Whom not to blame
We should be very clear from the outset that the subprime crisis is not an indictment of subprime loans as such. These mortgage loans are higher risk loans and there is nothing wrong with higher risk loans as such. We know in advance that such loans will have higher default rates. Lenders knew this, and they charged higher interest rates accordingly.
The question is why these default rates soared well above expectations beginning in the year 2006.
The current Secretary of the Treasury, Henry M. Paulson, Jr., is quoted as saying that the subprime crisis "came about because of some bad lending practices." This explanation sounds plausible. After all, the crisis arose because lenders like banks and mortgage companies made bad mortgage loans that led to a startling increase in defaults and foreclosures.
Banks and mortgage companies made many loans that soured. If we leave aside the issue of fraud, we can say that they did not intend to make bad loans. Their expectations were that the loans would be paid off, but these expectations were frustrated. The key factor is that they expected home prices to continue to rise and instead prices reversed and fell. Lenders then had egg on their faces. They looked as if they had adopted bad methods of making loans.
But Paulson’s story is shallow and superficial. Why, after hundreds of years of accumulated experience evaluating borrowers and making loans, would lenders suddenly began making what they thought were good loans that turned out really to be bad loans? Why would they do this not only across the United States but also in several other countries? Why should their methods of assessing risk have suddenly turned sour in 2006 and 2007? Why would loans in some states turn out to be much worse than in other states? And can Paulson’s story possibly explain real estate booms and busts that have occurred worldwide for centuries? It cannot.
Mr. Paulson blames the subprime crisis on banks and other lenders. He blames the regulated market, but he doesn’t explain why bad lending practices suddenly came to the fore in 2006. He explains neither why such a large volume of these bad mortgage loans occurred, nor why they were concentrated in the subprime category, which is the category of higher risk loans to people with lower quality credit records.
Blaming bad lending practices and blaming the market is really no explanation at all. It is like blaming the greed of the lenders. Why should an epidemic of greed and stupidity suddenly occur? Why should it be worse in Colorado than in adjacent Wyoming?
We need to go deeper than bad lending practices or market failure to understand the subprime crisis.
The housing bubble
The subprime crisis is manifested in three related phenomena. These are (a) declines in the prices of houses, (b) increased numbers of foreclosures, and (c) declines in the values of mortgage loans purchased as investments. The subprime crisis has several other interesting aspects to it such as fraud that are worthy of examining in separate articles, but these three are central. If we understand why and how each of these occurs, then we understand a great deal about the subprime crisis.
The drops in housing prices occur after steep rises in home prices. The declines are most severe in those states where the preceding price rise has been the steepest. In other words, where there have been housing price bubbles, they burst. Housing prices reverse downwards.
The impelling force behind the subprime crisis is the housing price rise — the bubble — followed by the housing price decline. The rise in house prices is critical, for when that stops and reverses, it increases foreclosures. The price peak of housing was late 2005 for some areas in the U.S. and by June 2006 occurred on average over all regions.
A great deal can be said about the manifold workings of bubbles. For our purposes, we need only note that the Federal Reserve thoroughly primed the bubble machine. Between 1975 and 1995, the growth rate of the narrowly-defined money supply was a very high 7.2 percent per year. Stock market returns, already strong, were propelled higher. The year 1995 was a year in which the stock market marched upwards with virtually no setbacks. It rose 35 percent. The next year saw a 21 percent rise. In the next 3 years, 1997—1999, the market doubled.
The housing market has had a large number of direct government stimulants. They include the government-sponsored enterprises like Fannie Mae and the FHA. They include removing the tax deductibility of auto and credit card interest while retaining it for mortgage interest. They include ending the capital gains taxation for house sales of less than $500,000 while retaining higher rates for stocks. The Fed’s largest contribution began just before the U.S. entered a recession in March 2001. In February 2001 the money supply, which had been stable for several years suddenly began a steep ascent. It rose until early 2005, the overall rise being 26 percent. This rise coincided with a steep rise in real estate prices.
The rise in money had many effects. It stimulated some parts of the economy as was its intent. It fostered a good times mentality. Investors thought it more likely that returns would be realized in good states of the economy. That is why they began to use more borrowing (or financial leverage) in buying homes, stocks, and other assets. They expected rather more returns to be realized in good states of the economy, and returns are higher in these good states. Investors did not know when the monetary expansion would cease, nor how strong its effects would be. The monetary expansion therefore engendered both speculation and leveraging. The expectation that prices will continue rising is hard to resist, because betting against it is a losing proposition as long as a monetary expansion continues. Conservative appraisals of home values began to be tossed aside in favor of higher valuations. This seemed only right since prices had been rising and continued to rise. Meanwhile, the 2001—2005 expansion made it possible for more marginal borrowers to look like better credit risks. The lenders began making loans with lower collateral values (or higher loan-to-value ratios).
Some of these practices, such as liberal appraisals, higher loan-to-value ratios, greater leverage, and lending to higher risk borrowers may be rational during an inflation, but they can, in retrospect and without justice, be termed bad lending practices. They are induced, however, by the money creation that the central bank has caused.
Those who cry wolf
Many warning voices were raised that the bubble would break. But a large number of these warnings were early. They were like the boy that cried wolf. During the boom, many people always wonder when it will end and are always predicting the game is about to end. The "bears" begin their wondering early in the boom, and they always look wrong as the boom keeps going for years. After awhile, no one listens to them. For example, several Fed officials (Susan Bies and Donald Kohn) warned in mid-2002 of their concerns about the subprime sector. They were 5 years early. Peter Fisher, a Treasury official warned at the same time.
On June 23, 2003, Christopher Byron published a stunningly accurate article in the New York Post. He wrote:
"Instead of giving the overall economy a sustainable boost, the Fed’s increasingly cheap money keeps pouring into just two sectors — the housing and home mortgage refinance markets — and it is creating what is shaping up as one of the most spectacular sector bubbles in memory.
"But first a thought or two on the Washington official whose endless supply of hot air has created not only this bubble but the dot-com mess before it, and who long ago deserved to be fired from his job: Federal Reserve chairman Alan Greenspan.
"No serious student of the economy any longer doubts that Mr. Greenspan’s cheap-money policy of the 1990s led directly to the stock market bubble that popped in the spring of 2000, pushing stocks and the economy into the downturn from which they have yet to recover.
"Meanwhile, his rhetorical waltzing has become utterly shameless, as he intones, in that ponderous way he has perfected, that the housing market has not swelled into a bubble — because, when it pops, the result won’t be a u2018negative’ for the economy but the disappearance of a u2018positive.’ Oh, puhleeze, Mr. Greenspan, do you take the whole world for fools?
"It is the speculative bubble in the housing market, fueled by lower and lower mortgage rates, that is alone propping up the economy, and everyone knows it. In this summer of 2003, the national pastime is no longer baseball or going to the beach — it’s going to the bank to refinance the mortgage.
"When the bubble will pop is hard to say, just as it is hard to guess the moment when the nation’s patience will at last be exhausted with Washington’s czar of financialoney. But one senses that time is starting to run out for both."
Byron’s brilliant article was 4 years early. He pinpointed where the blame should be placed. But more than that, the fact that he and others were so early virtually proves that one cannot blame bad lending practices for the subprime crisis. During the money inflation, many practices are quite rational that subsequently, after the bubble has burst, look ill-advised and bad. But since the inflation may go on for years, it is not foolish to indulge in them. One takes a calculated risk that there is more money to be made during the boom than to be lost once it breaks. The inflation is such that one might say "We are all speculators now."
Why foreclosures rise
A critical step in the subprime crisis is the one that leads to more foreclosures. The causation runs from the drop in house prices to the subsequent foreclosures. The key papers that document this process are here and here.
When house prices fall, borrowers discover that the amounts they have promised to pay (via mortgages) for their houses exceed the worth of their homes. Under certain conditions, this sets in motion defaults on loans and foreclosures. More borrowers fail to make their mortgage payments and are foreclosed.
When the value of a house, which is the mortgage loan’s collateral, falls below the amount owed on the loan, the borrowers have an incentive to walk away from the loan and deliver the house back to the lender. Defaulting on a mortgage is always an option. The borrower can "put" the house back to the lender. This incentive is powerful. Why should a borrower pay off a loan for $200,000 and end up with a house worth $150,000? He loses $50,000 by doing this. If he can walk away from the loan, and he can, then he has a strong incentive to do so. Borrowers began defaulting on their loans, and this was a rational response to the decline in housing prices.
When the home value drops below the promised loan payments, the borrower has negative equity. That is a necessary condition for walking away from the house because if the equity is positive, the homeowner is better off selling the house. But negative equity is not a sufficient condition for putting the house back to the lender. Other factors enter into this decision. If the interest rate on a variable rate loan resets higher, then the borrower has a greater incentive to default. If a person’s income is lower, a loss of $50,000 means more to him and he is more likely to default. If the borrower thinks that the housing market will recover and house prices rebound, he may keep the house.
But in fact these factors were working to increase foreclosures. In May 2004 the short-term interest rate on 3-month Treasury bills was 1 percent. It had been in that neighborhood for 19 months. It then commenced a steady rise to over 5 percent, reaching that level in June 2006. The subprime loans were concentrated on persons with low incomes, so that when housing prices began to decline in late 2005, that factor worked to increase defaults. And because housing prices were declining, the outlook for a rebound in prices was dim.
Foreclosures began to rise in 2005, which was the peak year of housing prices. They then soared. Rises of 100—200% in various localities in 2006 occurred, and further doublings and triplings were the rule in 2007. Nationwide, the average increases each year were somewhere around 50—100%.
Why investors lose
The bubble had burst and foreclosures rose rapidly, concentrated in the subprime loans. Meanwhile, financial institutions and others that held these loans (as lenders) lost huge amounts on their investments. This led to a deeper and more general credit crisis when borrowers turned away from all sorts of other loans, such as credit card and automobile loans, that had been packaged up and sold as securities. This too is a separate story that should be told in more detail.
When the bubble burst, investors who buy and sell mortgage loans recognized that the houses as collateral were no longer enough to cover the loan value. They viewed the loans as more risky for several reasons, which is why the securities backed by these loans dropped in price. In the first place, there would be more foreclosures so that the cash flows servicing the securities would fall. Secondly, the worth of the securities now depended far more on the ability of the borrowers to keep making the payments. But since subprime mortgage loans had been specifically made to people who do not have a strong ability to pay off their mortgage debts (people who are poor credit risks), the security risk rose dramatically. The value of the securities backed by mortgage loans plummeted, and those who held these loans as investments (the lenders) suffered the value losses.
Paulson’s call for more regulation
In February of 2008, Mr. Paulson testified before the Senate Banking Committee. He said of the subprime crisis: "I don’t come from the school that says the private sector itself will deal with it. I believe there needs to be a regulatory response, a policy response."
Paulson thinks there were bad lending practices and that regulation can cure them. What is regulation but what the Russians tried for 70 years and couldn’t make work? What is regulation but what the French kings imposed for hundreds of years? We are told in Clive Day’s History of Commerce, which Mr. Paulson can download for free from Google books, of the manner in which Colbert’s regulations held back French manufacturing. "His instructions for dyeing contained 317 articles, to which dyers must conform…These regulations grew constantly more complicated; an official said in 1787 that the regulations on manufactures filled eight volumes in quarto." Colbert "sent out agents everywhere to study industries and to talk with the manufacturers, that he might legislate to the best advantage." Today our Congress holds hearings and solicits testimony. "One man, however, cannot know a hundred businesses better than the men who are carrying them on. Colbert and his successors were ignorant of many points, were deceived in many others. The result was a mass of regulations of which many were utterly bad, injuring both producer and consumer." This perfectly well describes Congress. It’s the situation that Americans face today.
Paulson in the Paulson Report blames government regulation for some part of the subprime difficulties, and as a solution he proposes to modernize regulation. This means he proposes to add to it, centralize it, and augment federal government power. For example, the report calls for a federal commission to regulate mortgage originations. There are probably already 317 articles to which banks that originate mortgages must conform. Apparently we need 317 more.
The patchwork of federal regulatory agencies comes in for scolding. The solution there, we are told, is to consolidate them. The Paulson Report recommends that the Federal Reserve should have important new powers as "Market Stability Regulator." The Fed would become virtually a financial system czar, with oversight over all sorts of financial market institutions, from banks to insurers.
There is a market stability regulator that Paulson never mentions, and that regulator is gold, or more generally market-produced money.
The report manages to blame the individual states for doing too little and for not doing what they do do uniformly enough. I quote:
"The high levels of delinquencies, defaults, and foreclosures among subprime borrowers in 2007 and 2008 have highlighted gaps in the U.S. oversight system for mortgage origination. In recent years mortgage brokers and lenders with no federal supervision originated a substantial portion of all mortgages and over 50 percent of subprime mortgages in the United States. These mortgage originators are subject to uneven degrees of state level oversight (and in some cases limited or no oversight)."
All of this is highly misleading. Those at the state level complain that the federal authorities already have enough statutes and rules. They fail at enforcement even when it comes to matters of fraud. Listen to Bart Bartholomew, president of the Colorado Association of Mortgage Brokers:
"HUD enforces federal statutes, but there are only 30 investigators for the country. That’s one HUD investigator per 1.6 states, Mr. Bartholomew added. u2018The cavalry is not coming. There are no mortgage police,’ he said. u2018There were over 2,000 purchase transactions alone last year in Colorado.
"u2018That does not include the refi transactions. The truth is, there is no way one person can possibly be expected to review that amount of transactions.
"u2018And we all know the federal government is not going to spend the funds necessary to enforce the rules and regulations that they have placed upon our industry,’ he declared."
Chris Holbert, president of the Colorado Mortgage Lenders Association, has hit upon some common sense and free market solutions to the problem of fraud in mortgage lending:
"Mr. Holbert raises the idea of forming a new position for a private attorney general, deputized in the justice system, to go after criminals who break the law, including RESPA and HMDA. u2018It’s a Wild West solution, but we think it’s intriguing,’ he said. u2018In the old days, they used to go hunt down the bad guys. Our legislatures have become very good at passing laws. What good does it do if it’s not enforced? It’s time to hold the state legislatures and Congress accountable.’"
Instead of hunting down drug dealers, imagine the novelty of making a significant dent in real crimes such as fraud. This is too much to expect of government, which is why a return to the Wild West (which was not so wild) solution is attractive.
Summary and conclusions
The proponents of greater government power are busily absolving government of any blame in the subprime crisis, deflecting criticism from government, and taking the opportunity to propose that greater government will prevent future such crises. And in doing all of this, they are busy blaming as culprits the greed of market participants, lenders, the market, the free market (even though it is heavily regulated), the capital markets, securitization, market instability, capitalism, illiquidity, bond raters, state regulation, and insufficient federal regulation.
It is rather easy to spread the blame and confusion around because the financial structures involved are novel and complex. There are many targets.
But we should place the blame squarely where it belongs, which is on government failure, that failure being in the fiat money inflation brought about by the Federal Reserve.
How are we to explain and understand the details of the subprime crisis? Is it a sudden outcropping of market madness? Is this an instance of a free market gone haywire? Is it a case of mass lender stupidity? Is it a case of greed and corruption? Is it a case of inefficient regulation by the states?
The subprime crisis is none of these. Its origin lies in a housing price bubble brought about by excessive central bank money creation and the subsequent puncturing of this bubble. The price declines in housing then induced the large rise in foreclosures of the recent past and present.
Fiat money inflations often bring on real estate booms followed by busts. These inflations are the common element in real estate cycles that span many countries and many centuries, and they put the lie to the hypothesis that bad lending practices are the culprit. Fraudulent money creation is the culprit, not faulty evaluation of the credit risks of borrowers.
Jesús Huerta De Soto’s book Money, Bank Credit, and Economic Cycles provides documentation of cases. For example, real estate prices fell by 50 percent by 1349 in Florence when boom became bust. That boom was fed by bank money creation:
"Evidence shows that from the beginning of the fourteenth century bankers gradually began to make fraudulent use of a portion of the money on demand deposit, creating out of nowhere a significant amount of expansionary credit. Therefore, it is not surprising that an increase in the money supply (in the form of credit expansion) caused an artificial economic boom followed by a profound, inevitable recession."
In the face of excessive money, lenders tend to adopt laxer standards for making loans. Borrowers and investors tend to use higher amounts of leverage. Asset prices rise. When the rate of money creation slows or halts and asset prices begin to decline, those who have bought houses at high prices, perhaps with little or no equity of their own, quickly find themselves in a position of negative equity, with their promised loan payments exceeding their house values. This induces default and foreclosures.
That is how the subprime crisis began. It then spread to other sorts of securitized loans and to capital losses of investors, including major banks, in all sorts of loans.
It is impossible for regulation of loans and lending to prevent future crises of the same sort from happening if central banks create excessive money. If loans are shut down, that is tantamount to not creating excess money, contrary to the premise. That will not happen. Instead, increased regulation will divert loans into channels that the authorities think will be safe from price decline. That will involve increased centralized control over the economy, which will stifle growth. And it will only shift the price pressures into some other markets. The crisis brought about by excess money will simply take on new forms if loan regulations are multiplied and made effective.
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.