Perverse incentives and the U.S. housing crisis

At the P2P Foundation, we pay a lot of attention, to the social protocols governing human interaction, i.e. the decision-making processes, the collective choice systems, the incentives and metrics. Humans are sensitive to being nudged in one direction or another, and an optimal social system harmonizes individual and collective interests towards the common good.

There is a dangerous and predictable myth doing the rounds in the U.S. right, that the housing crisis was caused by social policy.

Barry Ritholtz from the Big Picture blog, explains why this is not so, and why the crisis results from perverse incentives:

Nothing in any of these Bush speeches that pushed for more lending to minorities and increased lower income home ownership caused the problem. Neither did any similar Clinton speeches. Nor did related the legislation related to the Bush speeches, nor did the CRA, nor Fannie Mae or Freddie Mac. Indeed, none of these actions required the sort of reckless lending that we saw from 2002-2007.

Understand this simple fact: In an ultra-low rate environment, where prices are appreciating rapidly, and mortgages are being securitized, ALL THAT MATTERS IS THAT THE BORROWER NOT DEFAULT IN 90 days (or 6 Months). The goal was to make a loan that did not default in that period of time, it cannot be put back to the originator.

As a mortgage salesman, you only lose your a fee if a borrower defaults within 3 or 6 months. What do you do to maximize your returns? The best way to do that — to put people in houses that would not default in 90 days — was the 2/28 ARM mortgages. Cheap teaser rates for 24 months, then the big reset. By then, it was no longer your problem.

Can you grasp what a monumental change this was? Instead of making sure that borrowers could pay back ALL OF THE 30 YEAR FIXED MORTGAGE, you only had to find people who could afford the teaser rate for a a few months. THIS WAS AN ENORMOUS AND UNPRECEDENTED SHIFT IN LENDING.

This is the key to the hosuing boom and bust, and ultimately underlies the entire credit freeze. And, it would not have been possible without the Greenspan ultra-low rates, which made the teaser portion (the “2” of the 2/28) of these mortgages so attractive.”

Fred Goldstein of Ionary has a good explanation of how the subprime is linked to the larger debt crisis picture:

In 1960, somebody wanted to buy a house in Passaic, so they went to the Bank of Passaic and asked for a mortgage. The banker knew the street and could find the house, and knew the applicant. The banker hired a known appraiser to verify the value of the house. After checking the applicant’s credit, they took 20% down and granted a mortgage, which they kept in portfolio.

In 1980, someone bought the house. They went to Big Regional S&L, who had a vague idea of the area and who hired an appraisal firm to send somebody to verify the value of the house. After checking the applicant’s credit, they took 10% down, required Private Mortgage Insurance, and granted a mortgage, which they sold to Fannie Mae.

Fannie Mae in turn bundled a bunch of mortgages and sold them to investors. BRS&L stayed on to service the loan.

In 2000, somebody else bought the house. They went to National Mortgage Chain, who hired an appraisal firm to validate the value of the house. They let the applicant have a “no doc” loan with 5% down. They bundled a bunch of these and sold them on the securities market, and hired a servicer.

In 2004, the homeowner refinanced. The market was up so he took out equity and got a 90% loan on the estimated new value. He went to Jose the Mortgage Broker who wrote a subprime 4% 3/1 with 6/2 caps no-doc loan with a big commission for himself. The mortgage company he turned it over to hired an appraiser who was more than a bit generous in estimating the value. The mortgage company bundled the loan and sold it to an investment bank, who mixed it up with other bundles and sold pieces of them on the securities market. The buyers of securities arranged credit default swaps from a hedge fund. The hedge fund sold the CDS ten times over. The security holders bought CDSs on five times the portfolio value, figuring that a default would trigger “The Producers”-like profits. The homeowner then defaulted when the rate reset up from 4% to 10%. But the CDSs were backed up only by other worthless CDSs. Bialistock and Bloom got caught. But they asked for a bailout, citing the old maxim, “if I owe you a thousand dollars, I have a problem; if I owe you a billion dollars, you have a problem.” So all that’s left to argue over is the size of their golden parachute.”