The Credit Crisis Visualized

Part I

Part II

Hat tip: Analiese.

Comments

  1. #1 AK
    February 23, 2009

    Nice. But he forgot to include a few things, such as deteriorating predictability of credit scores, the building of second tier derivatives, completely off-the-wall risk models, the credit rating agencies’ using risk models developed by the vendors rather than doing their own evaluations, the collapse of a major housing bubble independent of the supply/demand-driven drop in housing prices, and the accumulation of businesses whose very model depended on rising housing prices: when housing prices stopped rising, these businesses began to fail, triggering a further credit freeze.

    Cases in point:

    How often in the last few years have you heard or seen advertisers wanting to help you “improve your credit score”? The algorithm behind these scores was developed without any assumption that people would be able to “game” the scoring system.

    How often in the last few years have you heard or seen advertisers wanting to set you up in business “flipping houses”, a business that only works when housing prices are predictably rising? Guess where the money for these businesses comes from? Guess what happens to it when the businesses fail?

  2. #2 Richard
    February 23, 2009

    The other things that were missed out were the well intentioned, but misguided expansion of credit to marginal borrowers. The origin of this expansion is often attributed to a discredited study by the Boston Fed which claimed to have found evidence of mortgage discrimination (the study was based on terrible analysis and poorly manipulated data). Anyhow, the study caused a stir that mortgages weren’t available to a group of the population. This got all sorts of well meaning legislators very upset.

    At the same time Fannie and Freddie are in trouble for mismanagement and fraud, and to redeem themselves they strike a deal with congress. Basically, they say – we’ll encourage lending to anyone with a pulse, if you let us alone.

    Congress, particularly the dems like this, as they are able to expand homeownership to a greater portion of the population. So a deal is struck and Fannie and Freddie start making loans to subprime borrowers. Wall street loves this because Fannie and Freddie are essentially backing the deal. Furthermore, Countrywide and Bear Stearns who aggressively pursue these mortgages are praised by the government for expanding home ownership.

    It would be nice to say that this is all due to wall street greed. Indeed wall street greed has a lot to do with it. But terrible government housing policy by well meaning, but clueless dems (pelosi, frank et al) had a lot to do with it.

    Finally, the defaults extend beyond the subprime because of the upward pressure on housing prices – largely driven by the new, previously non-existent subprime demand – results in more prime borrowers over extending themselves. People buy second and third houses, take out huge mortgages, etc.

    While there are calls for more regulation, ultimately, much of our problems today are due to very bad government policy. In general, markets function pretty well when left alone. Its when government policy distorts incentives and risks that things get ugly.

  3. #3 Stephanie Z
    February 23, 2009

    Right, Richard. The impetus to get lower-income borrowers into houses where they can build equity is what drove fraudulent mortgage applications from brokers. Yep, that must have been it.

    The problem is that we treated “the market” as the only appropriate place for the money we’ll need in the future, kind of like that push to privatize Social Security. Only we can’t use “market” money for anything that won’t help a company meet an analyst’s predictions, so we’re generally stuck with short-term, self-defeating investments, like buying a company to cut its payroll, or these paper investments that look great as long as you don’t know how they actually work.

    Yes, the problems today are caused by very bad government policy, but it has little to do with regulation. It has almost everything to do with the idea that the only thing money is good for is making more money.

    Adding half a note of “wall street greed” doesn’t make your tired, old song any sweeter, dude.

  4. #4 Greg Laden
    February 23, 2009

    I just want to add in a couple of other factors that I know where happening over the last 15 years or so. I don’t know if these matter.

    1) The presumption that home ownership trumps renting in all respects from the renter/owner point of view. While this may often be true it is not always true.

    2) The presumption that home ownership = good or at least better citizenship. This is probably at least somewhat true, but I mention it is an actual factor in the push for broadening home ownership. (Other than real or perceived discrimination, etc.)

  5. #5 Richard
    February 23, 2009

    Stephanie.
    Ahh, it was all due to the fraudulent mortgage brokers…if only. Talk about a tired old song. That one’s a classic golden oldie. But really misses the point.

    Banks have been lending on houses for years and years. They have a pretty good idea of what is a good loan risk and what isn’t. They are good at measuring and assessing risk. They wouldn’t have ignored the subprime market for years if there was money to be made.

    What it took was a push to get more lending to lower income folks (and a global credit glut). It isn’t rocket science to see that the risks of these borrowers was greater than the traditional mortgage pool. Fannie and Freddie (with government mandates) actively encouraged Countrywide and Bear to look beyond traditional measures of credit worthiness – to take a more “flexible view”, and of course the banks did.

    So you get lots of folks buying houses for the first time who get in over the heads. But often (and this applies to the prime borrowers also), they assume that because the housing market has been going up they can build equity and perhaps cash out at a later date. Or at least refinance.

    It’s the availability of cheap credit, and the upward pressure on house prices that keeps the bubble going. Eventually, as with most bubbles, it burst, and those in the most tenuous position are the ones who capitulate first – the folks who are over extended.

    I am sure that there were some fraudulent mortgages, but I don’t think that was the main driver, a contributing factor sure, but not the main one. The main cause was greed and a failure to see the downside.

    Wall street jumped on the band wagon, as did many many individual home buyers. Folks who through option-ARM or balloon mortgages could now afford (at least in the short run) a home that they never would have been able to.

    As for the comment that “The problem is that we treated “the market” as the only appropriate place for the money we’ll need in the future” – you are free to put your money anywhere you want. Nobody is making you invest in the market.

  6. #6 Richard
    February 23, 2009

    Greg – you raise good points – why is homeownership considered so important? We are one of the few countries that gives tax breaks for mortgage interest. Why don’t we give tax breaks for rent? It makes no sense really.

    Owning a home isn’t even that good of an investment. Average long term appreciation on most homes is not much above inflation, and that ignores the significant costs of ownership. In fact homeownership is more akin to buying a car – a depreciating asset. It is the land that makes the thing more valuable.

    There may be social benefits to home ownership – but its not clear whether they merit the cost.

    Either way, its an interesting question.

  7. #7 AK
    February 24, 2009

    @Richard:

    Finally, the defaults extend beyond the subprime because of the upward pressure on housing prices – largely driven by the new, previously non-existent subprime demand – results in more prime borrowers over extending themselves. People buy second and third houses, take out huge mortgages, etc.

    Once they over-extend themselves, prime borrowers become sub-prime. Don’t forget that a lot of these risky mortgages were jumbos made to people in middle or even upper income brackets.

    But more importantly, IMO, there was a real housing bubble beyond the upwards pressure from greater demand. This started with a real increase in housing values as social factors (mostly internet related) made it easier for people to live longer distances from their work. Expectations made it continue past its normal stopping point (like a beach-ball released underwater popping all the way out of the water then splashing back: the splashback represents the collapse of the bubble).

    The proximate cause of the stall and collapse in housing prices was almost certainly the rise in gas prices. This both squeezed people who had bought homes too far from work, and squeezed the market as prospective buyers suddenly saw much less value in houses too far from work. It spiraled from there.

  8. #8 Moopheus
    February 24, 2009

    “At the same time Fannie and Freddie are in trouble for mismanagement and fraud, and to redeem themselves they strike a deal with congress. Basically, they say – we’ll encourage lending to anyone with a pulse, if you let us alone.”

    However, F&F got into the this rather late in the game. Yes, they were corrupt and greedy, and Barney Frank is a doofus, but most of the subprime water had already flowed under the bridge, as it were. 85% of “subprime” lending was private lending through nonbank brokers to investors–most subprime lending didn’t meet even the more lax GSE “confoming” loan standards, which had constraints on loan size, LTV ratios, and documentation. A lot of this MBS actually ended up overseas, much in European banks. Most of these lenders weren’t subject to CRA reporting either, so gov policy regarding minorities had very little to do with it. And, I don’t believe gov policy was for people to lie about their incomes on loans or for brokers to keep plugging numbers into the underwriting system until it gave them a number it liked, or for banks to pressure appraisers, or….I could go on. Some mortgage fraud? Where was there not? Throughout the bubble, F&F were actually losing market share, fast. They were not blameless, but the bubble didn’t happen because of them, but in spite of them.

    Also, at the peak of the bubble, 40 to 50% of all sales were non-owner occupied–i.e., speculative buying. In some markets–Miami, Vegas, and the like–there were whole condo developments with no occupants, only speculators.

    Another thing we sometimes forget is that the bubble was global–England, Ireland, Spain, Portugal, India, Australia, and China had simultaneous bubbles. It should be noted that India’s banks will survive because their regulators strictly enforced capital requirements and limitations on riskier investments.

    There are some bad government policies on housing–mainly special tax breaks that should be eliminated–that did contribute.

    The cause of the collapse of the bubble was the bubble–it was fundamentally unsustainable. When you get to the point of 105% financing on liar loans to bad risks, you’ve pretty much gotten to the bottom of the barrel and there’s no next round of greater fools to be had. Teaser-rate ARMs were just time-bombs waiting to blow, and they did, right on schedule. As to blame, there’s plenty of that to go around. There’s a lot of ideological finger-pointing, but this was a bipartisan, international clusterfuck of greed and stupidity in which no participant is blameless. Indeed, the question, “what the fuck did you THINK was going to happen?” comes up again and again.

  9. #9 AK
    February 24, 2009

    From Scientific American (Dec. ’08):

    …[I]nvestment bankers from the largest institutions pleaded successfully with Securities and Ex­­change Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day. This decision, a real event described in the New York Times, freed billions to invest in complex mortgage-backed securities and derivatives that helped to bring about the financial meltdown in September

    […]

    These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio. Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants.

    […]

    In aviation, controlled flight into terrain describes the actions of a pilot who, through inattention or incompetence, directs a well-functioning airplane into the side of a mountain. Wall Street’s version stems from the SEC’s decision to allow overreliance on risk software in the middle of a historic housing bubble. The heady environment permitted traders to enter overoptimistic assumptions and faulty data into their models, jiggering the software to avoid setting off alarm bells.

    […]

    These number wizards and their superiors need to study lessons that were never learned during previous market smashups involving intricate financial engineering: risk management models should serve only as aids not substitutes for the critical human factor.

  10. #10 Moopheus
    February 24, 2009

    “[I]nvestment bankers from the largest institutions pleaded successfully with Securities and Ex change Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day.”

    One of those bankers was Henry Paulson, representing Goldman Sachs.

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