12 Facts About the Mortgage Market

By May 1, 2013, 2:51 PM Author's Blog  

Paul Willen recently presented a paper on the housing crisis here at Bentley University.  It might be the best paper I’ve read on the subject.  Since it’s not my area, I don’t know if their ideas have already been discussed on the internet, but if not I strongly recommend people take a look.  The paper is too long and exhaustively documented to present in a short blog post, but their “12 facts about the mortgage market” provide a hint:

Fact 1:  Resets of adjustable rate mortgages did not cause the foreclosure crisis.

Fact 2:  No mortgage was “designed to fail.”

Fact 3:  There was little innovation in mortgage markets in the 2000s.

Fact 4:  Government policy toward the mortgage market did not change much from 1990 to 2005.

Fact 5:  The originate-to-distribute model was not new.

Fact 6:  MBSs, CDOs, and other “complex financial products” had been widely used for decades.

Fact 7:  Mortgage investors had lots of information.

Fact 8:  Investors understood the risks.

Fact 9:  Investors were optimistic about home prices.

Fact 10:  Mortgage market insiders were the biggest losers.

Fact 11:  Mortgage market outsiders were the biggest winners.

Fact 12:  Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in collateralized debt obligations (CDOs) did.

Each assertion is fully documented.  There is lots of fascinating information:

A focus on mortgage companies alone understates the role of the OTD model, however. Starting in the 1970s, the OTD model was adopted by other financial institutions, most importantly savings and loans (S&Ls), which financed the majority of U.S. residential lending in the postwar period. S&L’s had historically followed an originate-and-hold model. By the late 1970s, however, rising interest rates had generated a catastrophic mismatch between the low interest rates that S&Ls received on their existing mortgages and their current costs of funds. This mismatch, which would eventually render more than half of S&Ls insolvent, encouraged thrifts either to turn to adjustable-rate mortgages or to sell the mortgages they originated to the secondary market.

Wait, I thought Paul Krugman told us that the pre-1980 period was the golden age of “regulation.”  And then there’s this:

Consider the Dodd-Frank requirement that loan originators retain 5 percent of the credit risk of certain mortgages. During the housing boom, would this requirement have stopped lenders from making bad loans? In 2006 and 2007, lenders originated $791 billion subprime loans. Had Dodd-Frank existed, lenders would have retained 5 percent of that amount or $40 billion of subprime credit. Overall loss rates of 35 percent would have saddled them with $14 billion in losses.54 Inspection of Table 4 shows that mortgage-related losses exceeded that amount for no fewer than eight firms individually. In other words, if every one of those firms had followed the Dodd-Frank requirement and originated the entire subprime mortgage market, they would have suffered smaller losses than they actually did.

I knew Dodd-Frank missed the boat, but it was even worse than I assumed.  And the reason why is simple.  The cheerleaders for the “deregulation” explanation of the crisis, such as the NYT, don’t actually want effective regulation, because that would make it harder for low-income people to buy homes.  Here’s the NYT:

It seemed an easy fix to prevent the excesses of the housing market: make home buyers put more money down.

But as the housing market starts to return and the subprime mess fades from memory, the issue is up for debate.

Lenders and consumer advocates — rarely on the same side of the issue — are now cautioning against down payment requirements. They argue that such restrictions could limit lending, and prevent lower-income borrowers from buying homes. They also contend that the new mortgage rules put in place this year will do enough to limit foreclosures, making down payment requirements somewhat superfluous.

The arguments seem to run contrary to long-standing beliefs about homeownership. For decades, experts have emphasized the need for a sizable down payment — a rule of thumb being 20 percent — on the premise that borrowers with a sizable chunk of equity in a home are less likely to walk away when things get bad.

“If our goal is to prevent foreclosures, I can’t think of anything more effective than requiring a down payment,” said Paul S. Willen, a senior economist and policy adviser at the Federal Reserve Bank of Boston.

The issue may not be so black and white. Regulators want to protect borrowers and promote homeownership. But they also want to encourage lending and insulate the financial system from future shocks.

Why am I not surprised?  The NYT wants ineffective regulation, like having to rapidly sign 50 meaningless “disclosure” forms when you refinance, instead of the current 25 meaningless disclosure forms.

My only suggestion to Foote, Gerardi, and Willen would be to focus on the Fed’s catastrophic policy failure, which allowed NGDP to plunge 9% below trend in 2008-09, as a key unforeseen factor that contributed to the severity of the housing debacle.  But that’s easy for me to say, they work at the Fed!

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