What "Real Estate Bubble" Means

Bonddad has a diary up at DailyKos:

The biggest problem with securitization is no one has a vested interest performing due diligence on the borrowers – the people taking out the mortgage loans.  The mortgage brokers write the loan and sell it to a large investment bank.  The investment bank pools the mortgage and carves it up into different bonds.  The bond holders don’t hold all the collateral, only pieces of it.  As a result, no one really owns all the mortgages for an extended period of time.  Instead, the most they own is a piece of a larger pool of mortgages.  

Let’s go back to the first few paragraphs.  Remember – we’re using collateral composed of residential mortgages.  What if we’re writing a lot of mortgages to people who aren’t credit worthy?  That’s the central problem with the mortgage securities market right now – mortgage brokers wrote a lot of loans to people who couldn’t afford them.  In other words, the collateral used as the basis for mortgage backed bonds was bad collateral.  No matter how you carve the cash flows, you’re still using collateral that will eventually default. 

In a word, no. I think he's got the picture backward. The problem didn't start with mortgage bankers making bad loans which were packaged into mortgage-backeds on Wall Street. The problem started with Wall Street deciding mortgage-backeds were the way to make money on a large scale, and then dumping a lot of investor cash on mortgage bankers, who then turned around and did what they needed to do to meet the demand.

There are two ways for mortgage bankers to increase the supply of mortgages for Wall Street. One would be to write more mortgages, which they did and implicates the uncreditworthy borrower issue. But the easier way is to write bigger mortgages, which was the real "central problem."

Mortgage bankers usually act as the outside brake on the price of a house. Buyers and sellers act under the presumption that the sale price they are negotiating will be limited to whatever a bank will lend on a given property. Now let's say the bank's incentive is to make that loan as large as possible, but the parties to the sale transaction don't realize the lender's incentives have changed. (This is what Duncan Black has talked about in the past - that borrowers trust the banks to tell them when too much is too much, and the banks violated that trust.) What happens is that asset prices can move up almost freely. This is what is meant by a "bubble": Too much money chasing too few assets. The money was generated from investors on Wall Street, and then flowed downhill until it caused housing prices to spike via the lending process on individual sales. That is, again, the problem began on the finance side, not the retail lending side.

It's also wrong to imply (as Bonddad does) that no one in the chain has a "vested interest" in the creditworthiness of mortgage-backeds or other securitized instruments. The problem is that most people in the chain were feckless. The incentives were fine. The people failed.

Having analyzed the problem wrong, I think Bonddad gets the solution wrong. He advocates regulating lending standards. The way this process should have been stopped is financial regulation of the Wall Street side, not the mortgage banking side. Certainly not the lending standards. The red flag wasn't that people were getting 95% loan-to-value, the red flag was that $X billion of mortgage-backeds were being sold when there wasn't $X billion of new mortgages that could be sustained by the economy. (Okay, the loan-to-value thing was also a red flag, but of the symptom, not the cause.) As Duncan has said, all you needed to look at was the ratio of home prices to rents to see the bubble, and from there it was easy to figure out the source of the problem.

Trying to fix the problem by treating one symptom just distracts from the real problem. Asset price bubbles always stem from too much money chasing too few assets. In modern America, that means Wall Street. Last time, it was internet companies, this time it was residential real estate. If you want to prevent this sort of thing in the future, do a better job watching, regulating and running Wall Street, not regulating lending standards for residential real estate, because next time it won't be residential real estate.

(Via Frank Bell at From Pineview Farm.)

Comments

[zenpundit]

You have it right.

I've had loans where I've put down 20 %+. loans that were 95 % to value, building loans, bridge loans that were effectively secured only on already mortgaged property. The germane issue in all of them was what I could afford to write a check for on a regular basis, not the ratios.

Modern market bubbles began with the South Sea islands company in early 18th century Great Britain and they have followed that pattern ever since. There's nothing wrong with fractionating risk per se as an investment so long as the structure of such investments doesn't incentivize people toward magical thinking. When that's occurring, tax and regulatory changes need to be made to shift risk-tolerant "high returns" investors to productive venture capital rather than unproductive bidding up of paper investments

[John]

This is one of the reasons why when I read bonddad I take it as one man's perspective, and not economic gospel, as his legions of DKos fans seem to. He can be interesting, but he's no soothsayer.

That Duncan Black on the other hand...