Roger Lowenstein's piece in this weekend's NY Times Magazine is one of the single best explanations I've yet read for how our nation's financial service industry got itself into the mortgage mess. Its an example of journalism at its finest, and is a perfect example of the type of work that we as a society cannot do without. It really is that good.
The bond-rating agencies like Moody's and S+P exist in a corner of the world of finance that until I read this article I simply did not understand. How Lowenstein was able to take such a complex subject and explain it in so simple and straightforward a way is really quite amazing.
Take this short section, for example:
In April 2007, Moody's announced it was revising the model it used to evaluate subprime mortgages. It noted that the model "was first introduced in 2002. Since then, the mortgage market has evolved considerably." This was a rather stunning admission; its model had been based on a world that no longer existed.
Poring over the data, Moody's discovered that the size of people's first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans -- that is, their total debt -- combined. This was rather intuitive; Moody's simply hadn't reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a "strong predictor" of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, "It seems there was a shift in mentality; people are treating homes as investment assets." Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners' equity had never been as high as believed because appraisals had been inflated.
Moody's assumed that past behavior was a good predictor of future behavior. It wasn't. Investing 101, and yet...
Between 2002 and 2006 the psychology of borrowers had changed dramatically. Instead of viewing a home as a place to live and a source of financial security, borrowers embraced a new vision of a house as a virtual ATM. When their perceptions changed, so too did their behavior. And shifting perceptions is something that most economic models simply cannot handle.
Markets may be rational, but people aren't. And given that people create markets, well... Unless we understand human psychology, we cannot understand the long-term behavior of markets. The past can only predict the future so long as the people in the future view the world in the same ways as the people in the past. Sometimes perceptions of reality matter more than reality itself. Traditional economics, with its insistence on a stable and rational human nature, cannot account for this. And that, I would argue, more than anything else is what creates bubbles.
The dot.com bubble was created because for a brief moment investors believed that the Internet had rewritten the rules of the economy. In retrospect that was irrational, but it didn't seem that way at the time. The mortgage security bubble was created because for a brief moment homeowners believed that the rules of the housing market had changed, and institutional investors largely agreed. That was irrational, but to a large majority of people it didn't seem so at the time. That's human nature. We love to believe that we have outsmarted the system, and hey, sometimes it is even true.
Until we learn to account for the psychology of bubbles, they will continue to occur. Even once we learn to account for them, it may turn out that they are something we are powerless to prevent. Perhaps bubble minimization is the best we will be able to do.
Anyway, please read the entire article. And when you are done, head over to Kevin Drum (here and here), Brad DeLong (here and here), and Jon Taplin for much, much more.
UPDATE: Also, this from Washington Independent:
So is the worst over? Not by a long shot. We still have a long way to go.
A single number tells most of the story. Between 2000 and 2007, Americans withdrew $4.2 trillion in free cash flow from their homes - in other words, $4.2 trillion in new mortgage debt that was not invested in new housing or in paying down old mortgages. Instead, it was spent on other stuff, like new cars and plasma TVs. For the three years through 2006, the free cash flow from mortgages was more than 7 percent of disposable personal income. That's why personal consumption could break all records at a time when real wages were falling.But when house prices suddenly tipped into free-fall in mid-2007, home mortgage financing dried up. By the end of the year, mortgage finance flows were about half the average for the previous several years. Pathetically, credit card borrowing jumped to an all-time high in the third quarter of 2007, but dropped right back by year end, as card companies quickly tightened the screws.
In the last half of 2007, households also began a major sell-off of financial assets, like stocks and bonds. Much of that must have come from already-paltry retirement savings...
House prices fell about 10 percent last year. A growing number of analysts expect another 15 percent - 20 percent price drop will be necessary to bring housing costs back in line with incomes. Some 8 million homeowners are stuck with mortgages worth more than the their homes' market value, even as consumers are increasingly squeezed by flat wages, soft employment and back-breaking price increases for gasoline and food.
What's happened so far, in other words, is just prologue for when recession really bites.
As Atrios would say: Wheeeeeeeeeeeee!
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