....back from vacation....
Let’s all agree first on the definition of the recent U.S. credit crisis. Basically, it was a reluctance of lenders to lend, at almost any interest rate, because of the heightened degree of uncertainty in the market. What caused the credit crisis? Of course, the answer is multifaceted and complex, the result of a vast array of interconnected, dynamic factors. But as with most market activities, there is a very straightforward explanation for the problem based on supply and demand. Let’s keep it simple, and paint with a very broad brush, but let’s get the causality right.
In this case, the mortgage market was functioning well. Bankers and home buyers were negotiating mortgages one-on-one quite successfully on the whole. Bankers gathered information on the borrower and used it, along with more general local and national market information, to set rates and loan conditions that fairly compensated them for the risks of default and prepayment. Some borrowers shopped lenders to find the best deal; some used the same bank that held their checking or savings account. Of course, there were unexpected defaults and prepayments: contracts neither predict nor control the future. But that’s what investments and loans and interest rates do: trade dollars today for uncertain payoffs tomorrow ….move liquidity from savers to borrowers…. voluntarily …. at fairly negotiated rates …with no guarantees of a certain outcome. And no one forced anyone to accept a mortgage loan they didn’t want.
Some hopeful homebuyers were turned down for a mortgage because they were not creditworthy. The rate they would have had to pay to compensate the lender for the risk of default was too high; the “price” of the mortgage – including the interest rate, down payment, fees, insurance and so on -- was too high for them given their income, the price of other goods, and their preferences. Again, this is a voluntary, free-market outcome.
Now introduce politics into the picture. Some politicians believed that home ownership was a fundamental right. Some felt they knew better than the private market who should get a mortgage, at what interest rate, and under what conditions. Laws were passed and mandates issued requiring banks and other lenders to approve mortgages they would have otherwise denied, the so-called “subprime” mortgages.
Many of these politicians justified the new laws and mandates by citing the positive consequences home-ownership has on local communities, including higher employment, tax base, sales of durable goods like refrigerators and dishwashers, and investment in local business. But this line of reasoning distorts the true underlying cause: home-ownership does not cause these positive side effects. The ability to afford a home is what causes these positive developments. And what enables the ability to afford a home is diligence, a solid work ethic, living within your means, saving, and responsibility – the very same factors that a lender takes into account when determining whether to grant a mortgage and at what interest rate.
These mandates and regulations would have had minimal aggregate effect on the market for mortgages if not for Fannie Mae. Fannie Mae was created by the government in order to reroute liquidity from one group to another; it did not evolve from natural, competitive forces to satisfy market demand. Instead, it was created through legislation to satisfy a political demand for social engineering. Banks approved subprime mortgages that they would have otherwise denied, even with the mandates, in large part because they could quickly and reliably get them off the books by selling them to Fannie Mae (and the other enterprises that evolved around Fannie Mae). Fannie Mae then took the mortgages, mixed them together in a big pool of future cash flows, and sliced and diced them into several new financial securities. Fannie Mae used the funds generated by the sale of these securities to go back to the banks to buy more mortgages, and the cycle begins again.
In order to describe how the mandates and Fannie Mae contributed to the credit crisis, I have to first explain the concept of diversification. Diversification is the reduction in risk (or uncertainty) per unit return. It occurs when assets with imperfectly correlated returns are held together in a portfolio. (Note that diversification does not reduce the average return of a portfolio, a common misperception. It reduces the variability of the portfolio’s return around the average return.)
My conjecture is that the financial models used to price mortgage-backed securities created from the Fannie Mae pooled funds overestimated the impact of diversification on the asset returns, underestimated risk, and served as a catalyst for the credit crisis. Basically – and I am grossly oversimplifying the process here – it was assumed that if one mortgage went into default, another would offset or minimize the impact on the portfolio return. But this was not the case in 2009, for a variety of reasons, all of them economic.
First, the supply of single family homes increased during this period. Why? If you were shopping for a home in the 2000-2001 period, you likely already know the answer. Your real estate agent or mortgage broker very likely asked you if you were planning to stay in the home or move in a few years. If you planned to move, the agent probably recommended an adjustable rate mortgage with a rate that would effectively reset in five to seven years. In that case, if interest rates rose, you could “sell the house for a higher price and pay off the mortgage.” Rates did rise, and lots of people were trying to sell their home in 2008 and 2009. A higher supply means a lower price, which put more people upside down on their mortgage.
Second, the overall economy was in a slump in 2009. Lower GDP means lower incomes and more people struggling to make their mortgage payments. Higher unemployment means less job security and fewer people buying homes. Lower demand for houses means lower home prices, and more people upside down on their mortgages.
Third, these economic and political developments-- an oversupply of homes, weak demand for homes, and mandates that created a disproportionate number of high-risk mortgages -- combined to create a perfect storm for mispricing the risk of mortgage-backed securities (and the insurance and derivative products they produced). The result was a strong positive correlation between the state of the economy and the default rate on mortgages. As noted above, a positive correlation between the returns on assets diminishes the diversification benefits from pooling assets into a portfolio. The magnitude and timing of the positive correlation was largely unanticipated by the market and assigned a very low probability in the scenario analyses of the risk-management models. The result? Mortgage-backed instruments and their derivatives were mispriced; their risk was underestimated and return overestimated. Foreclosures ensued, liquidity dried up, Congress blamed Wall Street and threatened more oversight and more regulation, when it was the interference from Washington in the private sector that caused the problem in the first place.