A Look Back at the Subprime Mess (or: Itzhak Ben-David Is a Prophet)

Back in June, 2007, we wrote a column about the research of Itzhak Ben-David, a Ph.D. candidate in finance at the University of Chicago (who has since accepted an assistant professor position at the Ohio State University). He had been studying the cash-back transaction — a real-estate sleight of hand in which cash-poor buyers received an unrecorded cash rebate from the seller in order to qualify for a loan.

This would result in the buyer sometimes borrowing 100 percent (or more) of the house’s value. That means that borrowers who were subprime to start with are taking on even more debt, creating a loan that’s just waiting to blow up.

Here’s my question: If an academic researcher like Ben-David knew as much as he did for as long as he did — while we wrote the article last summer, he’d been working on this research for a long time — why were so many people, including smart people at sophisticated institutions, caught off-guard by the subprime developments?

Take a look at a few key paragraphs of the article and tell me how much clearer the warnings could have been, and how lax the safeguards were:

[Ben-David] found that a small group of real estate agents were repeatedly involved, in particular when the seller was himself an agent or when there was no second agent in the deal. Ben-David also found that the suspect transactions were more likely to occur when the lending bank, rather than keeping the mortgage, bundled it up with thousands of others and sold them off as mortgage-backed securities. This suggests that the issuing banks treat suspect mortgages with roughly the same care as you might treat a rental car, knowing that you aren’t responsible for its long-term outcome once it is out of your possession.

At first glance, these cash-back transactions, while illegal, might seem a victim-less crime. After all, the seller gets his house sold and the buyer gets to move in with his family. The real estate agent, the mortgage broker, the attorney, and the appraiser are all paid their commissions or fees. Even the bank that made the loan comes out ahead, since it earned its fees on the transaction before passing along the mortgage to investors.

But Ben-David argues that there are at least two potential losers. The first is the honest buyer who won’t take a cash-back offer and therefore can’t buy a house — all while the illegal cash-back transactions are artificially driving up home prices in his neighborhood.

The second loser is the investor who bought the mortgage-backed securities. If a house purchased with a cash-back transaction goes into foreclosure, it is soon discovered that the home is worth less than the value of the loan. This, plainly, is not good for the shareholders of such assets. While people who hate rich people may get a thrill from the idea of wealthy shareholders being swindled by a bunch of small-time mortgage hustlers, keep in mind that mortgage-backed securities are the sort of conservative investment widely held by pensioners and other regular folks.


It all comes down to greed in a comission based system. The house of cards is just beginning to fall. There are many unqualifed people in homes right now that are in bad loans. The big shake out is coming down the line.


DJH, Mike, and the like need to remove their tinfoil hats.

And yes the market is rational, OVER THE LONG HAUL. OVER 30 YEARS it's rational. Overvalued assets always return to their real value, undervalued assets always return to their real value whether it's regulated or not.

This isn't even the beginning of our financial woes in the USA. The runup to the great depression was preceded by cheap credit. The economy crashed, (read overvalued assets returned to their real value) and everyone ran around with assets now worth less than they paid, now with everyone stuck with undervalued assets they couldn't pay their loans and their lenders couldn't recover the full value of the loan. basically dollars vanished in a puff of logic.

Now we're seeing something similar, everybody including the government is leveraged! There's no physically possible way we can meet our loan obligations of the nation as a whole.

(Hence the falling value of the dollar)


Justin McGuire

"If an academic researcher like Ben-David knew as much as he did for as long as he did...why were so many people, including smart people at sophisticated institutions, caught off-guard by the subprime developments?"

This isn't uncommon when a crisis occurs, there's often a few people somewhere who made a very dedicated study a few years back, and came to a very rational conclusion that a mess is nigh.

For an example, look at Enron--a small group of Cornell student studied them in 1998, and came to the conclusion that they were manipulating their earnings. This was years before the WSJ and the rest of the world caught on.

(read part 7 of http://www.gladwell.com/2007/2007_01_08_a_secrets.html)


"I favor continued low levels of regulation, but only if we can somehow enforce absolute transparency. For example, why not have a strict ban on any off-balance sheet financial transactions?"

I hate to pick on an individual. So I will clearly state that this kind of thinking represents a widespread problem in our country - an inability to connect two thoughts with a train of consistent logic. We see this problem throughout our political system.

Can anyone explain how it would be possible to enforce a ban on off-balance sheet transactions without much more stringent regulation than we currently have?

Subprime Exec

I don't think anyone was "caught off guard". I think everyone saw it coming. It's just that each player chose to respond differently. Many buried their heads & hoped for the best - which works about half the time on Wall Street (my estimate, of course). But many people in the industry tried to do something about it. Example: I was in the subprime mortgage business for 14 years. The company that I worked for, Accredited Home Lenders, was considered the most conservative & cautious lenders. This caused us to lose a great deal of business to the lenders who had more agressive lending guidelines, looser ethical standards & even lower interest rates. AHL's president & CEO stated in January 2006 that market was in trouble & due for a correction. Even as guidelines got easier & rates got lower, AHL began tightening it's standards & raising it's rates in order to be better prepared for the fallout.



mfw13 -

You seem to be missing the point that this practice fraudulently increases the market price, which affects far more than just the individual buyer and sellers for whom you hold so little sympathy.

This means that even people who COULD afford the fraudulently inflated prices end up paying more to the realtors, mortgage brokers, and lenders in commissions, discount points, and interest payments. They lose investment income on the money they use for their down payment. They probably won't default, but the industry vultures still get to feed, gluttonously, for all the years those mortgages remain in effect. Then, assuming the owners eventually sell, they get hit again because the market will (most likely) by that time have lost the fraudulent inflation.

Focusing on the "greedy and stupid" buyers who bought more than they could afford is like focusing on the soapy film of a bubble, alone, and ignoring all the air inside it.

As to the "how could this happen" question posed in the blog post... I concur with Mark @4 above. Of course they knew full well what was happening, when it was happening.



There's a lot more to the subprimes mess than just the cash-back scheme.

Some people long before June 2007 who made the prediction about the subprime mess, like David Melcher and his hedge fund Balestra Capital.

They placed their bearish bets and are making a killing (http://www.finalternatives.com/node/2162).

As others have pointed out, the IBGYBG philosophy (I'll be gone, you'll be gone (wihtour bonuses)) has as much to do with it as anything.

If Ben-David is so smart he should have sold financials short like Balestra did.


They were not caught off-guard by it. Their rewards simply exceeded the risks. Individual bonuses and compensation earned will not be returned. They were right.

nj realtor

Anyone with half a brain in the industry saw this coming for a long time now. I really hate to say it, but a large part of the problem is non english speakers that trusted mortgage brokers and realtors of their own ethnicity. These brokers got them the so called "American Dream" of home ownership. Most of these people had no business taking on such an investment. They used utility bills and employer verifications because they literally had no credit, besides not having 2 nickels to rub together. Where does a guy making 25k a year get the nerve to purchase a 400k home? I had many closings where I represented the home seller and the borrowers that showed up to sign off on the mortgage were people that I had never seen before. These deals were all manufactured by the mortgage brokers and realtors who were helping "their people" buy a home. They were also helping themselves to major points on the front end. I have seen up to 12 points charged on mortgages like this. The people many times spoke no english and trusted the mortgage broker to take care of it for them. They would sign off on notes and leins that were not even translated. They all had lawyers to "look out" for them. Most of the lawyers only spoke English. The mortgage brokers did all the translating. Although it bothered me,there was nothing I could say as long as my clients were taken care of properly. They were not my clients, and they were represented by attorneys. If I have seen this between 10-20 times a year, for about 3-4 good years, multiply that by all the realtors around the country working in urban and semi urban areas...the numbers are astounding. By the way, green cards were never a consideration to obtain these mortgages. These were sales that never should have been transacted in the first place. And this is only a part of the downfall.



I've got no sympathy for investors in CDO's....they violated the first rule of investing, which is never to invest in anything you do not understand.

I've also got very little sympathy for the people who took out these loans...they were greedy and trying to live above their means by buying more house than they could actually afford.

The people I do feel sorry for are all those who have lost their jobs because other people were greedy and/or stupid.

But that's what you get when you underinvest in education to the point that most people graduate from high school and many gradaute from college while being financially illiterate.

A course in personal finance should be mandatory for a HS diploma!


Quoting post # 3

"But that's what you get when you underinvest in education to the point that most people graduate from high school and many gradaute from college while being financially illiterate."

Very true. A stretch for this topic but...I was standing in line at the airport with a bunch of college kids going to Jamaica for springbreak and they were trying to explain to each other the exchange rate between Jamaican dollars and U.S. dollars(60 to 1). They didnt have a clue. They kept saying things like a Red Stripe will only cost 30 cents and a gallon of milk only a dollar.


Until the banks rethink their incentive structures for their securities traders and IB guys, we're going to keep having these problems.

If I get my annual bonus based on performance, and the sky's the limit, you bet I'm going to go after questionable investments. They're not going to dock me for losses, but they'll stuff me full for huge earnings. The worst they can do is fire me, and I'll take my millions and go open a restaurant.

I don't think the banks will do this on their own. I'm a conservative and not a fan of regulation, but this may be a place where we need it. Maybe the SEC should step in and say you can't keep making it so lucrative for traders to buy into these sorts of questionable securities. Especially if the Fed is going to bail the banks out when they blow up.


This is a great question: "If an academic researcher like Ben-David knew as much as he did for as long as he did - while we wrote the article last summer, he'd been working on this research for a long time - why were so many people, including smart people at sophisticated institutions, caught off-guard by the subprime developments?"

The answer to it is fairly simple: "Of course they knew it all along, it was all part of their plan!" The whole idea behind these lending practices was to get more money into the housing market -- i.e. by allowing more people to buy, people who hadn't qualified as buyers previously -- so as to raise the value of real estate beyond its (then) saturation point.

In other words, the market used these subprime borrowers to create (artificially) a housing bubble.

For them to have heeded the advice of "prophets" like Ben-David and stop these practices, would have removed these added funds from entering the housing market, and that would have caused the bubble either to deflate or break, which they couldn't allow to happen.

In short ... too many people were making too much money on this artificial bubble, to do anything to stop it. As usual, it was all about the money.



Several of the 1st 10 posters have made astute comments about the proximate cause of the fiasco, but the root cause is ideology. You had a guy heading the Federal Reserve who loved his theories about how markets work better than the facts out there in the real world. And theory said "hands off" This led him to remark that he didn't think the Fed had the power to regulate the shaky standards used to approve loans as the bubble grew dangerously thin, a power that remarkably the Fed discovered AFTER the bubble burst. You have a party in control of the Executive Branch of the government that hates regulation and thinks the market solves all problems; even the current plan by the Treasury just shuffled the deck around and doesn't add new regulation, as Paul Krugman points out.

In short, the people in charge were blinded by right-wing ideology about the markets. You could have had 10 studies, a 100 studies. It wouldn't have mattered. Any problem discovered would have been labeled "minor" and one that the free market, working its magic, would take care of on its own.

The result is the taxpayers will bear the burden of bailing out the rich folk who've already made their billions in bonuses and fees. The small taxpayers, that is. Last I checked, permanently eliminating the estate tax is still part of the Republican plan.



Best metaphor I've heard (and used) to describe the whole mess:
It's like kids tossing a football around inside the house. Everyone has fun, nobody wants to stop, but everybody scrambles to point fingers when it gets out of hand and the lamp gets broken.


Just to be clear, the interesting question is why sophisticated investors such as Bear Stearns, WaMu, Lehman Brothers, UBS, et al., messed up on such a large scale. These institutions were caught holding the bag on billions of dollars of bad loans.

And Dubner, I think that we'll find better answers in the field of psychology than from economics regarding these sorts of phenomena. People overvalue their ability to accurately assess risk, they go with the crowd, and they get burned.

Ken H

Financial markets began a long march toward de-regulation in the 1970s. Most of the outcomes of this have been positive, largely in the form of more fluid, flexible capital flows. The global economy sends money where market conditions dictate, independent of the efforts of any central bank to control those flows. I think that has been nearly uniformly positive for economic growth around the world, and the ability to smoothly respond to market disruptions.

But over that same time frame, we've seen repeated examples of the disruptive effects of opaque investment innovations. ("Don't invest in securities you don't understand.") Twenty-five years ago it was the S&L crisis. Then came junk bonds. More recently Enron and others created derivatives of futures, which still today, I don't think anyone really got, except maybe Jeff Skilling. Now, we see the pernicious effects of CDO's and SIV's. In between, we saw lots of off-balance sheet financing of credit subsidiaries. When will we learn that non-transparent financial instruments always (read ALWAYS) lead to speculative manipulation to generate excess returns.

I favor continued low levels of regulation, but only if we can somehow enforce absolute transparency. For example, why not have a strict ban on any off-balance sheet financial transactions? Even 401(K) assets could easily be reported, so investors had a full view of the financial obligations and assets held by a firm.



"If an academic researcher like Ben-David knew as much as he did for as long as he did - while we wrote the article last summer, he'd been working on this research for a long time - why were so many people, including smart people at sophisticated institutions, caught off-guard by the subprime developments? "

You answered your own question with the break outs of winners and losers.

The guys who made money (agents, mortgage brokers and lawyers) are not the same guys who lose in this deal (home buyers and individual investors).

The profiteers had no skin in the game here. In fact, it wasn't even the banks that made the lousy loans who lost in this case. Instead it was the banks (and others) who bought the lousy loans who ended up paying the price.


We all know the justification/rationale used by the lenders/real estate agents etc. that caused this mess. It was individually rational to do so, expected benefits were clearly greater than expected costs.

In relation to why so many of the institutional investors were burned was because they are just that. Institutional. They are in direct competition with one another. Analysts at say Bear-Sterns could be left red-faced if they disagreed with what an analyst at Lehman reports and therefore no-one has the guts to call a spade a spade. Getting your market outlook 'wrong' is not really going to affect your career if everyone else got it 'wrong' too. It's the economic equivalent of the inertia principle.


I am fairly convinced that Goldman, Bear, Citi, Merrill, JPMorgan et al knew this wouldn't end well. I speculate that they were off only in the timing. Its been argued that the stock market is fairly rational... I disagree. For evidence, see the savings and loan crisis, the tech boom and bust, CDOs, SIVs, derivatives, etc. All cases of assets being wildly overvalued by the market, only to crash later. I would imagine the investment banks were looking at this saying "this doesn't add up... but lets make as much money as we can while we have the chance, and get out before it blows up" and just poorly timed their exits. The only company that really saw it coming and planned reasonably well was Goldman, who fared better than many, but still took a beating. Maybe they saw a collapse coming in 2009, and it just arrived too early.

Think about it, had these been more traditional mortgages (where you get it from a bank, and they hold it until its paid off) the big banks (Citi, B of A, etc.) would be flat out bankrupt. But they were able to pass a huge portion of the garbage onto others, while pocketing massive fees along the way. Pretty clever really.

I recall reading in 2004 or 2005 (I was still in college) about ARM resets and the implications it would have on the real estate market. In late 2006 I was kicking myself for having heeded that advice and staying out of real estate while my friends bought Mercedes with money from HELOCs.

In hindsight I was lucky, my portfolio is down 15%, but I have 10% of my salary from my first 3 years out of college in liquid assets, while they have $80k in negative equity in an illiquid asset (though, they still have their mercedes).