My Views on the Crisis — A Summary Statement

Arnold Kling

1. Causes

In hindsight, I think that the crisis was caused by
a) creation of the secondary mortgage market (50 percent)
b) low down payment mortgages (30 percent)
c) the “suits vs. geeks” divide (15 percent)
d) other (5 percent)

The more I think about the secondary mortgage market, the less I like it. Any widespread benefits, such as lower mortgage interest rates, are microscopic. On the other hand, several times (not just recently), the market has been used to create or enhance regulatory loopholes that undermined the safety of the financial system as a whole.

My point about low down payment mortgages is not a slam at minority home buyers. It is a statement that widespread home borrowership (where “owners” have little or no equity) is a recipe for volatility in the housing market. If we had kept low down payment lending confined to FHA (the low end of the housing market) and VA (a limited pool of eligible borrowers), I am convinced we would not have had such a big bubble and a big crash. Note, however, that there were property bubbles in other countries, and I do not know how much of a part lower down payments played, if any, in those bubbles.

My point about suits vs. geeks is that too many people did not understand the risk characteristics of these loans. I disagree with James K. Richards, who claims that the risk modelers got it wrong. The risk modelers told Richard Syron of Freddie Mac not to plunge into subprime lending with so little capital. The risk modelers at Goldman kept that firm from making the sorts of mistakes other companies made.

The decline in house prices was not a Black Swan. It was a highly plausible scenario. The problem is that the suits did not grasp the impact that such a decline would have on mortgage securities. The clueless suits include regulators, which explains why the crisis took them by surprise. It also explains why I do not trust them to come up with the best solution.

Decent, upstanding people say that we have to trust Ben Bernanke, Henry Paulson, Barney Frank, and other leaders. The public are considered rubes for not respecting the establishment. In this case, the public happens to be right. The suits are clueless.

2. The Current Risks

The economic ship faces a number of icebergs. Oil markets are taking wealth out of the country. House price declines are taking paper wealth away from ordinary families. On the horizon, there could be an adverse shift in the terms of trade. The number of hours that the average American has to work to earn enough to buy a bottle of French wine, a pair of Italian shoes, or a Chinese-manufactured product could (should?) be much higher than it is today.

In this context, the consolidation in the financial sector is a relatively minor issue. The only policy challenge is to keep banks functioning. There are many ways to do that which do not involve speculating in mortgage securities.

3. Housing markets

Housing markets are very distorted right now, because of low down payment lending and the bubble. Many of the mortgage defaults, at least in the first wave, came not from owner-occupants but from speculators. A rallying cry of “keep borrowers in their homes” is rather empty when a lot of the borrowers never occupied the homes in the first place.

We need housing units to be occupied, at whatever rent or price clears the market. We need owners to be legitimate, meaning people who can afford reasonable down payments and mortgage payments. Getting from here to there is not easy, but I suspect that the more government intervenes, the longer and more painful the process will be.

4. Political economy

I do not think that the private sector is blameless. I do not think that the public sector is blameless. I do think that lobbying and corruption are endemic in the mortgage securities business. We ought to be trying to let that cesspool gradually dry up, rather than throwing taxpayer money into it.

I find it unsettling that Congressional leaders would announce that they have a deal and then fail to pass a bill. It used to be that the definition of having a deal was having the votes to pass legislation. It didn’t used to be a form of bluffing.

I find it unsettling that the establishment is promoting fears of another Depression. It used to be that worries about another Depression were confined to obscure books written by crackpots and lunatics. Today, the fear of a Depression is being promoted by the establishment, while those of us who are trying to remain calm and measured are treated as crackpots and lunatics.

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