Thursday, April 28, 2016

Housing: Part 141 - Prejudice Clouds Thinking about the Banks

The New York Times has an article about new investigations into Morgan Stanley's role in the housing bubble (HT: John Wake).  Typical evidence from the article:
The documents suggest that the primary way Morgan Stanley guided New Century was in contracts that spelled out the kinds of loans the bank was willing to buy in pools of mortgages. A 2006 term sheet said that the bank wanted a $1 billion pool to be at least 85 percent adjustable-rate mortgages, with at least 75 percent of the pool to include a prepayment penalty. And it dictated how many loans the bank wanted from various geographic regions.
So, do you get that?  Do you see how dastardly Morgan Stanley was?  They told a mortgage originator what sorts of mortgages they would like to buy.  Dirty bums.

I will tell you that, on principle, whenever I do something like buy a new car, I refuse to tell the salesman anything about what kind of car I need.  Why?  Because I'm not an animal.  I have morals.  Whatever sorts of cars the factories are making, I'm sure those will work just fine.

Seriously, though, it amazes me what a low bar there is to imagining what sort of nonsense banks were up to.  I suppose the idea here is that, since they were predators, these sorts of impositions are just ways to extract fees from helpless customers.  As if this is just a one way street.  The fat guy in the tux, with dollar bills stuffed into his chest pocket and a fat cigar in his mouth, maniacally laughing after sending out his new more devilish plans.

But, these are just standard risk management issues.  Remember, by the time these private loan pools were numerous, the Fed Funds rate was nearing 5% and the yield curve was flat.  At that point in the cycle, ARMs are commonly used.  The level of ARMs was not even high (pdf), relative to past levels.  The reason, I presume, that they wanted ARMs was because reasonable borrowers would be more apt to use ARMs, and when rates are high or rising, adjustable rates eliminates interest rate risk.  This is finance 101 stuff.  Same deal with the prepayment penalty.  The fact that mortgages can be refinanced makes mortgages much less valuable as interest rates rise, increasing the spread lenders have to charge.  As rates rise, if prepayments aren't mitigated somehow, lenders have to charge higher rates (which, here, means that Morgan Stanley would demand a higher rate on the mortgage bonds).

This idea that ARMs were some sort of conspiracy is so dumb, I don't know what's happened to the world.  People used to know these things.  The housing "bubble" ate our brains.  This is made more exasperating by the fact that rates went down after those 2005 and 2006 ARMs were originated.  Nobody lost their house because rates went up on their adjustable mortgages.  They lost their homes because the mortgage industry was shuttered, their equity vanished, and once the broader dislocation hit, many lost their jobs and couldn't make payments, sell, or get refinanced.  Most defaults happened after 2008, by the way, when rates were WAY down.

And, they "dictated how many loans the bank wanted from various geographic regions."  Um.  OK. Why does this warrant a mention?  If you work for a bank that buys mortgage securities and you DON'T dictate how your holdings are geographically diversified, please go into your boss' office and inform them that you are firing yourself.  This is basic stuff.

I really don't know how to address this stuff in the book.  So many of the details like these have little credibility to me.  But, there is the problem that in a nation with millions of mortgages, especially in the middle of a housing supply bust, there is bound to be a set of credible anecdotes about actual fraud, and there are bound to be even a few whole operations that operate at the border, or over the border, of reasonable tactics.  But, the problem is this is all bathed in what can only be called bigotry.  Anecdotes become generalized to "what Wall Street was doing" and this is combined with trumped up and incoherent accusations that frequently simply don't mean anything.  These are basic, well known tools of bigoted thinking.  Bigotry in some form has always been a problem in human endeavors, because these tools are effective.  And it usually doesn't go away because people notice what they are doing and adjust.  It goes away by generations slowly succumbing to lived experience.

For this reason, I almost prefer to not address it at all.  This will lead many readers to dismiss my other arguments.  But, I think many of those readers will not be on the margin of readers who might consider my thesis, anyway.

Any input is welcome.  This may be the most difficult issue I have to tackle, rhetorically.  Is it enough to simply tackle the empirical issues (the lack of rate-triggered defaults, the normal behavior of ARM originations, the fact that these cases all focus on banker's actions after 2004 - generally after the peak of ownership and prices).  Is all that enough without having to act like a defense attorney in the witch hunt-of-the-day?

19 comments:

  1. Helocs and house prices were central to the crash. Heloc credit lines were pulled in 2008 and house prices really cratered in 2008. You are correct, Kevin.

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    1. Also, when the commercial paper market crashed, the main line banks had to take the loans back onto their books from the SIVS. The big banks underwrote the commercial credit market for shadow bank loans. When investors started rejecting the MBSs, the loans went back on the bank balances, forcing them to slow lending in the real estate sector. They still loaned to businesses, but GDP was tanking. But when they stopped lending to real estate, and when they pulled the heloc lines of credit, lots of investors defaulted and owners lost credit. At that point house prices became destroyed, more in some areas than others.

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    2. And finally, securitization itself, which failed, was based on mispriced risk on the MBSs issued. That mispriced risk was adopted at Basel 2 so the Fed and central banks were responsible for that as well. Once investors the world over decided there were flaws in that paper, the CP market crashed and the banks took billions back onto their balance sheets. The Fed could have bought the paper, could have done something to clear this out of the big banks. But it refused to do so.

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    3. So, people say that it was against the law for the Fed to by CP in 2007 as the CP market was crashing. Well, that is true, however, Patrick Kennedy introduced a bill in the House of Representatives giving the Fed power to buy it. And it was introduced in 2/9/2007, just months before the commercial paper market started to crash. These people knew what was going to happen and yet the Fed still did nothing.

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  2. I think you have to tackle this subject, Kevin. Your book will be a lantern in the fog and when everyone around you has lost their minds, you need to be the voice of sanity. The truth will ring true; and when enough people hear it, the tide will turn. You are like the first historian to tackle this life event. Looking at it with a fresh perspective. Throughout this series of blog posts, I have been amazed as you noted that you needed to change your thinking because new data supported a different view. It's refreshing to know that the data informed your direction, rather than you twisting the data to support a preconceived notion. You were way more scientific than the rest. You have found many yolks, you need to show what you've found in the clearest way possible. Just my 2 cents...

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  3. The bigotry against bankers and lenders has a long and dark history.

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    1. But the big banker and lender is the Fed. So the bigotry, if you call it that, is justified. If Morgan Stanley knew that the risk was higher than people knew it was wrong. It is like the Bank of America, which actually told the truth saying that the Fed misprices risk and everyone piles into the trade. The US would be better off just rejecting basel completely like the Chinese do, and maybe things would not crash so badly.

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  4. Since 2008 the goal has been to seize the narrative of the recession, to bash the other side---liberal, conservative, left, right.

    Kevin can speak the truth and I hope someone is listening.

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  5. Just imagine you are writing a climate change book. At some level there is a portion of the population that no amount of charts and data will convince, because they see it as a political issue and not a scientific one. They view data as manipulation of their experience, and the fact that you got a book deal means you are already beholden to corporate overlords. That being said I think if it fits with the rest of the book you should address it, because it will change the minds of some people.

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  6. I don't disagree with your larger point, but I would like to quibble with one of your points about ARM issuance and the yield curve. generally ARMs make more sense in a steep curve, as ARM rates are indexed to short rates and fixed are priced as a spread to longer rates (simplifying of course). in a flat curve environment you get to lock in a rate at very low payup. in a steep curve environment you pay much more to lock it in so it makes sense for fewer to pay up for that.

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    1. You would think so, but there is a lot going on there. There is expectations, there is the spread, etc.
      I think this is one of many areas where attribution error taints the public conversation. Few of us would take on an ARM in a steep curve environment because a steep curve implies expectations of rising rates, and we don't want to introduce a cash flow shock into our budget. Also, those expectations mean that lenders have less prepayment risk, so they can lower the spread on fixed rate.
      But, a yield curve that is flat suggests some expectation of falling rates. This makes the risk to the borrower of an ARM lower and it also increases the spread lenders are willing to take on fixed rate loans because prepayment risk is now higher.
      I believe the data is pretty clear that ARMs are more frequently used during a flat curve. This is one area I have more research to do on. But, the idea that ARMs were being used in the 2000s because households were being reckless in order to lower their initial payments doesn't seem to be borne out in the data. After 140 posts of this series, that doesn't surprise me any more.

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  7. Thanks for the input everyone - and the kind words. I feel like I am already putting the reader in a tough spot, basically saying we fought an unnecessary war. I'm afraid of being too alienating. I'm also afraid that I lack credibility because there are so many stories from the trenches about reckless loans and securities, especially late in the boom - and the facts, such that they are, are frequently true. So I'm afraid it will introduce limited topics which readers can dismiss as unrealistic, and lead them to miss the forest for the trees.

    But, your input is duly noted. The IW focus group says the topic needs to be fully addressed.

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  8. For whatever my two cents are worth, I would start the book by clearly stating the popular right-wing or left-wing narratives of the 2008 recession are self-serving and inaccurate.

    I think that is a good and true platform...

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    1. I think I have a preface that will give a good shock to the reader. I'll see what the editors/reviewers think of it. I'm trying to stay away from left/right terminology because my thesis will be difficult enough for a new reader to believe already, without triggering political defensiveness. I try to use the Open Access/Closed Access framing, which I think draws on natural inclinations and goals that most people share. My problem with regard to this post is that one inclination most people share is distrusting finance and blaming finance for poor outcomes, so it is difficult for me to build on this disconnect in a way that readers might react to positively. I can use a graph that shows how the bust hurt the poor because of new credit constraints, and most readers will empathize. But, I think a lot of readers will balk at the idea that bankers weren't at the center of it, with a reaction of either (1) "my sister was foreclosed on, and the bank didn't give a crap about what they were doing to her" or (2) "I worked for a mortgage broker and you should have seen the crap we were originating. This is naïve claptrap." I'm not going to get far with those readers by explaining that there is a deep-seated bias at work against financiers that affects perceptions. But, as some here have noted, I'm probably not going to pull those readers along anyway.

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    2. The central bank was at the center of it. It mispriced risk, causing MBSs to be rated AAA, which allowed for securitization. Then it allowed Basel 2 to apply mark to market and other nonsensical behavior, like not buying bad paper, which turned the housing crash into a Great Depression.

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    3. Don't forget, Kevin, after mark to market, Bernanke said this and he is credited for stopping a depression, but he should have stopped mark to market: “…commercial real estate loans should not be marked down because the collateral value has declined. It depends on the income from the property, not the collateral value.” Ben Bernanke, Feb. 24, 2009

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  9. Kevin, if you're hoping to get around the inborn prejudice against banks of your prospective readers, I might suggest emphasizing the role of banks as middlemen of the crisis. That is, that banks are creatures of the circumstances as much as anyone else. You may even concede that banks are greedy and profit-driven, but that this is always the case, and 99% of the time it doesn't cause bubbles any more than greedy grocers or car salesmen trying to make as much profit as possible causes bubbles in their respective markets.

    The banks moving toward adjustable rate mortgages was just them compensating for rising interest rates; the increase in subprime mortgages is a reaction to changes in the pool of borrowers due to rent inflation driving more people into the mortgage market.

    Perhaps draw an analogy between banks and food vendors during a famine. Famine drives up the the price of potatoes; naturally people blame the potato seller for squeezing his starving customers, but the blunt reality is, he only does that that because the supply is so low; and shutting down the potato vendors as punishment only means fewer potatoes getting sold; fixing prices would save some customers money, but fewer people would get to eat, etc. In other words, it's the famine, not shady potato sellers, that is the problem.

    Your famine, of course, is housing supply restrictions and central bank monetary policy. Maybe this sounds cynical, but if it is inevitable that people are going to want to hate someone for what happened, it may be pointless to try to defuse the hatred, and rather you may as well redirect it toward the institutions most responsible. I'm reminded of what Timothy Mason said of historians, which I guess is just as true for economists: "If historians do have a public responsibility, if hating is part of their method and warning part of their task, it is necessary that they should hate precisely."

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    1. Mark the only problem is, the Fed exists to please the banks. So, how much input the banks had on the Fed adopted mispriced risk and bogus AAA ratings is hard to say. Certainly they had some responsibility. After all, David Li worked for JPM. And the banks could have asked the Fed for help in defending the commercial paper market, which was the TBTF banks' link to the Shadow banks. Certainly RE lending stopped abruptly because the CP market crashed. That is fact. But, then, we had the Fed not buying the paper and mark to market was implemented. It is almost like they wanted austerity and a Great Recession.

      All those SIV loans that could no longer be spread by securitization were suddenly transferred back to the balance sheets of the banks. And at that point it was over, but it didn't have to be over.

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