Econolypse Ethics Money Responsibility

Perpetual Prosperity Psychology and the Housing Bubble

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Something about the housing bubble narrative bugs me: Conspiracy. Evil bankers conspired to bilk Americans by financing home loans to people who could never pay, to then repackage bad mortgages as good investment products. While I lauded Matt Taibbi news analyses in 2010 and 2013 for exposing financial institution malfeasance, the blame game always seemed to ignore one other party’s culpability: Borrowers.

New research paper “Changes in Buyer Composition and the Expansion of Credit During the Boom” is a fascinating post-bubble autopsy. Its conclusions, if they survive the test, rewrite the bubble narrative, which revision makes more sense to me. 

Shared Guilt
Perhaps that’s because of where I started surveying the mess, three years before it became one. A decade ago on this site, I posted insightful prescient analysis “Pop Goes the Housing Bubble“—not that it garnered much attention. In August 2004, my wife and I looked at buying a home in suburban Maryland. But after a month of looking, and doing some qualitative research, I concluded that a housing bubble had inflated and would someday burst. Twelve months later, I posted the analysis, wanting to warn anyone and everyone about the risks of taking on or refinancing a mortgage.

At the time, I had little knowledge about derivatives, looking instead to attitudes and behaviors of lenders and borrowers. I identified a trend I called “equity trading”, where by refinancing mortgages existing homeowners skimmed off value that artificially pushed up home prices. The process created more equity to take later and fostered perception that home prices would continue to rise. I wrote in August 2005:

Banks and mortgage companies can’t seem to lend enough or people borrow enough. Most of my friends that are homeowners have refinanced their mortgages in the last 18 months, cashing out equity in their houses. Most of these same people already had refinanced for a lower interest rate. The new rash of refinancing often goes into new cars, big-screen TVs, and other purchases not related to home improvement.

As equity trading rose and the process, coupled with supply-and-demand logistics, lifted home values, lenders and borrowers assumed greater risks. More:

High house prices compel people to borrow more than they can afford, a circumstance I already had anecdotally observed here in the Washington area. The dangerous loans essentially defer the real payment burden, as people pay interest up front and gamble on increasing equity and low interest rates (if the loan is adjustable-rate mortgage, or ARM).

The false housing economy existed based on a simple premise: Home prices would continue to rise. In writing about the new study for the Washington Post, Robert Samuelson sees in the data something I observed anecdotally in 2004-2005: “Bubble psychology. It arose from years of economic expansion, beginning in the 1980s, that lulled people into faith in a placid future. They imagined what they wanted: perpetual prosperity”.

That’s exactly what I experienced as a non-homeowner a decade ago. Most of my friends encouraged me to buy, to invest in a home. Housing prices were rising and borrowing was easy, they insisted. But I saw many troubling signs of mass hysteria that ignored obvious warnings like the unbalanced mortgage-to-rent ratio (They should be about equal, but mortgages were 35 percent to 40 percent higher on average nationwide).

While Matt Taibbi and others crafting the “blame the greedy banks” narrative aren’t necessary wrong, the viewpoint presented isn’t right either. Banks can’t lend if people don’t want to borrow. Everyone succumbed to the perpetual prosperity delusion. Its naive to think any financial institution, which is after all a collection of people, in hive-mind fashion plotted against its customers and shareholders.

Both parties, lenders and borrowers, share blame for the bubble economy, which cheap credit enabled. The financial institutions’ culpability is more about what they did to cover up stupid behavior, to shift the blame, and to capitalize on the government bailout.

Key Findings
This afternoon, I sped-read the report, which is more than 40 pages with appendices. The National Bureau of Economic Research is publisher and there are three authors: Manuel Adelino, Antoinette Schoar, and Felipe Severino. I excerpt from the introduction, which summarizes the key findings:

First, when we relate individual mortgage size to income, measured either using borrower income from mortgage applications or average household income from the IRS, we see that the growth in individual mortgage size is strongly positively related to income growth throughout the pre-crisis period. This means that there was never a decoupling of mortgage growth and income growth at the individual level, the relevant measure for lending decisions.

Second, we show that there was an expansion of credit along the extensive margin: poorer neighborhoods have an increase in the number of loans being originated, with modest changes in individual DTI that are similar to those in high income zip codes. This happens because new home buyers had increasingly higher income levels than the average household living in these areas. At the same time, neighborhoods that experienced strong house price growth see a rise in average mortgage size, but again at DTI levels close to previous periods, since the average income of these buyers also went up significantly.

Third, we document how aggregate mortgage origination in the U.S. was distributed by borrower income levels. The large majority of mortgage dollars originated between 2002 and 2006 are obtained by middle income and high income borrowers (not the poor). While there was a rapid expansion in overall mortgage origination during this time period, the fraction of new mortgage dollars going to each income group was stable. In other words, the poor did not represent a higher fraction of the mortgage loans originated over the period. In addition, borrowers in the middle and top of the distribution are the ones that contributed most significantly to the increase in mortgages in default after 2007.

Stated differently: The majority of borrowers are whom I observed them to be, at least in the Washington, D.C. area, a decade ago. Existing or prospective homeowners of means. The lending problem wasn’t one of banks singling out people who were bad risks but rising home prices making most every borrower a bad risk. There, banks were culpable by pushing ARMs, which later inflated, after the bubble burst.

Had equity trading not artificially lifted consumer property values and had more home buyers sought to purchase a place to live rather than something in which to invest, there might not have developed a huge disparity between a borrower’s means vs the property’s over-valued price.

Meanwhile, regulatory changes allowed banks to lend from larger pools of capital outside the customer base, which removed an important check on mortgages. From my vantage point, the real crime is what happened after the bailout, which extinguished the economic wildfire that should have cleared out the financial institutional deadwood, but instead left behind a pile of consumer debt and debris.

Photo Credit: Blondinrikard Fröberg

1 Comment

  1. Quite true all in all Joe, but you shouldn’t overestimate the financial smarts of a lot of people that these mortgages were sold by some pretty dodgy characters. All in all, I also think that the US wasn’t helped by the ability to just hand in your keys and walk away from your debt as the law allows. Here in Australia as well as all of Europe and Asia, you cannot do that. You incur the difference the bank/mortgage company gets for your house and the mortgage value as an ongoing loan with the only escape being personal bankruptcy. Bankruptcy is a much bigger thing outside the USA and takes a lot longer to recover from, restricting the sort of financial decisions an individual is able to make for 10 years. Obviously this has implications for risk taking but it sure does concentrate your mind when you take out a loan!

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