If all the loans were given the old-fashioned way, from the bank to the borrower, with no further bundling and reselling, and if the same number of people defaulted on their mortgages as have today, would the effect on the financial system have been the same?
If no, then the “innovative financial instruments” are to blame, and the defaulting borrowers are merely a trigger. Just because someone gets a violent and near-deadly reaction to peanuts, you can’t call the peanuts the “disease”; it’s that person’s body that is overreacting; other people are fine with exposure to that external factor. Similarly, other financial systems might have been relatively fine with exposure to the sub-prime issue.
So, my question is: would we still be facing financial meltdown if all the loans had been of the old-fashioned, direct, type?
If not, then blaming all the lax lending standards and idiots who bought homes they couldn’t afford is not really getting to the real cause of the meltdown.
I suspect not. But at the same time, I think the economy would have been a lot more sluggish for the last several years. Exotic mortgage products made it possible for people to use their houses as ATMs, which drove consumer spending to higher levels than it would have been otherwise.
I’m of the [minority, it seems] view that the whole economy has been inflated by artificially cheap credit, and that we are in for a serious downturn whether we transfer all the bad loans to the government or leave them with the banks that made them.
The default rate is 1 in 11. We have to find a way to keep them in the house and making payments. If your house is dropping in value by about half. it is hard to get them to continue making payments. If you bought for 400 and your house is now worth 250, why do you stay? to make big payments on a house that is not worth it. You can get out and rebuy next door and pay a hell of a lot less. The numbers are not there.
This is exactly my point. The economic loss is there, and there is nothing anyone can do to make it go away. You can try to figure out how to distribute that $150 between the lender and the borrower, but as a practical matter, the borrower has the power to walk away and stick the lender with the whole thing. You can add it to the national debt, but that just means the whole country has to eat it.
To the first part of the OP’s question, I don’t know if sub-prime and other unconventional mortgages were the cause, consequence, or both of the asset bubble. But given that the bubble existed, it was and remains unavoidable that it would burst.
The question is not what caused the bubble. The question is, given that the bubble in house prices burst, and we saw some percentage of mortgages default, did this necessarily have to result in a meltdown of the economy?
Would we have a meltdown if all these mortgages defaulted, but the market wasn’t immersed in a complex web of interdependent “financial instruments”?
I think you’ve missed the thrust of the OP’s question. What he’s asking is “Would the housing bubble on its own caused the credit crunch? Would the bailout be necessary if there was just the bubble, but no uncertainty as to who was left holding the bag?”
Personally, I think that the answer is obviously no. The whole point of the bailout is to remove uncertainty from the market by buying up mortgage-backed securities that noone can accurately value. Remove the uncertainty from the equation and you remove the need for the bailout, and then (assuming the bailout is actually going to solve the problem), you remove the crisis.
Thing is, the housing bubble was in no small part driven by the availability of sub-prime mortgages, and those mortgages were only available because they could be packaged and resold on the securities markets. If the risk couldn’t have been dumped onto the securities market, no lender would have offered people those mortgages, and without those mortgages the demand for housing would have been much, much lower leading to correspondingly lower housing prices.
Even if lending returned to storefront banking methodology, there would still be a considerable risk of consumer default. Not all defaults or bankruptcy filings are the end result of reckless spending. Acording to an article in the Project Hope journal, as many as half such defaults may be partially due to giant medical bills which the borrower had no alternative other than to rack them up.
Health care has to be paid for at some point, and it has to be paid for everyone. The fact that the public is effectively going to be covering bad debts arising from medical expenses is simply the transfer of wealth that must happen to provide adequate health care for all. Since we won’t pay for it up front through a national insurance plan, we pay more for it later.
In America we all play the lottery game in which the unlucky losers have expensive illnesses and inadequate insurance, or no insurance. I don’t think there are winners. Link.
But many housing markets around the world experienced a huge increase in home prices, often equal to or exceeding the US increases, even though these markets lacked sub-prime mortgages, mortgage-backed securities, and other “innovative financial instruments”.
So, I don’t think mortgage-backed securities were the cause of the bubble. Unless you have a cite showing that countries with mortgage-backed securities and other “innovative financial instruments” experienced bigger housing bubbles than countries without these instruments.
So, based on your observation, mortgage-backed securities are fine and cause no trouble, until the housing market starts getting into a bubble, in which case they accelerate the bubble and when the bubble finally bursts, they lead to a meltdown of the whole economy.
If you’re expecting anyone to be a cheerleader for derivative securities and insist that they can’t ever cause harm, you’re going to be disappointed. All I’m trying to point out here is that these securities are not the root of all our problems in and of themselves.
I’m not a financial historian, but those were CDOs being traded back then, which are the same securities causing problems today. The market wasn’t as big, and the mortgages backing them were not subprime, but the securities themselves haven’t changed.
They are the root of the problem, because any tool that works well when the real world “behaves” and collapses and brings destruction when faced with reality and its ups and downs is not a tool that should be used.
If engineers build a bridge that can hold 100 people as long as they are not running, but will collapse and kill everyone on it if some people start running, this would be a disgrace. Yes, if some people do start running, they will be the “trigger” for the collapse of the bridge. But, designing such a bridge, which ignores the reality that people sometimes run on bridges, is willful ignorance, incompetence, stupidity, … The design of the bridge (and its designers) are the root cause of the collapse of the bridge.
To you use your analogy, then, you would be against mortgages. Mortgages are in general are no-recourse loans. Meaning, if people default on them, because of bankruptcy protection (or other laws), then the most the bank can get is seizure of the property. If everyone started defaulting on mortgages, banks’ credit lines will start to retract, and the economy would grind to a halt a lot faster than what is happening now, bank runs would not be out of the equation. What you’re trying to argue is some sort of fairy tale system where there is no risk. These mortgage backed securities are designed to spread risk across the market. If people started defaulting all over the place, any economy would shut down. To answer the question in your title, even subprime mortgages were modeled with a certain default percentage in mind, and risk (or interest) was made accordingly.
Oh, and derivates (which is essentially what a mortgage backed security is) has existed for a very, very long time. The ones that exist today aren’t really much different from the ones 200 years ago (they’re more sophisticated because of advanced modeling and such, but the principles are the same). There is no one single answer for the state of the economy.
Isn’t it also true that the sufferers would have been different? The mortgage-backed securities allowed investments banks to suffer huge and unhedgable (because of the uncertainties of the risk) losses. If we were only talking about straight commercial bank mortgages, some of the commercial banks (i.e. WaMu, Wachovia) might still have gone under, but not the secondary parties like Bear Stearns, Lehman Brothers, and AIG. The big players on Wall Street would have been around to pick up the pieces of the commercial banks, and the credit issues would not have been as acute.
I think the key point, as mentioned previously, is that many of the really bad subprime loans would not have been made absent the ability to securitize them.
It would be a grave mistake to assume that subprime mortgages are the primary issue driving the current financial crisis. Take a look at this article, scroll down a bit to the bar graph. Subprime mortgages are the AAA investments of the derivatives market, relatively speaking. At least you do have a tangible asset–a house–that can be valued and loss can be figured pretty easily. Other credit default derivatives based on infinitely more complex businesses and transactions are the really scary time bombs. The energy futures speculation market alone is a headache of Jovian proportions.
The only fairy tale system is the one that is currently in place.
You talk of “If everyone started defaulting on mortgages”. But in the current situation, only small percentage of mortgages have defaulted (roughly 5% if I am not mistaken [ 0.2% of homes have faced foreclosure in June 2008, so over the past 24 months that would lead to about 5% of all homes]). In addition, house prices have fallen, but not too much (~20% nationwide, I believe), so banks should be able to recoup much if not all of the amount of the mortgages that defaulted.
So, if the current system cannot handle a small percentage of mortgage defaults and a 20% decrease in home values, then this is the one that was built on fairy tale assumptions that “home prices always go up” or “percent of mortgage default s will be tiny”.
We have seen how well this has worked, haven’t we?
Can I have a cite proving that “people started defaulting all over the place”?
What is the percentage of mortgages that have defaulted? (If my calculations above are correct, it should be around 5% in the past two years, hardly a cataclysm)
More significantly, what is the value of all defaulted mortgages as a percent of all mortgages out there (because most of the mortgages that defaulted, I assume come from the lower end of the economic spectrum, so their total value is smaller than mortgages that did not default)
Also, can I have a cite that “any economy would shut down” if the same number or percent of defaults had happened?
Obviously, the model was *woefully *inadequate or the default percentage they assumed was naively optimistic. Otherwise, why did the whole system collapse, if they had taken into account the probability of defaults (and home price reductions) properly?
I like that you are still calling them “sophisticated” with “advanced modeling”.
These securities are shit and the models used are shit.
There is nothing advanced or sophisticated about making naive assumptions that don’t take into account real-world behavior and collapse when they come face to face with reality.
As to the fact that derivatives have existed for a long time, if the newer incarnations are so different and “advanced” compared to older ones, there is no reason to “trust” the new ones based on the track record of the older ones. (I don’t remember his name, but there was an article in the Wall Steer Journal several months ago, where someone who was one of the instrumental people in bringing “complex financial instruments” into existence and into widespread use, wrote a book stating something like “We have created a monster”, and that no one knows how bad it will get once we face a downturn. I believe he said that the level of interconnection between companies using these financial instruments, and the fact that many of them use similar formulas that makes their behavior correlated, will spell disaster for the market once things start going south. So, obviously, he was referring to the newer incarnations of derivatives, and the fact that derivatives existed before in other forms is no comfort)
I don’t know if I’d call them good. Having a large number of financial institutions that depend on mortgages collapse, not to mention the homeowners being foreclosed on would not be a good thing. However I believe the mortgage crisis would have been smaller, more contained and less likely to lead to a credit crunch and possible total economic meltdown if the mortgage-backed securities were not in the mix.