A reader asks: My 28-year-old son just purchased his first home. He has a job but makes very little money. Nonetheless, he was able to make this important first investment because the house was available for sale as a result of foreclosure. This economic circumstance reduced the price of the house to the point that, inspite of his meager means, he was able to afford it. Where did the difference in the foreclosed debt and the value in excess of the price he paid in the transaction come from? Ironically, he is entitled to the Government’s $8k tax credit for first-time home buyers which he did not need to affect the purchase.

This is another way of asking how something can be worth $100 one day and $50 a year later. It’s the same object. Nothing in it changed.

The short answer is, prices don’t always reflect an asset’s “value” accurately. (There’s a school of economics that believes in the “Efficient Market Hypothesis.” They’d disagree with me, but that’s a conversation for another day.)

The market can screw up. Maybe that asset wasn’t worth $100. Maybe its value is $50, but something went horribly wrong and people mistakenly thought it was worth $100. That’s what economists mean when they call it a “bubble.”

Or maybe its value is $100. Maybe something has now gone horribly wrong and people mistakenly think it’s worth $50. That’s what banks told us back in late 2008 and early 2009, during the whole “nationalization” debate. They said the price crash was only temporary. When markets regain their senses, they’ll realize the assets were worth $100 all along…or at least $90.

A lot of economists are writing a lot of books and papers to explain why house prices rose and fell so precipitously. I’m writing one of those books, so I can’t fully answer the question here. If you ask Robert Shiller, he’ll tell you it’s because people just get irrationally exuberant sometimes. If you ask Edward Glaeser, Joseph Gyourko, and Albert Saiz, they’ll say it’s because demand outpaced supply for awhile.

But home prices weren’t the only thing rising and falling. Debt — consumer credit, mortgage loans, etc — exhibited “bubble” behavior too. Many of us think the “credit bubble” caused the “housing bubble.” In this case, the price of debt was too low, causing people to borrow too much.

Economists have a lot of opinions about this bubble too. Raghuram Rajan argues that the Fed kept interest rates too low, and people couldn’t keep up with the interest payments when rates rose. Charles Calomiris and Peter Wallison blame Fannie Mae and Freddie Mac for originating mortgages to people who couldn’t pay them back in the long run (and for buying those mortgages, increasing the demand for them). Susan Wachter, Adam Levitin, and Andrey Pavlov rest the burden on Wall Street, whose insatiable appetite for securitized junk created a growing demand for risky mortgages.

So, to return to the question, where did the difference come from? Depends whom you believe. Wachter, Levitin, and Pavlov have the most convincing evidence to support their case. The other arguments have too many holes to be the primary cause, but all probably played a contributing role.

There’s another way to look at this question: How did $11 trillion of wealth disappear?

We tend to think of wealth as something we can hold in our hand. If someone’s wealth decreases, it must go somewhere, right? Not exactly. Wealth contains a lot of promises (that’s all debt is: a promise to pay in the future) and prices (which, as we’ve learned, can change in a heartbeat).

On that note, I’ll conclude by directing you to Princeton economist Uwe Reinhardt’s must-read answer to this question: Where All That Money Went.

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Samuelson, a Washington Post columnist, calls Fannie Mae and Freddie Mac “economic mongrels” whose “losses stemmed from unrealistic ‘housing affordability goals’ [and] lax lending in pursuit of higher profits.” Not only is this statement factually incorrect, but nowhere in the entire op-ed does he explain why Fannie and Freddie exist in the first place. If you’re trying to criticize their policies and resolve the “question of what to do about” them, that’s kind of important.

In June 2009, I wrote one final op-ed for my most loyal readers. This one didn’t make it into the Hazleton Standard-Speaker, for which I had stopped writing a couple weeks earlier. Since there seems to be a lot of ignorance about the issues I discussed, let’s make it public:  

The United States is exceptional.

Whether our country is exceptional in the way it is typically depicted is a debate for another day, but we are indeed one of the few nations who can claim one specific mantle: the long-term, fixed-rate mortgage.

Not quite as sexy as you’d hoped?

The United States has gone through a mid-life crisis. It wanted the sleek sports car and the sexy mistress, and it forgot how good its stable job and family had been to it since its wedding day. It jumped on adjustable-rate mortgages, when the old-fashioned fixed-rate mortgage was sitting at home, just as beautiful as the day they met.

It got caught. Now, before estrangement leads to divorce, it’s time to come back home.

Unless you’re a banker, it probably comes as a surprise that 30-year, fixed-rate, prepayable mortgages don’t exist in many countries. Imagine the challenge a bank faces. First, the bank borrows your money in the form of deposits; then it loans that money out in the form of mortgages. It only keeps a fraction of your money in its vault as a reserve to pay daily withdrawals. Economists call this “borrowing short” and “lending long” because the deposits are short-term instruments (since you withdraw from them on a pretty regular basis) and the mortgages are long-term instruments (since they don’t have to be completely paid off for thirty years).

Now picture what happens when inflation rises. Suddenly, everything costs more, so you need to withdraw more money — which, of course, means the bank needs to give back more of that borrowed money. In order to do so, the bank needs to get back some of the money it leant so it can pay you. If they had used adjustable-rate mortgages, interest rates would automatically rise with inflation, so you would owe more money on your interest payment — and the bank would therefore have more money with which to pay depositors.

But they didn’t use adjustable-rate mortgages. Not in the twentieth-century United States. They used fixed-rate mortgages, so you don’t owe any more money than your usual interest payment. Since it is a long-term instrument, you won’t pay it back for many years, so the bank has no way to get the money it needs to pay the depositors.

The bank goes bankrupt, which is a shame because it means banks would shy away from long-term, fixed-rate mortgages.

Fixed-rate mortgages are good for consumers. As real estate economist Susan Wachter explained to Congress earlier this week, “Individual households are the least-well-equipped to weather instability in the financial system.” The solution, in economist-speak, is “duration matching.” You plan to live in your house for the long-term, so it makes sense for your mortgage to be long-term and not subject you to “unpredictable short-term cost fluctuations.”

A fixed-rate mortgage, Wachter explained, is also fairer: “Consumers do not want to have to worry about whether fine print or predatory lending will result in them losing their home and their investment. Consumers want the process of financing homeownership to be fair and transparent.” With adjustable-rate mortgages, in contrast, rates can rise when consumers least expect it, they can’t pay their monthly due, and the bank forecloses. And that is exactly what has triggered much of the bursting housing bubble of the last few years.

How can we encourage banks to lend long-term, fixed-rate mortgages without endangering their solvency?

That was the question the government sought to answer in 1968 when it created the Government National Mortgage Association, known colloquially as “Ginnie Mae.” (…) “Fannie Mae,” the Federal National Mortgage Association, had been around since the Great Depression as a government agency, but by 1968 the Johnson administration had decided to sell the company to the public to fund the Vietnam War. Ginnie Mae was spun off as the remaining government-owned portion during the sale.

Ginnie Mae was tasked with purchasing government-issued mortgages and securitizing them. They would buy up loans made by agencies like the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA); then they would bundle them together and sell shares in them in the manner described in my last column about securitization—except without the tranching.

In 1970, Congress established the Federal Home Loan Mortgage Corporation, which you know as “Freddie Mac,” to buy and securitize mortgages that the government did not insure. Their purview was the “conventional market,” which included all private-bank-issued mortgages less risky than the “jumbo” class. Fannie and Freddie would end up competing for this market.

Fannie, Freddie, and Ginnie were only allowed to securitize fixed-rate mortgages, which resolved the dilemma banks faced in trying to give consumers what they wanted. By securitizing fixed-rate mortgages, they gave the banks a market in which to sell their mortgages, increasing the profit potential of fixed-rate mortgages and giving the banks a bigger incentive to issue them to consumers. They also standardized the MBSs, which made them easier to sell — which in turn made more investors want to buy them. Economists call this “increasing liquidity.” The upshot for consumers was that the increased demand for MBSs put more pressure on banks to sell mortgages, so they lowered interest rates to attract more borrowers.

The other advantage of the “government-sponsored enterprises” (GSEs) was that they assumed all default risk. If a mortgage underlying one of their MBSs went south, the GSE would pay the investor out of their own pocket. The GSE did not, however, bear interest rate risk or prepayment risk. (If interest rates rise, the value of a fixed-rate mortgage decreases because the investor can make more money by lending to someone else who would pay them the higher interest payments.) Because investors didn’t have to worry about whether the mortgages would default, they were willing to pay a higher price, which made banks even more willing to issue fixed-rate mortgages — which meant even lower interest rates for consumers.

All this sounds like a win-win. Where did the GSEs go wrong?

[...]

Private banks began securitizing mortgages in the 1980s…because it was a good way to make money. But throw in poor capital requirement formulas and the loophole of off-balance-sheet vehicles, and it becomes a great way to make money. Try to fix the regulation by putting inept rating agencies and obviously biased internal risk managers in charge, add a bad probability model, and you have a recipe for too much debt and too risky securitization.

But why was the securitization so risky? After all, the GSEs had been doing it since 1968, and they didn’t seem to have any trouble.

The GSEs have strict standards. They are not allowed to securitize subprime mortgages, which underlie most of this crisis—another reason why it is ludicrous to pin the blame on them. Private banks, on the other hand, can securitize whatever they want. In the run-up to the peak of the housing bubble, private banks securitized increasingly risky mortgages—subprime mortgages belonging to people with high likelihood of default, adjustable-rate mortgages whose eventual rate increases would make it difficult for consumers to make their interest payments, and so forth—because more mortgages meant more profits and more market share. Since private-label securitizers do not guarantee default risk as the GSEs do, they had no incentive to keep risky mortgages at a reasonable level. If the mortgages defaulted, they figured, it would be the investor’s problem. (Of course, they were all buying each other’s MBSs, so one bank’s apathy is another bank’s problem.)

The rest [is well known by now]. Lending standards declined, low interest rates fuelled the boom, etcetera. The GSEs did not securitize these risky mortgages, though near the height of the bubble Congress pressured the FHA to insure mortgages with no down payment, which was clearly a bone-headed move. Where the GSEs got in trouble was with their portfolio. As private companies, they try to make a profit and increase market share just like the banks. They created a portfolio to buy riskier MBSs from the private banks because they were losing market share as the private-label securitizers were getting all the subprime business. Unlike their traditional business, the portfolio subjected them to all risks: default, interest rate, and prepayment. This portfolio [and the general decline in housing prices, caused by private securitization] is what caused the GSEs’ losses, triggering their eventual nationalization.

One can make the argument that privatizing the GSEs removes the “privatized profits and socialized losses” incentive, but recent experience suggests that you do not have to be “government-sponsored” to have your losses socialized by the government. The GSEs are too big to fail, just like Citigroup and Bank of America, and privatizing them won’t do a darn thing to change that.

What privatization will do is kill the long-term, fixed-rate mortgage, the foundation of American housing for half a century. Unlike the mortgage interest tax deduction or local land use regulations, the GSEs did not increase prices without increasing homeownership. Unlike low interest rates and lax lending standards, the GSEs did not encourage people to buy houses they could not afford or banks to buy risky assets with too much debt.

For forty-one years, the GSEs have done nothing but make the American dream a reality for people who might never have had the chance in their absence. After the crisis is over, they should be returned to their original status, perhaps as a regulated public utility so we are clear on the public/private allocation, but without their portfolio. They should have a strong regulator, whereas previously their regulator was powerless in the face of the massive GSE lobby. The result would be American exceptionalism at its finest.

That’s a very short version of the story I tell in my forthcoming book. Remind me to ship a copy to Robert Samuelson when it’s published.

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There’s one thing about Jdimytai Damour that I can’t get out of my head.

By now, you’ve heard Damour’s tragic story repeatedly. At the age of 34, the Wal-Mart worker was trampled to death by early-morning shoppers on Black Friday. You’ve probably heard all the moralizations, too—fingers wagged at the decline of moral values and the rise of consumerism—but here’s the part I just can’t shake: We killed him.  

No, I know you and I were not in Valley Stream, New York, on the morning in question, but we were there all the same, weren’t we? Two thousand people just like us stormed through those doors. Damour wasn’t killed by toys or sales or religion gone awry. Maybe those culprits all played a role, but as they say about the gun, they didn’t pull the trigger.

It was our feet that pounded him one-by-one. I’d guess it’s a lot like drowning. The weight of the crowd compresses his body until he can’t feel individual feet anymore, just an ocean wave coursing over him. He opens his mouth, but he can’t breathe. He tries to roll over or push the wave off his chest, but he can’t move. He sees blood, but he can’t tell where it’s coming from. Just as he goes into the kind of shock that squeezes every organ in terror, the picture recedes to black in a shroud of unimaginable pain.

And that’s how we did it. People just like us. Of course, we’d all like to believe that we would have stopped it. We would have seen him and helped because we weren’t raised like that. We have morals. We don’t value a 25% discount on blenders over a human life.

But in a crowd of 2,000, there were plenty of people like you and me, and that didn’t save Jdimytai Damour. Maybe they didn’t see him. Maybe they didn’t care. One thing is for sure, though: They were there, and they were part of that crowd. The crowd that killed Damour.

Economists are quite familiar with crowds. Until recently, most of them have ignored them in their research, but economists generally see business cycles as inextricably linked to the behavior of crowds. Ask any sociologist, and they will tell you that people can act 180-degrees different from their normal disposition when you put them in a crowd. We know it as mob psychology. Economists know it as price bubbles.

In the 1990s, the Case-Shiller Index, which measures housing prices across the country, had been flat overall (with a few gyrations) since World War II. In fact, since 1890, it had only risen 10%. Since WWII, that number was slightly negative. From 1997 to 2006, it rose by more than 80%. Unless the cost of building a house has increased exponentially (and it hadn’t), that’s a bubble.

The bubble itself occurred for all the reasons this column pointed out last week (and last year), but you’re probably wondering how it spiraled into a financial crisis.

Let’s say we place a bet on a basketball game. You bet on the favorite to win. They are national champions, first place in their conference, and undefeated. My team has only won half its games, but it’s looking for an upset. Lo and behold, we pull out one for the record books. You don’t understand. How could your team have lost? The odds were in your favor. Tough luck, you owe me.

That’s how Wall Street looked at the housing market. Housing prices had been going up at unprecedented rates since 1997, so they kept betting on them. They bet on mortgages, and then they bet on those bets. Then they bought insurance to cover their bets in case they lost, which made them bet more because they figured there was no downside so long as they bought enough insurance.

Just as your basketball team kept winning, housing prices kept going up—until the bubble finally deflated. Suddenly, everyone owed more money than they had because they made their bets on borrowed money. Since they didn’t know how many “bad debts” everyone had, they just stopped lending. Lending and borrowing is the lubricant of the economy, so you do the math.

Don’t forget they all bought insurance to cover their bets. Unfortunately, the insurance companies (especially AIG) didn’t think they would ever have to pay up. Like the banks, they thought housing prices would never fall. How could their team have lost? The odds were in their favor. Tough luck, they owe everyone, and they don’t have the money either.

Real estate economists Andrey Pavlov and Susan Wachter demonstrated this phenomenon—how Wall Street misprices assets and insurance by understating the risk they’ll go south—in 2006, but it must have fallen on deaf ears in Washington. In fact, they went in the opposite direction. In 2005, bank regulators told the Bush administration that unrestrained lending practices had led to this enormous bubble on which dangerous bets were being made, but lobbyists got the White House to ignore their warnings until it was too late.

Sure enough, the latest research by Pavlov and Wachter shows that the more aggressive the lending in a particular region, the more painful the housing price crash. Of course, they already knew that. Their recent paper applies to various regions across the United States in the current crisis, but over two years ago, they showed how “underpricing risk,” as it’s called in econ-lingo, exacerbates market crashes by looking at eighteen—count ‘em, eighteen warnings we ignored—other countries where this phenomenon took place. Everything old really is new again.

That’s the power of crowds. We may not have made dangerous bets or sold crazy mortgages, but we sank our teeth into debt, bought those houses, and never for a moment stopped to think that housing prices might fall. People just like you and me.

Note: The Pavlov-Wachter links direct you to the latest versions of these papers, so the publication dates may not correspond with those cited above. In my column, I was referring to the original drafts. (And in the interest of full disclosure, I have worked for and occasionally collaborate with Professor Wachter; I consider her a close friend and mentor. Her work, including much of the above column, will play a prominent role in my forthcoming book.)

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