Should Greenspan have stopped the housing bubble?

I recently overheard someone bashing Alan Greenspan for not doing something about the subprime mortgage market. That something seemed a little fuzzy, but seemed to involve stopping banks from offering those dreadful, dreadful loans.

This seems to be a fairly common sentiment, so I think it's worth pointing out that the latest data we have shows that the overwhelming majority of subprime loans are still in good standing. Subprime securities are taking a bath because defaults are higher than were expected, not because everyone who got one is in trouble. The 85% of homeowners with subprime loans who are currently making their payments might not agree that Alan Greenspan should have, in his ineffable wisdom, prevented them from getting loans.

Nor, so far, is there much evidence that the subprime problems are causing much fuss in the broader financial markets. So it's far from clear to me that Alan Greenspan should have acted--and indeed, far from clear to me that Alan Greenspan could have acted effectively.

There's a disturbing tendency to think that every problem is the result of inadequate regulation. In fact, America's bank industry is, as Tyler Cowen points out, one of the most heavily regulated in the world. And not every problem can be solved by better regulation--some things simply can't be regulated without causing bigger problems than they solve. There is no perfect regulatory state that will allow us all to live in a serene economic paradise, and the sooner we stop looking for one, the more effective our regulatory state will actually be.

Update In calmer consideration, that was too flip. But the financial holocaust that was widely feared has not come to pass, and is looking less likely to occur with each passing day.

Comments

Nor, so far, is there much evidence that the subprime problems are causing much fuss in the broader financial markets.

I'm speechless.

Posted by Person | November 28, 2007 6:19 PM

I'd like to give Megan the benefit of the doubt on that statement, because she is smart, but that is a ridiculous comment, especially when she is saying "fuss" rather than, say, deep damage. No one can doubt that there has been "much fuss in the broader financial markets" the last few months. Maybe she can chime in on what she means. Certainly the two big equity market slumps (August and the last couple of weeks) were directly related to subprime problems: hedge fund redemptions in the summer from investors bailing out of CDOs, and the problems with financial stocks in particular in the fall. Or perhaps she means that there has been no credit crunch? But there has -- hence the deal among the major banks on SIVs a couple of months ago. Megan, please clarify.

Posted by think twice | November 28, 2007 6:53 PM

I'm surprised that regulators allowed securitization of mortgages in the first place, actually. Seems like it breaks the link between the party taking the risk (the investor) and the party evaluating the risk (the mortgage originator.)

Once that link was broken, lenders were playing with other people's money. They had very little incentive to make sure borrowers were able to repay. In fact, as bank after bank made money chasing the high fees on subprime, they had every incentive to join the rush and ignore repayment problems on borrowers.

This would seem to be exactly the sort of issue you'd expect regulators to concern themselves with. So although I don't blame Greenspan personally, someone definitely dropped the ball.

Off-balance sheet creations like SIV's and so on also strike me as increasing systemic risk and removing transparency. What are regulators for if not to prevent problems like that?

As for subprime borrowers, just wait until their loans reset before you pat them all on the back for keeping current. Most of those loans were created in the last two years, and haven't seen resets yet. Plus, since by definition subprime borrowers put little down, they were probably underwater on their loans the day they signed (since it costs 6% to sell a house.) With a 5% drop in national prices (more like 20% in California and Florida, where most subprime loans were made), they are really underwater now. I can't see any reason why they would keep paying on a loan higher than the value of the home. I don't see how they can refinance when they are underwater.

This problem will only get worse.

Posted by Michael | November 28, 2007 7:09 PM

Banks have lost hundreds of billions of dollars of market cap, bond insurers on the verge of downgrade, mortgage-backeds trading at assumed loss levels of more than 30%. You can buy short term Countrywide debt at 50% annualized yield. Agencies are hinting at "putting" mortgages back to originators, many of whom are banks. There really is plenty of "fuss" in the financial markets, and it's pretty broad.

I though the equity markets had caught on, until Tuesday.

Posted by "Mindles H. Dreck" | November 28, 2007 7:21 PM

That something seemed a little fuzzy, but seemed to involve stopping banks from offering those dreadful, dreadful loans.

We must run in different circles. Almost all of the "it's Greenspan's fault" rhetoric I have heard has centered on his interest rate policies rather than the regulatory responsibilities.

Posted by Max Points | November 28, 2007 7:43 PM

Nor, so far, is there much evidence that the subprime problems are causing much fuss in the broader financial markets.

Yeah, it's not like large financial insitutions like Citigroup and Merrill Lynch have been affected... oh wait...

Or it's not like the Fed has had to cut interest rates in response to recessionary worries... oh wait...

But it's not like millions of ARMs are set to reset in the next two years... oh wait...

Posted by Hans Moleman | November 28, 2007 7:46 PM

That something seemed a little fuzzy, but seemed to involve stopping banks from offering those dreadful, dreadful loans.

No, that something was, very specifically, lowering interest rates to 1% in order to allow lenders to make loans with ridiculous teaser rates, in turn allowing the real estate industry to create "home equity" out of thin air (that was massively borrowed against by existing homeowners).

Posted by Hans Moleman | November 28, 2007 7:51 PM

You "overheard" someone, Megan? You were just walking down the street? Over at Economic Principals, David Warsh lays out exactly why he things Big Al was a great big jerk.

http://www.economicprincipals.com/

Posted by Alan Vanneman | November 28, 2007 8:22 PM

Moer to the point, Greenspan ran his mouth touting the adantages of ARMs. Here is one comment out there among many:

http://biz.yahoo.com/pfg/e03greenspan/

What a hack.

Posted by Nat | November 28, 2007 9:55 PM

No offense Megan, but it is really obvious that you got an MBA. Really typical.

Draining away: four problems that could beset debt markets for years
By Gillian Tett

Published: November 27 2007 19:06 | Last updated: November 27 2007 19:06

http://www.ft.com/cms/s/0/aeb5d6ae-9d13-11dc-af03-0000779fd2ac.html

Posted by d | November 28, 2007 11:06 PM

If you never miss a plane, you spend too much time in airports.

Similarly, any system which doesn't get into some amount of trouble every once in a while is over regulated.

Posted by luispedro | November 28, 2007 11:27 PM

Yes, regulation may not be the answer, but the "financial holocaust less likely" comment flabbergasted me. Can you look at this IMF mortgage reset chart and conclude anything but that we're still in the first inning of these troubles?

http://calculatedrisk.blogspot.com/2007/10/imf-mortgage-reset-chart.html

The option ARMs are just as toxic as sub-prime (if I remember correctly, there's already a lot of delinquency and 80% of current borrowers are only paying the minimum payment, growing their principal every month), and in markets like Los Angeles and Phoenix a ton of people with prime ARMs initiated 2004-2006 and minimal downpayments are already 10-25% underwater what they paid.

I've assumed the press and politicos characterize this as a "sub-prime" problem nearing its end because there's no upside in bearing bad news, but does no one get it? Or am I missing something?

Posted by Ed | November 28, 2007 11:51 PM

The question is not "is the housing market screwed"--it is--but "has the broader market priced in the likely future problems already". If it hasn't, things will get much worse. If it has correctly estimated the level of future defaults and the subsequent financial reaction", then things won't get much worse. If the markets have overreacted, than things will get somewhat better.

Posted by Megan McArdle | November 29, 2007 12:04 AM

Heh, I can see it five years from now: "Okay, okay, fine, you have a point. What I was just getting at was, no one actually *died* in the citizens' raid on Fort Knox, unless they were *already* in deteriorating health."

Posted by Person | November 29, 2007 2:00 AM

Ed,

"I've assumed the press and politicos characterize this as a "sub-prime" problem nearing its end because there's no upside in bearing bad news, but does no one get it? Or am I missing something?"

obviously MM should dial up her favorite search engine/quote machine and do some research..

"Banks have lost hundreds of billions of dollars of market cap, bond insurers on the verge of downgrade, mortgage-backeds trading at assumed loss levels of more than 30%. You can buy short term Countrywide debt at 50% annualized yield. Agencies are hinting at "putting" mortgages back to originators, many of whom are banks. There really is plenty of "fuss" in the financial markets, and it's pretty broad.

I though the equity markets had caught on, until Tuesday.

Posted by "Mindles H. Dreck" | November 28, 2007 7:21 PM

I had thought that she and Mindles were buds, though, apparently, they haven't had the opp to compare notes recently..

And, if anyone is interested in piercing this toss-off: "but "has the broader market priced in the likely future problems already". If it hasn't, things will get much worse. If it has correctly estimated the level of future defaults and the subsequent financial reaction", then things won't get much worse. If the markets have overreacted, than things will get somewhat better.

Posted by Megan McArdle | November 29, 2007 12:04 AM

they shoud take a peek at the FedRes' new-and-improved 43-day repos

Posted by Mark E Hoffer | November 29, 2007 7:55 AM

this: http://calculatedrisk.blogspot.com/2007/11/upside-down-in-america.html

should give a peek into the types of 'loans' that have 'securitized' over the last few years...to call a healthy swath of these ABS/CDO creations: "Horsemeat in the stew", is to unfairly smear food-adulterers.

The cats have only just begun to spring forth from the proverbial sack..

Posted by MEH | November 29, 2007 8:10 AM

Wall Street Failed in CDO `Lottery,' SEC's Sirri Says (Correct)

By Jody Shenn

(Corrects losses in the third paragraph.)

Nov. 28 (Bloomberg) -- Securities firms and banks sold ``too many lottery tickets'' tied to U.S. mortgages and failed to look closely enough at their growing risks, the head of the Securities and Exchange Commission's market regulation division said today.

Financial companies had ``a significant risk management failure'' on so-called super senior classes of collateralized debt obligations made up of asset-backed bonds, Erik R. Sirri said at a conference in New York, according to the text of his remarks published on the agency's Web site.

Merrill Lynch & Co., Citigroup Inc. and other banks that underwrote CDOs have announced mortgage-related losses for the third and fourth quarters of at least $47.2 billion, a tally that includes non-CDO holdings, according to data from JPMorgan Chase & Co. Losses on CDOs may reach $77 billion for the banks and about $260 billion marketwide, JPMorgan analysts said.
...
The way that super-senior CDO value can fall quickly can be mimicked by other assets, such as options to sell securities at prices above current ones, he said.

``There is a spectrum of lottery tickets that can be written,'' offering little upside for the seller and potentially large, sudden losses in a worst-case scenario, Sirri said.

Banks also often relied on prices from ``other market participants'' instead of internal assessments to gauge the worth of super-senior CDOs, leaving them ``flying blind,'' he said.

http://www.bloomberg.com/apps/news?pid=20601208&sid=a6If4AxARHG0&refer=finance

Posted by MEH | November 29, 2007 8:23 AM

We are friends, but we don't compare notes. As someone who lives in these very fussy financial markets I just disagree. As we have on a few other topics.

Posted by "Mindles H. Dreck" | November 29, 2007 10:14 AM

The obvious question, to me, is could Greenspan have done what your overhearee wanted, anyway?

My impression of the Fed's powers are that they're limited almost entirely to setting the prime rate, not securities regulation. (The SEC has that responsibility, yes?)

Posted by Sigivald | November 29, 2007 1:12 PM

I don't think it was "too flip", it was precisely true and precisely what needed to be said, and how.

Posted by Noah Yetter | November 29, 2007 3:54 PM

The financial meltdown which Meghan thinks is looking LESS likely every day appears to more credible observers to look MORE likely every day - guys like Barry Ritholz (http://bigpicture.typepad.com/)

Posted by Voice of Reason | November 29, 2007 4:02 PM

"But lenders have sought refuge in more vibrant areas — notably agriculture, which has benefited from the rise in global demand and the sudden boom in ethanol production.

Richard Brown, president and chief executive of the Krause Corporation, which makes soil-tilling equipment at its factory in Hutchinson, Kan., relies upon lines of credit from banks to smooth out the seasonal nature of the business. Though it sells its products mostly in the spring and fall, the company must make them year-round.

Mr. Brown said banks had been calling him relentlessly to offer new loans.

“They’re trying to maintain their business and get past the subprime debacle, and where can they go?” Mr. Brown said. “Agriculture in this country is very strong.”

But in other parts of the economy, notably the auto industry, access to credit has tightened considerably, as banks steer their limited capital away from companies with declining sales.

A year ago, when he needed new machinery, Doyle Hayes, president and chief executive of Pyper Products, an auto parts maker in Battle Creek, Mich., went back to the local branch of Comerica bank, where he has been doing business for years. He borrowed $300,000.

Last week, when Mr. Hayes needed $140,000 for a new robot, he did not even bother to inquire at the bank. “We knew what the answer was going to be,” he said, meaning the bank would have turned him down. “When the auto industry goes down, anything that has four wheels becomes suspect.”"

http://www.nytimes.com/2007/11/29/business/29lend.html?pagewanted=2&_r=1
http://bigpicture.typepad.com/

Posted by MEH | November 29, 2007 5:16 PM

I'm surprised that regulators allowed securitization of mortgages in the first place, actually. Seems like it breaks the link between the party taking the risk (the investor) and the party evaluating the risk (the mortgage originator.)

Once that link was broken, lenders were playing with other people's money. They had very little incentive to make sure borrowers were able to repay. In fact, as bank after bank made money chasing the high fees on subprime, they had every incentive to join the rush and ignore repayment problems on borrowers.

Incentives? You may have noticed that subprime lenders aren't exactly swimming in piles of gold coins a la Scrooge McDuck right now. And other lenders aren't doing particularly well either. Sounds like an incentive.

Any securitization -- not just mortgages -- can create the problem you see. The problem in this case was that investors were either overly greedy -- they knew the risks, but chose to invest anyway, gambling they could get out before the bubble burst -- or they were stupid. I mean, it's not as if anybody living in the U.S. didn't see the ridiculous advertisements for no-doc option ARMs. If they went ahead and invested in CDOs without asking questions about the quality of the underlying mortgages, that's hardly the fault of regulators.

I can't see any reason why they would keep paying on a loan higher than the value of the home.

Because homelessness is bad? The "value" of the home is only relevant if one wants/needs to cash out the home (either through a HELOC or through a sale). Otherwise, the value of the home is that you get a roof over your head.

Of course, that doesn't address the people who can't afford the monthly payments at all. Those people will stop paying -- but that's a percentage of the percentage of people who got subprime loans.

Posted by David Nieporent | November 30, 2007 7:35 AM

It isn't just subprime. There are rising cumulative non-performing stats in prime categories. As it turns out (in a sort of duh moment) the Cumulative Loan-to-Value has been a much more reliable indicator of probability of non-performance. FICO scores under 620 don't have the strongest correlation with non-performance in recent years.

Most of my sources for this stuff are proprietary, but Calculated Risk has some excellent commentary, including the "we are all subprime now" post, as I recall.

And in addition to defaults, we have a full-blown liquidity crisis caused by the uncertainty of the "structure squared" problem. This, in and of itself, may claim a high profile victim - it doesn't have to be a function of realized final losses, but simply a run on the bank.

I've been in the bond/interbank markets for 20 years and I've never seen the bid side evaporate like this. Market prices from the services are nonsense - you have to put something out to bid to get a value. When you do, many dealers will simply pass. 1991, 1994, 1998 and 2001-3 were picnics compared to this. Hopefully we'll make up the severity with brevity. It's a little better this week, but not enough to trust. After all, we had February's "isolated" problems, and July's "contained" problems...

Posted by "Mindles H. Dreck" | November 30, 2007 1:58 PM

Mindles,

Good of you to post, finally some actual sanity, on these boards, about the current state of the credit market's freeze-up.

How do you like the 'repo' action, in never seen before quantities, coming out of the CBs ?

Posted by Mark E Hoffer | November 30, 2007 6:13 PM

Re: As for subprime borrowers, just wait until their loans reset before you pat them all on the back for keeping current.

You are confusing subprimes with ARMs. Too different types of categories. There are subprime ARMs (which are the core of the current crisis) and subprime fixed loans (which are largely sound). Likewise conventional ARMs (also a problem) and coventional fixed loans (very little trouble here beyond the usual defaults caused by job loss and medical bankruptcy)

Posted by JonF | November 30, 2007 8:00 PM

"I'm surprised that regulators allowed securitization of mortgages in the first place, actually. Seems like it breaks the link between the party taking the risk (the investor) and the party evaluating the risk (the mortgage originator.)
Once that link was broken, lenders were playing with other people's money. They had very little incentive to make sure borrowers were able to repay. In fact, as bank after bank made money chasing the high fees on subprime, they had every incentive to join the rush and ignore repayment problems on borrowers."

The real estate appraiser's role in the mortgage process has been hamstringed by this very process. This exacerbates the entire problem. The disconnect between the ultimate mortgage holder and the originator creates a situation in which the appraiser, whose role is to determine the value of the asset, is often coerced by the originator to value the asset to a pre-determined (often inflated) value. There is little market incentive for the originator (who has no equity interest in the mortgage transaction) to use appraisers who refuse to appraise the property to whatever value the originator needs to make the deal profitable. The originator has no financial interest in the loan after it leaves his/her desk, and there is no tough regulation in place to protect the role of the appraiser. The originator most often chooses the appraiser and will choose the appraisers who "bring in the deal".

Ultimately these loans end up in huge portfolios of over-valued assets. During a slowing economy as individual homeowners lose jobs and can't pay mortgages and then can't sell their houses due to over-valuation it aggregately affects the entire market. A growing economy can mask this but a contracting economy begins to uncover it. What is required are stronger regulations on the origination side to protect the independence of the valuation process.

Posted by Jacqui Durrett | December 1, 2007 8:08 AM

The collateralization of debt also caused the problem that there was no real immediate pain/feedback if the CDO constructors happened to guess wrong on the risk levels. It became an exercise in financial engineering, with more and more slices getting constructed, stamped "AAA" and sold off, with the unspoken assumption with hey, now the risk is off our plate, we don't have to worry about it.

If mortgage providers had had to hold the notes until full pay-back, you can bet they would have cast a much more critical eye over borrowers actually proving they had the income streams they claimed to have and thought much more deeply about the ability of their borrowers to repay.

Posted by grumpy realist | December 1, 2007 9:54 PM

Is this a joke?
I live in Temecula California, and this is a total debacle here, every 10th house or so is empty or have renters who wont maintain the homes.
To get out of my neighborhood I have to drive past 16 homes, 5 have burned lawns, 3 have for sale signs, 2 short sales 1 foreclosed.
The foreclosed one is 2 doors down, before the owner left he destroyed the inside, poured cement down the pipings.
The fence that borders the street he tore down, the bank put up an ugly orange mesh temp fence to keep people out of the back yard.
We paid 516k in march 05, now if we had to sell we would get maybe 250-275k max.
We started looking for condo for our daughter, in Rancho Santa Margarita we found one 2+2 that was worth 375k few years back, our offer was accepted at 190k.
Your article is way way off, on the verge of being completely ridiculous.

Posted by Julie S. | December 2, 2007 12:43 AM

Julie--Ms. McArdle has been shown to be be extremely gullible and clueless about many different topics in finance and economics. This is just the most recent example.

Posted by grumpy realist | December 2, 2007 12:05 PM