Foreclosure crisis caused by "bubble fever" not lack of data
The foreclosure crisis was not the result of exploding option ARMs, poor housing policies or a lack of data.
Instead, Paul Willen, senior economist and policy advisor for the Federal Reserve Bank of Boston, blames it on a type of bubble fever that infected borrowers and financial institutions alike.
"It wasn't the insiders who deceived borrowers and investors," Willen said when speaking to a panel at the HousingWire REperform Conference in Dallas. "It was the idea that this was one of the greatest real estate booms in American history."
In fact, Willen suggests all of the common causes typically assigned to the downturn are wrong.
First and foremost, he says the adjustable-rate, exploding mortgages blamed for loan payment shocks were not new to the marketplace. And the majority of borrowers who lost homes had fixed-rate mortgages or had already defaulted before the ARMs reset, Willen asserted.
No documentation loans, where borrowers provide no paper evidence backing their creditworthiness, also shouldered some of the blame. But Willen shot down that narrative saying "the idea of low documentation mortgages is not new."
To prove his point, he pulled out an ad from the 1980s, which clearly promoted no documentation home loans.
it's also wrong to suggest the investment banks had no clue about the possibility of a meltdown, the Fed economist asserted Thursday. In fact, Willen uses 2005 data from the now defunct Lehman Brothers to prove this point.
Lehman apparently conducted stress tests of mortgages inhouse. Under a meltdown-worst case scenario, the investment bank reached an outcome on subprime mortgage deals where lenders could end up foreclosing on one-third of the loans in the pool.
"The analysis underscores investors’ knowledge about the sensitivity of subprime loans to adverse movements in housing prices, and it refutes the idea that investors did not or could not determine how risky these loans were," Willen wrote in his research report.
So why did Lehman moved forward anyway? Like homebuyers who anticipated rising prices, Willen said the investment bank minimized the likelihood of a complete meltdown situation.
"In particular, the meltdown scenario—the only scenario generating losses that threatened repayment of any AAA-rated tranche—was assigned only a 5% probability," he said.
The takeway from the study, Willen said, is "bubbles are like earthquakes" and no one can predict when they will happen.
"Asset prices go up and then they come right back down," he added.
Willen warns that too many assumptions are dangerous when dealing with asset prices and even today's low interest rates.
"It's especially dangerous when everyone is confident nothing will happen," he said. "That is when the system is really vulnerable. There are people who really believe that interest rates will not go up over the next several years, but that could become a concern if interest rates do go up."