Balkinization  

Sunday, October 12, 2008

What We Still Don’t Know About the Mortgage Crisis

Ian Ayres

A crosspost from Freakonomics blog:

On Tuesday, September 16, at a rally at the Colorado School of Mines, Barack Obama criticized John McCain, saying:



Just today, Senator McCain offered up the oldest Washington stunt in the book: you pass the buck to a commission to study the problem. But here’s the thing; this isn’t 9/11. We know how we got into this mess.



It’s one thing to criticize McCain for inaction, but I disagree with Obama’s claim that we know how we got into this mess. In fact, if pushed, I would say I knew a lot more about the causes of 9/11 than I do about the causes of the mortgage crisis.


I just read Robert Shiller’s excellent book, The Subprime Solution, and he makes a powerful case that the end of the price bubble in residential real estate was the crucial triggering factor.


Indeed, the graph, based on the Case/Shiller U.S. National Home Price Indices, is prima facie evidence of a bubble that expanded and popped:


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The dramatic downturn in housing prices was the key trigger — causing an increase in mortgage defaults. But the next step in the meltdown seems to have been the byproduct of 1) high leverage at investment banks and other financial intermediaries and 2) uncertainty over how much of the default risk was held by particular intermediaries.


Assessing a firm’s exposure is complicated by the massively complex web of derivatives and tranches oftentimes unreported in firms’ balance sheets. Firms like Lehman Brothers suddenly had trouble borrowing when lenders had trouble assessing the value of the security they offered. When you’re massively leveraged, just small increases in uncertainty over your asset value can dry up your ability to refinance your debt.


But to my mind, there are still dozens of important unanswered questions.


How much of the crisis was caused by subprime borrowers who made mistakes by borrowing (i.e., would not have borrowed if they had better information)?


Some proportion of the loans had very low down payments and low interest rates for one or two years. It might have been a rational choice for someone to take a chance on homeownership — putting very little money at risk and thinking (correctly): “If housing prices continue to go up, I’ll be able to refinance my house when the two years are up.”



In 2005, Elizabeth Warren gave a paper at Yale’s Legal Theory Workshop, and I called her on a claim in one of her footnotes that down payments for first-time homeowners were minuscule.


I was sure this claim had to be wrong. There is no way banks can loan money with virtually no equity cushion. But guess again.


According to The Washington Post, “four out of 10 first-time buyers used no-money-down mortgages in 2005 and 2006, according to surveys by the National Association of Realtors.” And the median down payment for first-time buyers in those years was just 2 percent.



With so little of their own money at risk, it shouldn’t be a wonder that many borrowers default when housing prices decline. Would you want to keep paying on a $200,000 mortgage when the house is only worth $150,000?


If you want to know why the mortgage system is so fragile, you should look to the drop in home equity — which was occasioned by low down payments and second mortgages that pulled equity out of houses where the owners paid off some of their outstanding principle.


But the problem of high borrower leverage was compounded by the high leverage of many of the firms that ended up holding the mortgage papers. Some investment firms were leveraged 30 to 1 (or more).


Years ago, Shiller called upon Freddie and Fannie to conduct “stress tests” to see whether they could survive a downturn in real estate prices. One of the chiefs had concluded that they could survive a 10 percent downturn in prices, but didn’t think it was plausible that prices would fall more than that.


I like Shiller’s “stress test” idea; but I’m also attracted to the New Orleans levee metaphor: Should our mortgage system’s levees be able to withstand a 20-year flood, or should we design them to withstand a 100-year flood? Levees are not costless. Neither are financial-safety measures.



We also don’t know the extent to which specific terms of subprime loans contributed to the spike in home foreclosures. Some of the loans (particularly those going to minorities) were at high interest rates not justified by the risk of borrower default. Some mortgages were interest-only loans, where the borrowers were not building up additional equity overtime. And many of the loans had teaser rates, which effectively required refinancing after two years.


My tentative take is that the low down payments were more important than any of these other factors as far as adding to systemic risk. Second place would be the effective refinancing risk (because after the house prices started to decline, lenders were not willing to lend $300,000 on a house that was only worth $250,000).


Third place would be the interest-only loans. If the down payments had been higher, interest-only loans would not have been much of a problem at all. There is a systemic benefit with amortizing loans: in a system where people borrow money at different times, there will be different amounts of home equity in the system. But this benefit is dramatically reduced by the ease of taking out second mortgages to pull out any built-up amortized equity.


I’ve done a lot of work on the problem of high borrowing interest rates, and marking up interest rates can exacerbate the probability of default. But while more needs to be known, I believe that this impact is likely to be less than the impact of these other terms. (These inflated rates, however, are a problem in and of themselves — and remain an action item for enlightened regulation.)


But I’m still not sure how many of the defaults are caused because borrowers can’t pay (for example, because of interest resets and the resulting need to refinance), and how many are caused because borrowers are choosing to walk away from mortgages that are seriously underwater.


We also don’t know the answers to parallel questions concerning the lending side. It’s easier to see the possible rationality in the behavior of the loan originators; to the extent that they were flipping the mortgages in the securitization market. But what we still don’t know is why the ultimate buyers were willing to buy.



Was this a failure of Super Crunching? Was it a failure of corporate governance (in that the managers of the buying firms had incentives to unprofitably grow their empires)? Was the failure caused by originator fraud (or the moral hazard of substituting bad-doc loans for what historically had been high-quality loan pools)?


I think it is probably some mixture of all three — with poor corporate-governance incentives particularly explaining the failure of the rating agencies to start downgrading the debt earlier.


Knowing the answers to these causal questions is important if we are going to craft useful policy responses. But that will be the subject of another post — which will more directly focus on Shiller’s subprime solution(s).


Comments:

Where was the legal profession as gatekeeper in all this? I've been an attorney for over 50 years and have handled my share of real estate deals until my semi-retirement about 10 years ago. When TV ads for undocumented mortgage loans popped up, I would have thought that real estate attorneys would have raised questions. In my early practice, the game was second and third mortgages at high interest rates, where lenders looked forward to foreclosing because of potential benefits. Then at least in MA statutes were enacted to regulate misuse. But there was too much cleverness out there and state rules were sometimes preempted.

I think the legal profession should take a hard look at its failures.
 

This comment has been removed by the author.
 

shag from brookline said...

Where was the legal profession as gatekeeper in all this?

Filing lawsuits against banks to compel them to provide mortgages to the uncreditworthy.
 

This analysis begs the question of why banks abandoned their old practice of requiring money down and borrower credit worthiness over the past 15 years?

From personal experience, the only way a bank would give my wife and I a mortgage coming out of the Army without any money down was a government subsidy in the form of a VA loan for my service. Thus, I suspect government subsidy was involved here. However, I doubt the VA was the cause of this since my wife and I still had to meet credit standards to get the loan.

So you need to ask yourself who was pushing government mortgage subsidies for the uncreditworthy?

I would suggest that you start with Freddie, Fannie and their sponsors.
 

Ian, I think you overstate the extent to which the problem was caused by people walking away from their mortgages when the house value fell. They still want to live there; they can't dump one mortgage and get another house at a lower price. Rather, they are trapped in the houses, unable to move because the unrealized loss would be realized. It requires some increase in price (such as a mortgage interest reset) or a bankruptcy to make them walk away.

The problem was that loans were being made to people regardless of their ability to pay, under terms that didn't require them to reduce the outstanding principal, in the belief that the underlying collateral would always cover the loan or that mortgage insurance would pay off. But the mortgage insurance was priced based on the same collateral price assumption. Then this debt was securitized and risks were insured against, again under the same assumption.

Because people were making money hand over fist financing houses, they threw more money into the housing market than was really needed (the bubble), and too many houses were built. Furthermore, the real economy began to slow and/or price inflation in oil and food stressed family income, so home sales slowed. But contractors were fully loaned up and had to reduce prices to sell. This price reduction had to be reflected in the market value of mortgage-based securities.

Another intensifying factor was that many mortgage lenders and mortgage-based security buyers were leveraged, either with commercial paper or bonds. As the value of their assets fell, the losses reduced the proportion of equity in their capital structures, increasing their leverage with the result that their commercial paper rates increased or they hit bond coverage limits or the rating of the mortagage-backed securities they issued was downgraded; all of this reduced their income and made it even harder for them to recapitalize.

Like the Crash of 1929, it was financial sector abuses which caused the current crash. In 1929, widespread fraud on the market led to the SEC Act, bank failures led to the Glass-Steagall Act and capitalization abuses in the utility industry led to the Public Utilities Holding Company Act. We should look for regulation in the general market (hedge funds, derivatives) and in the housing market (mortgage originators) as a consequence of this crash. With investment banks now inside the tent of bank holding companies, we also need increased regulation of the extent to which bank holding companies can use the capital of their banks' depositors to fund speculation by their investment arms. We probably also need to undo the recent bankruptcy law changes to increase dischargability and/or debt adjustment to rectify the moral hazard of lending.

We also need to do something to limit the risk and guarantee the return within specialized investment accounts, such as 401ks, IRAs and 529 plans. These accounts represent what little household savings we have here in the US, and for them to be wiped out leaves terrible holes in peoples' lives.
 

No need for a commission. Ira Glassman at NPR has already explained this [pdf link]. We know this recipe:

1. Lots of money looking for a safe, high return investment.

2. Greedy people up and down the food chain willing to shave a lot or a little off their basic honesty to get a piece of the action.

3. Perverse incentives.

4. "Savvy" operators who believe their technology allows them to suspend the normal rules of risk and reward.

5. Near the end, people willing to out and out break the law in a desperate attempt to cover their losses.

This is the same recipe as the Enron fiasco. Heck, it's the same recipe as the Tulip Bubble. There's no mystery here.
 

As someone currently working with homeowners who are trying to either save their homes or get out of the house and save their credit, I have just one view of how some of these people were sold loans that they simply couldn't afford by unscrupulous mortgage brokers and lenders who made a commission off of how bad a loan they could sell someone. The Community Reinvestment Act had nothing to do with the sub-prime meltdown because CRA lending institutions are still REGULATED - and CRA loans are for the most part not going into default.

The advent of “stated documentation” or “no documentation” loans has had a disastrous impact on the lower middle class in this country – a scenario would go something like this.

Borrower: I can't afford that house, I can only pay $1,500/month including everything because we only make $50,000/yr and have kids.

Mortgage Broker (MB): Don't worry, I will get you a loan that only costs that much.

B: I'm not ready to buy a home, I want to buy a home but I don't have a down payment

MB: we will get 100% financing – no money down.

(after much wrangling and high pressure sales)

B: OK here are my tax returns and 1040, see what you can get me.

The Broker now goes out and finds a sub-prime lender (like Fremont who flipped almost 100% of their loans within 3 months of origination) finds out what the Borrower would qualify for, writes an application for the loan (usually falsifying their income in a stated documentation loan), gets an “optimistic” appraisal of the house which is usually more than the purchase price, and notifies the borrower that he/she found the borrower a mortgage.

MB: The loan is a little more than $1,500, but you'll be able to afford it .

B: How much more?

MB: That is not up to me, ask the lawyer at the closing.

B: Will I need a lawyer?

MB: No, don't worry, there will be a lawyer at the closing, just go and sign then you have your new home.

At closing with an inch thick pile of documents to sign the borrower is rushed through the signing with the attorney representing the lender there.

B: This is too much, I can't pay this much

Atty: That is not my problem, this is the loan you agreed to, if you don't like it, you can cancel it in 3 days. But you might lose any deposit you've put down.

Lender's agent: you will lose your $X,XXX deposit that you put down if you do not sign. And don't worry, you can refinance before the rate goes up.

Borrower worried about losing their deposit and feeling pressured by the lender and attorney who are in a hurry signs the loan documents as the pages are flipped for him/her, not realizing that he purchased two loans, the first a 2/28 ARM for 80% of the value with a 7.5% teaser rate and a fully indexed rate of around 15% which will increase by 6% + LIBOR (never less than 7.5%) and the first jump is 3 points in 2 years, also there is a prepayment penalty on the first 3 years of the loan. The second loan is a 15 yr loan for 20% of the value at about 10.5-11% fixed interest mostly loan with a large balloon payment at the end.

Also, in the loan are large broker fees, discount points and perhaps a yield spread premium split between the lending agent and broker – both of whom had to collude to get this person into a mortgage that they knew this person could not afford. The broker and lending agent represented that they were working for the borrower when they were not, they worked for themselves and made a commission on getting a person into a worse loan than they qualified for (shown in HUD-1 documents as “discount points” or “yield spread premium”)

But what does Sub-Prime Lender care? It has already got a contract or is about to make a contract with Trust-X and Servicer-Y to purchase this mortgage (or more likely a bundle of mortgages), and Trust-X and Servicer-Y when the fraud, discrimination, or other statutory violations are alleged will hide behind holder in due course doctrine which “protects” them from affirmative legal action against them for the practices of the originator and broker. In a non-judicial foreclosure state, like Massachusetts, there is no defense to a foreclosure since the foreclosing servicer does not have to go to court (except to ensure that an owner of the house is not an active service military) and the owner has no chance to claim any legal defense to the foreclosure unless they declare bankruptcy which provides an automatic stay until the bankruptcy is sorted out.

So when everyone originating the loans is incentivized to commit fraud or at least look the other way because not only are they making a lot of money on bad loans, but they never have to live with the bad loans since they sell them immediately. We love to blame the borrower for signing the contract instead of the financial institution who had a much more sophisticated understanding of the disaster they were creating. And yes, the legal profession, i.e. the lenders attorneys, were doing their jobs properly and zealously representing their clients.
 

The comment thread at Freakonomics includes several references to a bubble-inside-a-bubble metaphor, which helps some. But it doesn't capture the relationship between the smaller and larger bubbles. The bursting of the mortgage bubble would have been bad enough by itself, at least for those directly involved. But it would not have brought down the whole financial sector. What brought down the financial sector was the unfathomable degree of leverage inherent in credit default swaps -- insurance policies written without adequate reserves to back them up (or even any reserves), for amounts totaling many times the value of the assets being protected.
 

Little Lisa's bro can blame Fannie and Freddie regardless of the facts. So let's blame Georgie and Dickie at least beginning in 2001 with their facts of guns, butter and tax cuts - and after 9/11, go to DisneyWorld, no need to sacrifice.
 

From personal experience, the only way a bank would give my wife and I a mortgage coming out of the Army without any money down was a government subsidy in the form of a VA loan for my service.

Technically, the VA doesn't issue loans. Rather, the VA issues a guaranty to protect the private lender against loss if you should happen to default. The benefit you receive is that the guaranty serves the same backstop role for the lender that the down payment normally would.

However, I doubt the VA was the cause of this since my wife and I still had to meet credit standards to get the loan.

The credit standards you had to meet were set by both the private lender you used and the VA. Not surprisingly, things like creditworthiness and entitlement are determined according to Freddie Mac's lending standards.
 

I think some investigation would be helpful, but it needs to be led by those who were calling the outcomes correctly for some time now, as they, rather than a bunch of politicians from the unification party of CYA, will make the most progress.

In the end, though, I think that despite legitimate focus on the Clinton repeal of Glass Stegall, two very significant items will have to end up being the heart of the problem.

First, the wildly easy credit policy of the Fed, which was used for political purposes to cover up the failures (almost from the get go) of Bush economic policies, using easy credit as a salve to make Americans less aware of the inevitable lifestyle adjustments awaiting them, as those policies knocked back family income and destroyed jobs.

Second, what you allude to briefly, the Buffet dubbed ticking time bomb of the unregulated derivatives market and the interplay with the 2004 regulatory rollbacks (spearheaded by Paulson wearing his Goldman's hat at the time) allowing the largest investment bankds to got from 12 to 1 leveraging to 30-40 to 1.

While you can't overemphasize the ez credit polices, imo, the biggest problems are always the ones that stem from lack of information - because you can't correct what you don't know exists.

This is why any real "solution" is going to have to tackle head on the issue neither candidate seems to feel comfortable talking to the American public about - the shadow banking/finance system and unbooked, unregualted derivatives like credit default swaps.

http://news.yahoo.com/s/nm/us_aig_swaps_wsj;_ylt=AnofVDNf4w5SuL56nNIlLXsDW7oF

Let's face it - subprimes were only about 1.5 trillion in total, with about half or so of that in ARMs. To date, the Fed has, in the last three weeks and in addition to the 810B "bailout" also thrown in 630ishB (when the first bill didn't pass) another 450ish after that, then another 150ish to buy commerical paper - - - if the problem was the gapstop on subprime defauls and the writedown value of the correlative real estate, things would be stabilized a long time ago on this ride.

The problem is that you have a hidden 50-60 (or more, or less) trillion dollar unregulated derivatives market and no one can tell anything about a company's holdings and riskes on those derivatives. It's not that 700B in subprimes might default, it's that the "bets placed" in the derivatives market for that 700B, might be 6 or 8 or 10 times that amount, and might be incurred by "bettors" not holding the defaulting mtgs and who can't be readily identified.

Those cascading defaults can then cause other lending and regulatory defaults relating to asset reserves and trigger cds bets on bonds to belly up, and on and on.

This is why there is so much support for the seemingly nonsensical concpet of buying at face value - not bc anyone thinks that is a good investment or taxpayer bet by itself, but bc it will help stave off the cascading defaults that are so feared. I don't necessarily buy the concept, but no one is really even trying to explain the perceived purpose and benefit of that approach to the public. I'm sure the "gurus" think that it is too complex to sell in a talking point, so it is of no political value to dig in and addrees the issue.

This is why, too, you can't really dig in and "fix" things without lining up the info on the problems that need fixing first.

Right now, the list includes the Glass Stegall repeal, rolling back the 2004 regulatory changes, and the EZ credit policies used as a salve for real wage and job growth, and a real estate valuation bubble (not a subprime, but an across the board in some markets, bubble).

Still, those are only the "seeable" factors. If they don't add the unseeables, the shadow system, and dig in and get a handle on the size and nature of that problem (wouldn't it be nice to know, within 10 trillion or so, the actual size of the market, much less prorata holdings?) then you have a huge buried risk that will be the festering infection that keeps spiking the fever and malaise.

It will be ugly and uncomfortable, but at some point that boil will have to be lanced and someone needs to start explaining that to the patient - Obama and McCain are both derelict in that, and IMO one of them may just lack the capacity to understand the problem.

All fwiw - hey, the dow is up right now, so everything is "better" right?
Or not.
 

Take a look at "The Fannie/Freddie Flat Earth Theory" by Dean Baker, 10/13/08 at:

http://www.truthout.org/article/101308A

Little Lisa's bro may fall off the edge (if he already hasn't).
 

Good post. A few comments.

1. The proof that more is needed than Obama said is that he found no fault with Paulson's plan to buy up toxic assets, which I dub Paulson's Folly, even though most economists were advocating what Gordon Brown did, what the eurozone is now doing (amid cheers from the stock markets), and what Paulson is now, with evident reluctance, committed to doing: recapitalizing those banks that are still salvageable.

(That said, Obama is far and away better positioned than McCain to see that we don't repeat the same mistake or make a similar one.)

2. As to what financial interests propelled the glut us to the current glut of subprime mortgages, I've been in the securitization world and can safely say that the craving for the asset began and ended on Wall Street. Fannie and Freddie were late to the game and were playing catch-up. They added to the problem but do not account for the lion's share of it.

3. As for what went on at the borrower's end, I've heard (without confirmation) that the majority of the subprime loans are second mortgages. If so, the urban (or rural) myth of liberal elites housing the unhousable is even more discredited than we've been told, and – apart from the machinations of Wall Street – the subprime proliferation had a great deal to do with (a) the failure of wages to grow and of healthcare to be rationally dispensed and with (b) the global economy's dependence on the US population's living beyond its allotted means. That made it vitally important for people here to tap the illusory equity in their homes.

4. The rating agencies did indeed fall down on the job. I know what it means to stress-test. I've spoken with a banker with whom I worked on securitizations (not mortgage-related), and, believe me, the agencies did not stress-test. There are hifalutin explanations of the lapse, e.g. that the agencies marked to model instead of to market. But the simpler explanation is that they knew which side their bread was buttered on. They were hired and paid by the investment banks rather than by the purchasers of MBSs. The rest is methodological gobbledygook.

5. If one wants to know how the crisis developed, seen from ground level (covering everything from MBSs to commercial paper, interbank loans, credit-default swaps, and deregulation), and if one wants to see how plainly Brown's fix was in the air while all the politicians fiddled around, listen to Ira Glass's two episodes on the subject. The scales will fall from your eyes. They are:

a. "The Giant Pool of Money" (at http://www.thislife.org/Radio_Episode.aspx?episode=355); and

b. "Another Frightening Show About the Economy" (at http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1263).
 

Corrections:

r.friedman: Banks do no make money hand over fist on subprime mortgages. Under a standard mortgage, the interest income consists of a basic interest rate and a risk premium to take in account the potential for default under normal credit standards. Subprime mortgages reduce or eliminate this risk premium meaning less income for banks.

r.friedman: There was no conventional leveraging at work here ala options. Rather, the government subsidy and political/legal pressure to extend subprime loans to the non-credit worthy artificially raised the prices of housing which provided an inflated valuation for later mortgages.

shag: The mortgage crisis has nothing to do with guns, butter or marginal income tax rates.

pms: You hit the nail on the head when you posted that: "Not surprisingly, things like creditworthiness and entitlement are determined according to Freddie Mac's lending standards."

mary: Fed short term interest rates bear no relationship to the long term interest rates charged for 30 year mortgages. Banks do not borrow under the former to finance the latter.

mary: There is no evidence whatsoever that derivatives contributed anything to the mortgage meltdown. This is a red herring to distract from the simple fact that the Government subsidized and applied considerable political and legal pressure on banks to extend subprime mortgages to the non-creditworthy. Derivatives did not create or increase the risk of this sub prime mortgage folly, but rather simply spread the risk created by the subprime mortgages to investors. While derivatives are making valuation of the sub prime mortgage failures harder to gauge for accounting purposes, the meltdown would have occurred to the same extent even if derivatives did not exist.

shag: The Truthout article to which you linked blames the mortgage failures on a bursting of the housing price bubble. However, the basis for that bubble was government subsidy and pressure to put more people into houses, creating an artificial demand which drove up the price of housing. Once the non-creditworthy bailed on their mortgages, the artificial demand was reversed and turned into a surplus of housing, bursting the bubble and putting credit worthy borrowers in the position of paying mortgages based on artificially inflated valuations for housing stock worth significantly less. The speculator at fault here was the government.
 

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However, the basis for that bubble was government subsidy and pressure to put more people into houses, creating an artificial demand which drove up the price of housing.

If this were really the way it went down, shouldn't you be voting Democratic out of anger?

President calls for expanding opportunities to home ownership
 

mary: There is no evidence whatsoever that derivatives contributed anything to the mortgage meltdown.

Of course there is - I gave some of it already. You can bury your head in the sand and ignore that one plus one equals two, but that just gives you a buried head, not a change in reality.

Derivatives did not create or increase the risk of this sub prime mortgage folly, but rather simply spread the risk created by the subprime mortgages to investors.

Wow - you really don't know anything about the, do you?


While derivatives are making valuation of the sub prime mortgage failures harder to gauge for accounting purposes, the meltdown would have occurred to the same extent even if derivatives did not exist.


No. It's a word your mother should have done a better job teaching you. We do actually know the value of subprime mortgage loans made and we can project from them, based on markets, types of loans, etc. current default risks. Your argument appears to be that the risks might be a lot less, bc the cds will act as insurance on the defaults and just spread that to existing investors, so the losses may actually be less. That's just not on track with reality.

I'm going to use fast working links to info that isn't behind a curtain, so they won't always be the best examples, but here's "the evidence" that the subprimes and the defaults of some portion of those subprimes could not be responsible for the current situation, but for the other elements of ez credit policies and the shadow financial system issues.

The first point I've already mentioned. Give or take, a few billion or so, the ENTIRE subprime market is about 1.5 trillion. http://findarticles.com/p/articles/mi_qa3631/is_200708/ai_n19433910
The residential mortgage market in 2006 was $10 trillion, representing one-quarter of the total debt market in the U.S. Over the past few years, the $1.5 trillion subprime mortgage market has experienced exponential growth.

So you have a total debt market (that means things like corporate bonds included) of around 40ish trillion. Of that, about 10 trillion is residential mortgages. Of those, about 1.5 trillion are subprime and about half (750 Billion) of those subprime are the really at risk adjustable rate subprime ( "Since the subprime ARM market is less than 7.5% of the overall mortgage market [of 10 trillion]")

Now take a look at what has been done over the last three weeks on the bailout front:

9/29 First bailout effort rejected, Fed pumps 630 billion into financial markets
http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a9MTZEgukPLY
10/3 We pass the bailout that has grown from 700 billion to 810 billion with Senate goodies.
10/6 & 7 Fed decides to add another 450 Billion by doubling its cash auctions to banks to 900 Billion
http://in.news.yahoo.com/241/20081007/1260/twl-fed-boosts-cash-auctions-to-900-bill.html

10/7 Money funds flee commercial paper, Fed decides to step in and start buying commercial paper, opening up 1.3 trillion in eligibility although actual purchases intended to be around 150B initially
http://sg.news.yahoo.com/ap/20081007/twl-fed-credit-crisis-1be00ca.html
10/8 Fed loans AIG another 35+billion (in addition to the 85ish billion from Sept, but we aren't going back that far)
http://www.forbes.com/markets/2008/10/12/aig-federal-reserve-markets-equity-cx_md_1010markets35.html
10/13 Europe backs banks to the tune of 2.3 trillion
http://news.yahoo.com/s/ap/20081013/ap_on_bi_ge/eu_europe_meltdown

None of this even includes the worldwide coordinated rate drops. Right now our Fed funds rate is at 1.5%. Our inflation rate, pulling out food and energy, is in the 3-4% range, our rate with energy and food added back in is at around 6.5-7.5. This means the Fed is basically giving money away - loaning at a few hundred basis points below the inflation rate

Your "posit," that all of this is not evidence that anything more than the fact that some percentage of subprime loans were going into default and would leave only some percentage of value in the foreclosure value of their collateral, fails. If you had a few hundred billion of real risk from subprime failures, that would have been addressed by actions of about a tenth - maybe even a twentieth or so - of the scale of what we have seen so far.

The problem, as people like Warren Buffet and Bill Goss etc. have pointed out for years, is not that people can't look at bond markets or mortgage markets and make a good stab at exposure, but rather that the lack of regulation of the shadow system and its huge size (a size that dwarves the subprime market on a scale of 35 or so to 1) are things that have not been able to be tracked or valued for years and cannot be valued vis a vis any institution or entity with ordinary due diligence.

http://www.time.com/time/business/article/0,8599,1723152,00.html
The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges.

Indeed, commercial banks are among the most active in this market, with the top 25 banks holding more than $13 trillion in credit default swaps — where they acted as either the insured or insurer — at the end of the third quarter of 2007, according to the Comptroller of the Currency, a federal banking regulator. JP Morgan Chase, Citibank, Bank of America and Wachovia were ranked among the top four most active, it said.

In addition to doubling up on risks, with holders on risky investments also acting as "insurers" of other risky investments (bond as well as mtg) the derivates fever hit the secondary market:
It also exploded into the secondary market, where speculative investors, hedge funds and others would buy and sell CDS instruments from the sidelines without having any direct relationship with the underlying investment. "They're betting on whether the investments will succeed or fail," said Pincus. "It's like betting on a sports event. The game is being played and you're not playing in the game, but people all over the country are betting on the outcome."
IOW, you had an unregulated, unreported series of bets by non-parties to the mortgage risk (or other debt risk) who took the "million dollars" at issue in the sporting event and made it a multiplicand for the unregulated cds market multiplier. God forbid that I should have to resort to wiki on this, but they do distill down the concept for someone like you who might, unlike you, actually be trying to understand:
http://en.wikipedia.org/wiki/Credit_default_swap
The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion
And going back to the Time article above, an equally worrisome issue to the amplification of the loss is that:
"An original CDS can go through 15 or 20 trades," said Miller. "So when a default occurs, the so-called insured party or hedged party doesn't know who's responsible for making up the default and if that end player has the resources to cure the default."
That's why there is so much counterparty concern. No one really has a good idea who is "at risk" on derivatives associated with mortgages that might fail, and to what extent. The Nov 2007 changes to the FASB rules tried to step in and make for generation of information, but what it really did was to put up so many mirrors that it became very hard not to see that the Emperor had no clothes.
Coupled with the changes in 2004 to SEC regulations
http://www.nytimes.com/2008/10/03/business/03sec.html?_r=2&ref=business&pagewanted=print&oref=slogin&oref=slogin
that let the big investment banks go hog wild on leveraging, and its ez to see why storms have been in the offing.
But please, feel free to go right ahead believing that the whole of the problem was that there were loans made to poor people, bc of an evil socialist policy.

That way, you won't have to trouble yourself to figure out why the socialist Wall Street Journal says pretty much matter of factly that:
http://online.wsj.com/article/SB122368147261224877.html
The derivative-contract problems would have driven AIG into bankruptcy;

I can hear your anquished cry - et tu, WSJ? It's very sad that they don't "understand" your point that there is just no EVIDENCE that derivatives are involved in the meltdowns.

Must be that pinko socialist Murdoch behind it all.
 

Mary:

The subject is is your claim derivatives caused the mortgage market failure. You apparently have conceded that point.

Now you claim to offer "proof" that the failure of the subprime market could not have caused the current crisis.

1) The fact the the $1.5 trillion dollar subprime mortgage market is a small fraction of the total debt market is irrelevant. It is the part of the market that failed. You do not point to failures in the other parts of the debt market.

2) The problem is not the scale of the actual default, which is likely a small fraction of the overall mortgage market, but who actually took the losses.

3) The amount of money the Fed provided the banks is also irrelevant. This money was meant to provide operating funds, not to pay off bad debt and is thus not a measure of the scope of the failure.

4) The CDS insurance market is a completely different subject has nothing to do with the bank liquidity problems arising from failed mortgages. Rather than making an argument on the subject at hand, you are simply cutting and pasting any negative article you can find.

Bottom line:

The government created the sub prime mortgage market to provide mortgage credit to the non-creditworthy.

This artificially inflated demand and the prices for housing stock.

Credit worthy borrowers entered mortgages on artificially over valued property. Often these mortgages were ARMs because it made economic sense during a period when interest rates were low and dropping.

The non-credit worthy in the sub prime mortgage market defaulted.

As foreclosed houses reentered the housing market, they depressed prices by adding to the supply of housing stock and, as a blight, became a drag on the resale of homes in the neighborhood.

Once the housing bubble burst, credit worthy borrowers found themselves in upside down mortgages where the mortgage owed was substantially larger than the now lowered market value of the home.

Interest rates rose. Those in upside down ARMs could not refinance into fixed mortgages because they lacked the equity, so they defaulted.

This chain of events would NEVER have happened without the government meddling creating a sub prime mortgage market for the non-credit worthy.

If you are looking for an unregulated predatory speculator to blame, I give you Fannie, Freddie and their sponsors in the Congress.
 

BDP:This chain of events would NEVER have happened without the government meddling creating a sub prime mortgage market for the non-credit worthy.

If you are looking for an unregulated predatory speculator to blame, I give you Fannie, Freddie and their sponsors in the Congress.


I assume you're aware that Fannie and Freddie's entrance into the subprime market is relatively recent and that the market existed long before they came along?

OO: As for what went on at the borrower's end, I've heard (without confirmation) that the majority of the subprime loans are second mortgages.

The majority of subprime loans are refis, a large amount of them being cash-out refis. A little over a third were purchases. The St. Louis Fed has a nifty paper available here that analyzes the market rather thoroughly.
 

Let's hope that little Lisa can explain this to her bro. George W started in 2001 with a surplus. First, there were his tax cuts, then the guns and butter after 9/11, resulting in exhaustion of the surplus Clinton left, followed by ever increasing deficits while we followed George W's post-9/11 DisneyWorld advice with no sacrifices. So when there arose a need to salvage Wall Street, didn't the large deficit spending that would continue especially with the Bush foreign policy put the fisc in further dangers, piling even more debt upon debt? So perhaps Georgie and Dickie, the same sex executive branch, flubbed the dub and not the traditional Fannie and Freddie. Maybe Lisa's bro should have been reminded by yesterday's Columbus Day celebration that the Nina, Pinta and Santa Maria did not sail off the edge, as Lisa's bro seems to have. He needs a bigger backpack for his lies.
 

To counter little Lisa's bro's backpack of lies, here's a link:

http://www.truthout.org/101408K

to "Private Sector Loans, Not Fannie or Freddie, Triggered Crisis" by David Goldstein and Kevin G. Hall of McClatchy Newspapers, 10/12/08. Little Lisa's bro is of Seinfeld's George Costanza's "It's not a lie if you believe it" school. He may believe the world is flat, but mere repetition does not make it so: Guilty of backpacking under the influence of right wing talk radio lies.
 

shag:

I posted before:

[T]he Government subsidized and applied considerable political and legal pressure on banks to extend subprime mortgages to the non-creditworthy.

I did not claim that the government made these loans and thus your McClatchy article noting that banks made these loans is yet another red herring.

If you believe that I am "under the influence of right wing talk radio lies," let's take a stroll down the memory lane of the Fed and the Dem media.

Here is a Fed governor favorably describing the genesis of the subprime market before it collapsed:

Remarks by Governor Edward M. Gramlich
At the Financial Services Roundtable Annual Housing Policy Meeting, Chicago, Illinois
May 21, 2004...

The growth in subprime lending represents a natural evolution of credit markets. Two decades ago subprime borrowers would typically have been denied credit. But the 1980 Depository Institutions Deregulatory and Monetary Control Act eliminated all usury controls on first-lien mortgage rates, permitting lenders to charge higher rates of interest to borrowers who pose elevated credit risk, including those with weaker or less certain credit histories. This change encouraged further development and use of credit scoring and other technologies in the mortgage arena to better gauge risk and enabled lenders to price higher-risk borrowers rather than saying no altogether. Intense financial competition in the prime market, where mortgage lending was becoming a commodity business, encouraged lenders to enter this newer market to see if they could make a profit.

This evolutionary process was pushed along by various federal actions. The Community Reinvestment Act (CRA) of 1977, and later revisions to the regulation, gave banking institutions a strong incentive to make loans to low- and moderate-income borrowers or areas, an unknown but possibly significant portion of which were subprime loans. The Federal Housing Administration, which guarantees mortgage loans of many first-time borrowers, liberalized its rules for guaranteeing mortgages, increasing competition in the market and lowering interest rates faced by some subprime mortgage borrowers. Fannie Mae and Freddie Mac, giant secondary market purchasers, sought to meet their federally mandated affordable housing goals by expanding into the prime and lower-risk segment of the subprime mortgage market. They now provide many direct mortgage lenders with other potential buyers for their subprime mortgages. Fannie and Freddie are both working on techniques to extend automated underwriting to the subprime market, an innovation that should further lower costs in this market.

Some data can illustrate these and other features of the subprime market. Table 1 shows the dramatic growth in subprime lending. Subprime mortgage loan originations rose by the whopping rate of 25 percent per year over the 1994-2003 period, nearly a ten-fold increase in just nine years. Even prime mortgage lending grew by a strong annual rate of 17 percent, reflecting many of the same trends. While the annual share of originations accounted for by subprime lending varies with credit conditions and the business cycle, this share has roughly doubled over the same period.


In 1999, the NYT reported:

In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders...

Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ''Yet there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.''...

[Raines pocketed nearly $100 million in this process]

In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980's.

''From the perspective of many people, including me, this is another thrift industry growing up around us,'' said Peter Wallison a resident fellow at the American Enterprise Institute. ''If they fail, the government will have to step up and bail them out the way it stepped up and bailed out the thrift industry.''
...

Fannie Mae, the nation's biggest underwriter of home mortgages, does not lend money directly to consumers. Instead, it purchases loans that banks make on what is called the secondary market. By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings...

In July, the Department of Housing and Urban Development proposed that by the year 2001, 50 percent of Fannie Mae's and Freddie Mac's portfolio be made up of loans to low and moderate-income borrowers. Last year, 44 percent of the loans Fannie Mae purchased were from these groups.

The change in policy also comes at the same time that HUD is investigating allegations of racial discrimination in the automated underwriting systems used by Fannie Mae and Freddie Mac to determine the credit-worthiness of credit applicants.


For more about the extensive role of Andrew Cuomo's HUD in compelling banks to extend hundreds of billions of dollars in mortgages to the non-creditworthy, read this investigative piece from that well known member of the Great Right Wing Conspiracy, the Village Voice.

Also in 1999, Ron Brownstein of the LA Times gushed:

It’s one of the hidden success stories of the Clinton era. In the great housing boom of the 1990s, black and Latino homeownership has surged to the highest level ever recorded. The number of African Americans owning their own home is now increasing nearly three times as fast as the number of whites; the number of Latino homeowners is growing nearly five times as fast as that of whites...

All of this suggests that Clinton’s efforts to increase minority access to loans and capital also have spurred this decade’s gains. Under Clinton, bank regulators have breathed the first real life into enforcement of the Community Reinvestment Act, a 20-year-old statute meant to combat “redlining” by requiring banks to serve their low-income communities. The administration also has sent a clear message by stiffening enforcement of the fair housing and fair lending laws. The bottom line: Between 1993 and 1997, home loans grew by 72% to blacks and by 45% to Latinos, far faster than the total growth rate.

Lenders also have opened the door wider to minorities because of new initiatives at Fannie Mae and Freddie Mac–the giant federally chartered corporations that play critical, if obscure, roles in the home finance system. Fannie Mae and Freddie Mac buy mortgages from lenders and bundle them into securities; that provides lenders the funds to lend more.

In 1992, Congress mandated that Fannie and Freddie increase their purchases of mortgages for low-income and medium-income borrowers. Operating under that requirement, Fannie Mae, in particular, has been aggressive and creative in stimulating minority gains. It has aimed extensive advertising campaigns at minorities that explain how to buy a home and opened three dozen local offices to encourage lenders to serve these markets. Most importantly, Fannie Mae has agreed to buy more loans with very low down payments–or with mortgage payments that represent an unusually high percentage of a buyer’s income. That’s made banks willing to lend to lower-income families they once might have rejected...

The top priority may be to ask more of Fannie Mae and Freddie Mac. The two companies are now required to devote 42% of their portfolios to loans for low- and moderate-income borrowers; HUD, which has the authority to set the targets, is poised to propose an increase this summer. Although Fannie Mae actually has exceeded its target since 1994, it is resisting any hike. It argues that a higher target would only produce more loan defaults by pressuring banks to accept unsafe borrowers. HUD says Fannie Mae is resisting more low-income loans because they are less profitable.

Barry Zigas, who heads Fannie Mae’s low-income efforts, is undoubtedly correct when he argues, “There is obviously a limit beyond which [we] can’t push [the banks] to produce.” But with the housing market still sizzling, minority unemployment down and Fannie Mae enjoying record profits (over $3.4 billion last year), it doesn’t appear that the limit has been reached.

 

Tom, thanks for the real world description of how this happened. I don't think the tool we need to understand this is number crunching, it's incentive analysis, and that's what you've given us. Thanks.
 

No comment.
 

Little Lisa's bro will soon be a hunchback as he expands his backpack of lies. Today's NYTimes has an Editorial on the subject of blame at:

http://www.nytimes.com/2008/10/15/opinion/15wed2.html?_r=1&ref=opinion&oref=slogin

that little Lisa's bro can ignore as he listens to Rush on his crystal set.
 

Mortgage fraud. Negative equity. Exotic loans. As the former assistant attorney general for the state of Minnesota and current attorney for the Housing Preservation Project, Mark Ireland has seen his fair share of cases leave homeowners defrauded or left holding mortgages they can't pay.
-----------------------
Sally
Internet marketing
 

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