Subprime, bank runs, and the Global Financial Crisis

A brief diversion to some background points.

A private securitization market suddenly came to dominate housing finance from 2004 to 2007 before collapsing and disappearing. That market was prone to a boom and bust cycle, and that tendency was heightened by use of overnight repo financing and credit derivatives related to those markets. That is one of the conventional reactions to the Great Recession housing bust that has some truth to it.

In Building from the Ground Up, I wrote about how the housing bust doesn’t really have the shape of the bust that was so widely expected. Atlanta is the clearest example of this. Home prices across Atlanta followed a flat trajectory relative to incomes until 2008. Then mortgage access was blocked. Low tier home prices then collapsed to an extreme scale. Eventually, they rose back up and eventually surpassed high tier home prices as rent inflation never seen before in Atlanta became endemic. There was no bubble that was reversed in Atlanta. Just a big stinking kick in the crotch to working class homeowners, and eventually renters.

On broader terms, I noted in Building from the Ground Up:

Other bearish observers concentrated on the trade deficit and debt held by foreigners, complaining that we were overconsuming, overbuilding, and overspending with borrowed dollars. They predicted a contraction because these things were considered unsustainable. Likewise, their doomsaying appeared to be accurate, yet the bust has not been associated with a falling dollar, declining public debt, or a reversal of foreign capital flows to the US or of the trade deficit.

The reason the crisis doesn’t actually look like the crisis they predicted is that the crisis wasn’t caused by any of those pre-crisis fears. The crisis was a self-imposed demand shock—a retraction in money and credit.

So, how should we think about this detail (CDOs, derivative, etc.) that seems to still be confirmed by a more parsimonious description of the bust? Is the unsustainability of the private securitization market confirmed by the collapse? Or, is this a sort of gestalt level p-hacking exercise? “Everyone was wrong about the other 19 things that were supposed to make a collapse inevitable, but at least they got this one right!”

How did this collapse play out?

First, many of the technical defaults in CDOs were due to expectations. As I noted in Building from the Ground Up:

On July 11, 2007, S&P issued a ratings downgrade on 612 subprime, residential, mortgage-backed security classes:

Although property values have decreased slightly, additional declines are expected. David Wyss, Standard & Poor’s chief economist, projects that property values will decline 8% on average between 2006 and 2008, and will bottom out in the first quarter of 2008.

This is notable for a number of reasons. First, an expected 8% nominal decline in the average home would be a major red flag for any central bank that hadn’t already become consumed with doomerism. Yet, the Fed held their target interest rate steady in August, after this S&P forecast (which was followed by market panics and emergency meetings), and at the time the standard text in FOMC press releases referred to an “ongoing housing correction”. Oof.

Even those expectations were pollyannaish. According to the Case-Shiller index, the average home price did decline by 8% by the first quarter of 2008, but they wouldn’t bottom until the first quarter of 2012.

The CDO markets were now in panic, based on those terrible expectations, without a functional price even for the high rated tranches. This is when the Big Short type speculators were cashing out, when expected losses created market panics. But, the actual cash losses to those securities didn’t generally hit until after the late 2008 crisis climax - after the regressive losses to housing collateral from the mortgage crackdown had taken well more than 8% off of working class home values across the country.

The Jackson Hole meeting at the end of August was where Ed Leamer and John Taylor chided the Fed for overstimulating housing.

Leamer told them, “With no lost sales to transfer forward in time, the low interest rates in 2002-2004 transferred sales backward in time, stealing sales that otherwise would have occurred in 2006-2009. In 2007 the housing sector of the economy is now paying the piper with very little possibility that a rate cut would make much of a difference. Once the wave has peaked and is crashing, there is not much that can be done to quiet the waters.”

The Leamer piece is a major touchstone for me because the timing is so important - coming right when its central thesis was exactly the point that policymakers needed to understand. But he was so thoroughly taken by the myths of the moment that he betrayed his own insight.

You can see the “oversupply” myth in the quote above. Elsewhere in the paper, he wrote that there were “policy conflicts between inflation targets and hypothetical housing targets. If housing were the target, our Fed has been missing the mark widely, most especially in the aftermath of the 2001 recession when the fed funds rate was held so low for so long. Best to remember that the teaser rates for mortgages came from Washington, DC, not from Wall Street, and not from your local mortgage originator.”

To the contrary, the mortgage cohorts with devastating default rates were the 2006 and 2007 cohorts that were originated when the Fed had hiked the fed funds rate above 5% and inverted the yield curve.

He committed a more subtle, yet important, error when he wrote about Los Angeles, “During the ‘bubble’ that is now leaking, it was the smaller homes in the lower-priced zip codes that experienced the greatest rates of appreciation. That run-up in relative prices of the less-expensive homes could be permanent if innovations in finance have permanently increased the fraction of homeowners, raising the relative demand for cheaper homes. But I doubt it. In 2007, all the anecdotes suggest foreclosures are differently favoring the lower-income neighborhoods, just as do the pink slips of labor market dismissals.”

As I detailed in “Price Is the Medium Through Which Housing Filters Up and Down” those low tier prices were permanently higher, and it had little to do with mortgage markets. Thanks to Leamer, and the rest of the profession, we implemented a 15 year natural experiment in mortgage suppression just to prove that point.

It’s sort of mind-boggling to think about all the interactions here between expectations, presumptions, current conditions, future conditions, etc.

In any case, you can see throughout Leamer’s paper that whatever peculiar and obviously dangerous conditions might cause those private securitization markets to fail, he was of the firm opinion that the Fed shouldn’t, couldn’t, and wouldn’t do anything about them. Standard and Poore’s was already projecting a nationwide 8% price drop. To Leamer, the Fed’s sins had already been committed. Housing starts (the thing he claimed was important!) had been collapsing for nearly 2 years. The FOMC had been busy that month with emergency meetings. Yet, the actual price collapse hadn’t happened yet. Defaults were only just starting to become problematic. CDO defaults were happening because of expectations more than past results. The start of the recession was still 3 months away.

Leamer’s housing construction signal was deeply into “it’s time to stimulate” territory. Yet there was still time to avoid most of the recessionary and crisis consequences. It was Leamer’s moment to save us from crisis.

Leamer, invited to “the room where it happened”, used that access to give a full-throated shrug. “What-r-ya-gonna-do?”

A month later, when the Fed was debating what ended up being a rate cut to 4.75%, infamous FOMC hawk Richard Fisher worried, “I’m very concerned that we’re leaning the tiller too far to the side to compensate risk-takers when we should be disciplining them.”

While Leamer had concluded that rate cuts couldn’t even help stabilize the housing market, Fisher worried that they would.

A year later, while the financial world was exploding, Fisher was on the speaker circuit explaining that “perhaps no financial system—no matter how enlightened its central bank or sophisticated its regulatory architecture or wise its Congress or executive—can prevent nature from running its course.”

Seriously.

Most of the mortgage defaults - the thing that actually affects cash flows to mortgage securities - happened after that speech.

Here’s my point. (I guess this isn’t the first time I have made this point.) There is a concept in economics called the “Lucas Critique”. Basically, in a nutshell, if policy targets a certain outcome, then that outcome isn’t a useful indicator of economic conditions or of causality.

A classic example of this is your home thermostat. Sunshine is correlated with warmth. But, if you set a thermostat in your house, its temperature isn’t correlated with anything. Yet, it would be wrong to conclude that sunshine is not correlated with warmth. And, it would be wrong to raise the thermostat temperature and then conclude that it must be sunny.

It was public policy that private securitization markets would fail. That policy choice wasn’t centralized. It was a plurality of various influencers. Some thought prices would collapse. Some weren’t sure. Some thought the recession would be shallow. Some thought it would be deep. But, they all agreed on a substantial core of wrong things that created a set of errors of omission and commission that pushed those securities into failure.

Mortgage security failures were a policy choice. They were a cause, not an outcome. They were the independent variable.

There were things about those mortgages and those securities that any reasonable person would worry about, and potentially try to avoid or regulate. But, they weren’t destined to failure. They were willed to failure.

That doesn’t mean they weren’t bad! It’s just that their badness wasn’t confirmed for the reasons you think it was.

Consider that those other 19 conclusions about the 2008 crisis that were incorrect might just make it more likely that the criticisms and complaints about the private securitization market are incorrect too. P<0.05 may not mean anything here. That can be the case even if you knew a guy in 2006 who was making bank by handing out mortgages like candy to unemployed cashiers. That certainly seems reckless. Was it reckless enough to create the downturn and crisis? Most people think we know that. But we don’t.

What’s the answer? It’s the Lucas “Critique”. It requires questioning our current convictions. It doesn’t necessarily have a good replacement for them.