Comparative Impact and Origins of the Mortgage Crisis

by: Markham Lee

Earlier this week there was a good article in the Wall St. Journal ($$Subscription Required) discussing the origins and potential impact of the mortgage crisis, sprinkled with quotes and insights from Former Fed Chairman Paul Volcker, Robert Schiller and George Soros. You can read excerpts from the interviews here. The article has a rather funny quote from Alan Greenspan regarding the housing bubble:

From the Wall St. Journal:

Former Fed Chairman Alan Greenspan frequently argued there could be no housing bubble. The high cost and inconvenience of moving "are significant impediments to speculative trading and...development of price bubbles," he said in late 2004.

The problem with Greenspan’s comment is that it ignores the fact that between 25-33% of all homes bought during the boom were bought by speculators, who had no plans to live in the homes. Furthermore, it didn’t factor in a lot of the bad consumer behavior around abusing HELOC, overspending on homes, etc. It’s a classical example of the people at the controls of the economy, having no clue about some of the microeconomic patterns that when considered on aggregate will have a tremendous impact on the economy.

Housing bubble denial, coupled with the nonsensical beliefs that housing would always go up, we’d never see a national downturn in housing prices and that homeowners would always pay their mortgages, is essentially what caused the housing crisis. The belief that “it couldn’t happen” in fact caused it to happen! Investors, lenders and homeowners made financial decisions based on their “beliefs”, not economics, an analysis of the underlying fundamentals or common sense. As a result, the nation is suffering from a situation that was completely avoidable if enough investors/lenders/home buyers had utilized good sense and simply made better decisions.

The lessons are pretty clear:

  1. When making a financial decision of any kind, it needs to be based on, well, MATH: an analysis of the fundamentals and economics surrounding the situation, as opposed “beliefs” around behavior that aren’t supported by a logical analysis of the situation.
  2. Bubbles are created when people throw common sense out the window and begin to throw capital at an asset class based on: fearing being left out, thinking that it’s a “sure thing”, “it will always going to go up”, “you can’t lose”. It’s the financial markets equivalent of someone trying to sell you the Brooklyn Bridge.
  3. Sustainability has to be a consideration when looking at any asset, business, market, etc. The housing boom simply wasn’t sustainable when you looked at the relationship between pries and incomes, coupled with the exotic mortgages used to buy the homes in the first place. The lack of sustainability was especially obvious when considered the confluence of cheap money and weak lending standards. Making big bets on housing continuing to go up when the market was obviously unsustainable was just plain stupid.
  4. If you use common sense, don’t get greedy and follow rules 1-3, you can really avoid a lot of pain.

Here are some other interesting quotes from Volcker and Soros:

Paul Volcker:

The new financial system -- shifting risk from banks to securities markets -- has worked "pretty well" up until now, says former Federal Reserve Chairman Paul Volcker.”We're going to find out if it works well for a major-league crisis."”

George Soros:

Old fogies like me expected the bust to come earlier than it did," says George Soros, the 77-year-old chairman of Soros Fund Management. "A lot of us got tired waiting for it."…

Housing fits a pattern Mr. Soros has observed since he entered the investment business in the 1960s. Economic fundamentals, he posits, are supposed to determine asset prices. But often a flood of capital makes an asset's fundamentals seem sounder than they really are, attracting even more capital. "Eventually, you reach a turning point," he says, "where the value of the collateral begins to decline, which reduces the willingness to lend, which reinforces the fall in the value of the collateral."

"There usually has to be a flaw in people's perceptions to set a boom-bust sequence into motion," Mr. Soros says. In the case of housing, he says, it was the assumption that, because home prices fall nationwide only in a severe economic slump, a diversified portfolio of U.S. mortgages made for a very safe investment.

Finally, in order to gain some perspective here is a quick chart comparing the current mortgage crisis to the stock market crash of ’00 – ’02.


The Wall St. Journal: “U.S. Mortgage Crisis Rivals S&L Meltdown” -- GREG IP, MARK WHITEHOUSE and AARON LUCCHETTI – December 10, 2007.

Image courtesy of the Wall St. Journal