Contributing Factors, Part One

Today and tomorrow, as a part of the Antiplanner’s continuing series about the 2008 economic meltdown, I am going to look at many of the supposed causes of the crisis and show that, while some of them may have made the crisis worse, none of them were the ultimate cause of the crisis. In some cases, I’ll quote a 2009 paper written by two of my colleagues at Cato. In doing so, I have to confess that, while we agree about what didn’t cause the crisis, I haven’t been able to convince all of my Cato colleagues, including at least one of the authors of this paper, about what did cause it.

I’ll also quote from William Cohan’s House of Cards, a book that is mainly about Bear Stearns. In fact, only the first third of the book is about the 2008 crisis; the rest is on the history of that company in the 75 years before that crisis. Unlike some financial writers, Cohan actually worked on Wall Street for 17 years, including a decade as a managing director at JPMorgan Chase. Perhaps this is why Cohan can supply of lot of insights and details missing from some of the other books I’ve read on the crisis.

Financial and political writers have blamed the economic crisis on deregulation, the Federal Reserve, the subprime mortgage frenzy, greedy bankers, and derivatives, among other things. These explanations can seem satisfying because they conveniently pin the blame on someone that we can regulate, outlaw, or otherwise control thereby preventing such crises in the future. Close scrutiny, however, reveals that few of them could have caused the crisis and many did not even contribute to it.

Deregulation: The popular narrative, spread by liberal economists such as Joseph Stiglitz and Paul Krugman, is that the evil Bush administration deregulated the banking industry, setting the stage for the economic collapse. The two problems with this narrative is that most of the deregulation took place during the Clinton administration and that deregulation actually had little effect on the crisis.

The most commonly mentioned deregulation was the 1999 repeal of the Glass-Steagall Act, which separated deposit banks from investment banks. This supposedly resulted in deposit banks (which are protected by the Federal Deposit Insurance Corporation) spending their depositors money on highly leveraged and risky investments that required taxpayer bailouts to protect the deposits.

In fact, all the repeal did was legalize what was happening anyway. To get around the law, banks created off-shore corporations known as special-purpose entities that freely invested in securities at virtually unlimited leverage rates. These entities became part of what was known as the shadow banking system. At most, the repeal of Glass-Steagall legalized practices that were already taking place.

More significant was passage in 2000 of the Commodity Futures Modernization Act. This was promoted by Treasury Secretary Robert Rubin and other Clinton administration officials as a way of reducing the power of the Commodities Futures Trading Commission (CFTC), which wanted to regulate credit default swaps.

While I don’t think CFTC’s 1998 proposal to regulate swaps would have had much of an effect on the crisis, the 2000 law also repealed an SEC rule requiring that someone using a credit default swap to insure a bond actually own the bond being insured. This opened the door for “synthetic” bonds, which didn’t actually represent any mortgages or other assets but merely mirrored the performance of those assets. By 2006, some estimated that half of all mortgage bonds were synthetic, which undoubtedly made the financial crisis worse when the underlying mortgages declined in value. But synthetic bonds or swaps did not cause the crisis itself.

My Cato colleagues conclude “that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.” Even after deregulation, they observed, banks still had to meet previous reserve requirements, and the problems took place only because those reserve requirements were too low because, in turn, most people underestimated the riskiness of mortgage investments.

The Federal Reserve Bank: “The Fed greatly abetted speculation in mortgages by keeping interest rates too low,” says Roger Lowenstein in The End of Wall Street. After the collapse of the dot-com bubble in 2001, the Fed lowered short-term interest rates, eventually reaching a low of 1 percent in June, 2003. It began raising them in mid-2004, but by June 2005 rates were still a low 3 percent (Lowenstein, p. 19).
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One problem with this explanation is that home prices actually began rising in the late 1990s. Further, there is little relationship between the Fed’s short-term interest rate and mortgage rates, which are long-term rates.

Greenspan always argued that central bankers can’t detect bubbles and shouldn’t try. Their goals should be to keep inflation low and deal with the effects of bubbles only after they have burst. My Cato colleagues agree, saying, “We are skeptical that economists can detect bubbles in real time through technical means with any degree of unanimity. Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy.”

The subprime frenzy: Left-wing writers blame the subprime mortgage boom on unscrupulous lenders taking advantage of poor, ignorant homebuyers. Right-wing writers blame it on liberal members of Congress who pressured banks to relax mortgage standards to lend to low-income people with poor credit ratings.

Both sorts of writers often tell a real or hypothetical story of some immigrant farmworker family making $14,000 a year conned into getting a zero-down-payment, adjustable-rate loan to buy a $750,000 home whose payments they won’t be able to afford once the initial teaser interest rate is adjusted upwards to a usurious 9 or 10 percent. The story often ends with the writer piously suggesting that “maybe not everyone should own their own home.”

The subprime mortgage business did boom in the decade before the collapse, and no doubt a few homebuyers were deceived by lenders. But subprimes were not the primary cause of the collapse, and defaults by low-interest homebuyers in particular did lead to the crisis. Instead, it appears that a greater problem was savvy investors using the relaxed lending standards to speculate on the housing bubble.

If defaults were a result of people not being able to afford their homes, then defaults would have started soon after the subprime industry began to grow in 1998. Interest rates on mortgages with teaser rates typically adjusted after about two years, so defaults should have started growing around 2000. Instead, default rates did not significantly rise until 2005, when the housing bubble had already peaked and prices in California and other bubble states were declining.

My Cato colleagues noted, “Housing data indicate that the majority of subprime hybrid [i.e., teaser-rate] loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans.” Similarly, JPMorgan analysts found that people who were defaulting on their mortgages were otherwise current on their credit-card debt and auto loans. As Lowenstein concludes, “people were voluntarily defaulting” because their homes were underwater, not because they couldn’t afford them (p. 79). This is supported by other analyses finding that most defaults were relatively wealthy people whose homes were underwater, not poor people who couldn’t afford their mortgages.

Curiously, one of the first mortgage companies to go bankrupt was a New Mexico company that specialized in “jumbo” loans to wealthy buyers. The default rate on Thornburg Mortgage’s loans was less than one-half percent, but as housing prices began declining, investors became reluctant to make the short-term loans Thornburg relied on to fund its day-to-day operations, and it went out of business in February, 2007 (House of Cards, pp. 4-5).

One more piece of data indicating that low-income buyers were not the problem is homeownership rates. In 1998, when the subprime market was just getting going, 66 percent of American households lived in their own homes. In 2004, at the peak of the boom, this had grown to 69 percent. Today, it has fallen again to 66 percent. This suggests that just 3 percent of homes–about 3 million–were low-income families who bought houses they couldn’t afford. Yet, during that time period, homebuilders built 11 million new homes and more than 39 million existing homes were sold. Those low-income buyers represent just 6 percent of the homes sold.

Relaxed lending standards contributed to the boom primarily by enabling speculators, not by encouraging people to buy homes they couldn’t afford. But while speculators may make a bubble worse, they don’t cause it in the first place.

To be continued tomorrow.