Monday, September 17, 2012

Boston Fed on causes of foreclosure crisis

Some economists at the Federal Reserve Bank of Boston have issued a "Public Policy Discussion Paper" in which they discuss the causes of the foreclosure crisis.  The paper is part of a collection of other Boston Fed reports that is available here.  Just scroll down to the second one, Paper p-12-2 which begins on page 9.

The paper is concise and makes twelve points that largely debunk the prevailing narratives on what caused the crisis:
  1. It wasn't caused my adjustable rate mortgage resets - if you converted all of those to fixed rates and not had the jump in monthly payments, only 12% of all foreclosures would have been effected;
  2. "Non-traditional mortgages" were the problem - they had all been around for quite a while without difficulty;
  3. "Innovative mortgage products" were designed to fail - They had all been around for decades and didn't fail until the mid-2000s;
  4. Government policy of extending loans to a broader segment of the population caused the problem - it didn't'
  5. The "originate to distribute" model of lending, meaning the person writing the loan will immediately assign it to someone else, had also been around for a long time without difficulty;
  6. "Complex financial products" like credit default swaps had been around for decades;
  7. Those who invested in mortgage-backed securities had a lot of information; they just chose not to pay attention to it;
  8. Investors fully understood the risks, they just didn't think the risks would occur;
  9. Investors were optimistic about housing prices
  10. Mortgage insiders like Bear Stearns were the biggest losers;
  11. Outsiders, at least those who believed values would decrease; were the biggest winners;
  12. AAA bonds backed by mortgages did OK; AAA bonds backed by "complex debt obligations" (i.e., the worst mortgage were pooled and then the top of the pool was deemed AAA) were disasters.
The authors conclude that it was excessive optimism about prices that caused this crisis.  In other words, it was a classic bubble.  Analysts prepared scenarios that predicted exactly what happened but no one took those scenarios seriously and so ignored them.  The author also observe that since it has been historically difficult to identify the existence of a bubble when you are in the middle of it, both the lending system and consumers must be forced into practices that would allow them to sustain a price drop of at least 20% and still survive.  It is only by building such resilience into the system that we will be able to withstand future collapses.

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