Anatomy of Mortgage Meltdowns

Stan Liebowitz has just posted a new paper on the mortgage meltdown at the SSRN site. Last winter, as he and I were discussing this paper via e-mail, he set out his ideas quite well, and Arnold Kling summarizes them here.

The way I think of the Liebowitz story (you should read his whole paper) is as follows.

First, various regulators put pressure on lenders to loosen underwriting standards for minorities and low-income borrowers. That provided the kindling for the housing bubble.

Next, increasing numbers of borrowers started speculating in homes. These borrowers were attracted by adjustable-rate mortgages, because they expected to sell the homes for a profit before the rates adjusted. The fact that we now have such a large inventory of unoccupied homes is consistent with the view that many of the new owners were speculators, not owner-occupants.

Liebowitz is a bit weak in explaining how Wall Street was able to sell so much paper backed by these risky mortgage loans. Although I think it is important to point out the role that government policy played in forcing regulated institutions to relax underwriting standards, I do not think that the private sector is blameless here. There was some very serious mispricing of risk going on. Nassim Taleb's Risk Animal and Wall Street over-confidence were important factors.

Kling makes a good addition to the Liebowitz paper. Even if mortgage lenders were under tremendous political pressure to grant more questionable loans, there was nobody forcing tertiary lenders to buy packages of these sub-prime mortgages.

To have a full grasp of the mortgage melt-down, we also must understand why the secondary and other markets systematically underestimated the risk of those bundles of loans.

My own suspicion is that the bond rating agencies, along with the mortgage-lending insurers, desire considerably more scrutiny.