We will publish our interview over the next few weeks, beginning now with a primer on subprime mortgages and the housing bubble, continuing on to discuss how these concepts led to the collapse of the investment banking industry, government intervention through bailouts, and how this “crisis” might affect the College’s economics department and its students’ career prospects.
For the basics, what are subprime mortgages?
Subprime mortgages are defined not as conventional mortgages so if I tell you what a conventional mortgage is, subprimes don’t meet those criteria…. The things that determine whether something is a conventional mortgage are the payment to the household income ratio, the debt to income ratio (that’s the homeowner’s debt), the loan to value ratio on the house, and then the size of the loan. Anything where those ratios are too big is defined to be non-conventional or, in the common jargon, “subprime.” And subprime means that Fannie Mae and Freddie Mac wouldn’t guarantee them…. The savings and loan institutions were the primary lenders of mortgages and originators and holders of mortgages from the great depression through the nineteen eighties. When the S and Ls went belly-up, Congress asked Fannie Mae to take a more active role in the secondary market and thereby provide financing, and they also instituted Freddie Mac… to be a competitor of Fannie Mae. They were trying to provide low-cost financing to homeowners… and they would borrow money and… use that money to buy mortgages, pack them into securities, guarantee them and then resell them. Now what made [Fannie and Freddie] particularly profitable and made them a very dominant player in the mortgage market is that they were called “government-sponsored enterprises.” And there was the thought on Wall Street that… their debt was implicitly guaranteed by the federal government. And there was a small amount of technical guarantee, but it was small relative to their total asset holdings. So S and Ls no longer existed and weren’t writing mortgages, but now Freddie Mac and Fannie Mae were providing mortgage financing in a conventional mortgage market. Fannie Mae and Freddie Mac had been controversial for a long time. They made enormous profits. In addition, it’s not clear that they actually lowered the cost to the homeowners… They basically were monopolies and they charged the same prices that Savings and Loans would have charged. In the early 2000s, I believe, there was an accounting fraud and there were some executives at one or both of these institutions that were doing some crazy things with the books to increase their compensation. They were kicked out and Congress was angry with them. But, and I think this is primarily the Democrats, and even, in fact, [Chairman of the House Financial Services Committee] Barney Frank basically said, “If you want to stay in the good graces of Congress, you need to make sure you’re providing better access for people who can’t afford normal mortgages. This has been basically telling Fannie Mae and Freddie Mac to get into the subprime business. And, [Fannie and Freddie] didn’t guarantee it, but they had begun to hold some subprime mortgage debt.
How did mortgages lead to the market’s fall?
After the stock market bubble — the internet bubble — burst, returns in general on financial assets were low and we have a very, very competitive financial industry, so people were scurrying around and trying to find areas where they could earn high returns and mortgage-backed securities became attractive. Investment banks such as Lehman Brothers and Bear Stearns could not compete with Fannie Mae and Freddie Mac because they didn’t have any kind of implicit guarantee of their debt [from the government], so they didn’t enter the conventional mortgage market and the only place to go was the subprime market. So the explosion of subprime mortgage investment lending is occurring through investment banks… On the way up, that feeds the housing market, allows homeowners who wouldn’t have otherwise been able to borrow to borrow, that drives up home prices. Unfortunately, that led some people to believe that home prices would only go up so they thought, “If I’m borrowing 90 percent and I’m only putting down 10 percent I don’t have to worry about that because a year from that my house is going to be worth 10 percent more.” So that psychology is the classic case of a financial bubble where people are buying things that they can’t afford in anticipation of the fact that the price of what they own goes up. And the explosion of subprime mortgages in the last five years contributed to the housing bubble. Again, it’s important to recognize, there are some good aspects to this in that there are some people out there who bought homes that use subprime financing who otherwise would not have been able to buy them and they will not be foreclosed and they’re better off as a result of this. But … there was a bubble taking place… [and] homeowners as well as investment banks were not paying sufficient attention as to whether or not these loans really made sense….
So supply exceeds demand?
Well, it’s a combination so that the demand is diminishing, supply is increasing because homebuilders look at these housing prices and say this is a great time to build so eventually you are going to have a situation where the price increases begin to slow and once you change the psychology that says, “Wait a minute, housing prices aren’t going to go up forever.” That by itself is sufficient to cause housing prices to start to fall because the new people coming in say, “I can’t make a subprime mortgage, I can’t depend on the price going up and I can’t pay the interest.” It’s a classic case. When bubbles burst, they burst quickly and it’s because the psychology that prices will always rise changes, and then there’s a free fall. By the way, the free fall in the housing market was not a free fall in prices. Housing prices certainly have come down, but what happens is people can’t sell their homes…. All of a sudden was there were many, many more homes on the market that wanted to be sold relative to the number of buyers who wanted to buy.
Did people put their savings in real estate, instead of the traditional banks, bonds or stock markets?
Yes, not homeowners, but in addition to the problems that we talked about with the homeowners, there also was speculation. There are people who were buying homes, not, in fact, to live in them, but to rent them out and then flip them — rent them out for a year and then flip them so that they could enjoy the capital gain…. But the problem was housing prices had risen so much faster than rental rates that as soon as the psychology that housing prices were going to go up forever changed, all of those speculators wanted to sell and wanted to get out so that it was exacerbated….