Fed Chariman Ben Bernanke recently inferred that the Fed's policy of low interest rates was not a major factor in the mortgage meltdown. That's right and wrong, and he's taking some heat for it. Let's sort it out:
He's RIGHT because low rates targeted by the Fed and endorsed by the originators (lenders) and backers (Freddy, Fannie, AIG, etc.) of those mortgages certainly improved the affordability of housing and homebuilding, a strong positive, contributing to the housing boom and a great deal of desirable new construction. Prudent capital investment by the private sector is a good thing, and it is encouraged by low costs of borrowing.
He's WRONG because those low rates supplied an inventory of low-cost funds enabling lenders to structure mortgages whose affordability, based on the available low rates, was only temporary. These low short-term rates, particularly when bundled with low payments (interest-only or less), could be locked in the early years of adjustable and option-ARM mortgages, creating the impression that in the relevant time horizon, homebuyers could afford larger mortgages than was actually the case. Demand for homes therefore overheated.
This in turn incented homebuilders to build more homes, and more elaborate homes, than the market could realistically bear. After all, there was raging energy in the market for new homes. But imprudent capital investment by the private sector, unbridled by the basic economic reality that even in good times affordability has its limits, is a bad thing, and it too is encouraged by low interest rates.
Low interest rates were, therefore, clearly an enabling factor, and Mr. B misses the point by suggesting that they weren't. That does NOT, however, mean that low rates were at fault.
Remember the basic principal that correlation does not imply causation? It's very much the case with respect to low rates and the housing bust. But that's not how it looked to homebuyers and homebuilders and banking regulators and mortgage insurers and insurance regulators and mortgage bankers and securities regulators and mortgage investors, none of whom comprehended (or in the case of those who understood, none of whom cared) that to generate more business in a time of low interest rates, mortgage lenders eased (read "abandoned") their underwriting criteria.
Instead, homebuyers and homebuilders were eager to borrow, Realtors and homeowners were eager to sell, mortgage insurers were eager to guarantee, mortgage bankers were eager to securitize, and mortgage investors were eager to purchase. Meanwhile, banking regulators, mortgage regulators, and securities regulators (inconveniently including the Congress in all cases) were sound asleep at the switch.
So, who's at fault for the housing mess if it isn't Ben Bernanke's interest rate policies and those of his predecessor (whose upward path he followed slavishly until abruptly reversing course)?
Is it just an exaggeration of the normal housing cycle? Is it Bush? Is it Obama? Is it mortgage securitization, which enabled banks to offload their mortgage portfolios to unwary investors via securitization (encouraged by McKinsey & Co. in the late 1980's as an intelligent means of boosting fee income and reducing the balance sheet risk of financial institutions)?
Is it the greedy old bankers and their shareholders who, in siren-like fashion, lured homeowners onto the rocks of bankruptcy in order to ultimately boost their costly portfolios of non-earning real estate foreclosures?
Well, no.
What happened was a confluence of greed and naïveté on the part of many. Greed, or at least a financial posture of opportunity and personal benefit, is a key engine of free market capitalism. It works because incentives have greater leveage than disincentives. On the other hand, we tend to think of those most interested in pecuniary advantage as being studied, purposeful, and well informed. But the mortgage meltdown is perhaps the best recent illustration that the most educated are not always the most knowledgeable, or at least the not the best informed.
Here's what they missed: The business model for lending changed dramatically between the late 1980's and the early 2000's. The lending model once required the banker to manage and collect his own originations, all done by the lending institution under studious regulation and oversight, something like this:
Underwrite -> Originate/Fund -> Service -> Monitor -> Collect Most (with interest)
It shifted, however, to laying off risk to non-originating mortgage investors, something like this:
Market -> Originate/Fund -> Sell -> Package -> Insure -> Securitize -> Place -> Trade -> Service -> Wish You Could Liquidate without Severe Losses.
Do you see the core differences? It's NOT the number of steps; that's largely tactical, involving specialized players. It's the elimination of "Underwriting" and "Monitoring" (both for one's own lending portfolio), and the clouding of responsibility and blame among numerous parties for their omission. And it's the failure to add one more crucial step - - Education - - to the brave new model of the housing market.
When lenders were investors, the underwriting and monitoring steps transpired within the same profit-seeking entity. It only made sense to originate only those loans that could reasonably be expected to be collected, with interest. When lenders no longer lay clam to the loans they originated, insurers, I-bankers, and investors needed to make sure they learned to underwrite and monitor such portfolios before acquiring them.
Commensurately, lenders and regulators by rights needed to warn investors in mortgages and mortgage derivatives that were predictably shaky at best. [Ironically, mortgage lenders themselves could have used this cautionary information, as they in fact ended up purchasing and suffering losses on prodigious amounts of these very mortgage securities for their own investment portfolios!]
The education didn't happen.
Personally, as a practicing Realtor and (erstwhile) developer, I don't fault borrowers for failing to surmise that the suspension of intelligent underwriting criteria and the regulation thereof were at the core of overheated housing markets. To be sure, some borrowers, builders, and Realtors should have figured this out, but most are simply not better informed regarding intricate market dynamics and complex securities derivatives than professional lenders, mortgage bankers, insurance companies, and their regulators. To many, a hot market is simply a chance to make up for icy cold markets of years past.
As a former banker and banking consultant, I'm confident that the commercial, mortgage, and investment bankers knew, or at least eventually figured out, what was happening. But net interest margins were down, they really liked the fee income, and they didn't grasp the wisdom of educating the other members of the housing & mortgage business system. They too are suffering for that lapse.
Insurers, professional investors, and regulators were simply caught off guard. Being paid to do so, all should have done their homework, but they failed to take to heart the basic math and elementary economics of mortgage lending without serious underwriting; of securities insuring, issuance, and investing without serious evaluation of risk. Yes, mortgage securities are complex to analyze to say the least, but highly sophisiticated systems to do just that have been developed by such genuinely brilliant risk management think tanks as Kamakura Corp. and have been deployed worldwide for years.
But it wasn't Ben or Alan, and we don't WANT it to have been Ben or Alan. Federal intervention in short term interest rates is at best a very poor motivator for the establishment of long term mortgage rates, requiring wider swings of the mighty yield curve lever than are prudent in the management of a multifaceted economy which has quite enough variables as it is for any sort of generalized confidence to materialize. This is the fallacy of conventional economics, which defaults much too easily to the G(overnment) factor for the guidance and motivation of markets which are best regulated by market forces and consistent oversight than by blatant, unpredictable, and costly intervention.
Sorry Ben. I wish you could cause the housing market to recover, but right now you can really only hinder the economy raising rates so much that longer term mortgage rates are be impacted at all. Instead, I hope you'll keep a watchful eye on inflation, the real beneficiary of your monetary influence, remembering all the while that rate instability is an equal foe. - David
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