Wednesday, 8 October 2008

Subprime bogeymen, and other myths

Via a comment on a recent post at EconLog (which contains the 'fantasy testimony' of the ever-brilliant Arnold Kling on the current crisis), I came across this Independent Institute Policy Report by Stan J Liebowitz, Professor of Economics at the University of Texas at Dallas.

A incisive and clear report, Liebowitz advances the hypothesis that the collapse in the mortgage market is the product of the ubiquity of the loose lending standards pioneered in the GSEs, Fannie Mae and Freddie Mac. He ties this in with the implicit guarantees to firms that these institutions would buy up loans with low-lending standards, incentivised by the political motive of increasing home-ownership beyond sustainable levels, and traces the role of the government-certified ratings agencies, free from honest competition, in underestimating default rates on these mortgages.

A particular highlight is his exposition, on pages 18 to 21, of the paucity of the explanation that a malevolent, greedy, 'subprime bogeyman' exploited the ignorance of poor and minority groups to sell them mortgages up front which they would be incapable of repaying. These two figures, from page 20, supply the death-blow to this populist explanation:

"The foreclosures on subprime adjustable-rate mortgages track closely with the foreclosures on subprime fixed-rate mortgages until 2005, at which point they begin to sharply diverge. Foreclosures on subprime adjustable loans began to increase in late 2005 and had increased by almost 300 percent by the end of 2007..."

"Fixed-rate prime defaults are also at all-time highs by the end of 2007, but not by much. This result is completely overshadowed, however, by the increased default rates of adjustable-rate prime loans, which increase by almost 40 percent over the same period and which reached levels unlike anything in the previous decade. Again, adjustable-rate prime mortgages are hit as hard or harder than the adjustable-rate subprime mortgages."
By showing that the increase in foreclosures in the adjustable-rate prime and subprime markets occur at the same time (contrary to the popular notion of the former being 'infected' by the latter), and that the percentage increase in prime foreclosures is greater than that in subprime foreclosures, Liebowitz puts to bed the notion that the subprime defaults are at the root of this problem. That is not to say that a greater proportion of subprime mortgages defaulted (as is evidently sensible - it is the increased risk of default that causes a loan to be classed as subprime), but that the subprime market was no worse, comparably, than the prime market; both were affected similarly, and the 'subprime bogeyman' does not feature in the prime markets in the popular story. The empirical data simply does not support the thesis that exploitative mortgage brokers created this crisis by selling poor uneducated people loans they could never afford to repay, no matter how much people at the Daily Kos insist.

The data does suggest, though, adjustable rate mortgages which reset were key to the wave of foreclosures - in both markets. In explanation for this trend, he shows how speculative buying of houses for the purpose of selling shortly afterwards, profiting from rising prices, led to an increase in the volume of adjustable mortgages. These are offered at initially low interest 'teaser' rates, and hence appeal to investors who expected to have sold the property within months. Far from losing his head, though, and proposing a ban speculation in the housing market, Liebowitz argues that
"the money for the speculation was made available by lenders who belived 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."
This 29-page report is one of the most cogent explanations of the mortgage collapse, and comprehensively dispels the 'subprime bogeyman' myth. It also complements Arnold Kling's case, which emphasises the absence of down-payments as a particularly worrying loose lending standard promoted by the GSEs, which all but guarantees default in the case of even a minor fall in house prices.

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