Mistakes were made: Foote, Gerardi, and Willen demolish the “Inside Job” hypothesis

Paul Willen recently presented a paper on the housing crisis here at Bentley University.  It might be the best paper I’ve read on the subject.  Since it’s not my area, I don’t know if their ideas have already been discussed on the internet, but if not I strongly recommend people take a look.  The paper is too long and exhaustively documented to present in a short blog post, but their “12 facts about the mortgage market” provide a hint:

Fact 1:  Resets of adjustable rate mortgages did not cause the foreclosure crisis.

Fact 2:  No mortgage was “designed to fail.”

Fact 3:  There was little innovation in mortgage markets in the 2000s.

Fact 4:  Government policy toward the mortgage market did not change much from 1990 to 2005.

Fact 5:  The originate-to-distribute model was not new.

Fact 6:  MBSs, CDOs, and other “complex financial products” had been widely used for decades.

Fact 7:  Mortgage investors had lots of information.

Fact 8:  Investors understood the risks.

Fact 9:  Investors were optimistic about home prices.

Fact 10:  Mortgage market insiders were the biggest losers.

Fact 11:  Mortgage market outsiders were the biggest winners.

Fact 12:  Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in collateralized debt obligations (CDOs) did.

Each assertion is fully documented.  There is lots of fascinating information:

A focus on mortgage companies alone understates the role of the OTD model, however. Starting in the 1970s, the OTD model was adopted by other financial institutions, most importantly savings and loans (S&Ls), which financed the majority of U.S. residential lending in the postwar period. S&L’s had historically followed an originate-and-hold model. By the late 1970s, however, rising interest rates had generated a catastrophic mismatch between the low interest rates that S&Ls received on their existing mortgages and their current costs of funds. This mismatch, which would eventually render more than half of S&Ls insolvent, encouraged thrifts either to turn to adjustable-rate mortgages or to sell the mortgages they originated to the secondary market.

Wait, I thought Paul Krugman told us that the pre-1980 period was the golden age of “regulation.”  And then there’s this:

Consider the Dodd-Frank requirement that loan originators retain 5 percent of the credit risk of certain mortgages. During the housing boom, would this requirement have stopped lenders from making bad loans? In 2006 and 2007, lenders originated $791 billion subprime loans. Had Dodd-Frank existed, lenders would have retained 5 percent of that amount or $40 billion of subprime credit. Overall loss rates of 35 percent would have saddled them with $14 billion in losses.54 Inspection of Table 4 shows that mortgage-related losses exceeded that amount for no fewer than eight firms individually. In other words, if every one of those ï¬rms had followed the Dodd-Frank requirement and originated the entire subprime mortgage market, they would have suffered smaller losses than they actually did.

I knew Dodd-Frank missed the boat, but it was even worse than I assumed.  And the reason why is simple.  The cheerleaders for the “deregulation” explanation of the crisis, such as the NYT, don’t actually want effective regulation, because that would make it harder for low-income people to buy homes.  Here’s the NYT:

It seemed an easy fix to prevent the excesses of the housing market: make home buyers put more money down.

But as the housing market starts to return and the subprime mess fades from memory, the issue is up for debate.

Lenders and consumer advocates “” rarely on the same side of the issue “” are now cautioning against down payment requirements. They argue that such restrictions could limit lending, and prevent lower-income borrowers from buying homes. They also contend that the new mortgage rules put in place this year will do enough to limit foreclosures, making down payment requirements somewhat superfluous.

The arguments seem to run contrary to long-standing beliefs about homeownership. For decades, experts have emphasized the need for a sizable down payment “” a rule of thumb being 20 percent “” on the premise that borrowers with a sizable chunk of equity in a home are less likely to walk away when things get bad.

“If our goal is to prevent foreclosures, I can’t think of anything more effective than requiring a down payment,” said Paul S. Willen, a senior economist and policy adviser at the Federal Reserve Bank of Boston.

The issue may not be so black and white. Regulators want to protect borrowers and promote homeownership. But they also want to encourage lending and insulate the financial system from future shocks.

Why am I not surprised?  The NYT wants ineffective regulation, like having to rapidly sign 50 meaningless “disclosure” forms when you refinance, instead of the current 25 meaningless disclosure forms.

PS.  My only suggestion to Foote, Gerardi, and Willen would be to focus on the Fed’s catastrophic policy failure, which allowed NGDP to plunge 9% below trend in 2008-09, as a key unforeseen factor that contributed to the severity of the housing debacle.  But that’s easy for me to say, they work at the Fed!



62 Responses to “Mistakes were made: Foote, Gerardi, and Willen demolish the “Inside Job” hypothesis”

  1. Gravatar of W. Peden W. Peden
    1. May 2013 at 04:44

    More regulations, more regulators, without any of the problems caused by regulations actually doing what they’re supposed to do. If you’re a regulator coming up with these schemes, what’s not to like?

  2. Gravatar of jurisdebtor jurisdebtor
    1. May 2013 at 04:57

    “Fact 7: Mortgage investors had lots of information.

    Fact 8: Investors understood the risks.

    Fact 9: Investors were optimistic about home prices.”

    When you have models having home prices rising into perpetuity, I would not say that anyone had complete information, knew the risks, or were simply “optimistic.” Diluted would be a more appropriate phrase.

  3. Gravatar of Michael Michael
    1. May 2013 at 04:58

    The elephant in the room is that homeowners, whether they have a mortgage or own their home outright, want high home prices. Requiring a 20% downpayment would push home prices down – I bought my home in 2009 with 10% down – if 20% was required I would likely still be renting… unless home prices fell far enough that 20% was affordable for me.

    At this point I have about 15% in equity – but if a strict 20% down requirement was imposed I have no doubt that it would remove enough buyers from the market that I would be pushed underwater.

    I think that the overall consequences of all of the various policies supporting homeownership has been bad, and moving back to a 20% down model would, in the long run, be better policy.

    But I think the transition from where we are today (low money down with most homeowners having a massive amount of their life savings tied up in their homes) to a 20% down model (with lower prices) could potentially be disastrous for the economy, depending on how it was implemented. Implementing a policy with teeth that requires a 20% down payment would, in effect, be a massive transfer of wealth from those who own homes (and who played the game by the current set of flawed rules and policies) to those who are able to buy homes under the new policies.

    This current system of housing policy and regulation seems like a much more appropriate target for the Austrian malinvestment critique than nominal income targeting, BTW.

  4. Gravatar of J J
    1. May 2013 at 05:15

    Professor Sumner,

    What do you see as the catalyst of the fall in NGDP? Is it just that NGDP fluctuates and the Fed didn’t prevent a small shortfall which led to the housing market collapse, which then led to a larger fall in NGDP?

  5. Gravatar of Geoff Geoff
    1. May 2013 at 05:19

    The idea that the Fed “failed” to solve the rising cash preference and credit deflation “problem” would seem to suggest that the Fed didn’t have anything to do with why so many people suddenly wanted to increase their cash preference in the first place such that NGDP fell underneath the Fed’s nose.

    There is no way that one can understand the Fed’s relationship with the division of labor economy, if one purposefully ignores the role the Fed played in the cause(s) of the sudden and rapid rise in cash preference.

    Why did the Fed find itself in a position of having to increase the rate of OMOs to reverse the effects of a rise in cash preference? MM theory has no answer. It is a symptom treating doctrine, which of course opens the possibility that the Fed itself is responsible for the prior cause of the subsequent effect that it “failed” to counteract.

    Also, it opens the possibility that a redoubling of the Fed’s activity, to solve what may be a cash preference “problem” that it itself created prior, would only intensify the same cash preference problem in the future, which means it would have to redouble its activity once again at some point in the future, and then again, and again, until cash preference becomes so high relative to what the Fed is trying to accomplish, that it would eventually lose control.

    We saw this almost happening in Australia, when cash preference got so high that the RBA found itself having to increase the money supply by over 20% annually by 2008, before it chose to reduce its activity, which of course brought about a partial liquidation of investments and a rise in unemployment.

    Since 2010, there has been yet another increasing trend in the RBA’s activity, and should the RBA try to prevent NGDP from falling, we can expect a continued acceleration in its activity, until the same alternatives present themselves once again.

  6. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. May 2013 at 06:38

    ‘Fact 12: Top-rated bonds backed by mortgages did not turn out to be “toxic.” Top-rated bonds in collateralized debt obligations (CDOs) did.’

    A point made by Ed Conard last year in his book


    He argued that lenders simply transferred the traditional 20% down payment (skin in the game) requirement from home buyer to MBS investor. The AAA rated tranches of MBS were designed to be the LAST to suffer losses on defaults, AA next to last…lowest rated tranches were also known as ‘first loss’.

    If the decline in the housing market had been 20% (or less) rather than over 30%, AAA tranches would have lost nothing.

  7. Gravatar of Mike Mike
    1. May 2013 at 06:51

    Seems to me #12 is the crux of Inside Job’s thesis — that the top rated tranches of the CDOs imploded. And that’s what the author agrees happened. The construction of those CDOs was truly sociopathic in nature.

  8. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. May 2013 at 07:04

    Well, this is clearly wrong;

    ‘Fact 4: Government policy toward the mortgage market did not change much from 1990 to 2005

    ‘….In reality, government officials talked at length about lending and homeownership in the 1990s and early 2000s, but actual market interventions were modest. In fact, compared to the massive federal interventions in the U.S. mortgage market during the immediate postwar era, government interventions during the recent housing boom were virtually nonexistent.’

    The GSE Act of 1992, HUD’s Best Practices Initiative of 93-93, the amended CRA of 1995, Clinton’a Housing policies generally….were hardly ‘non-existent’. (And I can’t find any mention of the Boston Fed’s role in all this http://www.bos.frb.org/commdev/closing-the-gap/closingt.pdf);

    Subprime loans went from about 1% in 1990 to about half of all home loans by the mid-2000s. This isn’t hindsight, as I’ve posted here many times before, Stan Liebowitz and Ted Day were were warning about ‘relaxed underwriting standards as early as 1993. Here’s their 1998 paper blowing up the Boston Fed’s fantasies about mortgage lending;


    ‘If we are correct, the media frenzy associated with the release of the HMDA data every year has been largely counterproductive for achieving an even playing field in the mortgage market. The “progress” that has been made in “helping” minorities may not be progress at all. After the warm and fuzzy glow of “flexible underwriting standards” has worn off, we may discover that they are nothing
    more than standards that led to bad loans. Certainly, a careful investigation of these underwriting standards is in order. If the “traditional” bank lending processes were rational, we are likely to find,with the adoption of flexible underwriting standards, that we are merely encouraging banks to make unsound loans. If this is the case, current policy will not have helped its intended beneficiaries if in future years they are dispossessed from their homes due to an inability to make their mortgage
    payments. It will be ironic and unfortunate if minority applicants wind up paying a very heavy price for a misguided policy based on badly mangled data.’

  9. Gravatar of marcus nunes marcus nunes
    1. May 2013 at 07:34

    Scott, If I understood this correctly, they want to generalize the “equality of outcomes” principle!

  10. Gravatar of Doug M Doug M
    1. May 2013 at 07:51

    all of these “facts” are mostly correct.

    Fact 3: There was little innovation in mortgage markets in the 2000s.

    The “option ARM” was a new mortgage product.
    We also saw FAS 133, which was an accountinting change for derivatives. It was an attempt to move derivatives onto the ballance sheet. But it created odd ballance sheet / income statement mismatches, which lead to a flurry of activty to hedge the risk of the hedges.

    There was also an accounting rule that required banks to capitalize the value of servicing rights, and treat it as income before the servicing had actually been done. People were hedging assets that did not exist.

    Banks were prettly clearly told that they should not have any skin in the game.

    Fannie Mae and Freddie Mac vastly expanded their leverage and their influence over the naughties. At the same time they were continuously involved in accounting scandals and CEOs of both FRN and FRE left in disgrace. Howard Baker was tring to rein them in in the 90s. Barney Frank wanted to “roll the dice.”

    The repeal of Glass-Steagall did nothing to cause the mortgage crisis.

  11. Gravatar of Suvy Suvy
    1. May 2013 at 07:53

    The primary problem that you never mention in your post is one of leverage and debt. When you have firms that are leveraged 40:1 or 50:1, a 2.5% move in their assets wipes out their equity. When every firm in your financial system is leveraged to that level and the total assets of your financial system move 2.5%, your entire financial system goes bust. At that point, it’s not a problem of liquidity(which the Fed can do something about); the financial crisis then becomes a solvency problem.

    On top of the financial system, you had households that were doing the same thing that the large Wall Street firms were doing. This just compounds the problem because an increase in the volatility of your assets completely smashes your balance sheet(as discussed above).

    Also, I think everyone here should take a look at The Big Short by Michael Lewis. He actually goes into what was actually going on in Wall Street at that time. There were people that were purposefully putting together junk CDOs to sell to clients that they knew were complete garbage. They would then buy CDSs to bet against the same junk CDOs they issued to their clients. Then, they would take all of those CDSs that return however many basis points every year and package those into a CDO and then sell it to clients to bet against it again. What happened was straight up fraud.

    On top of this, most of the country thought that house prices could keep going up at a rate that was double or triple NGDP. How that could be sustainable for the rest of eternity is beyond me?

  12. Gravatar of Suvy Suvy
    1. May 2013 at 08:03

    Also, this paper never mentions credit default swap even once. I give very little credence to a paper that doesn’t talk about the CDS marketplace even once when talking about the 2008 financial crisis. Some of the stuff in the paper is factually wrong.

    “MBSs, CDOs, and other “complex financial products” had been widely used for decades”

    Credit default swaps were first developed in 1994 and were only widely used starting in the 2000s. From 1998 to 2007, the CDS marketplace increased from $300 billion to $62.2 trillion. In other words, the size of the marketplace increased by 20,700%.

    Much of the stuff they say in the paper is really just complete nonsense. They just cherry pick almost all their facts and some of it is just blatantly false(see above).

  13. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. May 2013 at 08:03

    This belongs on a previous thread, but it is too funny not to be seen;


    HAP were using bad data in their paper!

    …it turns out that on the New Zealand question, at least, it’s Reinhart and Rogoff who are right, and Herndon, Ash and Pollin are wrong.

    National income accounting is an old concept, though modern measurements of gross domestic product didn’t exist until the 1930s. And many countries — including rural New Zealand — didn’t start counting their national income until much later. The data we have has been reconstructed by economists using forensic techniques.

    Unfortunately, when it comes to New Zealand, we are now finding out that the numbers many economists have used are just wrong. In this case, the culprit is none other than the celebrated Maddison Project, which Nobel laureate and New York Times columnist Paul Krugman endorsed as an essential data source just this past weekend. He is no fan of Reinhart’s and Rogoff’s work.

  14. Gravatar of Randomize Randomize
    1. May 2013 at 08:03

    I’ll have to read the report but my initial reaction is this:

    Given the level of fraudulent information attached to the mortgages that were being sold and the subsequently bogus bond ratings, it’s hard to believe that numbers 7 and 8 are all that true. Granted, it may not have been the *bad* mortgages that caused the market to drop but they, like a ponzi scheme, were bound to shake out when prices fell and may very well have turned a regular correction into a full-blown collapse.

  15. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. May 2013 at 08:05

    ‘Also, this paper never mentions credit default swap even once. I give very little credence to a paper that doesn’t talk about the CDS marketplace even once when talking about the 2008 financial crisis.’

    There would have been no problem with the derivatives if the underlying source for their value–the home loans themselves–were sound.

  16. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. May 2013 at 08:07

    ‘Also, I think everyone here should take a look at The Big Short by Michael Lewis.’

    That would be the last place I’d go.

  17. Gravatar of Suvy Suvy
    1. May 2013 at 08:20

    More nonsense from the paper:
    “No mortgage was “designed to fail””

    There are documented stories of people who had no income that had multiple mortgages(it went up to 5 or 10) or pilots who had $40-50k of income that had 10 different mortgages. You’re kidding yourself if you think that debt was serviceable.

    You wanna talk about fraud, take a look at this:

    There were banks selling things they knew were garbage. This is blatant fraud that should be outlawed. There should be people in jail for this kind of stuff.

  18. Gravatar of J J
    1. May 2013 at 08:24

    Professor Sumner,

    You should check out Cochrane’s two most recent posts on his blog. I’m curious to hear your thoughts.

  19. Gravatar of Suvy Suvy
    1. May 2013 at 08:26


    I’d much rather look at Michael Lewis who has actually worked in the field and met with the insiders that were involved with the situation than a few guys who clearly didn’t check their facts.

    As for your point about home price assumptions, I actually refer to that in my post. How can people think house prices can sustainably grow at a rate double or triple NGDP for the rest of eternity? I will say this though, if we have a financial system that requires people to be sensible and behave somewhat rationally, we have a terrible financial system that needs a lot of work. People are going to keep making dumb financial decisions that are based on emotion rather than logic. This has happened for millenia and will continue to happen.

    Randomize is right when he says the entire system was built up like a Ponzi scheme. You need more money to keep coming in than leaving and the reason more money kept coming in rather vs money leaving was because of rising leverage. Once leverage couldn’t rise anymore, everything dropped like a stone.

  20. Gravatar of Suvy Suvy
    1. May 2013 at 08:33

    “Mortgage investors had lots of information”

    Not even the people that were issuing these securities knew what was in them. There were CDOs that were created by taking the income provided by random CDSs and packaged into bonds. How could anyone possibly know what was in the CDOs? There were CDOs with thousands of pages of the stuff that was underlying them. Does anyone honestly think that any of those pages were read? On top of this, you had many thousands of CDOs each with thousands of pages. None of that stuff was read and no one could have possibly understood what was going on. There was simply too much complexity.

    These guys mention Michael Burry, but the people at the Fed claimed no one could have foresaw this. Anyways, here is the paper that Michael Burry wrote after the entire financial system almost went bust. I think the guys that wrote this paper should take a look at it:

  21. Gravatar of o. nate o. nate
    1. May 2013 at 09:43

    It seems the authors of this paper go to great lengths to try to downplay the role of financial innovation in the crisis. The way they emphasize certain facts and downplay others creates a misleading impression of the role of innovation, IMO. It would be a bit like arguing that automobiles couldn’t be responsible for LA’s smog problem since mass production of cars started in the 1910s and there was no smog problem in LA until the ’50s. It’s true that a lot of the mortgage-related products and securities had antecedents that predated the crisis, but if you zero in on the products most directly implicated in the crisis (specifically subprime mortgage securitizations and ABS CDOs backed by them), it’s hard to deny that they exploded in size in the years immediately preceding the crisis and that they were responsible for an outsized share of the losses at the largest banks. In fact, the authors do acknowledge, in the section entitled “MBSs, CDOs, and other ‘complex financial products’ had been widely used for decades” that “It is true that there was dramatic growth in the use of subprime ABS to fund loans, as well as the use of ABS CDOs to fund the lower-rated tranches of subprime deals” in the 2000s. Talk about burying the lede.

  22. Gravatar of o. nate o. nate
    1. May 2013 at 10:46

    It’s weird that the abstract is so out of step with the content of the paper. The abstract says that “borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices”. But if you delve into the paper, specifically the discussion of Fact 12, you’ll find a startling indictment of behavior that should have been identified as irrational at the time, and, the authors imply, could have been with better risk management practices. To me, this is probably the most important part of the paper, but you’ll find no hint of it in the abstract:

    “[D]uring the peak of the mortgage boom, mortgage analysts at UBS published reports showing that even a small decline in house prices would lead to losses that would wipe out the BBB-rated securities of subprime deals (Zimmerman 2005). At the same time, UBS was both an issuer of and a major investor in ABS CDOs, which would be nearly worthless if this decline occurred. Why didn’t the mortgage analysts tell their coworkers how sensitive the CDOs would be to a price decline? This question goes to the heart of why the financial crisis occurred. The answer may well involve the information and incentive structures present inside Wall Street firms.”

    This very much goes against the “hoocoodanode” attitude of the abstract, and implies room for improvement in risk management.

  23. Gravatar of John Thacker John Thacker
    1. May 2013 at 11:31

    Your “only suggestion?” Surely you’d like to remove all the multiple references to the word “bubble” and “bubble theory” from there, Scott?

    “Requiring a 20% downpayment would push home prices down – I bought my home in 2009 with 10% down – if 20% was required I would likely still be renting… unless home prices fell far enough that 20% was affordable for me.”

    Indeed, people would shift to renting. But people who need to rent still need to live somewhere. In the short term, there presumably would be some amount of decreased household formation (people still living with their parents), but that should be an effect holding back home prices anyway.

    If you would still be renting, you’d be renting somewhere. So wouldn’t we be likely to see lots of owner-occupied dwellings converted to rental units first, rather than a dramatic fall in house prices and increase in rents? I think it likely that you’d see a shift in the percentages of people renting vs. buying, but it’s a little less clear about home prices. (It’s possible that not all homes are easy to convert to rentals, in which case we’d have extra rental-friendly units built and prices would decline.)

  24. Gravatar of Bill Woolsey Bill Woolsey
    1. May 2013 at 11:40

    “Why am I not surprised? The NYT wants ineffective regulation, like having to rapidly sign 50 meaningless “disclosure” forms when you refinance, instead of the current 25 meaningless disclosure forms.”


  25. Gravatar of steve steve
    1. May 2013 at 11:41

    The one thing that never gets explained is no-doc loans (liars loans). I guess you could say they were not DESIGNED to fail, but it has long been known that handing out loans w/o assessing risk leads to losses. Also, while they are technically correct that this was not new, when banks had tried to do this in the past, regulators had stopped it. The state AGs recognized that these loans were trouble and tried to stop them, but the OTC stopped them.


  26. Gravatar of Ricardo Ricardo
    1. May 2013 at 11:42

    Off thread-topic, but:

    On CBNC this afternoon, May 1:

    (http://video.cnbc.com/gallery/?play=1&video=3000164566 at about 09m30s into that video)

    Bill Gross of PIMCO says:

    “We’ve gotten 3.4% nominal gdp growth over the past 12 months…

    And, basically the Fed, although its informal, is targeting a 5% nominal gdp level, is targeting 2.5% inflation and hopefully 2.5% real growth. We’re not getting what monetary policy, not has promised, but has tried to deliver.”


    It seems the market (at least some large, influential players) have suspected for awhile that the implict target of Fed policy is some variant of NGDP targeting. (Yeah, ok, not explictly.)

    Even with large market participants knowing that, they still believe a significant portion of the effects have just been to “artificially” inflate asset prices.

    There’s a recent change in market consensus/opinion that has shifted perceptively on two fronts:

    1- Monetary policy *can’t* deliver the needed(or hoped for) boost to the real economy (at least in the US)
    2- Fiscal tightening is too aggressive and is slowing growth (at least in the US)

  27. Gravatar of rcyran rcyran
    1. May 2013 at 11:54

    No mortgage was designed to fail?

    Nice try – let’s take a look at a bank called Downey Savings which failed in 2008. About 90% of its loans were no doc,option only ARMS. The bank reported exceptionally good (because they were fake) profits for several years and the bank execs took out nice bonuses. And then it blew up and saddled the FDIC with a $1.4bn loss.

    Exec compensation:

    Notice that the CEO was paid over $1.5m a year in years before blow up – and all the top execs were paid ALL IN CASH, no equity. The CEO had received earlier equity awards- and dumped the stock in the run up before the crash.

    This is what the financial statements of a bank that ONLY wrote mortgages designed to fail looked like.


    “Facts” 3, 4 and 8 are equally silly and misleading.

  28. Gravatar of Michael Michael
    1. May 2013 at 12:43

    John Thacker, that’s a very good point I hadn’t considered. How have price to rent ratios changed over time? I know they rose in the early 2000s, and have fallen since 2008, but what about over the long term?

  29. Gravatar of James in London James in London
    1. May 2013 at 12:52

    In mid-2006, and especially at the end, and then throughout 2007 banks who had lent to broker-originated borrowers were finding something really weird, unprecedented, happening. Borrowers were defaulting on their first, yes first, payments. The best banks pulled back, the worst carried on, especially if the securitisation market was still open. This strange pattern had never happened before, and could only be caused by widespread origination of liar loans. And financial innovation that meant the ultimate holders of the risk were several stages removed from that origination.

    Of course, this happened because of immensely widespread optimism on ever-rising house prices. While it was unprecedented for the housing market, earlier booms and busts in Commericial Real Estate loans or the 1970s Lesser Developed Countries debt crisis showed such irrational exuberance in the finance sector isn’t that unusual.

    And you can still argue that a normal end to this exuberance was then exacerbated by the monetary policy-makers. The article seems something of an attempt to say, “don’t blame us, mate!” whitewash.

  30. Gravatar of John Thacker John Thacker
    1. May 2013 at 12:56


    Over the long run, the price to rent ratio has been pretty stable, which makes sense since renting and owning are substitutes. It definitely went up a lot in the early 2000s, and fell back to the long term level after prices crashed. Again, that makes some sense; the ratio should also track expected changes in home prices. Changes in differential regulation or tax treatment of owning versus renting could have an effect, but I’d have to think more about it.

  31. Gravatar of Doug M Doug M
    1. May 2013 at 13:25


    Regarding CDS and “betting againts your customers.”

    Swaps are a zero sum game. When one of your customers takes a position on a swap, the bank must take the other side. When it comes to swaps banks are merely well paid bookmakers. They are always betting against their customers.

  32. Gravatar of Bill Ellis Bill Ellis
    1. May 2013 at 13:51

    In other news…THe FOMC says not to worry about the “Sumner Critique.”

    For immediate release
    Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

    Bolded mine.

    If I recall right…Brad Delong thought the “Sumner Critique” was valid because it addressed “the world as it is, not the world we want” (paraphrased from memory )… referring to what the FED could actually do politically.

    In this regard the World has changed to the one we want… The Fed won’t strangle fiscal stim induced growth by upping interest rates.

    Bit too late of them.
    Unless there is another shock that spikes unemployment again soon. (I don’t see it in the cards) All the change is in the direction of austerity. The best we anti-austerity folks can hope for is a blunting of the trend.

  33. Gravatar of Suvy Suvy
    1. May 2013 at 14:01

    Doug M,

    Aren’t all derivatives a zero-sum game? I can’t think of a single derivative that isn’t a zero-sum game.

    My point has to do with the fact that the banks were intentionally selling bonds to their clients for the sole purpose of betting against them. Banks like Goldman Sachs were creating bonds that they knew were less than junk for the sole purpose of betting against them on the other side. I have no problem with people or financial institutions speculating in the CDS marketplace. Banks like Goldman Sachs were issuing bonds that they knew were complete garbage for the sole purpose that they need something to bet against; that is blatant fraud.

    Is it okay if my bank sells your mom’s pension fund a bond that we designed that we knew was below junk, masking it as investment grade, and then betting against it after we created the bond and got rid of it? There is no way that should be legal.

  34. Gravatar of Adam Adam
    1. May 2013 at 14:26

    I’m confused by the second block quote. Why are we comparing, for example, Citigroup’s losses to the losses that originators would have suffered had the 5% requirement been in place? Citi’s, and others, losses came from being left holding the bag.

    I don’t know what Citigroup’s mix of origination/aggregation was, but isn’t the 5% require more targeted at the CountryWides and the Scott’s Mortgage Shacks of the world? That is, isn’t the 5% meant to change the incentives for those who were originating loans with no intention of holding them, and thus try to create some additional incentive to actually do the work to underwrite the loans they originate? Some (many?) of them were vastly smaller enterprises than the big bank behemoths, so I don’t really see how a comparison to the losses of orders of magnitude larger institutions is particularly enlightening.

    I’m also not terribly comfortable with the implication that these entities would have lost less as a result of the 5% rule, which isn’t right, but perhaps that implication was not intended.

  35. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. May 2013 at 15:09

    ‘Banks like Goldman Sachs were creating bonds that they knew were less than junk for the sole purpose of betting against them on the other side.’

    That’s just not correct. Goldman usually took the opposite side of the bet only when they couldn’t find another customer to do so. That’s how they got stuck with part of the long position in the John Paulson trade. Also, derivatives are a cheap (more efficient) way to re-balance a portfolio’s risk profile. So, buying protection one month and selling it another is easily understood by changes in the market.

    Btw, Michael Lewis hasn’t worked in finance since the 1980s.

  36. Gravatar of Jim Glass Jim Glass
    1. May 2013 at 15:53

    Swaps are a zero sum game. When one of your customers takes a position on a swap, the bank must take the other side.

    No, it sells the other side in the typical case. It certainly *can* sell the other side, so there is no “must” about it.

    When it comes to swaps banks are merely well paid bookmakers. They are always betting against their customers.

    No, bookmakers don’t bet against their customers. They make the market in getting customers to take opposing sides of the bet, setting the price (line) to equalize quantity of demanded action on each side of the bet. They make their profit from “the vig”, the fee they collect for their services, regardless of the bet outcome. (They typically take a position only when forced to in order to make a market — there is no risk in their profit from the vig but a lot of risk in taking a position, so any position they take is inferior on a risk-reward basis, and they well know it).

    Yes, the banks operate very much this way too, and to the extent they do they are indeed just like bookmakers.

    Two wrongs can make a right!

  37. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. May 2013 at 16:44

    The explanation for this one is pretty good;

    ‘Fact 12: Top-rated bonds backed by mortgages did not turn out to be “toxic.”
    ‘Top-rated bonds in collateralized debt obligations (CDOs) did.’

  38. Gravatar of ssumner ssumner
    1. May 2013 at 18:35

    J, The cause of the fall in NGDP is that the Fed didn’t have a policy of NGDPLT. Other problems including backward-looking policy; they should have targeted the forecast.

    o. nate, I noticed that too. Here’s my take on what they were trying to say:

    1. Insiders lost huge sums, whereas outsiders (mostly uninformed, made a fortune. That goes against the standard insider job/fraud view.

    2. The decisions generally looked rational if you assume house prices would continue to zoom upward. Of course they acknowledge that it was irrational to expect house prices to keep zooming upwards.

    3. The one exception was 12, where even within firms there was apparent irrationality.

    I entitled this “Mistakes were made” because I think that’s their claim–the big problem was mistakes, not fraud. And I agree. They aren’t saying there was zero fraud, you can always find fraud in good times or bad, bubbles or not. But that wasn’t the big story. the big story is huge mistake swere made about house prices, and also about CDOs.

    Steve, Even the liar loans were quite profitable until the house prices fell.

    Bill Ellis, The bolded section has nothing to do with the Sumner Critique, as it says nothing about how Fed policy in late 2012 responded to the expected fiscal austerity.

    Everyone, I’d encourage people to read the paper before taking a position. No more time tonight.

  39. Gravatar of Suvy Suvy
    1. May 2013 at 18:38


    “Also, derivatives are a cheap (more efficient) way to re-balance a portfolio’s risk profile. So, buying protection one month and selling it another is easily understood by changes in the market.”

    I have no problems with derivatives. All sorts of firms use derivatives for perfectly fine reasons. I’d just like to see things that carry systemic risk, like CDS, be put onto an exchange and traded in a sensible way. There are all sorts of reasons why banks would own CDS, like for hedging purposes.

    “Goldman usually took the opposite side of the bet only when they couldn’t find another customer to do so.”

    That’s not true. By 2007, when the banks started to realize that everything was about to come crashing down, they were scrambling to get on the other side of the trade to hedge their positions. I’m sure that there were banks that were shorting these bonds well before 2007. Actually, Greg Lippman with Deutsche Bank called the whole thing a Ponzi scheme in 2005 and was shorting in back in the mid-2000s. He was the head CDO trader at Deutsche Bank at the time and the management knew exactly what he was doing. This was going on while Deutsche Bank was still selling CDOs to its clients.

  40. Gravatar of Suvy Suvy
    1. May 2013 at 18:46

    “Michael Lewis hasn’t worked in finance since the 1980s.”

    True, but the 3 guys that wrote this paper haven’t worked in finance at all. On top of that, you said “that would be the last place I’d go”, referring to my comment that everyone should take a look at The Big Short. The paper actually references The Big Short a few times.

  41. Gravatar of Scott Freeland Scott Freeland
    1. May 2013 at 19:10


    What about the Libor-fixing scandal? If you believe the following BBC article, this manipulation/fraud began in 2005.


    In my view, the major banks have been out of control for at least 20-30 years, from bogus NSF fees and fraudulent analyst ratings and accounting(remember the early 2000s?), to Libor-fixing and foreclosure fraud, I would be very surprised if the banking crisis wasn’t partially the result of an inside job.

    I don’t doubt that incompetence played a role and I don’t want the government juicing the mortgage market or creating moral hazard, but I don’t think you can dismiss good old-fashion fraud here.

  42. Gravatar of steve steve
    1. May 2013 at 19:26

    scott- If prices keep going up, what loan doesnt make money? Frankly, I kind of think I would rather have our bankers be frauds than people who think prices can only keep going up. Fraud or stupid is a tough choice, but you can jail fraud.


  43. Gravatar of Benjamin Cole Benjamin Cole
    1. May 2013 at 20:02

    Excellent blogging.

    Always forgotten is that there was a parallel collapse in the CMBS market, that is the commercial mortgage market. These were pools of mortgage made on commercial property. All adult buyers, lenders, packagers, bond-raters, ultimate buyers.

    Commercial property values got broke in half, investors got creamed.

    No, it was not urban darkies who collapsed the global financial system.

    It was weak AD.

    It was NGDP, stupid.

  44. Gravatar of Geoff Geoff
    1. May 2013 at 20:49

    M2 annualized growth has slowed to just 1.7% the last three months.

    If this keeps up, a financial crisis is inevitable.

  45. Gravatar of TravisV TravisV
    1. May 2013 at 21:39

    Dear Market Monetarists,

    Do y’all have a standard response to this point by Nouriel Roubini about the dangers of the gigantic monetary base we have now?


    “The exit from the Fed’s QE and zero-interest-rate policies will be treacherous: Exiting too fast will crash the real economy, while exiting too slowly will first create a huge bubble and then crash the financial system.”

  46. Gravatar of Peter Schaeffer Peter Schaeffer
    1. May 2013 at 22:12

    Fact 2: No mortgage was “designed to fail.”

    That is simply not true. Back in 2006 I was approached by a poor friend who was negotiating a mortgage and asked to review the terms. The lady owned the house outright (she inherited it from her family) and had no mortgage. However, she did owe back taxes and the home needed some repairs. She was scared that the city (Houston) was going to toss her out (they weren’t) and that some of the repairs (electrical work) were urgent (not clear either way).

    The lender would only loan a minimum of $55K and the interest rate was outrageous (10%+). There was no way this lady could make the first payment (her income was quite low and she was struggling with cancer).

    W\e discussed her situation at considerable length. She was terrified about her back taxes (I told her not to worry which was correct) and seriously considering taking the loan. I tried to dissuade her in various ways to little effect. Finally I said

    “If you sign this loan agreement, you will lose your house, your family (including a disabled child) will end up in the street, you will lose everything you have, and it won’t take long”

    That didn’t get much of a reaction either. However, she never took the loan and her uncle helped her out with her tax and repair problems.

    Who was the lender? New Century Financial.

    This was very clearly a mortgage “designed to fail”. Was it the only one? Or one of millions? I think the answer is obvious.

  47. Gravatar of Peter Schaeffer Peter Schaeffer
    1. May 2013 at 22:19

    o. nate,

    Smog started in the 1940s in LA. At the time, it was thought that a new synthetic rubber plant was the culprit.

    Great comments otherwise.

  48. Gravatar of ssumner ssumner
    2. May 2013 at 06:14

    James of London. I think the article does blame bankers. It says bankers made lots of boneheaded mistakes. And they lost a ton of money.

    Scott, I don’t see how Libor relates, nor do I see much evidence of foreclosure fraud playing a significant role.

    Steve, See my answer to James. I agree that mistakes might have caused more damage than fraud. “Worse than a crime, it was a blunder.”

    Peter, I think they meant no category of loan. Obviously one could not argue that every single loan was sound, that would be crazy. But they show that certain categories of loan, like subprime, did well when prices were rising. And investors expected prices to keep rising. Rates were so high on subprime loans that investors could make lots of money DESPITE HIGH DEFAULT RATES.

    Everyone. I see lots of people making criticisms that are answered in the paper. Please read the paper before posting.

  49. Gravatar of Housing Crisis | Daniel J. Smith Housing Crisis | Daniel J. Smith
    2. May 2013 at 06:25

    […] http://www.themoneyillusion.com/?p=20937 […]

  50. Gravatar of J J
    2. May 2013 at 06:29

    Professor Sumner,

    The Fed has had a policy of not NGDPLT for a long time. What changed? Perhaps I am mistaken, but I believe you have said that the housing ‘bubble’ was not a bubble. If housing prices fell because NGDP fell, then what caused the initial fall in NGDP? I understand that the Fed could have prevented it, but what underlying conditions changed that meant the Fed’s monetary policy was no longer adequate to keep NGDP stable?

  51. Gravatar of Scott Freeland Scott Freeland
    2. May 2013 at 18:14


    As I understand it, many mortgage rates were based on Libor and the banks manipulating that rate might have made mortgages affordable that shouldn’t have been. Am I missing something here?

    And I point out foreclosure fraud just to highlight a pattern of fraudulent activity by the major banks over the past 20+ years. These are truly evil people. That’s my point.

    While I understand that pointing out a general pattern of what should be criminality does not a case make when it comes to the motive for the lending frenzy, one shouldn’t be surprised if it turned out fraud was a big factor.

  52. Gravatar of Scott Freeland Scott Freeland
    2. May 2013 at 18:46


    It also occurs to me that you’ve argued that the financial problems at the banks were made vastly worse by the failure of Fed policy, and this policy failure obviously shocked the world Hence, the bankers could have been committing fraud all along, and may have done so sustainably if not for bad Fed policy.

    My brother was in the mortgage industry from the early 2000s until 2008, and he said that representatives from major banks were coming into his office and picking loan applications out of their reject box. He said his office already had extraordinarily loose standards and that there was no way anyone could think those loans wouldn’t fail at very high rates. These were loans that initially they dared not even try to sell to banks, or anyone else.

  53. Gravatar of ssumner ssumner
    3. May 2013 at 06:08

    J, The initial fall in housing was not due to falling NGDP. In the past I’ve said I don’t know what caused it–perhaps the crackdown on immigration played a modest role, other factors also contributed. NGDP growth initially slowed because the Fed stopped increasing the monetary base. Then in late 2008 the demand for base money soared for various reasons (low nominal rates, IOR, uncertainty, etc.)

    The second down leg of housing prices was caused by NGDP falling.

    Scott, I don’t think anyone is claiming the Libor manipulation had a material effect on mortgage rates. And I think most of the foreclosure fraud reflected errors, not evil intentions.

    Regarding mortgage loans intended to fail, you haven’t addressed the arguments in the paper. Why are those arguments wrong?

  54. Gravatar of Lorenzo from Oz Lorenzo from Oz
    3. May 2013 at 15:45

    Great paper. I was struck my their observations on bubbles, their difficulty for economic theory and that outsiders made the big killing.

    The problem for economic theory I suspect (apart from not fully grasping that there is no information from the future and the implications thereof) is that all information is treated as equal. If so, then long run trends count as much as any other information. But that was only true for outsiders, who looked at the long run trends, and made a killing.

    But all information is not equal. Information that comes from experience is much “richer”, much more intense–i.e. much more connected to other bits of information and emotions–than information that does not. Information which has such connected resonance is more powerful than distilled stats in a graph from things that happened to someone else years ago. (Unless you are an outsider to whom a market is just a market and the long term trends are what you habitually look at.) The experience of years of rising house prices is and was patently very powerful for those involved in the pattern; particularly when associated with future hopes. Particularly when there is no information from the future.

    Abstract reasoning was the last thing to evolve; the wonder is not that we do it badly at times, the wonder is that we do it at all.

    The paper makes me feel quite good about a recent post of mine (prompted by one of your posts) on bubbles and asset price volatility, though it could do with adding in the inequality of information.

    (And on “destined to fail”, the mortgages certainly were not designed to lose money for the people offering the mortgages, but lots of them did.)

  55. Gravatar of Lorenzo from Oz Lorenzo from Oz
    3. May 2013 at 15:48

    That should be “by their observations”.

  56. Gravatar of ssumner ssumner
    3. May 2013 at 18:32

    Lorenzo, This is a very good point:

    “But all information is not equal. Information that comes from experience is much “richer”, much more intense-i.e. much more connected to other bits of information and emotions-than information that does not. Information which has such connected resonance is more powerful than distilled stats in a graph from things that happened to someone else years ago. (Unless you are an outsider to whom a market is just a market and the long term trends are what you habitually look at.)”

  57. Gravatar of Lorenzo from Oz Lorenzo from Oz
    4. May 2013 at 07:28

    Thanks 🙂 The thought was inspired by the paper.

  58. Gravatar of The Home Borrowership Crisis | askblog The Home Borrowership Crisis | askblog
    5. May 2013 at 05:14

    […] This paper from last year was cited the other day by Scott Sumner. […]

  59. Gravatar of Larry Siegel Larry Siegel
    5. May 2013 at 19:22

    The Maddison Project contains “data” going back to the year 1 (not a typo) so obviously it contains back-reconstructions. I also use this source in my work, and I assume that readers will be at least somewhat familiar with it and not believe that I am quoting economic data collected in real time in Jesus’ day.

    R&R should have said, in a footnote or elsewhere (and I blame editors for many mistakes that authors sometimes appear to make), that the underlying data source, the Maddison economic data base, was not collected in real time and includes backfills.

    If the contraction in the New Zealand economy really happened, and the debt-to-GDP ratio in that country is what R&R said it was, then the data point should be used. You can’t throw out data just because you don’t like them. You have to have real evidence that the data are incorrect.

  60. Gravatar of Linky Friday #26 Linky Friday #26
    15. June 2013 at 07:13

    […] More indication that, as far as the banking-housing crisis goes, they knew not what they did. For those that missed it, a previous linky post drew attention to this article, coming to the same […]

  61. Gravatar of Skepticlawyer » Bubble trouble: all information is not equal Skepticlawyer » Bubble trouble: all information is not equal
    18. June 2013 at 01:22

    […] post is partly prompted by this comment and this paper (pdf) (via) on the US housing price bubbles and busts and (greatly) extends this comment by myself. It is also […]

  62. Gravatar of No Inside Job No Inside Job
    22. February 2015 at 01:26

    […] Scott Sumner takes note of a paper that contradicts the “Inside Job” theory of the housing/finance crisis. Here’s the twelve bullet point summary: […]

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