Senator Elizabeth Warren is perhaps best known for advancing the narrative that the 2000s housing bubble, collapse, and Great Recession, from which much of the US and the world have yet to fully recover, were the result of “unfettered Wall Street bankers tanking the economy” by “tricking borrowers” into bigger homes and debts than they could afford. This, she asserts, was helped along by the banks’ dramatically increasing lending to “subprime” borrowers, thereby fueling a real estate bubble and then ushering in a “subprime foreclosure crisis” that “spread to” the rest of the economy.
Based on this thesis, she has proposed numerous new regulations, none of which address the root cause of the housing and foreclosure crises in the US and around the world. Nor does she address the massive leveraging-up of most developed countries’ household sectors, whose debts continue to weigh upon the world economy.
The Role of Central Banks
As we will show, the root cause of these evils was the volatile shift in policy interest rates set not by the “unfettered” market but by the central banks. If Senator Warren wishes to prevent the next bubble and financial crisis by “reining in” the banks that caused the last bubble and crisis, she should focus on the central banks. By occupying a unique position which puts her in charge of reforming the financial system, and failing to address the root cause of the imbalances that she is charged with preventing, Senator Warren stands in the way of someone else picking up that mantle and getting the job done.
The story of the bubble, bust, and crisis follow a pattern familiar to followers of the Austrian school. In the late 1990s in Europe, and the early 2000s in the US, the central banks cut their policy short-term interest rates by several hundred basis points. The stated purpose of this “accommodative” monetary policy was to “stimulate” more “lending, spending, and investment.” This is a decades-old strategy straight from the Keynesian playbook. The result was a global housing bubble, a massive leveraging up of US and EU consumers, and, when rising consumer prices forced the central banks to allow the short rates to rise back up, a foreclosure crisis and the Great Recession occurred. Below, we analyze this series of events in greater detail.
The Bubble in Housing Prices
About 5 percent of homes in a given market will sell in a year. Purchase mortgages are approved based on loan to purchase price (typically 80–95 percent), income-to-payment ratio (typically about 3:1), and credit score. Loan amortization can extend to 40 years (Spain), with most markets (e.g., the US), dominated by 30-year amortization. The combination of high LTV and long amortization makes the loans, and the buyers’ price points, highly rate sensitive.
The effect of the central banks’ rapid 4–5 point rate cuts was that in markets dominated by floating or short adjustable rate mortgages (ARM), and in the US, in which ARM share of purchase mortgages rose from 10 percent to 50 percent, purchasers suddenly — and temporarily — had about 50 percent more purchasing power despite flat or declining incomes. That boost to purchasing power fueled the run-up in prices. Revealing exceptions include Canada which had markets dominated by 5-year ARMs with 25-year amortization. In Canada, the central bank implemented a modest shift in policy rate, producing a more modest bubble. Germany was also an exception, where the market was dominated by 10-year term/pricing with 20–25 year amortization. In Germany, ten year yields did not change, and no bubble occurred.
In the US, homeowners can often refinance at will with no prepayment penalty. And they can refinance with cash-out, based on loan to value (LTV) determined via an appraisal — a comparison to the prices paid in arms’ length transactions for comparable houses (comps). A comp is valid for twelve months, no matter how many appraisals cite it. But nearly everyone refinances at the same time — when the rates fall. From 2003–2006, on comps established via those few sales per year, nearly every homeowner with a mortgage refinanced — half of them with cash out, based on the rate-inflated values.
The result was that mortgage debt, and household debt in total, doubled in the absolute and nearly doubled in relation to GDP and household income. The savings rate fell to near-zero as savings were replaced by the temporary “wealth effect” of rising home prices. The loan proceeds were spent — which had been the Keynesian central bankers’ stated objective all along — accounting for 75 percent of US GDP growth from 2003–2006. The mid-2000s refi boom planted the seeds for today’s economic problems: households in developed economies leveraged up, buying imports from developing countries (fueling the BRICs bubble), and paying for that spike in current spending with thirty-year debt that is still being paid down today.
A Flood of Housing Supply
Home builders are financed at floating rates based on the central bank policy rate, often with carried interest. The rate cuts reduced homebuilders’ cost of capital by half, enabling them to over-build in response to the rise in prices. The result was a permanent increase in supply that would go to market just as the policy rates temporarily boosting prices were allowed to rise back up — a mal-investment cycle straight out of the Austrian textbook. Much of the remaining 25 percent growth in US GDP from 2003–2006, and much of the growth in employment (apart from retail, hospitality, and the military), occurred in construction and real estate related fields — reflecting personal mal-investments in bubble-related skills.
The Inevitable Collapse
There are two related reasons that policy rates could stay so low for so long: (1) central banks are mandated to achieve “price stability” — not “price reality” — thus giving them room to inflate in an otherwise deflationary environment, and (2) the prices of the assets financed with the new debt, such as real estate and commodities, are excluded from the central bankers’ price aggregate.
But eventually, consumer prices did rise, and the central bankers’ hands were forced. When the central banks began to allow policy rates to rise up to market levels, house prices were immediately affected. In the US, the Fed began to hike in 2004, the last year of double-digit price increases. The result of the temporary, rate-driven inflation of house prices, the leveraging-up of developed countries’ household sectors on the basis of those inflated prices, and the mal-investment in supply could produce only one result: a collapse, leaving millions over-extended homeowners and home builders, millions of unemployed workers who had been lured into construction during the boom, and millions of mortgage loans in default due to rates re-setting and collateral values plummeting from their rate-inflated levels.
The Subprime Side Show
One ironic result of the cash-out refinance mortgage boom was that, temporarily, leveraged borrowers found themselves quite liquid — in possession of the cash-out proceeds before they were spent. Until they were spent, they were available to make mortgage payments. As a result of this and the enhanced ability to refinance, mortgage default rates across all credit scores declined.
In some markets, like the US, some institutions took rising collateral values and falling default rates at face value and loosened their risk tolerance, making more loans to individuals with low credit scores. Subprime loan origination, about 8–9 percent of mortgages for many years, rose from 2004–2007, reaching 23 percent of originations, but never accounted for more than 12.5 percent of all mortgages outstanding. The story of Wall Street investment banks securitizing subprime loans and securitizing the bonds backed with subprime loans, and of AIG, starving for yield, issuing credit default swaps — default insurance — on the loans and bonds — is well-known. But that is a Wall Street event.
In 2007–2009, the entire mortgage and housing market collapsed — both Wall Street and Main Street, subprime and prime. One eighth of US mortgages were subprime. But by 2010, one third of US mortgages were underwater.
Subprime default rates were higher than prime default rates, but subprime accounted for only 30 percent of foreclosures.
Someone with a 550 credit score defaulting on his loan does not cause three other people with 700 credit scores to default on their loans. And in many countries that experienced the same policy-rate-driven boom-bust cycle in housing and mortgages, there had been no significant increase in loans to people with low credit scores. Spain, for example, did not experience the same run-up in subprime lending, but had a bigger boom-bust cycle because it experienced a longer period of suppressed policy rates and its mortgages amortize over 40 years. Whether or not Wall Street’s response to values, default trends, and interest rates was reckless, rational or in between, Wall Street did not cause Main Street’s problem. In fact, Main Street’s problem existed years before Wall Street’s problem. Whatever one may think of the rationality of the growth of subprime lending, the idea that “subprime tanked the economy” is patently false.
Policy Responses of Senator Warren and other Progressives
Since 2008, Senator Warren and other Progressives have focused in on the Wall Street problems without addressing the Main Street problems. In occupying the mantle of “financial system reform champion,” and the job of “preventing another 2008,” and failing to focus on the larger, Main Street problems, Senator Warren stands in the way of the kind of reforms that might actually prevent another collapse.
If Senator Warren had truly wanted to prevent another house price bubble and collapse, she could have taken steps to shield the US housing and mortgage market from volatile central bank interest rate policy — outlaw or limit ARMs, or require banks to underwrite ARMs at sensitized rates, or revise the appraisal rules so as to limit the number of times that a given sale can be used as a comparable sale to assess loan-to-value for cash-out refinance transactions, or apply lower LTV thresholds to cash-out refinance transactions than to purchases, much in the way that banks apply low LTV thresholds to loans against low volume stocks.
Of course, such reforms would in effect require mortgage lenders to emasculate monetary policy, given that the stated goal of the Keynesian policymakers’ rate cuts was to increase lending, spending, and investment, which was temporarily achieved in the private sector only via the housing bubble itself. And it would still leave central bankers with the ability to temporarily suppress interest rates further down the curve, and to fuel bubbles in commodities and other sectors. The results of such bubbles would be no different from the result of the housing bubble: over-leveraged firms and households, and unemployed workers who are unlikely to be hired quickly because their skills are bubble-related thus not in demand.
The best solution clearly would have been, and is, to require the central bank to maintain stable money, rather than stable consumer prices (when a fall in prices would otherwise lift the real wages of the 99 percent rather than lifting the price of financial assets traded by the 1 percent); through such a prescription, she could have done much to eliminate the cause of the bubble-bust cycle altogether, and to truly benefit the economic class she wants to help.
It is never too late, if the senator wishes to avoid a recurrence of the bubble, bust, and recession, she should refocus on the root cause of the last bubble, bust, and recession. Just as it is never too late for her to reverse her positions on wage floors and credit extension to marginal borrowers. But until she does, and as long as she continues to advocate for misguided proposals that exacerbate or distract from the problems she cites, she will remain a danger to her own cause.