The US has wasted its “sub-prime” mortgage crisis. The story of how and why this has happened is of interest not only for its own sake, but for the broader themes it reveals.
I am a theoretically trained economist who started investigating US housing finance markets more than 20 years ago. Nobel laureate Robert Shiller and I separately made proposals to reduce systemic risk in the market. Yet our reform efforts went nowhere during the good times. We could not grab scarce public, press, or political attention with the claim that an apparently well-functioning system was profoundly flawed.
Naïvely as it turned out, we each believed that the housing finance crash might finally cause more fundamental questions to be asked. After all, our ideas on risk sharing were directly relevant and would have lessened the impact of the crash. We each made specific proposals to speed recovery from the crash. For a while it seemed as if there would be real progress.
Our hope was short-lived. Nothing positive has come out of the “sub-prime” crisis. The changes that have been made treat the name and ignore the illness. The US housing finance system is in worse shape than ever. The policy reform process is broken, and there is no quick fix in sight.
The breakdown of the reform process is as simple to understand as it is tragic. Public servants can all too easily prevent experts from judging their performance. This leaves an inexpert press and a readily distracted public as the only sources of reformist pressure. The press commentates on policy responses based on ideological mandates from an ideological readership. The public tweets approval. Unexamined, institutions and opinions continue to ossify. Why change what may or may not be broken?
To understand how deep and broad the problems are, consider an apparently more effective reform effort in the aftermath of the Challenger crash. In that case, unlike in the case of housing finance, the Rogers Commission was given a broad mandate and in Richard Feynman it included one particularly profound and independent expert. He identified an “O-ring” seal as the immediate cause of the crash. The press conveyed these expert findings to the public, which pressured policymakers into reforming NASA.
Even in the case of Challenger, resistance to expert input reared its head. In fact Chairman Rogers sought to exclude Feynman’s criticisms of NASA, whereupon Feynman refused to sign the report. In his personal observations, Feynman expressed his attitude to NASA management. He noted that Challenger was mission 25, yet that management claimed to believe that the odds of a crash were 1 in 100,000. He famously stated:
NASA owes it to the citizens from whom it asks support to be frank, honest, and informative, so that these citizens can make the wisest decisions for the use of their limited resources. For a successful technology, reality must take precedence over public relations, for nature cannot be fooled.
That NASA is not alone in putting PR ahead of reality is witnessed by the behaviour of the Federal Housing Administration (FHA) in the post-crash period.
This is an institution that issues risky mortgages with just 3.5% down payment. Each year it is required to report back to Congress on its performance, and make projections for the year ahead. Projection errors are assessed in the ensuing report.
From 2005-2009, actual performance fell short of projections by amounts ranging from US$681m to US$5.1 billion: the news was apparently all bad.
From 2010-2013, actual performance fell short of projections by amounts ranging from US$2.7 billion to US$22.8 billion. Apparently the news was worse.
After years of denial, in late 2013 FHA ran out of funds and went to treasury for its first bail-out.
The problems with the review were evident to concerned experts. A 2010 paper “Reassessing FHA Risk” identified several biases in risk assessment all giving rise to under-estimation of losses. I personally testified to Congress on the most egregious error:
The problems in the actuarial review first came to our attention when Joseph Tracy, Executive Vice President and Senior Advisor to the President of the Federal Reserve Bank of New York, noticed that FHA prepayment behaviour changed radically in 2009. Many mortgages that were significantly under water, which traditionally do not prepay, suddenly started to prepay. It is as if a group of particularly sick patients at a hospital suddenly appeared cured.
The cause of this apparent miracle cure turns out to be poor record keeping when one FHA mortgage is “streamline-refinanced” into another. To use the hospital analogy, it is as if very sick patients had been moved to a new room for treatment, yet were recorded as having been cured and discharged from the hospital… With this form of record-keeping, a hospital could boost its apparent success rate by moving patients frequently between rooms.
Joe Tracy requested linkage data to do the calculations correctly, but his request was met with silence.
The difficulties are far deeper than this. Policymakers control not only the data that they provide but also the reform process. Consider NASA’s announcement of its overhaul in the wake of the Challenger crash:
Sweeping personnel and organisational changes begun immediately after the accident are now complete… Special attention is being given to the critical issues of management isolation and the tendency toward technical complacency, which, combined with schedule pressure, led to an erosion in flight safety.
Fast forward less than 15 years to January 16, 2003, and mission 113. Space shuttle Columbia broke up on re-entry over Texas.
The subsequent investigation identified the same flaws in NASA’s culture that Feynman had earlier pinpointed:
This culture… acted over time to resist externally imposed change. By the eve of the Columbia accident, institutional practices that were in effect at the time of the Challenger accident—such as inadequate concern over deviations from expected performance, a silent safety program, and schedule pressure—had returned to NASA.
The problem is deep and pervasive. Many policymakers have much to fear from exposing their activities to experts who might attract public attention to their failings. Without experts, their performance simply cannot be assessed. This liberates spinners, which is a positive for most in the press, whose technical training leaves them unable to sort through the competing claims of knowledgeable experts and less knowledgeable policymakers and pundits. Even when reform is called for, it is not possible to effectively monitor implementation when experts are kept at arms’ length.
Let me return briefly to the case of US housing finance policy. One must predict that Fannie Mae, Freddie Mac, and the FHA will survive unscathed. Without fundamental re-thinking, risks will be allowed to multiply unseen. The seeds are even now being sown for the housing crash of 2025-35 and the bailout of 2027-37 (I am no Nostradamus, and nor was he).
How many other disasters are brewing in distinct policy areas due to this fundamental breakdown of the reform process?