Mortgage crisis: We had it coming

By: Robert Zaller

Posted: 10/31/08

Some years ago, my son was thinking of buying a house in the San Fernando Valley and asked my advice about getting an adjustable rate mortgage. I told him to stick to the old fixed rate. Happily, he did.

Recently, Alan Greenspan was asked about the adjustable rate mortgage - and sub-prime-driven housing bubble that has brought capitalism's house of cards crashing down all over the globe. Greenspan replied that he had never advocated ARMs, and had always bought his own houses (like John McCain, he didn't disclose how many he had) at fixed rates of interest.

Greenspan - whom you may recall as our high priest of finance - created the housing bubble by cutting interest rates to the bone as chairman of the Federal Reserve. This bubble was intended to replace the tech bubble (also created on Greenspan's watch) that collapsed in 2000 and popped us into a nasty recession. Housing prices, rising unsustainably for some time already, went through the roof. My son's house doubled in value in five years. Walking around his pleasantly upscale but by no means affluent neighborhood, I wondered who was forking out $800,000 to $1 million for ranch houses with little yard space, even in Southern California. Even without the benefit of a degree in economics, it occurred to me that very few people could afford such prices, or that banks could believe in the ability of such borrowers to meet their loan obligations.

It turns out that the banks didn't believe it. Instead, they were perfectly happy to repossess homes on default. In effect, buyers had been giving them a return on property the banks knew they'd have back in a few years at double or triple value. They could then sell to the next round of buyers, and make the same killing. In effect, all the buyers bought was the illusion of home ownership. They were merely renters of the bank's property. Why, after all, should the mortgage department sit for 30 years at a decreasing rate of interest on property it could turn over with enhanced equity in four or five?

As for the buyers (whom Henry Paulson is so determined to punish for their poor judgment), they were not entirely irrational in their calculations. On the same assumption the banks made - namely, that housing values would go up indefinitely - they could buy houses they knew they couldn't afford, and sell them at a profit before their ARMs made them unaffordable. Such rational buyers would view their purchases instrumentally, and their houses not as homes to live in, but as temporary assets to be exchanged. Of course, the risk was on the buyer - that he could sell before the hammer of foreclosure came down on him, and that he could turn a profit on his investment.

It's hard to say - there's no research on the subject that I know of - how many home buyers fit this model of the rational investor. I know my son didn't; he just wanted a home to raise his family in. When even this market was exhausted, however, the banks hit on sub-prime lending; that is, lending to unqualified borrowers the banks knew would shortly default. At this point, the game shifted from hypothetically rational calculators (banks and buyers betting against each other) to something worse than loan-sharking. There wasn't a name for it before, but we have one now: predatory lending. Sub-prime buyers were seldom if ever sophisticated enough to try to game the system, and in any case they lacked the resources to do so: banks could force foreclosures just by ratcheting up the ARMs.

Few banks, however, bothered to play the game out to the end. They bundled dubious mortgages with other forms of debt into so-called collateralized instruments that could be sold as financial commodities. Homeowners on long-term, fixed-rate mortgages such as myself would notice every so often that the bank that owned their mortgage would change. Vaguely, such homeowners were aware that what had once been a face-to-face relationship between a lender who knew in detail one's income status and general financial condition and a borrower who made monthly payments to that lender for a prescribed term had been replaced by something different. One's debt, owed by a particular person to a particular institution, had become a commodity, to be sold or resold without reference to the underlying creditworthiness of the original loan. There was, indeed, no way of unpacking a collateralized instrument to see how much bad debt it contained. And when ARM and sub-prime mortgages stuffed the sausage with tainted meat, the world economy was bound to get very, very sick. The question of the moment is whether it will recover, and at what - or I should say, whose - cost.

Watching Greenspan's recent appearance before Henry Waxman's House Banking Committee was like watching the high priest, discovered at last to be a heretic, recanting before the high tribunal. But the fact is that Congress shares the blame for the current fiasco, as do legislators and regulators abroad. Everyone was happy to foster the illusion that the real estate bubble could go on indefinitely, and the giant Ponzi scheme built on it.

And what of the business schools, Drexel's included, that sent out the new Michael Milkens of high finance to keep the scheme afloat? The Chronicle of Higher Education, in its Oct. 10 issue, posed a question for the academic community: "Does the Financial Crisis Affect the Teaching of Economic Theory?" Well, you'd hope it would! Kevin Christ of the Rose-Hulman Institute of Technology, replied, "I am often surprised (and a bit frightened) by the hubris that we've somehow nurtured in our students .... At some point ... we have to ask ourselves if we have been teaching theory or ideology."

Cristian Ioan Tiu of SUNY Buffalo suggests that "This crisis is built on the foundations of financial illiteracy," and asks "Why can't we teach the unemployed guy sitting on the porch of a crumbling house that the price of the house may go down and not just up?" Michael Klein of Tufts suggests that the Great Bust of '08 will offer "unique teaching moments." A silver lining at last!

Two thousand years ago, the Roman poet Lucan said that human life is ruled by a pair of tyrants called hope and fear. Nowadays, we're told that markets are ruled by greed and fear, a small but significant shift in the equation. Just a question of my own, though: isn't it possible to devise a system for the equitable distribution of goods and services that answers to some value other than greed or fear? Isn't it possible to feed the hungry, conserve the planet, and honor the values of genuine culture and community?

Not under the modern system we call capitalism. Not now, not ever.

Robert Zaller is a professor of history. He can be reached at op-ed@thetriangle.org.