GFC 2008: cock-up not conspiracy

A new study by the US National Bureau of Economic Research has found that the reason for the high default in mortgages prior to the 2008 financial crisis was not, after all because of loans to sub-prime lenders.

It builds on the conclusions of the Massachusetts Institute of Technology who have long maintained that sub-prime lenders were not to blame when they established that the the higher the mortgage the more likely the default.

The New York Fed have also reported that prior to the crisis, purchasers were investing in property with a view to holding it for a year or two and then selling it on at a profit. If that meant they were rather over extended they didn’t mind paying a higher interest rate because their intention was to hold the property only for a short time. These loans were subprime only in the sense that people had one or two of them (or more) and for a house in which they were not living. The NY Fed chart below shows significant increases in the number of mutiple mortgages prior to the crisis.

And people who do not live in the property have less compunction about defaulting the loan. So, unsurprisingly the National Bureau of Economic Research (NBER) finds  “the rise in mortgage delinquencies was virtually exclusively accounted for by real estate investors.”

So property speculation was the reason for the defaults, and by people who considered themselves sufficiently secure to indulge in it in the first place. And they were those the banks considered to have a sufficiently good credit rating to take on the loan to offer the banks a reasonable rate of return.The NBER finds that the share of single-mortgage borrowers who couldn’t keep up their loan repayments barely altered between 2005 and 2008, indeed mortgage defaults in those with the lowest (quartile) incomes actually improved in the years running up to 2008!

The problem was that old one – that both households and banks believed in everlasting house price increases.

So when a contributor to The FT (Alphaville) claims that the inflow of European money to finance newly securitised mortgage products allowed even more lending to the those people speculating in property, particularly when European Banks seem to have little idea what they were buying, the conclusion is correct. Clearly without this ability to sell on the loans, further loans would not have been possible and so the market may well have calmed and ‘corrected’. But when the FT article claims that “fraud [was] committed in the mortgage loan process” that, on the basis of National Bureau of Economic Research and New York Fed evidence, seems an unwise claim

In fact the whole episode begins to look much less like conspiracy and much, much more like cock-up.

The banks would prefer conspiracy because it suggests they were cleverly deceived.

In fact it rather looks as though it was a classic ‘Minsky moment’ where a simple improving market leads to confidence and then over confidence.

And all the banks were as serenely over confident as everyone else.

 

 

 

 

Comments

  1. Marco Fante -

    Peter,

    I might beg to differ with you a little on this one:

    ‘But when the FT article claims that “fraud [was] committed in the mortgage loan process” that, on the basis of National Bureau of Economic Research and New York Fed evidence, seems an unwise claim”‘

    NBER and NY Fed, maybe, SEC – no.

    Take, for example, the case of leading US Mortgage lender, Countrywide:
    “The Securities and Exchange Commission today charged former
    Countrywide Financial CEO Angelo Mozilo and two other former executives with securities fraud for deliberately misleading investors about the significant credit risks being taken in efforts to build and maintain the company’s market share. Mozilo was additionally charged with insider trading for selling his Countrywide stock based on non-public information for nearly $140 million in profits.”

    https://www.sec.gov/news/press/2009/2009-129.htm
    https://www.theguardian.com/business/2009/jun/04/countrywide-angelo-mozilo-fraud-sec
    http://www.nytimes.com/2009/06/05/business/05insider.html?pagewanted=all
    http://www.nytimes.com/2009/06/05/business/05insider.html?pagewanted=all

    That said, I do nonetheless agree with the overall message of your article. Researching this topic years ago I found an article from Australia’s central bank revealing that US “sub-prime” loans accounted for less than 13 per cent of mortgage debt outstanding at that time.
    http://www.rba.gov.au/speeches/2008/sp-ag-160508.html

    On reflection, I thought it difficult to see how the finances of a mere 13 per cent of American mortgage holders could be responsible for the greatest financial crisis since The Great Depression. The sub-prime debacle may have triggered the crisis but did not cause it. The cause, as you suggest, was a market-wide bubble driven by property speculation on the part of middle-class landlords.

    The sub-prime narrative, as most of us know it, is one of dirty, bad-apple banksters and poor people who should never have borrowed. That story has always been a concoction designed to cover the fact that just about everyone involved was culpable to some degree. Nice, clean, respectable, white folks included.

    1. Sean Danaher -

      Marco
      Indeed. I haven’t researched in detail but would recommend the “Big Short” http://www.imdb.com/title/tt1596363/ – which is scary. The term “banksters” is a good description; nearly everyone seems unprincipled and wanting to make a fast buck.

      Apart from in Iceland it seems the “banksters” have gotten away lightly. In my home country Ireland the GFC was pretty devastating with the country bailing out the bankers and the best part of a lost decade. Speaking to an Irish builder friend of mine he agreed that many people stretched themselves too much but said “who is to blame the heroine addict of the pusher supplying the heroine?”

      In the UK which was much less badly hit the GFC was used an excuse to implement the “austerity” agenda. Its telling that whereas Ireland which was so much more badly hit by the GFC has now recovered well, whereas the UK economy is in a zombie state.

    2. Peter May -

      Fair enough! The FT article’s general tone is that fraud was widespread – I suppose it could have been, though the research I found doesn’t seem to suggest that. But even if it was the important bit is that fraud really was not the reason for the crash. Property speculation was.

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