Paul Krugman wrote an excellent short critique (New York Times, September 16, 2018) of a new Ben Bernanke paper on the causes of the Great Recession. Bernanke is saying that the post-Lehman credit crunch caused the greatest damage. Krugman is saying, no, it was the real estate bust. Bernanke wrote a good response. But in my view, Krugman is correct. Indeed, even some of Bernanke’s data seem to me to support the view that the real estate bust and accompanying consumer pullback were the largest cause of the depth of the recession. As an example, the following graph from Bernanke’s response suggests to me that most of the depth already was built-in when the financial panic began in September 2008.
As you can see from the graph, durables PCE actually reached its nadir in October 2008. And the consumer pullback explains various other data sets that show the economy continuing on a downward trajectory until about May 2009. I also think that Bernanke, for understandable reasons, does not credit the public’s reaction to governmental confusion in September and early October of 2008 as a major factor in the continuing consumer pullback that knocked demand dead and, therefore, discouraged capital investment. But the spectacle of the Secretary of the Treasury on bended knee before the Speaker of the House asking her to pass a hastily-thrown-together three-page bill to save the economy coincided with the worst days of the panic.
The discussion of what made things worse than in a usual recession is interesting, and I guess there will be no clear winner or answer. But I don’t think the more correct answer necessarily leads to a better public policy posture because, in any event, one can see that a more robust financial system would have been beneficial and that preventing the housing bust would have been beneficial. To bail out or not to bail out also always will remain a moot point. And a better-prepared Administration always would have helped.
But why were real estate prices so high that the bust could bring down the economy?
Even if you are wonked out by all the ten-year anniversary argumentation about the causes of the GR and GFC, there still are some points I hope you will consider.
What is missing from the cited Krugman-Bernanke discussion is the crucial question of why the U.S. residential real estate market was so inflated pre-2007. The answer to that question will tell us the real causes of the real estate bust because without the inflated prices there could not have been a real estate bust of nearly the same proportion. (I am not being critical of Bernanke and Krugman here—that was not their subject.)
Some people blame a real estate mania, sort of like the legendary tulip mania of the 17 th century. And there was a real estate mania that built from 1997 through 2005. But real estate booms always are based on unsound mortgage finance, and manias cannot create constantly rising prices without unsound financing. Therefore the financing has to be the culprit.
Peter Wallison, who was a member of the National Commission that looked into the causes of the crisis, claims the unsound mortgage finance was due to government policies to support low-and-middle-income housing. I do not dismiss that factor as a peripheral cause. But it was not a major cause.
The major cause was the flow of mortgage finance that came from privately securitized mortgages between 2004 and 2006. Those are the years that housing prices took off, and it was that injection of about $3 trillion into the mortgage market in those three years that enabled the boom. The following table shows what happened to the mortgage market in those years that was without precedent.
Table created by the author from IMF Publications data (my 2009 book, Debt Spiral p. 154).
As the table shows, total mortgage originations did not increase significantly in 2004-2006—originations had been high in 2002 and 2003. But in 2002 and 2003, Fannie and Freddie accounted for over 50% of originations and private label securities accounted for 14% or 15%. In 2004-2006, Fannie and Freddie’s share dropped 32, 31 and 30%, while private label now accounted for 30, 38 and 38%, more than double the normal proportion, while total originations remained high.
$3 trillion of mortgages was funded by private label securities in 2004-2006. But (1) Why did that funding come into the U.S. mortgage market at that time? And (2) why did it fund mortgages that were so poorly underwritten?
Securitization was not new. But until 2004, it was largely the province of Fannie and Freddie. What changed was that the investment banks saw an appetite in the global securities market for privately underwritten securities that would pay a few basis points more than the Fannie and Freddie securities that had an implied government guarantee.
To feed that appetite, the investment banks had to create securities that had a high rating—double or triple-A. The securities buyers would not look very much beyond the rating. Thus the rating agencies were the key to the process, and the rating agencies, principally Moody’s and Standard & Poor’s, proved compliant, basing their ratings on historical mortgage data on well-underwritten mortgages despite the fact that the new mortgages were not well underwritten. Indeed, to feed the growing appetite for apparently sound investments that carried a few extra basis points of yield, the investment banks gradually encouraged weaker and weaker underwriting criteria over the three-year period, but the rating agencies seemed to pay no attention to that.
Who were the buyers of these securities? I know of no data that tell us exact proportions. Fannie and Freddie appear to have bought about 20%--but perhaps they bought the best 20%. European banks and conduits established specially to fund the purchase of these securities were more major purchasers—probably of a majority in amount. The role of the European banks is illustrated by the following graph that shows French, German, Swiss and U.K. banks alone adding about $3 trillion to their dollar investments from the beginning of the euro era through 2006. The European banks were able to increase their funding so much because they appeared to have the informal guarantees of their home countries and because their regulators had lax capital requirements that permitted enormous financial leverage.
Growth of dollar assets of French, German, Swiss and U.K. banks
(Data from BIS Table 9D, graph by author)
Some European banks—most prominently, German Landesbanks whose liabilities were guarantee by German states—established Dublin-based structured investment vehicles (SIVs) that issued “asset-backed commercial paper” in dollars to fund the purchase of complex securities that were created using the private label mortgage-backed securities. The SIVs thus funded purchases of long-term mortgage-based securities with short-term commercial paper that had the implicit guarantee of their founding banks. These SIVs were the first institutions to blow up in August 2007. (Barclay’s was a principal architect of these quicksand-based special purpose vehicles.)
What caused the market to stop funding poorly underwritten mortgages?
In 2006, increasing numbers of homeowners proved unable to meet their obligations, and foreclosure numbers began to mushroom. Numerous mortgage originators failed in late 2006 and early 2007, alerting the marketplace that there were serious problems. At the same time, in 2006, house prices began to decline for the first time in recent memory. The market was spooked, and by September 2007, the foreclosure tsunami was in full view, bearing down on the American financial system and economy. Less well-known at the time, it was bearing down on the European financial system as well.
After the first few months of 2007, there were no more buyers for the complex mortgage-based securities (principally CDOs), and the mortgage market effectively ceased to function for the kinds of loans that they had funded. And that caused the cascade in which house values, foreclosures, job losses, securities margin calls and write-downs caused insolvencies at all kinds of banks and destroyed the lives and financial health of millions of Americans. The carnage would have been even worse had the U.S. Government not finally stepped in to help in October 2008.
Real estate booms end in busts
Once the real estate boom got beyond a certain point, probably by early in 2005, it had to end in a bust. Only the size of the bust was in doubt. We know that from numerous studies of real estate markets. See, for example, a Stijn Claessens and M. Ayhan Kose paper for the IMF entitled Financial Crises: Explanations, Types and Implications, which is a review of the scholarly literature on financial crises.
The apparently booming economy of the years 2004-2006 was illusory
The apparent success of the U.S. economy in 2004-2006 was based largely on American consumers using their homes as ATMs by refinancing as their homes increased in value and lending became increasingly loose. The loose lending included astonishing home equity lines of credit at 125% of LTV that were offered by some American banks. The following table (from my 2009 book Debt Spiral, p. 7) depicts how wan the U.S. economy would have appeared had the housing boom and home equity spending not occurred.
The table is a bit complex, but if you focus on the bottom line, you will see that without the housing boom, the economy hardly would have grown at all. That is especially important because when we look back from 2018 to find a time against which to measure economic progress since the end of the Great Recession in 2009, we should not look at 2007 because the apparent financial health and wealth of the American consumer at that date were illusory. We must look back at least to 2003—and maybe even earlier. The 2007 comparisons will mislead us.
“Things are seldom what they seem;
Skim milk masquerades as cream;
Highlows pass as patent leathers;
Jackdaws strut in peacock feathers.”
“Very true, so they do.”
The captain didn’t know what Buttercup was driving at. But maybe you can guess what I am driving at.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.