I haven’t seen The Big Short, which opens tomorrow, but I’ve read (and own a copy of) the book and cite it in American Nightmare. Based on the trailer, the movie appears to focus on the notion that the financial crisis was caused by greed and lack of bank regulation, an idea endorsed by Paul Krugman.
As both Krugman and New York Times writer Neil Irwin point out, the movie’s notion that only a few people were able to figure out there was a housing bubble is wrong; many people realized there was a bubble (or bubbles). What the heroes or antiheroes in Michael Lewis’ The Big Short figured out was a way to profit from the bursting of the bubble. While it is possible to “short” stocks, i.e., bet that their price will go down, it normally isn’t possible to short bonds, such as the packages of mortgage bonds that banks were selling.
However, the bond dealers were hedging their bets by buying insurance policies (known as credit default swaps) on their mortgage bonds. A few investors realized they could buy such insurance without actually owning the bonds, thus profiting if the value of the bonds fell. The drawback, as I point out in American Nightmare, was that they would have to pay regular premiums on the insurance–something that isn’t necessary when someone shorts a company’s stock. Those few investors who were willing to pay the premiums until the financial crisis made billions of dollars.
What Krugman and the movie’s makers fail to understand is that greed wasn’t the cause of the crisis at all. Everyone is greedy, in one sense or another, and almost every transaction we make results from such greed. The mortgage bonds didn’t fail because the mortgage loans were bad, because they were made to subprime borrowers, or because the banks were being deceptive. Nor was it lack of regulation; indeed, none of the regulators foresaw the crisis any more than the banks, and to some degree, it was regulation itself that caused the crisis.
Instead, the real issue was house price volatility. Before cities began using urban-growth boundaries and other containment policies, home prices were not very volatile. Thus, a bank could lend to a subprime borrower with confidence because, if the borrower defaulted, the bank could repossess the house and sell it to someone else. Even if they lost money on the resale, in most states (California being a notable exception), they could go after the borrower to make up the difference.
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What few people understood was that urban containment policies had made housing prices far more volatile than they had been in the past. Those policies were first implemented in a few states in the 1960s and 1970s, and house prices in those states began experiencing booms and busts. But it was not until the 1990s that nearly half of all American housing was subject to such regulation and such volatility.
Moreover, contrary to popular belief, the financial crisis didn’t happen because people were defaulting on their loans. Most defaults took place only after the crisis as people lost their jobs. Instead, the crisis was the result of the rating system used to evaluate bonds. The rating companies, believing that house prices were not volatile, initially rated the bonds highly. When they realized that prices were more volatile than they thought, they reduced those ratings.
These ratings reductions led to the crisis. When a bank lends depositors’ money to someone else, it must keep a cash reserve in case depositors wants to withdraw some of their money. This applies to bonds as well. However, the reserve for a bond rated AAA is very low; the reserve for bonds rated AA, A, or B are successively higher.
So when the ratings companies downgraded a bond from AAA to AA or A, the banks who held those bonds were required to increase their reserves to cover the reduced ratings. Bear Sterns and Lehman Brothers were among those that didn’t have the cash to do so, and so–like Mortimer and Randolph not being able to come up with cash to cover their orange juice bets in Trading Places–they went broke. More and bigger banks, particularly Citibank, were about to go broke when the feds stepped in to stop the crisis by loaning hundreds of billions of dollars to those banks.
Yes, there were subprime loans, but they had nothing to do with the increased volatility. That was entirely due to urban-containment policies. Yes, there were defaults, but they didn’t cause the crisis. That was entirely due to banks not being able to meet the increased reserve requirements when bond ratings declined.
So you can blame the financial crisis on land-use regulation. Or you can blame it on the bond ratings companies’ misjudgment of housing price volatility. Or you can blame it on federal regulations imposing reserve requirements on banks. But you can’t blame it on greed, on subprime loans, the repeal of Glass-Steagall, or Federal Reserve Bank interest rates, as those things applied in all 50 states yet bubbles took place in less than half of those states.
“But you can’t blame it on greed, on subprime loans”
I agree with the Antiplanner that land use regulation was a cause of price volatility. However the fact that home buyers were being allowed or encouraged to lie about income in order to get subprime loans must have contributed to the volatility. Brokers issuing these loans and passing them off as being issued to credit worthy buyers should have been prosecuted and jailed for fraud. The practice seems to have been so widespread that anyone selling on these mortgages either knew or should have known what they were doing. The price bubble and the default rate on loans would not have been as devastating had loan brokers not been committing fraud. The sad fact is that without jail time for fraud brokers were rewarded for deceptive business practices. They have learned that they can commit serious fraud with no penalty, a bad omen for the future.
“But you can’t blame it on … Federal Reserve Bank interest rates”
Yes. Yes you can.
https://mises.org/library/federal-reserve-policies-cause-booms-and-busts
This is great. Tomorrow the Antiplanner is going to tell us why land use restrictions caused the September 11 attacks, too.
But seriously, land use restrictions don’t cause price volatility. Volatility happens because people like the Antiplanner convince other people that housing prices will go up forever because of those darn land use restrictions. Never mind that housing prices historically don’t rise that much, things are different now, we were told, because of evil government limiting the supply.
When prices started falling it wasn’t because government suddenly repealed all its land use restrictions. Rather, enough people started realizing that maybe prices wouldn’t go up forever, and that maybe all those houses out in the Nevada desert really weren’t worth a million dollars anymore.
Rather, enough people started realizing that maybe prices wouldn’t go up forever
And business people and investors realized that they had made poor choices based on the availability of cheap money. It was cheap to borrow all that money to build those Nevada houses. It was cheap to borrow all that money to buy those Nevada houses.
>Ohai
>December 23, 2015 at 12:05 pm
>This is great. Tomorrow the Antiplanner is going to tell us why land use restrictions caused the September 11 attacks, too.
9/11 happened because of federal subsidies for transit and a lack of land use restrictions that allowed too much density.
http://ti.org/antiplanner/?p=1676
>If there were no federal subsidies to New York City transit, it is possible that the subways would decline and not be entirely replaced by buses. If so, downtown Manhattan might lose some of its allure as a job center. Would that be so horrible? A lower-density Manhattan might have had less attraction as a terrorist target.
It was Paulie:
…who encouraged and approved of the Fed inflating housing prices to a bubble. Any protestations to the contrary are simply diarrhea of the mouth.
New York Times Opinion
For once, I’m not buying this. The areas which had the worst performing real estate were those which do not have significant land use restrictions. The crisis was clearly a result of poor loan portfolios and, yes, sub-prime and alt-A loans. That the crisis hit before the major defaults is because the market eventually figured out that the defaults were coming, and panicked.
The government was certainly largely at fault, but not through land use rules. One major cause was government requirements to loan to buyers who were poor credit risks. These rules were a direct result of poorly thought out anti-racism laws (CRA, etc), and they changed the entire nature of the residential mortgage markets. Prior to the mess, mortgage institutions generally serviced the loans that they issued – they had “skin in the game” when it came to assessing default risk. CRA and the behavior of Frannies changed the market to one of securitization, where loan originators sold off the loans.
The whole thing was quite complex, but the most glaring caused was the change in financing of real estate, not the regulation of land use.
Since 2008 Mr. O’Toole has made this post with a few alterations numerous times. “The housing downturn was caused by land use regulation, not this or that.” The replies generally come in as something like “No, it was this one thing that did it, not all those other things.” My reply is always that perhaps it was all of those things; unethical behavior of traders and lenders, unethical behavior of borrowers, poor regulations of the financial sector, poor Fed policy, and yes, land use regulation (to name a few). Anyone who points to one aspect and says “This is THE reason,” is trying to sell you something. In Mr. O’Toole’s case, he’s selling his flawed antiplanner ideology.
What strikes me bout housing is that while it’s something everyone consumes, at any one time there’s very little of it being bought and sold. Small changes in availability of financing or restrictions in supply have an exponential effect.
“Yes, there were defaults, but they didn’t cause the crisis. That was entirely due to banks not being able to meet the increased reserve requirements when bond ratings declined.
” ~Antiplanner
Either I’m completely missing something obvious or Mr. O’Toole is. If a loan is in default because a borrower can’t or will not make X number of payments in a row ( 3? 6? ), banks loaning or not loaning money can not be the cause of a default. The cause of a default is a borrower who can’t make the payments or who will not ( underwater; can’t find a renter for the home they’re renting out; etc ).
”
. The rating companies, believing that house prices were not volatile, initially rated the bonds highly. When they realized that prices were more volatile than they thought, they reduced those ratings.”
~Antiplanner
While price changes in housing contribute to default rates, at the end of the day the ratings agencies address default rates, not volatility. Subprime fell apart in 2006. The bubble had burst long before the ratings agencies started lowering ratings on MBS’ in the summer of 2007.
While I don’t doubt the contribution in terms of supply restrictions, a lot of work needs to be done to show that the urban growth boundaries are the driving force. For example, while nodoc, alt-a and other loosey goosey mortgages have been around for decades, they were barely used until the 1990s. How does one separate the take off in the use of these urban growth boundaries and related restrictions from the takeoff in use of these loose mortgages? I’d like to be proven wrong but I haven’t seen anything by anyone to date that leads me to believe it can be done.