Editor’s note: This is the first of a two-part series.
"According to a recent ‘Nightline’ program, none of the Wall Street executives who engineered the subprime debacle have been convicted on criminal charges. Why do you think that is?"
I think that the most obvious answer is the correct one: The authorities were not able to find sufficient evidence of criminal behavior in any of the cases they investigated (and they investigated many) because there wasn’t any to be found. Imprudent violations of firms’ own internal policies abounded, but such violations are not criminal.
Underlying your question, and implicit in the "Nightline" approach, is an assumption that the subprime debacle was engineered by a profit-hungry group of lenders and investment bankers who, for some unknown reason, decided to run amuck. Given that assumption, the failure to convict anyone must mean either that law enforcement has been co-opted or that all the suspected criminals who were investigated were clever enough to destroy all evidence of their misdeeds.
But both the assumption and its implications are wrong. True, lenders and investment bankers are profit-hungry, but they are always profit-hungry, so this does not explain anything. Profit-hungry lenders in the 1990s made mortgage loans only to borrowers who met rigorous standards applicable to their capacity and willingness to repay. During the period 2000-2006, in contrast, profit-hungry lenders made loans to many borrowers who did not meet these same standards.
Profit-hungry lenders did not change their character between these periods; what changed were the circumstances under which their decisions were made.
In the later period, they operated in a housing bubble. A housing bubble is a market environment in which rising house prices generate an expectation that price increases will continue indefinitely. The central feature of a bubble is self-reinforcement, where price increases lead to actions that further stimulate price increases. The expectation of rising prices is the air in the bubble.
Economists don’t completely understand what causes bubbles, but they appear intermittently throughout history, beginning with the Dutch tulip mania in the 1600s. A central feature of all bubbles is that very few of those participating in them realize that they are in a bubble. A few mavericks and misfits not part of the social fabric of the industry affected may perceive what is going on — in our recent housing bubble, a few of them made fortunes betting against the market — but the great majority reinforce each other in the belief that the price increases will continue. The absurdity of this belief does not emerge until the bubble bursts, when it becomes painfully evident.
In a housing bubble, it is extremely difficult to make a bad mortgage loan. If the borrower’s income is inadequate, several devices are available to reduce the payment during the first few years. At the end of that period the loan can be refinanced with the reduced payment extended, with confidence that the increase in house value during the initial period will cover the higher loan balance and settlement costs on a new loan. If the borrower can’t make the payments, there will be sufficient equity to allow him to sell the house and pay off the loan balance.
In the worst case where the lender is forced to foreclose, the equity generated by rising prices will be sufficient to repay the balance and cover the foreclosure expenses.
Continuing price increases make underwriting requirements, which are designed for a static environment, largely irrelevant. By ignoring them, lenders do good deeds, making homeowners out of people who never thought they had a crack at homeownership, and in the process make money for themselves.
In a bubble, everybody wins. Until they lose.
With the perspective provided by hindsight, it may be difficult to believe that so many intelligent people, including CEOs of major public companies, believed (or acted as if they believed) that house prices would rise forever. But it really wasn’t that implausible. For one thing, they didn’t have to believe that prices would rise forever, only that the price inflation would last through their tenure — when it ended, the resulting problems would then be someone else’s. Until the crisis, furthermore, there had not been a nationwide decline in house prices since the 1930s, only local ones that were invariably mild and short.
The optimism generated by bubbles is also contagious. To appreciate its force, consider that the bank regulators were caught up in it almost to the same degree as the industry players. The regulators did finally realize what was going on, but only a few months before the bubble burst — far too late to do anything constructive about it. And the regulators were not subject to any of the internal pressures that blinded the corporations operating within the bubble.
A bubble generates a subtle shift in power within corporations — a shift largely unrelated to the table of organization that shows who reports to whom. Power shifts to those who direct operations within the bubble, who are responsible for engineering substantial "profits" for the firm. Even CEOs with strong personal doubts could not bring themselves to explain to their boards why they had curtailed operations that were generating such great results. And both top management and boards feared incurring the wrath of major shareholders if they fell behind competitors who were earning enormous "profits" by operating within the bubble.
In the previous paragraph, I put the word "profit" in quotes because after the bubble burst we realized that they weren’t profits at all, they just looked like profits at the time. One of the major features of the housing bubble was what might be termed "profit illusion," and dealing with it is the key to any successful policy designed to prevent another bubble in the future. This is discussed next week.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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