Why Did the Mortgage Crisis Happen, Part 5

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.

Comments

[Wayne Pruner]

Interesting series Bill. The secuitization part is a bit above me. I seems that smart people were just trying to out smart other smart people to find another way to make a profit. I think part of the current problem originated because the pool of qualified buyers had shrunk and in order to keep profits coming in, the pool had to be expanded by dropping lending standards. Surprise! People who had a history of not paying their bills were defaulting on their mortgage. Sub-prime loans were not all bad. Many people who would not have normally been able to buy a house, are now making motgage payments and have a piece of the American Dream. Mortgage types thought that appreciation would keep being double digits and cover over all questionable loans. Appreciation of that magnitude for any extended period of time would have put us in a far worse mess than what we are in now.

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[Jules Carney]

I was actually glad to come throughout your post now. It really helped me make sense of some of the consequences I was having with the subject.

Thanks for sharing!

[Idaho Real Estate]

Why did the mortgage crisis happen? Simply google President Bush's state of the unions in 2002, 2003 & 2004. He wanted all Americans to have the American dream of home ownership. He mandated Freddie Mac and Fannie Mae to eliminate down payments and ease credit requirements. The result is a historic housing collapse in this country. Many will argue with me but this did not happen during the Reagan, former President Bush or the Clinton Administration. This happened during George Bush's reign and it is just one of his many blunders that have left this country in economic hardship that has not been seen since the great depression.

[Grafton MA Real Estate]

Much of the issue stems from the fact that the mortgage programs that were in place should not have been offered to begin with. Mortgage products with no money down were offered much too easily to anyone breathing. These products were made for people to fail.