Anatomy of a Train Wreck

Stan J. Liebowitz looks at the Anatomy of a Train Wreck: Causes of the Mortgage Meltdown. Liebowitz is Research Fellow at The Independent Institute, Ashbel Smith Professor of Economics and Director of the Center for the Analysis of Property Rights and Innovation at the University of Texas at Dallas.

In his report Liebowitz asks a number of questions: Why did the mortgage market melt down so badly? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be?

In the executive summary of his report the key paragraph is

This report concludes that, in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs, and housing activists universally praised the decline in mortgage-underwriting standards as an “innovation” in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The price bubble, along with relaxed lending standards, allowed speculators to purchase homes without putting their own money at risk.

In his conclusion Liebowitz writes

We are experiencing one of the worst financial panics in the post-WWII era. Everyone knows that the increase in mortgage defaults has been the primary driver for these financial difficulties. The mortgages with outrageously lax underwriting standards that have been justifiably ridiculed in the press are not unusual outliers but unfortunately are representative of a great many mortgages that have been made in the last few years.

The question that is being asked is the correct question: how did it come about that our financial system allowed such loans to be made, condoned such loans, and even celebrated such loans? The answers that are being given are not yet the correct ones, however. The main answer that is being given, that unscrupulous lenders were taking advantage of poorly informed borrowers, does not fit the evidence nor does it dig deep enough.

The “mortgage innovations” that are largely the federal government’s responsibility are almost completely ignored. These “innovations,” heralded as such by regulators, politicians, GSEs, and academics, are the true culprits responsible for the mortgage meltdown. [...]

The political housing establishment, by which I mean the federal government and all the agencies involved with regulating housing and mortgages, is proud of its mortgage innovations because they increased home ownership. The housing establishment refuses, however, to take the blame for the flip side of its focus on increasing home ownership—first, the bubble in home prices caused by lowering underwriting standards and then the bursting of the bubble with the almost catastrophic consequences to the economy as a whole and the financial difficulties being faced by some of the very homeowners the housing establishment claims to be trying to benefit.

Later in the executive summary Liebowitz says

The recent rise in foreclosures is not related empirically to the distinction between subprime and prime loans since both sustained the same percentage increase of foreclosures and at the same time. Nor is it consistent with the “nasty subprime lender” hypothesis currently considered to be the cause of the mortgage meltdown. Instead, the important factor is the distinction between adjustable-rate and fixed-rate mortgages. This evidence is consistent with speculators turning and running when housing prices stopped rising.

In his conclusion he goes on to say,

But let’s not blame the speculators here. There is nothing wrong with speculation or speculators. At fault is a mortgage system run by flexible underwriting standards, which allowed these speculators to make bets on the housing market with other people’s money. It was a system that invited the applicant to lie about income. It was a system that induced applicants to watch a video instead of providing solid evidence about their financial condition.

Even that would not be so bad if the people making the money available were aware of its use and knew that they would have recourse to getting their money back. But the money for the speculation was made available by lenders who believed the housing and regulatory establishment when this housing and regulatory establishment said that such loans were safe. Since the housing and regulatory establishment consisted of mighty government agencies and highly educated academics, it was not unreasonable for the lenders to assume that the claims made for flexible underwriting standards were correct. Unfortunately, the claims were not correct although most of the housing and regulatory establishment continue to argue otherwise.