The general key point is captured here:
Our point isn't that bankers didn't make stupendous blunders. It is that the roots of the mania and panic are so much larger than any single financial security, compensation practice or regulation. And those roots are found as much in Washington as on Wall Street.
Start with the Federal Reserve, which for years kept interest rates below the rate of inflation and thus created a global subsidy for credit. Bankers and investors had an incentive to sell and take on more debt. A Journal survey of economists this week found that a majority now think Fed policy was a major culprit. Providing a rare source of wisdom at yesterday's hearing was FDIC Chairman Sheila Bair, who explained how the Fed's monetary policy helped inflate the housing bubble.
If the commissioners are looking for historical guidance, they might consult the late Charles Kindleberger's classic, "Manias, Panics, and Crashes: A History of Financial Crises." On page 10 of the Fifth Edition paperback, the good professor declares that "The thesis of this book is that the cycle of manias and panics results from the pro-cyclical changes in the supply of credit." (Our emphasis.) An inquiry that ignores the sources of credit that fed the mania is like a history of the Civil War that ignores slavery.
Also missing this week was anyone from Fannie Mae and Freddie Mac, the mortgage giants that turbocharged the housing boom. With their implicit taxpayer backing, Fan and Fred held or guaranteed more subprime and Alt-A loans than anyone—much more than the combined holdings of the four bankers represented this week.
So long as Fan and Fred kept increasing mortgages to low-income borrowers, the dynamic duo's political protectors kept fighting off efforts to cap the size of Fan and Fred's mortgage portfolios. The pair would ultimately hold or guarantee mortgages amounting to more than $5 trillion. That sum is greater than the annual GDP of Japan, the world's third largest economy, and yes, a whole lot bigger than the balance sheet of Goldman Sachs. A serious inquiry will examine the business practices of Fan and Fred, the long battle to rein them in, and the Members of Congress who blocked reform.
There is more of an overview here and a rebutting of blame on EMH:
But is the Efficient Market Hypothesis (EMH) really responsible for the current crisis? The answer is no. The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low. The fact that the best and brightest on Wall Street made so many mistakes shows how hard it is to beat the market.
This does not mean the EMH can be used as an excuse by the CEOs of the failed financial firms or by the regulators who did not see the risks that subprime mortgage-backed securities posed to the financial stability of the economy. Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies were fooled by faulty models that underestimated the risk in real estate.
From 2000 through 2006, national home prices rose by 88.7%, far more than the 17.5% gain in the consumer price index or the paltry 1% rise in median household income. Never before have home prices jumped that far ahead of prices and incomes.
This should have sent up red flags and cast doubts on using models that looked only at historical declines to judge future risk. But these flags were ignored as Wall Street was reaping large profits bundling and selling the securities while Congress was happy that more Americans could enjoy the "American Dream" of home ownership. Indeed, through government-sponsored enterprises such as Fannie Mae and Freddie Mac, Washington helped fuel the subprime boom.
Our crisis wasn't due to blind faith in the Efficient Market Hypothesis. The fact that risk premiums were low does not mean they were nonexistent and that market prices were right. Despite the recent recession, the Great Moderation is real and our economy is inherently more stable.
But this does not mean that risks have disappeared. To use an analogy, the fact that automobiles today are safer than they were years ago does not mean that you can drive at 120 mph. A small bump on the road, perhaps insignificant at lower speeds, will easily flip the best-engineered car. Our financial firms drove too fast, our central bank failed to stop them, and the housing deflation crashed the banks and the economy.
Important lessons were ignored as relayed in a conversation with Vernon Smith:
Money is a problem both in the world and in the asset trading markets in the laboratory.
So the laboratory results make it very clear that it’s cash flopping around in the system that tends to give you these runaway asset market bubbles.
I think of the housing bubble as the asset bubble that blindsided the economy. If you look at bubbles in stock markets they do not cause general problems in the economy. We had the dot com stock bubble that ran all through the nineties and peeked out in 2000 and crashed and you had about 10 trillion dollars loss in asset market value as a result of that stock market bubble and it had a minor affect, small affect on the banking system and the economy generally. On the other hand, if you look at 2007 when we lost about three trillion dollars in value in the housing market it devastated the banking system and the reason for this is really I think quite clear.
And so what that means is that bubbles in the stock market if there is a problem the problem is borne by the investors in the market. On the other hand if you have people buying houses with very low or zero down payments and the prices of homes starts to decline right away those homes, those loans that the banks have made are underwater, the banks start then to get into trouble. They have a balance sheet problem and as soon as the banks are in trouble it puts all kinds of people into difficulty that may have had nothing to do or they may not have had anything to do with what was going on in the stock market. So if the banks are under pressure and not making loans all sorts of people may be hurt and they may not even be homeowners. They rent and they haven’t been contributing to the problems, but they nevertheless may suffer. So there is a big difference here between asset market bubbles where people are required to collateralize all of their borrowing and cases as in the housing market where they’re inadequately collateralized and so there is no cushion, no nothing to protect sort of the systemic risk in the banking system if those asset prices decline.
I don’t think there is anything you can do to prevent bubbles. I think we’ve had frequent stock market bubbles that have self corrected and the burden of those bubbles and the pain is basically borne by the investors in those markets and you do not have collateral damage to the economy from bubbles in stock markets like you have in bubbles with housing and generally with consumer durables and I think the solution in the housing and the consumer durables markets is the same as the solution that we’ve worked out institutionally in stock markets and that is require these purchases to be reserved, collateralized.
We learned all about amortizing loans. We learned about having 25 or 30% down payments for homes. We learned that in the 1920s and 1930s because if you go back to the 1920s there were lots of bank loans being made. The state banks were making loans on real estate that were interest only loans. They tended to be short term loans, three and four years. You paid only the interest and then when they came due you rolled them over and that turned out to be part of the difficulties, certainly not all of them. A lot of them the problems in the twenties were not only credit financing of home sales, but all sorts of consumer durables. You had for the first time in the twenties the development of buy now pay later for all sorts of durables like furniture and automobiles and that credit binge in the twenties was an important part of the collapse that took place in 1929 and 1930. And one of the things that you saw in the 1930s was the disappearance of the unamortized housing loan. If you compare for example 1928 and 1938 mortgage loans by banks. In 1938 they’re amortized and in 1928 many, half of them were not amortized, so there is an example where we had institutional learning, but somehow that memory faded. We forgot that lesson in the case of the housing markets and that’s what gave us a recurrence you see of a lot of the same conditions of the 1920s and ’30s. We’ve seen repeat of that from about 1997 to 2006 was the boom period in the housing market and then the collapse since then. And you know we have kind of a nice controlled experiment in one of the states. I don’t think it’s generally realized that Texas law (and this law dates back I think to about 2001 or 2) prohibits lending, making unamortized loans on a home. They prohibit balloon payments. There is a provision requiring that whatever the payment and loan stream conditions are the principle has to rise. That is as you pay of a loan you more and more of the money is going in to reduce the amount of the loan and what is interesting is that when if you look at the Case-Shiller Housing Index and how it blossomed up from 2000 to 2006. It was rising 75 or 80%. In Texas prices only rose 30 percent. And so it’s clear that this Texas law made a substantial difference there and it seems to me those are very reasonable kind of property type regulations in which you say that people don’t have a right to buy homes without putting up some, a reasonable cash down payment and that the loan be amortized. And so that’s not a heavy handed regulation. It’s a very reasonable benign type of regulation: give people rights to take action that are consistent with sustainability and stability.
Well the evidence that the Federal Reserve System, the Federal Open Market Committee and Bernanke did not anticipate the kind of trouble we were in is indicated by looking at the difference between the press release they put out in August 7, 2007 and the one three days later on August 10th. On August 7th they were reiterating that they would hold the federal funds rates steady and I think at that time it was five and a quarter percent and that they still anticipated the possibility of inflation and then three days later the press release points out that a number of financial markets are likely to experience considerable stress. And well, tell me about it. The mortgage market had completely collapsed and it was the derivatives market that was the tipoff. And its collapse was the first indication that the whole mortgage market was in serious trouble and no one has I think better expert econometric and economic analysis than the Federal Reserve, but it doesn’t mean that they can predict was is not predictable and so it’s clear that the experts were surprised and blindsided by that development, but I think it’s to Bernanke’s credit that he moved in what seemed to be a pretty decisive way at that time to dramatically enhance the liquidity of the banking system.
The problem is that what was happening I think in the mortgage market indicated that what the banks faced was a solvency problem, not just a liquidity problem. Now sometimes of course it’s hard to tell the difference. You have a solvency problem you see if the fundamental value of your assets are less than the value of your obligations that’s different from a liquidity problem in the sense that you just have a short term need for funds and of course you can have if you have a short term need for funds and a lack of liquidity that can cause distress sales and create a solvency problem, but and I think that’s the way that Bernanke saw the situation he was in, in August 2007 and it’s also I think pretty much how he saw the developments in the early thirties, in the early part of the Great Depression that the Federal Reserve System had simply not supplied sufficient liquidity to keep the system from creating an insolvency problem. I don’t really agree with this. I think in both cases that both in 1930 there is evidence that the banks had a solvency problem because of the loans that had been extended on residential and also commercial properties and those prices had started to, had come down and in fact that had been developing for already for three or four years in the late 1920s just as it had been developing, the defaults were starting to move up in our economy already by 2005, 6 and 7. It started to become then critical in 2007.A lot of the knowledge in the economy is this kind of can do practical knowledge learned by practice and the same thing is true at the level of experts and formulating central bank policy. It’s a matter of practice and you can have a good understanding of say the 1930s about what happened then, but it doesn’t mean that when you’re in the middle of a storm you will recognize that it’s happening around you because it’s just a different kind of understanding based upon practice and not necessarily the kind of academic analysis and knowledge that we get through econometric analysis and studies. And I think that’s basically a problem, and it means that you shouldn’t have too high expectations as to what the ability of our experts to deliver is. They’re going to be fallible and what we’ve seen I think and throughout this crisis is both in the Federal Reserve and also in the U.S. Treasury and other agencies of government you’ve had people learning as they go and a lot of the policies are being made up as they go. And that’s I think and inevitable consequence of the imperfection of our knowledge and the limits of our ability to practically manage complex systems like the U.S. economy.
Various devices were used to encourage private lenders to more aggressively make loans on homes to be purchased by people of modest income and what we got from that was a particularly strong demand for homes at the low end of the pricing tier. If you look at the Case-Shiller Housing Index and if you divide that index into three tiers, the low price tier, the middle price tier and the high price tier from 2000 to 2006 the prices that went up the most were the low price tier. The low price tier of homes rose the most, the greatest percentage and fell by the greatest percentage after the collapse and so those policies didn’t actually help those people in the sense that it ended up in many ways we hurt the people we most had a most heartfelt desire to help and the middle price tier homes rose less rapidly than the low and the higher priced tiers rose the least. So the impact of the housing bubble was felt disproportionately in the lower income buyers of homes, so I think I would begin not with any notion that we need a radical reexamination of the regulatory framework, but just introduce some of the institutional learning that we’ve already achieved and let that institutional learning stand and not interfere with it.
Compare the path of a US home price index with the path of a Canadian home price index see here . A less radical undermining of lending standards requiring meaningful down payments matters.