit" immediately after the home was finished. Surely some economists who specialize in the homebuilding sector should have noted, with some alarm, not only the growing inventory held by builders, but the "shadow" inventory of empty homes held by the "investors/flippers".

I find it puzzling that the packagers or purchasers of huge portfolios and derivatives of mortgages, apparently, did no quality control work. In these "hot" areas, wouldn't, at least, a spot check by a company appraiser have spotted a tendency of "soft appraisal" standards? How about a spot check to see if borrowers WERE working where they claimed and at salaries claimed?

Lastly, it seems both Becker and Posner lean toward thinking most of the bad loans are to folks who could barely qualify for a loan, while the truth will be that of many, many "upscale" buyers buying too much house on too much leverage in hopes and expectations of cutting a fat hog as their large "investment" continues to soar in value. The "investor/flippers" too will be a huge source of bank losses.

Pres Bush even mentioned that your loan is no longer housed at your friendly local Savings and Loan, and who should know better as brother Neil's Silverado S & L gave tax payers a billion dollar drubbing during the last "banking crisis". But he's right, loans are now hot potatoes to be "sold" as fast as possible so as to book the profit and lay the risk off to Fanny or Freddie backed investors. Is it possible that these "sophisticated" Wall Street hot shots are buying and selling a pig in a poke w/o due diligence?

Ha! yes, and a year or so ago there was a wise old Wall Streeter who was lamenting that buyers of derivatives (complex risk/reward instruments that have the effect of turning the low risk portion into a bond, while others take the higher risk/reward portion) had NO inkling of the quality what was in their portfolios. All, of course is fun, fun, fun until the tide goes out.

As for advising "do nothing" perhaps. But many will recall the days of the last "crisis" and what happens when ten percent of the homes on a street or the condos in a building have been foreclosed, dark. Round two was the mismanagement of "Resolution Trust" (another quasi Fed outfit) that came in a sold the foreclosed condo at a price half what the other owners owed on their mortgages. It's easy to imagine what effect that had on those owners to "suck it up and tough it out".

Surely a start is as Bush has tried to do; get those who are all set to change 7% "teaser rates" into 11% kill the golden goose rates to back off. At this point those owning such instruments ARE going to be disappointed by either tremendous rates of foreclosures or doing w/o rapacious returns.

The former course will tend to ameliorate falling home prices and a domino effect as well as allowing many families to stay in their homes. Looking back the Resolution Trust found that their least costly "work-outs" were leaving the owners in place; taking them out and bearing the costs of foreclosure, bringing the properties up to par and reselling was far more costly.

Noah Horton

One other element of this episode that I believe merits mention was the cash-out refinance behavior that drove so many of these loans. It frightens me that we have government officials considering helping borrowers who used mortgages not to finance a home, but to finance luxury goods, vacations, remodeling and the like.

On the topic of non-home debt, it seems to me that the subprime discussion is the tip of a larger consumer debt iceberg. Do you have comments on the issue of revolving consumer debt that I believe may cause the next debt crisis? While I generally frown on any regulatory paternalism, it seems hard to categorize 20%+ credit cards as anything but predatory.

dWj

You note that "lenders already have strong incentives to help these borrowers since lenders are also hurt by foreclosures". It is my understanding that the Bush/Paulson program is mostly attempting to address securitized mortgages in which, indeed, both the lenders (investors) and the borrowers benefit from the freeze, but the contractual agreements surrounding the securitization are unclear as to whether the servicers of the mortgages have the authority to make these adjustments to the terms of the loans. What Bush and Paulson seek to do is to provide uniform definitions for certain terms that show up in these documents, and to define them (in a reasonable way) such that some of these frictions are reduced.

Stephane

Economists of the austrian school do propose an explanation for such "clusters of errors". This theory does not conveniently blame the Chinese, and points instead to the distorsion of production and fluctuation of interest rates caused by monetary policy. What do you think about the austrian business cycle theory?

Jack

DW Yes...... I too am not familiar with just how Paulson expects plans to accomplish what they are talking about. It is the case that the investor bought an 11% (or so) contract and would have to be willing to cooperate. It strikes me as well that the lender might lower the rate and STILL take a lot of foreclosures. Fortunately, I guess these instruments are in the hands of large investors such as mutual, or retirement funds. And, ha! interesting to wonder about a fund manager agreeing to modify the terms of contracts that are, in essence owned by millions of fund members.

In technical terms, I think "servicers" are only those who've contracted to process payments for a small fee per month and that their role would be that of just telling lenders (which in some cases would be their own institution) "Hey, you've got a 15% late pay situation; what do you want to do?"

Yes, I think the DC leadership would be along the lines of establishing some generally uniform guidelines that might help with the problem of "Who's going first and what are we going to do" which would probably be an anti-trust issue if "competing" lenders met in a vault somewhere.

Bernard Yomtov

This belief in the beneficial effects of greater knowledge about mortgage terms is inconsistent with the evidence that the most sophisticated banks and investment companies, including Merrill Lynch, Citibank, and Morgan Stanley, have written down their housing investments by billions of dollars. No one can reasonably claim that these banks lacked the skills and knowledge to evaluate all the terms of, or the likelihood of repayment, on the subprime and other mortgages that they originated or held as assets.

To me this is the most puzzling aspect of the crisis, and one that ought todraw more attention. What does this tell us about markets and economic rationality, especially in financial markets, when these sorts of buyers blunder so badly?

Remember that this crisis is not just a matter between buyer and seller. There are substantial effects on the entire economy, yet I see little in the way of reflection on this aspect of the problem.

merjet

Another factor of the crisis touched upon by a couple comments is the SIVs (structured investment vehicles) owned by the ultimate creditors for the subprime mortgages. The mortgage lenders and investment bankers take pools of mortgages and repackage them, slicing and dicing and shifting risks into a multiplicity of tranches. Many of these tranches were bought by SIVs and not well understood by the buyers. The tranches -- especially the ones very dependent on how much interest will be collected from the mortgagees -- are very difficult to value, given the dearth of history and observable trading prices. Add to that triggers in the SIVs to liquidate assets when estimated market values fall and the situation becomes ripe for a panic.

Bill

Goldman Sachs is now predicting a $500 billion bust and people are alarmed.

But wait a second. At the peak there was $10 trillion in real estate equity and $10 trillion in mortgage debt. I’m familiar with three real estate markets, all of which are different. One is down 35% from the peak, another down 20%, the third down 25%. Figure I live in hard-hit areas and the actual average national drop from the peak is 20%.

That equates to $4 trillion in lost real estate wealth. I find it hard to believe that the bank’s exposure is limited to $500 billion. Prices are still dropping as far as I can tell.

I predict that Paulson will be deposed for his work at Goldman Sachs in an attempt to prove fraud by those who purchased the investments.

Steve

The structured credit products in which many subprime loans wound up were designed to apportion a high anticipated default rate among risk-seeking and risk-adverse purchasers. The most risk-adverse bond purchasers would be protected if defaults were less than a high threshhold, in some cases 10%, and risk-seeking bond holders were rewarded with higher spreads. So it is not prima facie inconsistent to believe that some percentage of subprime borrowers were ignorant while the
investment banks were not. Risk-adverse investors were, I believe, betting that their bonds would have a short duration, as rising house prices
made it possible for marginal home equity holders to refinance (as most of this paper was sold at a discount, a AAA coupon of 50-100bp over LIBOR for
three or four years was quite desirable). The assumption made by lenders was that rising house prices would limit the risk period to a few years while minimizing losses from defaults. With the corollary that the ignorance of the borrowers, whatever its true extent, would be nullified by refinancing at or near the time of the first rate reset.

Stephane

"interest rates were likely to increase from their unusually low levels" : Unusually low based on what criteria? How would one know when interest rates are not unusually high or low?

The whole point of the lending industry is to clear the market of intertemporal choice. Borrowers who favor present goods over future goods are allowed to exchange with lenders who have the reverse preference. The interest rate resulting from this market process expresses the relatives prices of present and future goods.

But what if, through monetary expansion led by the central bank, the interest rate on the money loan market is artificially lowered? This creates an optical illusion which distorts the economic calculation. The natural time preference cannot be discovered by market participants. Borrowers and lenders alike are led to believe that future goods are more valuable compared to present ones than they really are. And so they are in monetary terms, but - and this is the crucial point - not in real terms. More money chasing few goods has created the illusion that some goods were getting more and more valuable because their price was inflated.

This phenomenon affects primarily long-term projects, because of the cumulative effect of interest : a small change in the interest rate has a great impact on the total cost of a 30-year mortgage. At some point it becomes clear that the future value of the good will never compensate the present costs incurred to purchase it. The optical illusion has simply led all market participants to bid up costs of housing to the point where they were higher than the future selling prices. The reason is that future goods were in fact not as scarce relative to present goods as they seemed to be under the artificially lowered interest rate.

We see then that inflationary monetary policy causes lenders and borrowers alike to make intertemporal exchanges that would never have been made, had the real time preference of participants been allowed to express itself in the interest rate. Moreover, it causes more ressources to flow into the construction market than selling prices can bear. These ressources being wasted, they result in a total output slump which can only be masked by further monetary inflation...

Not Ambrose Pierce

"Frivolous lawsuit," a action filed by someone else, normally from a rival faction or group.

"Necessary litigation," an action filed by you.

rob

Many Austrian economists predicted the housing bubble years ago as it is fully explained by Austrian business cycle theory. The credit expansion induced by the Fed is to blame. Stephane does a good job explaining whats occurred.

Rob

"Market forces should be determining interest rates. Its the distortion of interest rates by manipulating the money supply that causes these bubbles to form."-Ron Paul

axel molotov

"No one can reasonably claim that these banks lacked the skills and knowledge to evaluate all the terms of, or the likelihood of repayment, on the subprime and other mortgages that they originated or held as assets." --

Don't the large losses these banks are currently incurring signal the opposite of what you're saying?

It seems that we shouldn't pick favorites (or in this case least favorites), but agree that the blame belongs with all parties involved: the banks, the lenders, and the borrowers.
And I must agree with Judge Posner in that we should do nothing in response, as opposed to some drastic monetary measures such as going back to a gold standard or freezing rates, because a) the economy will bounce back, and b) why should my tax dollars help out someone who purchased a $700K house on a $60K/year salary.

axel molotov

"No one can reasonably claim that these banks lacked the skills and knowledge to evaluate all the terms of, or the likelihood of repayment, on the subprime and other mortgages that they originated or held as assets." --

Don't the large losses these banks are currently incurring signal the opposite of what you're saying?

It seems that we shouldn't pick favorites (or in this case least favorites), but agree that the blame belongs with all parties involved: the banks, the lenders, and the borrowers.
And I must agree with Judge Posner in that we should do nothing in response, as opposed to some drastic monetary measures such as going back to a gold standard or freezing rates, because a) the economy will bounce back, and b) why should my tax dollars help out someone who purchased a $700K house on a $60K/year salary.

Jack

Rob If Ron Paul is so concerned about the money supply I wonder if he is brave and honest enough to criticize Bush and his fellow Party members for flooding the market with over four trillion in deficit spending??? The Fed, until very recently has done about what it has been doing for which, more of the criticism has been that of having their foot on the brakes.

St. Darwin Assissi's cat

Thank you for another excellent blog experience

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Bill

I think the choice of words describing the role persons have played in this problem has confused your analysis.

First, many of these institutions were not "lenders"--they were loan originators, or were loan packagers. Since they did not retain risk--they had little incentive to select carefully, or to disclose (since ultimately they would not bear a risk of default). The reason the investment banks got stuck was that the real lenders--those who were buying the CDOs--started realizing that they were buying riskier assets, and ceased purchasing, leaving the packagers with a hot and melting package of debt.

Second, I would not criticize compulsory disclosure of information. Information is essential for markets to work, and we cannot presuppose that all actors have an incentive to disclose information when, in fact, they have a greater incentive to withhold it.

In fact, greater information may be what is necessary to unclog this mess, because at least persons will be better able to assess risk. A pig in a poke does not draw the highest price.

Mike the lawyer

More information may be valuable, but I'm skeptical. Economists errors can often be traced to either (i) assuming the market has digested or can digest more information than it has or can or (ii) assuming the market is more rational than it really is. People have a limited appetite for information -- just like any other limited resource -- and are seldom perfectly rational. I'm not an expert on Austrian economics (it's been 30 years since I read On Human Action), but I imagine the business cycle is partly explained by imperfect information and imperfect rationality, both of which are largely inevitable. Government intervention risks rewarding irrationality and therefore making such otherwise poor decisions more rational.

Jack

Mike sez:

Government intervention risks rewarding irrationality and therefore making such otherwise poor decisions more rational.

Government "intervention" is a given as capitalism can not and never has worked without "governors" (of the sort that keep it and other machinery from self-destruction). It should be something of a hoot to see what the slumbering FDIC-FSLIC, SEC and others charged with oversight of our financial institutions have to say when hauled up before Congress.

Currently, the "debate" is that of bailing out the savvy bankers (who now plead unknowing naivete) who created this mess, or trying to find solutions that will patch up half a trillion dollars worth of "troubled mortgages" w/o tossing 25 million "home owners" into the streets and having half a Trillion bucks worth of bank-owned real estate.

This deal is very, VERY big, with massive ramifications and is too far gone to putz around with standing on failed ideology.

Jack

Bill correctly summarizes:

First, many of these institutions were not "lenders"--they were loan originators, or were loan packagers.

Since they did not retain risk--they had little incentive to select carefully, or to disclose (since ultimately they would not bear a risk of default).

The reason the investment banks got stuck was that the real lenders--those who were buying the CDOs--started realizing that they were buying riskier assets, and ceased purchasing, leaving the packagers with a hot and melting package of debt.

......... But what is actually going on here?

First the originator sits down in a face to face with the home buyer to QUALIFY them for a loan and fill out the application.

....... the next screen is that of a standardized "DU" or "direct underwriting" done by a computer using the pre-agreed upon criteria. (A much lesser number of loans are then handled by a human underwriter when there are circumstances that are a bit unique.)

...... The loan is not fully approved until the criteria are met to make the loan "saleable". So surely???? the "packager" (loan wholesaler) and the ultimate lender SHOULD be spot checking a portfolio to make certain it IS what has been claimed.

...But surely "the fault" is not only the lack of quality control, but the terms themselves that amount to "investors" of one sort or another having 100% or more of margin with which to speculate on the housing bubble.

Now who is responsible for allowing 100% loans, but even higher percentages including wrapping all of the substantial "closing costs" into the loan such that the property is already "underwater" by the amount of the sale and transaction costs which can easily total 10%? (Realtor plus loan and title costs)

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