Why Did the Mortgage Crisis Happen, Part 5
Submitted by Businomics Blog
In Part 1, I asked why the mortgage mess happened, and why did it happen when it did.
Part 2 explains the role of the Great Moderation and the mild housing cycle in the 2001 recession.
Part 3 explains the role played by securitization of mortgages.
Part 4 explains how the 2001 recession set up the trigger for the current crisis.
In this final segment, I look at the future and provide some suggestions for policy.
I think that the Great Moderation will continue, for reasons explained in the Mark Thoma interview on the Businomics Audio Magazine. However, it was not the Great Moderation alone that caused a sense of invulnerability regarding housing; it was also the strength of housing in the 2001 recession. All players in real estate and mortgages have lost the notion that housing is always stable. We’ve been slapped across the face by reality. It will be quite a long time before anyone in this country thinks that housing is a no-risk proposition.
Securitization is here to stay. It makes a lot of sense, especially compared to using the Savings and Loan industry model for funding mortgages. But investors in the mortgage market have learned a bit. First, they’ve learned that housing prices don’t always go up. Second, they’ve learned that the senior tranches can take losses. Third, they’ve learned that the ratings agencies aren’t very good at evaluating risk of complex instruments. Fourth, they’ve learned that combining a bunch of CMOs into a CMO-squared does not remove systemic risk. It may help reduce the risk associated with investing in mortgages originated in one location, but it does not eliminate the risk that the entire country’s real estate market goes south.
What about the trigger? That will happen again. At some point in the future, mortgage interest rates will fall at a time when home prices have been firm. However, we will not have a mortgage mess of this magnitude again until the lessons of this cycle have been forgotten. I peg that time period - by unscientific judgment - at about 20 years.
Here are some tips for policymakers:
1. This mess is not as much about subprime mortgages as the overall housing market.
2. Fraud was present, but was not the cause of the mess.
3. The people who made big mistakes have learned from their experience.
4. Some of the practices that enabled the crisis are actually good.
Let me expand on that last point. We have three ways to finance homes, unless someone comes up with something smarter:
I) short-term mortgages, like five years or less.
II) long-term mortgages financed by depository institutions, which engendered the Savings and Loan crisis
III) securitized mortgages
Don’t be overzealous in attacking securitization unless you want to return make mortgages unaffordable to the middle class, or you want another S&L crisis.
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November 13th, 2008 at 12:37 pm
I retired in 1995 as a financial planner and had a good working knowledge of how mortgages worked. In 2006 I sat in my kitchen with a mortgage broker trying to set up a loan for my daughter. He told me about NINA loans and negative am loans and I am sitting there saying to myself that this is all going to lead to a big problem. If someone like me could see the writing on the wall what were the experts thinking and are these the same people who are now in charge of getting us out of this problem?