Origins of the Crisis

Reporters Bethany McLean and Joe Nocera have written a book about the recent financial crisis called All the Devils Are Here. A very knowledgeable reader writes:

Bethany McLean and Joe Nocera usually don’t have ideological axes to grind and, though journalists, usually have a solid if not expert grasp on the finance world when they cover it….they are just more or less balanced purveyors of the conventional wisdom with more facts and conceptual understanding than the typical political journalist.

In the world of journalism, that counts as high praise. Our reader also says, however, that Eric Falkenstein’s critique at Falkenblog is correct:

The bottom line: this train wreck was inevitable. … An interesting note is that some players did notice things were amiss in real time. In 2005, Greg Lipmann noted vastly higher default rates when home prices [rose] ‘only slightly’ as opposed to in ‘double digits’, highlighting that unsustainable price appreciations were necessary to prevent a collapse in these mortgages. Andy Redlief noted that in one presentation 85% of the mortgages were to take money out of a house (‘cash-outs’), as opposed to buying a house. When he asked the company executive if these had different loss rates, the exec said he did not know, but presumed they were the same. This presumption, Redlief knew, was not innocuous, and supposing it so implied a massive amount of wishful thinking.
These are the kind of signals that are interesting, because they highlight how one could have seen this all coming in real-time. Redlief notes that it was not a handful of people who saw this coming–the theme of Michael Lewis, a great writer who is more often than not completely wrong on his main them–rather, there were about 50 hedge funds he knew of trying to short this stuff in 2006. Now, I was not close to these asset classes, so when things fell apart in 2007, I had no idea that teaser-rate ARMs had grown from 31% to 70% over the prior 8 years, or that no-documentation loans were up from nothing to 30% by 2006. Those kind of statistics were not highlighted in real time.
Worse, loan originators appear to have been on a mission that could have only ended with massive failure. For example, one firm had to come up with a policy when silly loan applicants supplied information that was unnecessary under their ‘no doc’ lending program. The extra information actually made it harder to qualify, so they found a sneaky way to erase such information (eg, documentation of insufficient income). By 2006, loan standards were basically nonexistent and such a scenario was not going to end well. …
So the real question is why everyone thought the market would always go up under this madness. …
Borrowers are treated as victims, gouged by lenders, who then get expropriated somehow, as if the homes bought with fraudulent statements, teaser interest rates, and no money down, was something they truly owned. The authors note ‘these mortgages weren’t bought, they were sold’. No, they were bought too. This only worked because borrowers were getting cheap if not free options on home prices, and these options paid off handsomely in the decade prior to 2008. They enjoyed cashing money out of homes throughout the housing bubble, and those stories facilitated more willing victims who were just as greedy and short-sighted as investors. The under capitalized home owner lost less capital than anyone in this fiasco, so I don’t see them as the ‘losers’ in this game.
In the end, all the top-level concern to increase home ownership failed. The ephemeral increase in homeownership was to people who never had the wherewithal or commitment to own homes, rather, the boom merely gave all sorts of people money they basically wasted. This highlights the folly of trying to fine-tune aggregate economic statistics, as homeownership is something you can have ‘too much’ of, as inconceivable as that might sound to some back in 2005. [Today we can’t have enough education.]

During the Bush administration, I received regular emails highlighting good economic news for which the administration, reasonably enough, wanted to take credit. I noticed that while other statistics bounced up and down amid the generally positive trends of the 2000s, one staple of these emails was the steadily increasing rate of home ownership, which seemed to reach a new high every month. It didn’t occur to the administration officials who compiled the emails that this rise in home ownership could be anything but a positive development. It didn’t occur to me, either. It turns out that we were not alone in our myopia.
SCOTT adds: My old friend Andy’s last name is spelled Redleaf, not Redlief. At least McLean and Nocera get the spelling right.


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