Arguments That Are Automatically Wrong: Mortgages

Sometimes you don’t have to know the right answer to be able to recognize a wrong answer. And sometimes just the method for getting an answer is enough to tell you that it’s wrong.

There are many subjects which I may not have time to fully investigate and become fully knowledgeable (if at all) on them, yet when seeing people who do write about them, I can nevertheless still tell that their arguments are full of crap.

Let’s take the argument that the government was not to blame for inflating the housing bubble. Here is an example (which I don’t mean to pick on as it’s far from the worst offender, but I came across it today):

the claims that Fannie and Freddie were the primary culprits behind the inflation of the housing bubble and the flood of fraudulent mortgages is nonsense. … the worse junk mortgages were not bought and securitised by Fannie and Freddie. These were packaged and sold by the investment banks, Goldman Sachs, Lehman, Citigroup and the rest. Fannie and Freddie got into junk mortgages late in the game, and even then, their primary motive was to regain lost market share.

This belongs to a species of argument, cherished also by the likes of Paul Krugman, that involves bringing statistical measures to bear so as to show that Fannie and Freddie didn’t buy ‘most of’, or a ‘majority of’, subprime loans, or didn’t issue subprime bonds, or whatever. The intent is to demonstrate that their ‘presence’ in the portion of the market deemed problematic (‘subprime’, or something) was small, and/or that other actors (investment banks, e.g.) bought the loans which were deemed problematic. The conclusion is that the government (Fannie/Freddie) can’t have been to blame.

It is clear that this argument is incorrect merely based on the methodology. The logic used is just plain incorrect, and in fact, economically ignorant. It cannot be correct.

This doesn’t mean I have a proof that the government was to blame. It just means that all the people I’ve ever seen saying it wasn’t, have crappy arguments that don’t hold water. They are using the wrong kind of argument, a kind that cannot possibly be correct.

Why is it the wrong kind of argument? Because it ignores how markets actually work, it ignores that supply and demand is fluid, it ignores that markets can be distorted/affected by large buyers/sellers, it ignores substitution effects – basically, it ignores economics. But this all remains true even if we’re talking about the mortgage market. And it remains true regardless of whether the distorting actor’s (the government’s) participation in this market was somehow limited to loans of a certain type.

The government poured money into mortgages, issued mortgage bonds with their ‘implicit’ backing, and meanwhile kept interest rates low. This all meant (1) it was relatively easy for homebuyers to get mortgages to buy houses, and (2) it was relatively difficult for investors to make decent returns giving loans to the same sorts of borrowers. In price terms, the ‘price’ of making the investment [mortgage loans to a bunch of regular Americans] had skyrocketed. And it had skyrocketed primarily because of the government. Not in spite of the government, and the government was not a side player: the government is the main player in this market.

But investors still wanted good returns. That didn’t change. Nor did the fact (encouraged by the government) that at that time, everyone still considered mortgage loans to Americans relatively safe. So, they demanded mortgage bonds (i.e., demanded ways of putting their money to work giving mortgage loans to people) that would pay higher returns – i.e., that would have an affordable ‘price’. This is the only reason the ‘private label’ mortgage-bond market exploded so much. It is the only reason that mortgage-backed CDOs ended up being created.

In short, the government (for various reasons good and bad) artificially bid up the price of a certain desired investment product A. This made it unaffordable (or at least, unappealing at that price) for a wide class of investors. Hence, a similar (but with lower standards) investment product B inevitably and predictably sprung up to meet that demand.

Now then. A Krugman could sit there and make pie charts all day long showing that the government only participated in product A not B. But that simply doesn’t prove anything. It doesn’t mean the government had ‘nothing to do with’ the creation of product B or the overall bubble in A+B. To assert otherwise, is an argument that is economically idiotic (in fact I doubt that a smart guy like Krugman – as opposed to whichever partisan hack writes his NYT columns – could actually sincerely believe it). It is automatically wrong.