What We Still Don’t Know About the Mortgage Crisis

On Tuesday, September 16, at a rally at the Colorado School of Mines, Barack Obama criticized John McCain, saying:

Just today, Senator McCain offered up the oldest Washington stunt in the book: you pass the buck to a commission to study the problem. But here’s the thing; this isn’t 9/11. We know how we got into this mess.

It’s one thing to criticize McCain for inaction, but I disagree with Obama’s claim that we know how we got into this mess. In fact, if pushed, I would say I knew a lot more about the causes of 9/11 than I do about the causes of the mortgage crisis.

I just read Robert Shiller‘s excellent book, The Subprime Solution, and he makes a powerful case that the end of the price bubble in residential real estate was the crucial triggering factor.

Indeed, the graph, based on the Case/Shiller U.S. National Home Price Indices, is prima facie evidence of a bubble that expanded and popped:


The dramatic downturn in housing prices was the key trigger — causing an increase in mortgage defaults. But the next step in the meltdown seems to have been the byproduct of 1) high leverage at investment banks and other financial intermediaries and 2) uncertainty over how much of the default risk was held by particular intermediaries.

Assessing a firm’s exposure is complicated by the massively complex web of derivatives and tranches oftentimes unreported in firms’ balance sheets. Firms like Lehman Brothers suddenly had trouble borrowing when lenders had trouble assessing the value of the security they offered. When you’re massively leveraged, just small increases in uncertainty over your asset value can dry up your ability to refinance your debt.

But to my mind, there are still dozens of important unanswered questions.

How much of the crisis was caused by subprime borrowers who made mistakes by borrowing (i.e., would not have borrowed if they had better information)?

Some proportion of the loans had very low down payments and low interest rates for one or two years. It might have been a rational choice for someone to take a chance on homeownership — putting very little money at risk and thinking (correctly): “If housing prices continue to go up, I’ll be able to refinance my house when the two years are up.”

In 2005, Elizabeth Warren gave a paper at Yale’s Legal Theory Workshop, and I called her on a claim in one of her footnotes that down payments for first-time homeowners were minuscule.

I was sure this claim had to be wrong. There is no way banks can loan money with virtually no equity cushion. But guess again.

According to The Washington Post, “four out of 10 first-time buyers used no-money-down mortgages in 2005 and 2006, according to surveys by the National Association of Realtors.” And the median down payment for first-time buyers in those years was just 2 percent.

With so little of their own money at risk, it shouldn’t be a wonder that many borrowers default when housing prices decline. Would you want to keep paying on a $200,000 mortgage when the house is only worth $150,000?

If you want to know why the mortgage system is so fragile, you should look to the drop in home equity — which was occasioned by low down payments and second mortgages that pulled equity out of houses where the owners paid off some of their outstanding principle.

But the problem of high borrower leverage was compounded by the high leverage of many of the firms that ended up holding the mortgage papers. Some investment firms were leveraged 30 to 1 (or more).

Years ago, Shiller called upon Freddie and Fannie to conduct “stress tests” to see whether they could survive a downturn in real estate prices. One of the chiefs had concluded that they could survive a 10 percent downturn in prices, but didn’t think it was plausible that prices would fall more than that.

I like Shiller’s “stress test” idea; but I’m also attracted to the New Orleans levee metaphor: Should our mortgage system’s levees be able to withstand a 20-year flood, or should we design them to withstand a 100-year flood? Levees are not costless. Neither are financial-safety measures.

We also don’t know the extent to which specific terms of subprime loans contributed to the spike in home foreclosures. Some of the loans (particularly those going to minorities) were at high interest rates not justified by the risk of borrower default. Some mortgages were interest-only loans, where the borrowers were not building up additional equity overtime. And many of the loans had teaser rates, which effectively required refinancing after two years.

My tentative take is that the low down payments were more important than any of these other factors as far as adding to systemic risk. Second place would be the effective refinancing risk (because after the house prices started to decline, lenders were not willing to lend $300,000 on a house that was only worth $250,000).

Third place would be the interest-only loans. If the down payments had been higher, interest-only loans would not have been much of a problem at all. There is a systemic benefit with amortizing loans: in a system where people borrow money at different times, there will be different amounts of home equity in the system. But this benefit is dramatically reduced by the ease of taking out second mortgages to pull out any built-up amortized equity.

I’ve done a lot of work on the problem of high borrowing interest rates, and marking up interest rates can exacerbate the probability of default. But while more needs to be known, I believe that this impact is likely to be less than the impact of these other terms. (These inflated rates, however, are a problem in and of themselves — and remain an action item for enlightened regulation.)

But I’m still not sure how many of the defaults are caused because borrowers can’t pay (for example, because of interest resets and the resulting need to refinance), and how many are caused because borrowers are choosing to walk away from mortgages that are seriously underwater.

We also don’t know the answers to parallel questions concerning the lending side. It’s easier to see the possible rationality in the behavior of the loan originators; to the extent that they were flipping the mortgages in the securitization market. But what we still don’t know is why the ultimate buyers were willing to buy.

Was this a failure of Super Crunching? Was it a failure of corporate governance (in that the managers of the buying firms had incentives to unprofitably grow their empires)? Was the failure caused by originator fraud (or the moral hazard of substituting bad-doc loans for what historically had been high-quality loan pools)?

I think it is probably some mixture of all three — with poor corporate-governance incentives particularly explaining the failure of the rating agencies to start downgrading the debt earlier.

Knowing the answers to these causal questions is important if we are going to craft useful policy responses. But that will be the subject of another post — which will more directly focus on Shiller’s subprime solution(s).

Amor de Nicholas

We know exactly what caused the problem, irrational, irresponsible people buying homes they should never have been in only because the banks dropped their lending standards.

What caused the crash? Greed, plain and simple. There is no deep, hidden, technical or scientific cause.

Nicholas Love


I agree with the case that "we really DON'T know what caused this mess". But I wonder if the roots of that not knowing go deeper than the questions highlighted here.

I referenced your excellent piece on my site - please check out what I had to say ...


Nicholas Love


Mike Pukmel

As strange as it sounds, there is no mortgage crisis, sub-prime or otherwise. The crisis is due to grossly leveraged derivatives (the "Collateralized Debt Obligations" and "Credit Defaultt Swaps"). I ask you: is there any bank, or banking institution in the USA, or most European countries, that would go bankrupt due solely to a %6 default rate in mortgage pools? Think about this for a momemt! If it were not for absurd leverage (Bear Stearns was over 33:1 at the time of their collapse) of these derivatives, there would be no crisis at all. Also, if it were not for the lack of capital reserve requiremennts for the unregulated Credit Default Swaps, most of our investment banks would not have gone bankrupt.

I disagree with you: we know a heck of a lot about why the current banking crisis occurred, a lot more than exactly what happened on 09/11.


To post #32, McCain is correct to call for a commission to study what happened. At this point hard data is lacking. We have some idea were to look but key players have to this point, I think, been less then honest in answers.

Did deregulation cause this mess? Or did the fact that regulation by it's nature is a political process lead to incentives that had nothing to do with the smooth operations of markets?

Or please tell me why so many subprime loans were made. Or why so many financial institutions fled to loan instruments that were away from the eyes of regulators and assumed to be less transparent. Why did buyers and sellers go to this black market?

I don't much care for either candidate but I do care about getting at the truth. Senator Obama should be calling for an independent commission to investigate, unless he has a motive to protect some people.


LuxuryYacht #27 is right. Have a read of this article (there's a few paragraphs of partisan rant at the front, you can ignore that) but it gives three common features of US loans that probably contirbuted to the mortgage crisis:


1) Non-recourse loans (as mentioned by LuxuryYacht)

2) Fixed interest rates for the life of the loan

3) Restrictions on prepayment penalties


Response to #29 from #17 - Redistribute wealth and population, as a solution against the issues in big markets.

On a certain level, I've always envied people in professions that can easily pick up an move to any location, like teaching. I'm an engineer, and work is far more sparse elsewhere in the country, and far less interesting.

I grew up in exactly the kind of town you live in. Lots and lots of people fleeing urban areas, and very eager to shut the door behind them to anyone else "discovering" the area. We want to have a family, and I want to expose them to the kinds of opportunities I couldn't imagine growing up in place like that. All the adults cooing about living there, while the kids went stir crazy.

Moving out of an urban center is not an option for me. It may work for you, but it doesn't work for everybody.


One thing I rarely see mentioned are the effects of bankruptcy reform from 2005 that make it almost impossible to file bankruptcy and keep the home, surely that lead to an increase in forclosures.


This is very interesting. Please expand on this! I also assume there is or will be more papers deconstructing these underlying causes and would love for you to post pointers to them!

Paul K

Obama's point is that we do know why it failed in the broad sense, if not which thing triggered it 1st. We can say that we know a house of cards collapsed, even if we are not sure which card failed 1st - the point is that with all that leverage, it is only a matter of time before it fails. The question of whether home owners knew they were in risky or stupid mortgages (e.g. interest only) is a good question, but we know that the people who sold them those loans knew they were setting those people up for failure. We also know that the institutions buying highly risky securitized loans either did not pay a lot of attention to risk, or bought CDSes to protect themselves, setting us up for the next failure point.

So, it would be useful to understand the exact "tipping point" where things started going downhill and why, and certainly understanding who knew what when. But, it is clear that failure was inevitable due to the way things were setup and the extreme leverage across a range of companies.



I think of the gambler at the track as "Credit Default Swaps" and the horses being bet on as the mortgages.

The association is constructed by the act of the bet.

So, while there may be a mortgage problem (4 Trillion?) and there may be a problem gambler (60 Trillion?) it can be worthwhile not to blame the horses for the gamblers problem, while acknowledging that there may be a problem with the horses too.

I really wish I could find out if my analogy is correct. I don't really know where to go for better information.

Bill Harshaw

A contributing cause, I think, was on the demand side. We have had high immigration rates for several years which created demand for housing units. In some cases the cost of housing was handled by people doubling up or new homeowners renting out rooms to relatives, friends, fellow immigrants. The owner's income by itself could not handle the mortgage, it depended on a supply of renters, which in turn depended on a continuance of the immigration. When people started talking and acting tough on illegal immigration, that pushed the new owners over the edge, and decreased demand, which may have been enough to pop the speculative bbbbbubbble.


Re: #13: I could not agree more with your assertion that the "underwater" factor does not- or should not- hold water. I am a car dealer and EVERY new car that rolls off this- or any- lot is instantly worth less than the loan payoff. The only things that prevent default are 1) the desire to keep possession of the asset 2) the desire to keep a decent credit rating and, though perhaps irrational, 3) the desire to actually fulfill the promise to pay, or put another way, to do what you said you would do. What ever happened to that? It's a fundamental element of the social compact, and yet it seems to be dismissed out of hand in economic and political analysis.

As regards the comments in #17: MOVE to another part of the country. That's another element of this whole crisis that has gone largely unnoticed. The real estate bubble was NOT equally distributed around the country, and part of the healthy fallout of this SHOULD be a redistribution of wealth, population, and jobs away from the 'oversold' major markets and towards smaller markets that largely avoided the bubble. We have seen a good number of major market "refugees" in my market (Chattanooga)and hopefully will continue to do so-



In Australia, if you can't pay your mortgage, you can't just hand the keys back and virtually repudiate your debt. Not only does the bank sell your house, but they can pursue you for the difference between what the sale raises and the amount outstanding. I think the very generous bankruptcy laws in the US makes it very easy for a bubble to burst, whereas in Australia there is a greater incentive to try as hard as possible to keep paying back the mortgage, regardless of the equity situation.

Joe E

Nice article.

I want to add the rating agencies' short - term prefiteering to the list of causes. They vastly over-rated these packaged sub-prime no-down payment mortgages. Their self defense was that default rates had been low, but there was plenty of evidence from earlier cycles that no-down payment mortgages default more and that mortgages to sub prime borrowers default more.

Because these ratings were way too high, the buyers of the packaged mortgage backed securities were misled into thinking they were investment grade. Demand for the packaged mortgages drove the frenzy to make and flip the mortgages at the retail level.

The rating agencies were paid a substantial premium over their regular fee schedules by the issuers of the packaged mortgages to rate them. The rating agencies could have stopped the whole thing in its tracks by exercising their auditor-like function and giving lower ratings to these securities, based upon their untried nature.

They didn't. IMHO a mix of ineptitude and greed.



Is there a historical precedent for a company which operated for years knowing that only a modest drop in a single commodity price would wipe it out?

The idea that the price of anything could go up by over 10% per year for many years in a row and could never drop by more than 10% seems absurd to me.


What do mortgage lenders and pregnant teenagers share in common?

If you ask a teenager how they became pregnant they will often respond that they didn't know? You know it is a lie. They know it is a lie. We have a generation that has more access to sex information then any generation in history, but they will still plead ignorance when forced to face the consequences of their actions.

How did our financial system get taken over by the equivalent of horny teenagers? They could reasonably predict the consequences of their steamy interactions. The safety measures they were using were highly questionable. Becoming increasingly promiscuous didn't help the matter. Yet when they end up in trouble, they claim they don't know how this happened.


About two perhaps three years ago, a story came out of some real estate conference in Wisconsin, about a speaker who warned of the dire consequences of all the ARM's that were starting to reset. The guy was president or past president of some professional real estate association. Some kind of banker I think. He predicted the foreclosures and the challenge to lenders would dwarf the S&L crisis. I wish I had listened more to his warnings. I would be much richer today.

My point is that many smart people saw this coming. In my travels I saw increases in real estate prices that were insane if based on increases in income. Most people were starting to talk about the insane price levels. But still a greater fool kept walking in the door.

I understand that the incentives became distorted. Potential buyers found it rather easy to speculate with other people's money. Blame Donald Trump and his show The Apprentice. Suddenly some people thought that highly leveraged real estate transactions were the path to the super rich lifestyle. And if you could buy a seat at the table for almost nothing, why not buy in.

I think their is some evidence that the ARM's resets and speculators entering the market are connected.

There might also have been a bandwagon effect. Rapidly increasing home prices may get people to buy today because the price will be much higher tomorrow. Plus if you can borrow at 5% and the home is going up by 8%, and you think this will continue for at least a few years, why not take the offer?

But some people could only get on the train if they had interest only loans, or other non traditional loans because, as mentioned, incomes were not keeping up with real estate price increases.

As an aside, where I live we did not see the rapid increase in housing prices. But according to local real estate agents home equity loans were restricting the number of houses for sale on the market. People just did not have much equity in their homes and could only sell their current home if they could acquire the new home with little money down. This was getting to be a real problem with corporate relocations in our community.

Why did lenders get so helpful? Why did they ignore historical guidelines about down payments and debt to income etc? Why did they become so leveraged? Were they really blind to the risks or were the short term profits so tempting that they preferred to look the other way.

Before the regulators failed, the owners of these firms failed. They paid millions in bonuses to people who were gutting their firms. Why? Were the owners that stupid? And why would an industry suddenly be full of stupid people who receive generous compensation?

Did years of sending political contributions to Washington make some of these firms feel that they were beyond the reach of regulators or lawsuits?

I don't know why people would buy financial instruments that lacked transparency. I'm not sure people were really that stupid but they apparently were richly compensated for acting that stupid.

As an aside, minorities often pay higher rates for mortgages then you would expect based on their credit history. I think this is because banks include a community risk premium i.e. the assumption that many minority communities suffer from disinvestment that over time reduces the value of the housing. It is really more a problem of lending in some communities that are viewed as at risk for tipping into slums.

It does make you wonder about fraud. If some mortgage brokers had criminal ties. And that with firms so leveraged, how much of a straw did it take to break the camels back?



This isn't rocket science. One can't ask what terms caused these mortgages to fail without asking what made prices to deviate from value. If prices never deviated from value, there would have been no bubble, and they would not have declined so substantially leading to people walking away and foreclosures. What determines value? VALUE IS THE INCOME TO PAY FOR IT. I'll repeat that since it seems a complete mystery to most people. VALUE IS THE INCOME TO PAY FOR IT. All else is minor. That means qualifying on fully adjusted rates and verifying incomes. Teaser rates and stated income loans are the critical factor because they separate prices from value, making prices depend on expectations of future prices, NOT income. This leads directly to bubbles. I don't understand why so many people have trouble with this. Do you really believe all these speculators had the income to pay for it? Did this money suddenly drop like manna from heaven and fail to show up in the income statistics? The income was never there, only increasing debt from rising prices.



I think we got into this mess because Republicans (and Democrats, to a lesser extent) realized that they could trick people into thinking that paying with plastic, then, later, home equity for stuff they can't afford is just as good for them as wages keeping pace with productivity.

Pushing profits to stockholders and corporate insiders at the expense of the workers to this extent would normally have resulted in revolt - if not in the streets, at least at the polls. But the debt-driven "circus" delayed the inevitable we are now experiencing.

Mike Liveright

1) re: Comment 13.


As I understand it, house loans are different, that is to say that one can "walk away" and the loan is canceled, were as other loans are leans against the full assets of the borrower... If true, then once the house value is below the outstanding loan value it is economically logical to default, excepting perhaps a bad credit rating. where as with a normal loan, even if the TV or whatever is less than the loan value if one walks away one is libel for the full loan value.

2) What I have not seen is the comment on the Government contributions. As I understand it:

2.1) Fanny and Freddy were buying up the "risky" loans, with the Government seeming standing behind Fanny and Freddy, thus making it logical for the banks to make the loans as they could then sell to the Fed.

2.2) There were pressures to loan to "risky" people to expand home ownership and so banks felt they had to take riskyer loans to satisfy the government.

Thus in addition to the problem of depending on the bubble, the banks were encurraged by the government to take the risks. True???