Unraveling the mortgage mess

Source: Barron's

As the latest attempt to explain the subprime crisis, this bestseller is useful as a factual compendium, but little more. It illustrates a common pitfall in many journalists' accounts of financial crises. Anecdotes about important players belong in crisis history. But readers seeking to understand such crises want to know why events happened together, in a particular sequence and with particular consequences.

It is the rare journalist who can organize a book to develop a coherent logic of causation and lace it with enough factual detail to make the interpretation compelling. Models of the genre include Wilfred King's History of the London Discount Market (1936) and Walter Bagehot's Lombard Street (1873). Alas, Bethany McLean of Vanity Fair and Joe Nocera of the New York Times fall far short of those models.

The thesis of the present book is that the recent crisis "was about human nature." Beginning with the premise that crises are inevitable consequences of human nature, McLean and Nocera list "all of the devils." Rather than explain, they simply illustrate human folly, greed and hubris, assuming that no more need be said. But as a statement about the history of crises of the sort we have just lived through, that view is demonstrably wrong.

Human nature is a constant, banking crises are not. Asset price booms and busts have been present in virtually all countries and all eras. But banking crises like the one we have just lived through do not grow on every country's, or every epoch's, tree. In particular, banking crises are much more common and severe than they used to be. A book seeking to understand the recent crisis must seek its answers in the institutional changes peculiar to recent decades. Obvious candidates identified by academic studies include politicized government control of housing finance and the expansion of government safety nets for banks, which altered the incentives of market participants in taking risk.

Even when they attempt analysis, the authors stumble. For example, they have a jaundiced view of financial innovation. They argue that securitization of mortgages led originators of the mortgage-backed securities to relax underwriting standards because they were selling to others the risks created by the mortgages. But underwriting standards in securitized credit-card pools have not suffered from such problems. Why was subprime MBS so different? Moreover, MBS-originating banks like Citigroup were retaining, not just selling, large stakes in their subprime securitizations—which is why they lost so much money from the instruments.

McLean and Nocera wrongly see Fannie Mae and Freddie Mac as victims of Wall Street innovation, rather than as blameworthy perpetrators of the crisis. But even the search for blame among market participants misses the point.

As the authors themselves are aware, the government established mortgage-lending mandates for Fannie, Freddie and others to increase each lender's share of mortgages for low-income borrowers. The number of creditworthy low-income borrowers was limited, and so mandates to dramatically increase everyone's supply of credit to that group of borrowers inevitably required the market to relax credit standards. In the late 1990s and 2000s, responses to the driving force of government mandates and subsidies for subprime lending included growing leverage, new protocols to forgive defaults to avoid foreclosure, innovative subprime MBS structures and the willingness to engage in "no docs" lending.

The authors deride the inflated ratings of rating agencies during the boom but fail to identify their source: the reliance by government regulators on ratings from the government-favored agencies. McLean and Nocera are so bent on arguing that human nature and financial innovation were at the heart of the crisis that they make some factual errors to buttress their case, mistakenly lumping together very different mortgage products. In referring to my work, they incorrectly define high-loan-to-value mortgages of the 1990s as subprime, and misinterpret my study as cheerleading the expansion of risky subprime mortgage finance. The high-loan-to-value lending was not subprime—as my study took pains to make clear—and was not related to government mandates or subsidies.

In the epilogue to All the Devils Are Here, McLean and Nocera offer little hope for improvement, writing that "no one can figure out what to do" to reform government mismanagement of the U.S. mortgage market. The authors' pessimism reflects their view that destabilizing innovation and "human nature" caused the subprime crisis. Happily, that is nonsense.

There are ways to fix our financial system and make it less crisis-prone. Now that the government has shown its willingness to absorb all mortgage losses, steps in the right direction include phasing in higher down-payment requirements, while at the same time winding down government subsidization of mortgage risk.

URL to original article: http://www.housingwire.com/2011/01/02/unraveling-the-mortgage-mess