Professors Atif Mian and Amir Sufi, economists who teach at Princeton and the University of Chicago, respectively, have enhanced our understanding of the origins of the Great Recession and the accompanying financial crisis. Their major contribution is the use of zipcode-specific data to show that the greatest losses of house values occurred in the poorest geographic areas and the greatest increases in lending that pushed up house prices that led to the bust took place in those same zipcodes. They also show that these same areas suffered economic downturns in advance of the financial crisis showdown in the fall of 2008. They use this new data, along with other data and reasoning, to show that the depth of the recession was caused by the extreme losses of home equity by ordinary Americans, not by the problems or failures of the banks.
I believe that Professors Sufi and Mian are correct that the real estate crash caused both the recession and the financial crisis and that the banks did not cause the Great Recession by getting into financial trouble and therefore failing to lend. I also agree with them that the excessive lending on loose underwriting standards led to the run-up in house prices that set the stage for the recession and financial crisis. In my own work I have reasons for these conclusions that differ somewhat from those advanced in House of Debt but I find the book's explanations useful and compelling. My paper from a conference on financial bubbles sponsored by the Leir Foundation last September will be published as part of a volume on the conference later this summer. I can make it available in pre-publication form to readers who would like to see it.
Professors Sufi and Mian are not after merely correcting the record, however. They are stalking bigger prey, and in that endeavor I think they have provided too little firepower. They see the Shared Risk Mortgage (SRM) as the solution to the debt problem. I am not against the SRM; indeed I suggested something quite similar on p. 304 of Debt Spiral (available on Amazon.com) five years ago. But making the SRM the principal means of financing homes would require a fairly complete rethinking of both mortgage finance and portfolio management. I think such a revolution is unlikely to occur and that there are simpler ways to deal with the debt problem, if as a society we really do want to deal with it.
House of Debt explains that a debt contract is quite inflexible. The borrower must repay on a fixed schedule and the lender has a right to demand that. In some circumstances, such as the falling house prices of 2006-2009, it would be better for both parties to have a flexible relationship in which the borrower's payments could be reduced to avoid default and its accompanying costs. These costs accrue not only both to the borrower and to the lender but also to the neighborhood and to the wider society. And it was those widespread costs that caused the depth of the recession. As early as the fall of 2007, many of us saw that this was happening, but there was no political will to take action, and the nature of securitization of mortgage debt, along with the complexities posed by second liens, made it hard to design a workable program. Some policy advocates like me only have the op-eds and back-up papers that the New York Times and Wall Street Journal rejected to show what I thought needed to be done. The SRM or a variation of that concept under which the parties' relationship would adjust automatically would have been very useful had it been in general use for a decade before the bust.
I was somewhat disappointed that Professors Sufi and Mian did not tackle some of the difficult questions that their research naturally raised. These include the question of who was making the mortgage loans in the low-income zipcodes? To what extent was it Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC), who were encouraged to lend in those areas by HUD regulations and Congressional mandate? To what extent was it banks responding to CRA requirements that they lend in the same areas? To what extent was it mortgage bankers that passed the loans on into Private Label Securitizations? And if the last, who bought those securities? Did Fannie and Freddie, who between them accounted for about 20% of the PLS market in the years in question, buy PLS that held preponderantly low-income zipcode mortgages? Or were these low-income zipcode mortgages primarily passed on through securitization to European banks that are estimated to have bought about 50% of the PLS issued during the years in question? We need to know the answers to those questions, and House of Debt would have been a good place to find some of them. But Professors Sufi and Mian already had their solution in the form of the SRM, so these questions may not have engaged them. For those of us that think other solutions may be easier to implement or preferable, these are vital questions that bear on American housing policy as well as the panoply of laws that govern the housing market.
At the end, House of Debt pleads for a society that is less reliant on debt and more reliant on equity financing. With me as their audience, Professors Sufi and Mian are preaching to the choir. I could not agree more. But they missed a great opportunity to lend their voices to the growing recognition that so long as monetary policy is conducted by tipping the debt markets up or down, society cannot reduce its dependence on debt without being schizophrenic. They point out that conducting monetary policy through banks has great shortcomings. But they do not attack the more fundamental problem of managing the economy by pushing debt up or down. That way of managing the economy has to change if society is to reduce its dependence on debt.
One can rejoin to my criticisms by saying that I am asking for a different or longer book. And I suppose I am, but the unanswered questions are tantalizing when the authors' data might have helped to answer them.
House of Debt contrasts nicely with Tim Geithner's recently published memoir, Stress Test. Geithner never directly addresses the question of whether the financial crisis caused the depth of the recession. But Geithner is very clear that had the banks not been rescued, the recession would, in his opinion, have become a depression. He regrets having to let Lehman fail; he excoriates FDIC Chair Sheila Bair for having enforced a haircut on Washington Mutual's bond holders. And although at the end of the book he tries (not very convincingly) to take a more nuanced approach, his mantra all along is to not let large financial institutions fail in a severe downturn because doing so will be bad for the economy. I am not second-guessing the decisions to put TARP capital into the big banks on Columbus Day 2008 or the decisions to provide liquidity to the markets. But I think Professors Sufi and Mian would question whether all of it was appropriate. They would have preferred to assist homeowners by reducing their debts, arguing that that would have helped not only the homeowners but the mortgage holders as well.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.