The brave new world of finance-10: Who’s to blame?

(For previous posts in this series, see here.)

As is typical with bubbles, people involved at all levels of the subprime mortgage debacle seemed to deliberately shut their eyes to any negative information, as if they thought that wishing things were just peachy would make it so. As long as nobody looked too closely at the structure, no one would notice that it was a house of cards, and the good times would continue forever. But they never do. The house of cards always collapses.

(Some observers have pointed out that it may not be completely accurate to call the current subprime crisis a bubble. In classic bubbles, the prices of the commodity fall precipitously to their pre-bubble values or even below. This has not happened yet with home prices but the crisis is not yet over. The behavior of the principal characters in this drama, however, exhibit all the qualities of those involved in previous bubbles.)

Who is to blame for this situation? To be sure, there is enough blame to go around.

It is true that some of the homebuyers were outright dishonest, colluding with brokers to fake documents and income in order to pass a cursory scrutiny before getting the money to buy houses they could not afford. And it is true that some of these homebuyers acted with almost unbelievable ignorance and even stupidity about what they were getting into when they signed the papers to buy their homes. The Cleveland Plain Dealer had an excellent series on the foreclosure crisis by Phillip Morris and one story featured a man with a well-paying job who lost his home because he did not keep up with his $1,200 monthly mortgage payments. Meanwhile he was spending $40 a day on the lottery, hoping to strike it rich!

But apart from the criminal and the almost criminally stupid, it is true that many people buying homes in these go-go times should have suspected that things were too good to be true, that it was unlikely that many of them could actually afford the houses they bought. And yet, the dream of owning their very own home for the first time must have been powerful enough that they were willing to believe the promises of brokers and bankers, who were merely using them to enrich themselves. We also live in a time when people are told that living beyond their means, spending money they might not have ‘stimulates the economy’ and is thus a good thing.

We now see a backlash, with some policymakers blaming these buyers for the mess they find themselves in. But apart from those who willingly participated in fraud, such attacks are unfair. Buying a house is an enormously complicated affair, beyond the comprehension of most people. Although I am fairly literate and numerate and reasonably savvy regarding personal finance, I recall being overwhelmed by all the legalistic documents that we had to sign when we bought our house. I could understand the key points, but there were pages and pages of detailed jargon that we were assured were standard boilerplate language. I recall thinking how easy it would be to be swindled by the bankers and other people involved in the process. I had to trust that they were acting in good faith. Has it come to a point where we each have to have a lawyer and accountant with us when we enter into any reasonably major transaction?

Homebuyers are largely dependent on the honesty of the professionals who they think are acting on their behalf. As Duncan Black (aka blogger ‘Atrios’) says:

The inability of the Republican lizard brains to even fake the slightest bit of empathy or sympathy for those experience economic troubles, or in fact to even restrain from outright hostility, is rather fascinating.

That isn’t to say all of those in foreclosures are victims. But there were a lot of people ripped off by mortgage brokers they thought were acting in their interests who instead were pushing them into crappier loans for bigger commissions. When you hire someone whose job you think it is to get you the best loan possible, and their incentives are actually to get you the shittiest loan possible and you are unaware of that fact, there’s a wee bit of a problem in the system.

But there were also more sophisticated buyers who were well aware that their mortgage interest rates would soon go up but did not care. They were those who believed in the ‘greater fool‘ theory and saw themselves as smart investors who were planning to sell their property for a tidy profit before the rates rose. And as long as the prices kept going up and demand was high, that strategy would have worked. But as the subprime crisis unraveled and the number of foreclosed houses started shooting up, there was a glut in the market, buyers became more fearful and choosy, and prices started dropping and even the richer, more sophisticated buyers found themselves stuck with properties they did not want. It was cheaper for them to cut their losses and to walk away from their property than to sell it for a huge loss. This constitutes another wave of abandoned home foreclosures.

Sadly, the end is not yet near for this crisis. 2008 will be another year in which many initially low-interest teaser adjustable mortgage rates will rise, leading to another wave of foreclosures due to people’s monthly payments rising above what they can afford. About 1.6 million homes were foreclosed last year and this year is expected to bring a similar number. The government and a consortium of six major banks involved in the subprime market announced a plan called Project Lifeline to give homeowners facing foreclosure thirty days more to try and refinance their homes so that they can afford them, but it is not clear if this will work. There are strong fears that this is inadequate.

Next: How did things get this way?

POST SCRIPT: Hype in sports

David Mitchell (one partner of That Mitchell and Webb Look) makes fun of the nonstop breathless hype by sports announcers, where every upcoming game is made to sound momentous. Here he is talking about English football (‘soccer’ in the US).


  1. says

    3 pennies worth of thoughts…

    I think ultimately the process of obtaining a mortgage needs to be much simpler. Maybe even one page. Including a ‘range of possibilities’ for monthly payments under certain circumstances.

    I think that personal finance education is woefully poor, especially in low income communities where people are the most vulnerable.

    I think it is also important for everyone to know that no actor in this drama wants to see foreclosures.

  2. Amandine M says

    Well Professor Singham, it has been a long time since I have taken a physics class from you but I have enjoyed reading your blog and transporting myself into your classroom once again… 🙂

    I have to comment though on these mortgage crisis discussions that you have posed. I think that it is quite important for your readers to understand that while these issues may be hitting the citizens of Ohio quite strongly, due to the manufacturing industry, motor vehicle industry and other similar dying industries that have kept the mid-west employed for many years, this is not the case for the costs of your country. Living in Washington D.C. (only for a few more months before I return home to the land of the Euro) I have witnessed the sprawl of the McMansions but also a revitilzation of the city. The home prices outside of the city have begun to decline slightly (but still maintining their $1 million plus price tags) and the homes in the city have actually increased in value. Our issue was the explosion of condiminiums that have only still suffered slightly. So much of this housing, and mortage issues that are raging through parts of the country have barely effected other parts of the nation.

    I feel, as you do as well, that if one is to pursue the “Americain Dream” of home ownership they really must educate themselves. Also, the effect of the mortgage crisis might actually pose a “good” problem. Potentially buyers might look at their mistakes and become more educated and those who did not fall into this crisis should take a hard look to learn before they blindly follow in the path of ARM mortgages.

  3. says

    I tend to agree that people potentially should have suspected something in such a crazy market for buying but ultimately it comes down to Lucas’s point that education is so low on such matters that the majority clearly just didn’t see it coming.

  4. says

    Who is to blame ? well, I thought Clinton was an excellent President until I discovered he was the one who allowed Wall Street firms to start doing mortgages, he was the one who passed the “no capital gains tax” if you own a property for years as a primary residence.
    1.) With more mortgage lender programs available, then obviousl the guidleines and underwriting will be looser so that it can get into the hands of the people who would not qualify otherwise.
    2.) More programs equals more jobs and less qualified loan officers. It just snowballed. I am surprised today that mortgage rates are still very low because as the dollar falls our economy gets weaker and oil goes up. The federal reserve has to start raising interest rates depsite the economy being weak. The USA needs a strong dollar. I do agree that inner city real estate and homes close to downtowns will be worht much more. America will experience the opposite effect of suburbia due to oil.

  5. says

    I tend to agree with Jame Cox above: people should have suspected something in a market like this. It comes down to the fact that education is so low on such matters that most people clearly just didn’t see it coming.

    homeowner loans

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