No folly has hurt the United States more than the housing bubble of this century’s first decade. “All of us participated in the destructive behavior — government, lenders, borrowers, the media, rating agencies, you name it,” Buffett wrote in his latest annual letter to shareholders. “At the core of the folly was the almost universal belief that the value of houses was certain to increase over time and that any dips would be inconsequential. The acceptance of this premise justified almost any price and practice in housing transactions.”
Those characteristically pithy sentences cut through much conventional wisdom that would pin the crisis on lax regulators, deceptive financiers or profligate borrowers. The problem wasn’t so much that people acted irrationally, based on what they knew, as that they behaved rationally — and what they “knew” wasn’t true.
Buffett’s common-sensical appraisal receives independent validation in a new paper by Federal Reserve economists Christopher L. Foote, Kristopher S. Gerardi and Paul S. Willen. Their data refute many oft-made accusations about the housing bubble.
Did adjustable-rate subprime mortgages — “exploding ARMs” and the like — cause the wave of foreclosures? No: Defaults on such mortgages did not surge after two years, when their interest rates reset; the worst-performing vintage, made in January 2007, had no interest rate “shock,” since rates had fallen substantially by January 2009.
Nor did sellers of mortgage-backed securities deceive buyers. Even the notorious 2007 Goldman Sachs deal known as Abacus AC1 CDO included enough information to determine the current delinquency status of every individual loan in the securitized package.
In fact, mortgage market insiders were among the biggest losers. As Foote, Gerardi and Willen put it, “the executives most likely to understand the subprime-lending process had made personal investment decisions that exposed them to subprime risk.” Bear Stearns, a big subprime player, went under in 2008 partly because of its hedge funds’ losses on subprime — a fatal diet of home cooking, you might say.
Meanwhile, “outsiders” such as John Paulson’s hedge fund made a killing. But Paulson, who famously bet against subprime securities, didn’t do so because he figured out that they were somehow “designed to fail.” Rather, he simply dissented from the belief that house prices were never going to fall significantly — and invested accordingly.
Widely held optimism about prices, the Boston Fed economists show, overrode all other considerations in the market. Investors knew, or easily could have found out, that mortgage underwriting standards had been relaxed. They just didn’t care, because “in the event that the borrower defaulted, then the higher price of the house serving as collateral would eliminate any credit losses.”
The same logic explains why so many households, including those with low wealth, played the game. Given the belief in eternal appreciation of house prices, you would have been crazy not to take out a 2/28 ARM with no money down, and maybe a little cash back at closing!
As Buffett notes in his letter, “Large numbers of people who ‘lost’ their house through foreclosure have actually realized a profit because they carried out refinancings earlier that gave them cash in excess of their cost. In these cases, the evicted homeowner was the winner, and the victim was the lender.”
Foote, Gerardi and Willen admit that economists are no closer to explaining the U.S. house mania than they are to understanding the tulip mania in Holland almost four centuries ago. They think the Federal Reserve’s interest rate policy or Fannie Mae’s interventions might have helped start the madness but can’t account for its timing or momentum.
We can clean up the housing mess and learn from it. But even the most enlightened policy can’t guarantee it will never happen again. Folly is human nature, and you can’t regulate human nature.