Lesson from the Subprime Meltdown by L. R. Wray

Reviewed by Reviewed by Joshua Frank from the Center for Responsible Lending

par Josh Frank

Mots-clés : crise financière

Langue : anglais

Wray analyzes the underlying causes of the subprime meltdown drawing heavily on Minsky and in particular his financial instability hypothesis. Wray’s analysis is thorough and insightful, but misses the opportunity to incorporate other heterodox schools of thoughts such as behavioral economics.

I ask the question not necessarily because your hands were on the levers, but you’re seen as one of the wisest of the wise men on Wall Street. And I wonder if you ever wish that you had perhaps spoken up or raised this issue?

I actually did raise them for years in my speeches. If you go back over the speeches I gave for the three or four years before this occurred, you’ll see a lot of reference to the underweighting of risk and the developing of excesses. But if you’re running trading rooms, you’ve got to run them every day and you’ve got to be in the business every day. And the kinds of views that others have around you of that kind may factor into what you’re doing. But fundamentally, you can’t go out of business. You can’t stop doing business. And that’s how the system just continues to move along that way.-January 2008 interview of Robert Rubin, Chair of Citigroup

In Lessons from the Subprime Meltdown, Wray deftly analyzes the underlying causes of the subprime meltdown by asking what led firms to behave in ways that ultimately proved utterly unprofitable. He draws heavily on the work of Hyman Minsky and in particular his financial instability hypothesis. Minsky saw financial instability as a consequence of a natural economic cycle, which moves from periods of stability to periods of instability. Minsky said that over a protracted period of good times, capitalist economies tend to mover towards more speculative and “Ponzi” finance. Therefore, stability itself can be stabilizing.

If any downturn appears to be led by the type of financial instability described by Minsky, it is the current one. Wray does a thorough job describing the financial developments many decades ago that led to the subprime meltdown. Wray is right on target in describing the roles of the various players involved. Contributing factors to the subprime meltdown include the use of securitization as vehicle for holding/financing loan balances, rating agencies and quantitative analysis that facilitated the growth of securitization, new borrowing instruments that had attractive short-term rates for consumers but greatly increased default risk, a move away from traditional loan documentation requirements, incentive schemes that rewarded mortgage brokers for loans that were not in the interest of borrowers and may have increased default risk, and a cycle of developers, real estate agents, appraisers, and brokers all working together to keep the cycle going. While all the players and market “innovations” had their role, much of the discussion is devoted to the important impact of securitization.

Minsky foresaw as far back as the 1980’s the potential problems of securitization. Securitization also fits in well with Minsky’s general framework as a financial innovation that “stretched liquidity”, something financial institutions generally seek to do to increase profits during stable, prosperous times. Financial instruments like securitizations require lower spreads than banks because they are not constrained by reserve ratios, regulated capital requirements, and some of the costs of relationship banking. The use of financial markets rather than traditional banking also took much of this lending activity out of the hands of traditional banking regulators. Wray cites incentives to increase throughput along with “credit enhancements” such as insurance on the securities, bankruptcy reform that “make it virtually impossible to get out of mortgage debt”, and prepayment penalties on loans as other factors that make securitization more attractive. One result of securitization was an enormous increase in leverage that multiplied the risk that firms were assuming.

The rapid spread of securitization, particularly into new types of loans and markets, required the facilitation of rating agencies and quantitative modelers. These models were “loosely grounded in highly complex valuation models based on short historical runs and highly sensitive to assumptions”. The quantitative models assumed past performance was a good indicator of future performance, despite the fact that they were based on a few years of rapidly rising housing prices and therefore did not account for systematic risk.

Wray is insightful and on target in both his analysis of the causes of the subprime meltdown as well as the major policy remedies. While Wray does not state any particular factor was most important than the others in creating the problem, his focus on securitization might be taken to imply that he considers this to be the most significant factor. However, in fact other changes and financial innovations were just as important in other ways.

Securitization (though it did other things as Wray points out) mainly acted to amplify risk, increasing the impact of missteps by the major financial institutions. But it is those missteps themselves that deserve more emphasis. Financial innovations towards new and risky hybrid adjustable rate mortgages with low starting rates and very high reset rates are key to the crisis. The de-evolution of documentation from “Low doc” loans, to “no doc”, then “liar loans” (where borrowers were allowed or even encouraged to lie about income and other information) and “Ninja loans” (no income, no job, no assets) was also a major destabilizing “innovation”. The role of mortgage brokers which were involved in the majority of subprime loans yet gave those clients on average a higher rate than if the client went to a bank directly (Ernst, Bocian, and Li, 2008) also played an important role. Wray does do a comprehensive job of mentioning all of these factors in his discussion, but it would have been valuable to see a little more on these other factors.

Wray’s discussion of solutions are also insightful and on target. The author is right to suggest current proposals and enacted legislation do not go far enough. Other ideas discussed by Wray include: bankruptcy reform to allow people out of predatory subprime loans, new licensing requirements for originators, stopping incentives that encourage risky loans, liability for the key financial institutions involved, new standards regarding ability of borrowers to repay, using fixed-rate mortgages as the default product particularly for low-income and first-time buyers, adding a 1-page plain-English disclosure of terms and fees. On this last point, the article is thin on compelling arguments even as Willis (2008) and others are questioning the usefulness of such disclosures. In fact, the paper offers almost no analysis of factors underlying the seemingly irrational demand for harmful mortgage products. Wray also suggests using policies that encourage small and medium size banking by avoiding consolidation and encouraging segmentation of banking. On a larger, scale Wray also correctly sees the importance of policies that bring lower/middle class incomes up for avoiding a similar meltdown in the future.

As Wray (2007) discusses more fully, we have a tendency to regulate only during crisis and to push towards a “free markets” view during times of growth and stability. Yet if Minsky’s view is correct, it is during the boom periods that the problems develop and reigning in overaggressive financial innovation is most necessary at these times. Regulating after a crisis can yield benefits, but it will always remain a step behind new innovations. What is needed is a change in attitude in regulators of the financial system such as the Federal Reserve. They clearly show a willingness to “lean against” rapid expansion in terms of monetary policy during periods of rapid growth. What is perhaps more useful is to lean against overly-aggressive financial “innovation” during these same periods. During boom years is precisely when regulators must withstand pressure from politicians and business in order to reign in market changes that are excessively speculative or that may be what Minsky termed “Ponzi schemes”.

There were a number of experts who saw trouble developing in the lending market long before it became a crisis. Wray notes that as early as 2000 Federal Board member Gramlich expressed concerns. Hirsh (2008) describes how Georgia Governor Roy Barnes foresaw some of the problems and instituted consumer protections in 2002 that were later greatly reduced under pressure from Freddie Mac and Fannie Mae along with mortgage brokers. The Center for Responsible Lending also was warning of the potential negative impact of predatory mortgage lending as early as 2000 (Stein & Pearce, 2000), and has issued a number of reports since then on the topic . Federal Regulators need to heed the warning calls before the next crisis happens and institute regulation to control excessive financial speculation and Ponzi schemes early in the process, rather than only after the crisis.

From a heterodox perspective, there are potential ties to other schools of economic thought that beg for further exploration. For example, part of Minsky’s analysis of what happens during periods of financial stability is “a radical suspension of disbelief”, which could benefit from insight from the behavioral economic literature. Wray has an insightful discussion of the “great moderation” (where it was thought that a number of factors made the economy far less vulnerable to shock) as an example of this suspension of disbelief yet at the same time states that those caught up in the boom behaved “ ‘rationally’ at least according to the ‘model of the model’ they had developed to guide their behavior” (p. 41). This appears to be as tautological as any neoclassical argument for rationality. It is about as meaningful a definition of rationality as suggesting that the Son of Sam murderer was behaving rationally given a model of the world that included a talking dog that was channeling Satan.

Much insight could be gained instead by acknowledging the basic irrationality implied by a “radical suspension of disbelief”, and using the rich behavioral literature to help us understand what this means for the evolution of financial instability and policy options. Behavioral concepts such as overconfidence, illusions of control, availability heuristic, framing effects, non-traditional time discounting, among others can yield much insight into the behavior of firms, investors, and consumers. It is important to recognize that while Minsky’s framework explains everything at one level, at a perhaps deeper level it explains little without reaching across schools of thought for additional insight. Many of the key actors were harmed by their own behavior, and to the extent that agency issues and misplaced short-term incentives do not explain behavior, some explanation based on systematic error in behavior is needed.

Some lines of evolutionary economic thinking can also help here, by providing insight into the innovation process as well as how short-term selection forces can overpower long-term interests. For example, Frank (2003) argues that market natural selection processes typically fail to evolve quickly enough to keep up with innovations/changes in market structure, and that instead natural selection often will be short-term and based on the inherent appeal of ideas (such as a belief in the “great moderation”) rather than long-term financial fitness.

Another important tie-in to general heterodox economic thinking is Wray’s emphasis of the misuse of models based only on a short history of market data with rising housing prices. The heterodox economic community has long expressed concern regarding the over-reliance on quantitative methods by traditionally-trained economists. This has been both in regard to theoretical modeling as well as econometric analysis. There could not be a more perfect illustration of this danger than Wray’s paper. The quantitative models that certified the safety of securitization instruments were highly sophisticated and used the latest econometric techniques. Yet it seems that the more innovations economists make in complex statistical methodology, the more vulnerable they become to missing the more obvious intuitive errors. This suggests a more general role that we as economists can play in addition to all the policy recommendations given by Wray. We must train our next generation of quantitative modelers better. They need to understand not only the latest techniques, but also the more basic methodological and logical considerations that are the hallmarks of useful research.

Ernst, K., Bocian, D., & Li, W. (2008). Steered Wrong: Brokers, Borrowers, and Subprime Loans, Center for Responsible Lending, April 8, www.responsiblelending.org/pdfs/steered-wrong-brokers-borrowers-and-subprime-loans.pdf

Frank, J. (2003). Natural Selection, Rational Economic Behavior, and Alternative Outcomes of the Evolutionary Process, Journal of Socio-Economics, 32(6), 601-622.

Hirsh, M. (2008). The Predators’ Ball; Fannie Mae and Freddie Mac have helped defang laws that might have prevented the subprime mess. Newsweek, August 25, 152(08).

Scloemer, E., Li, W., Ernst, K. & Keest, K. (2006). Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners, Center for Responsible Lending, December, www.responsiblelending.org/pdfs/foreclosure-paper-report-2-17.pdf

Stein, E. & Pearce, M. (2000). Legal Issues Concerning OTS and Harmful Home Lending Practices, Coalition for Responsible Lending Issue Paper, January 19, www.responsiblelending.org/pdfs/legal_issues.pdf

Willis, L. E. (2008). Against Financial Literacy Education, Iowa Law Review, November (forthcoming).

Wray, L. R. (2008). Lesson from the Subprime Meltdown, Challenge, 51(2):40-68.

Wray, L. R. (2007). Lesson from the Subprime Meltdown, Working Paper No. 522, The Levy Economics Institute, December.