What if all those reviled Wall Street insiders were victims of the housing meltdown and global crisis, just like the unwitting homeowners who got in over their heads with huge mortgages?
A paper written by a trio of relatively obscure Federal Reserve Bank of Boston researchers is raising some uncomfortable questions about exactly what triggered the nation’s epic housing downturn and all the financial carnage it wreaked.
The real culprit, in fact, may have been a speculative fever, akin a modern day Yukon gold rush, that engulfed both bankers and borrowers alike.
It’s a premise that if accepted, raises some uncomfortable questions about the federal government’s wrenching overhaul of our nation’s financial regulations.
After all, if it was bubble fever rather than greedy bankers that were to blame, the highly unpopular Dodd-Frank Act, already under heavy fire, looks even more suspect.
“The bubble theory therefore explains the foreclosure crisis as a consequence of distorted beliefs rather than distorted incentives,” the Fed researchers write.
In fact, the idea that speculative mania is to blame is just now starting to gain traction in academic circles, wrote Christopher L. Foote and Paul S. Willen, senior economists and policy advisors at the Federal Reserve Bank of Boston, and Kristopher S. Gerardi, a research economist and assistant policy advisor at the Federal Reserve Bank of Atlanta.
And one reason for its rise in popularity is that the conventional narrative behind what triggered the housing market collapse is crumbling under closer inspection.
That narrative goes something like this: Greedy mortgage broker cons unwitting and naïve borrower to sign onto a mortgage that looks affordable, but is wired to explode.
The broker picks up his fee and sends the mortgage along to the investment banker, who also knows there’s trouble, but doesn’t care since he can cash in as well. The banker bundles the faulty loan with others like it, then offloads the whole package on unwitting investors, using fancy financial engineering to prevent anyone from figuring out the true nature of the deal.
Basically, it’s a story of how wrong incentives, coupled with greed, blew up the housing market and nearly plunged the global economy into a repeat of the Great Depression.
It’s a great story. It has inspired an Academy Award-winning film and is now pretty much accepted conventional wisdom.
And, according to the Fed researchers, it also just happens to be dead wrong.
Speculative Frenzy
Take the supposedly devious practice of brokers writing mortgages and then selling them to investors. Well, that’s been going on for a century. And what about all those devilish innovations, like low-doc loans, that got their start during the bubble years? Well most have, in fact, been around for decades, the report notes.
Blaming the federal government doesn’t work either – it has been subsidizing the housing market in a big way since Congress passed the GI Bill during World War II.
So if big bad Wall Street or fumbling old Uncle Sam aren’t to blame for housing collapse, then who or what in the world should we be pointing the finger at?
The Fed paper offers an intriguing alternative: A whole society that temporarily lost its mind in a speculative frenzy.
In fact, there are more than a few past examples of this, starting with the Dutch tulip mania of the 1630s and the notorious South Sea Co. bubble in 18th century England, right through Florida land deals in the 1920s and tech stocks in the 1990s, the researchers note.
“Bubbles do not need securitization, government involvement, or nontraditional lending products to get started,” the Fed paper contends.
Certainly the actions of all the players in the housing bubble, from home sellers and buyers to mortgage brokers to investment bankers, all look fairly foolish now with the benefit of years of hindsight.
But strip away hindsight and recall the widespread belief during the bubble years that housing prices would just keep going up and up, and all that craziness has logic to it.
Refighting The Last War
In a particularly telling passage, the report notes:
“If both groups believe that house prices would continue to rise rapidly for the foreseeable future, then it is not surprising to find borrowers stretching to buy the biggest houses they could and investors lining up to give them the money. Rising house prices generate large capital gains for home purchasers. They also raise the value of the collateral backing mortgages, and thus reduce or eliminate credit losses for lenders. In short, higher house price expectations rationalize the decisions of borrowers, investors and intermediaries.”
If you buy into this argument – and it certainly is compelling – then it raises serious questions about whether the Obama administration and its Democratic allies in Congress have wasted years trying to shove the wrong set of reforms down Wall Street’s throat.
Dodd-Frank, for example, tries to realign incentives to prevent the kind of pass-the-buck mentality that supposedly helped keep the housing bubble inflating. The act, for example, requires lenders who write mortgages to keep a slice of the credit risk of these loans even after they are sold to investors.
But measures like that seem unlikely to prevent another bubble. After all, economists have little idea what actually sparks these speculative frenzies, with the area wide open for new research, the Fed paper notes.
Given human nature, it seems likely we are fated to endure another speculative bubble in the years and decades ahead, though whether it will come again in real estate or some other totally unrelated field is anyone’s guess.
Instead, the Fed researchers suggest that regulators would be better off focusing on making the banking industry more resilient to potential bubbles.
Otherwise, we will send up refighting the last war, and we all know how successful that is.
