Seeing Through Data

Hat-tip to David Dayen of Firedog Lake for pointing out a paper from three economists with the Federal Reserve that pushes the outer limits of common-sense.  Why Did So Many People Make So Many Ex Post Bad Decisions?  The Causes of the Foreclosure Crisis, by Cristopher Foote, Kristopher Gerardi, and Paul Willen of the FRB Boston, Atlanta, and Boston respectively.

The authors present 12 “facts,” many which are iffy at best, showing that the bubble was some sort of “collective self-fulfilling mania.”  Arguing (of course) against banking regulations they seem to be saying a modern-day Svengali hypnotized tens of millions of people to take crappy loans.

Before moving onto their twelve facts they demonstrate an alarming lack of understanding about MBS and MBS-related products:

“.. the top rated tranches of Wall Street’s mortgage-backed securities performed much better than the top-rated tranches of its collateralized debt obligations, another type of structured security.  This discrepancy occurred even though both types of securities were ultimately collateralized by subprime mortgages, and even though both types of securities were constructed by the same investment banks.”  - Why Did So Many People…, Pg. 4.

Keep in mind how mortgage CDO’s work; bankers would take, say, ten slices from ten different batches of MBS of loans that were rated non investment grade.  They’d then bundle them together and rate the top part of the new bundle — the very same loans that had been judged non investment grade — as magically now being investment grade.

CDO’s are analogous to somebody trying to sell you a pile dog droppings.  You’d rightfully saying “have you lost your mind: it stinks.”  Then they’d return with a new pile, made up from 1/10th of the pool of ten different piles, along with an expert who said really doesn’t stink.  Most people would believe both the expert, in this case the bond-ratings agencies, and the seller had lost their mind.  Instead, they believed it didn’t stink and, apparently, so to do these three.

Given a fundamental misunderstanding on how these products work it’s clear they have a similar misunderstanding about how the entire field works.  Let’s move on to those twelve facts.  I’m paraphrasing for brevity.

1. Exploding ARM’s didn’t cause the mess.
Their rationale:  People repaid them during the bubble so it must not be the exploding ARM’s.
My rebuttal: They repaid them because they could obtain financing.  When they could no longer refi, which bankers could and should have anticipated, and the loans exploded, those loans caused a predictable mess.

2. No mortgage was designed to fail.
Their rationale: Nobody would design a product to fail.
My rebuttal: Nobody would design a product to fail .. unless they made lots more money selling it and maintained no liability for the failure than a well-designed product.

3. There was little innovation in mortgage markets in the 2000s.
Their rationale: Option-ARM’s and the rest have always existed.
My rebuttal: Yep, and were seldom used.  Their use exploded in the mid 2000′s and the economy exploded shortly thereafter.

4. Government policy towards mortgages didn’t change much from 1990 to 2005.
Their rationale: Government started making no down-payment loans to soldiers fifty years before so the no-down loans to, say, the homeless dude are the same thing.
My rebuttal: No .. it’s not.  WWII veterans had a certain level of inherent underwriting: they’d just returned from years of fighting where they’d cooperated with other countries to kick the crap out of the Axis and, oh yeah, they were alive to take out a loan.  Pulse loan borrowers didn’t meet this criteria.

5. The originate-to-distribute model was not new.
Their rationale: Servicing has been around forever and was used extensively by S&L’s in the 1980′s.
My rebuttal: Umm.. Ahh… Seriously!?  1,000+ S&L bankers ended up in jail.

6. MBSs, CDOs, and other “complex financial products” have been widely used for decades.
Their rational:  In 1977 Salomon Brothers arranged the first private market MBS deal; CDO’s came along in the 1990′s.
My rebuttale: Lew Ranieri, head of the Solomon MBS desk, has repeatedly stated the modern MBS is nothing like his MBS and he’s right. He’s an early, loud, vicious, and vocal opponent of what his invention morphed into. Look, dynamite can be used to help build tunnels and bridges or used by terrorists.  That’s why we strictly regulate its use.

7. Mortgage investors had lots of information.
Their rationale: Self-evident .. they did have lots of information. I use it.
My rebuttal: They were relying on those AAA ratings and everybody knew it. Borrowers listened to their crooked mortgage brokers and crooked appraises; investors listened to the crooked ratings agencies. Dumb?  Probably. Fraud?  Yes, since both mortgage brokers, appraisers, and ratings agencies knew their paid-for opinions were being relied upon. You’re all economists and know the problems of information asymmetry.

8. Investors understood the risks.
Their rationale:  Lehman released models showing a 17% decline in housing prices would cause enormous investor losses, labeling this a “meltdown.”
My rebuttal: Again, information asymmetry.  Anybody whose home only lost 17% from the height of the bubble here in FL would be dancing on their tables. Labeling this “meltdown” rather than “reality” speaks for itself: they didn’t understand.

9. Investors were optimistic about house prices.
Their rationale:  Lehman and others showed home prices appreciating.
My rebuttal: Yes, they did .. didn’t they?  I don’t remember many investment bank analysts warning about bubbles in 2005.

10. Mortgage market insiders were the biggest losers.
Their rationale: They melted their banks down.
My rebuttal: But the  people who melted the market kept the big bonus checks, even while their banks were smoldering. It’s not about the “banks,” but the people in them. I’d also personally urge the authors to talk to some parents who lost their home about how they explained it to the kids about who the genuine biggest losers are.

11. Mortgage market outsiders were the biggest winners.
Their rationale:  Famous housing shorts, who were not involved in housing except to buy CDS, made a killing.
My rebuttal: True, but insiders who came before them made an even bigger killing, though they killed their own banks in the process.  It is disingenuous to ignore the amounts of money pocketed by insiders  during the bubble and, instead, to look only at both parties after the economy melted down.

12. Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in CDO’s did.
Their rationale: The AAA’s haven’t melted down.
My rebuttal: Yet.  Which is why I’ve been frantically aggregating data and not writing much. Those AAA’s are doomed.  They’ve been playing games to keep them performing but reality always catches up.  The data is compelling: we’re near the end of the AAA-rated road.

In closing the authors maintain “If home buyers knew that future borrowers would not have access to the same financial innovation, they would not have bid up house prices in the first place.”  My rebuttal: Since the meltdown precipitated massive one-sided market interference to prop up banks they should have been regulated.  That is, if lenders were regulated they would not have been able to cause the bubble in the first place.