Why Did the Mortgage Crisis Happen, Part 2

Yesterday I posed the question of why the mortgage mess happened, and why at the time that it did.  There were two fundamental building blocks of the crisis: the Great Moderation and Securitization.  The aftermath of the 2001 recession provided the trigger for the mortgage mess.  In this post, I explain the role of The Great Moderation.

The Great Moderation is the new world of macroeconomic cycles that began in 1983. In the United States and around the world, recessions became milder and less frequent. (There's a great interview with Mark Thoma about this topic in the Businomics Audio Magazine.)  The chart of rolling 20-quarter standard deviation of real GDP changes illustrates the calming of the economy:

 

Back in 1983, a business executive with 25 years of experience would have experienced five full business cycles. Today, an executive with a quarter-century of experience has only gone through two full cycles. We are less experienced in dealing with recessions because of the Great Moderation.

The Great Moderation by itself lowered fears of recession, but the nature of the most recent recession (not counting the current cycle) also reduced concerns about a possible downturn in housing values. The 2001 recession was triggered by a decline in business capital spending, especially in high tech and communications. Housing suffered relatively little; it was the mildest housing cycle of the postwar recessions.

As a result of the Great Moderation and the strength of housing in the 2001 recession, the housing sector appeared to be recession-proof. This was a mistake, and those of us who like to examine long data series knew it, but financial types prefer to look at recent data. When I attended my first Credit Policy Committee meeting as a bank economist, back in 1988, the experienced lenders priced consumer loans based on a five-year average loss rate. I was thunderstruck! The five-year period did not go far enough back to include a recession. In fact, credit policy coming out of a severe recession tends to be tight, so we were probably looking at abnormally good credit history. This is the kind of stuff that financial people should do a better job at.

Next: the role of securitization in the mortgage mess.

Comments

[Mike Lion]

Please discuss the role of the Community Reinvestment Act as renewed in 1995 (First passed in 1978, I believe).

This Act forced lower standards for borrowers on banks, and led to things like no-documentation loans and no-down payment loans. Banks that dis not comply were threatened with disapproval of merger plans or plans for new branches.