Market Distortions


On the blog Carpe Diem, Mark Perry shows One Chart to Explain the Entire Financial Crisis (see post of the same title on July 29).   Here’s the chart, for Ed Pinto at the Census Bureau:

Before 1995 less than 5% of mortgages were made on homes where the buyers put less than a 3% down payment on their home.  By 2008, that increased to 40% of mortgages.

The old rule of thumb for mortgage companies was 20% down payment.  There was good rationale for that hurdle.

If you had 20% to put down on a home, it demonstrated to your lender that you had developed responsible financial behaviors.  The 20% made homeowners more likely to take care of their property because they had a substantial equity stake in it.  It also gave lenders some cushion for home price fluctuations.  If you stopped paying the mortgage and the lender foreclosed and sold the home, there would be a good chance that they would get all of their money back and the owner would get some back.

The chart shows a gradual, but only slight increase in this percentage from 1980 to 1995, and then it picks up shortly thereafter.


I think several things happened. All led to market distortions.  That is, the signals and feedbacks that had previously worked well in keeping the housing market healthy stopped working.  They got distorted.

First, politicians became overly concerned with increasing home ownership rates. They leaned on Fannie Mae and Freddie Mac to make it a priority to make it easier for folks to buy homes.  This led to relaxing the previous 20% down payment rule-of-thumb.  Politicians had the cause-and-effect backwards.  They thought that home ownership led to responsible behavior.  In reality, responsible behavior leads to home ownership.

Second, math and stats geeks started building financial models on Wall Street and folks believed they were far smarter than than really were.  Folks thought this new era of financial modeling could reduce the risk of making risky loans.  It turns out they were wrong.

Third, as Russ Roberts points out in his paper, government had established a history of bailing out financial institutions deemed too important to fail.  This led to a moral hazard that caused the leaders of such institutions to take risks they may not have otherwise taken — thus lending to folks that they would not have lent to 20 years earlier.

As Roberts has been known to say, Capitalism is a profit and loss system.  Profits encourage risk taking.  Losses encourage prudence.  Take away the losses (or spread them across everyone) and prudence goes away.

The absence of  prudence was the market distortion that led to the crisis.

These three things all contributed to reducing prudence — or the fear of loss.  They distorted the signals in the housing industry causing it to “heat up”.  It turns out incentives do matter.  If politicians thought owning sandwich shops was a good idea and backed loans on sandwich shops, it’s not hard to imagine that we would get many more sandwich shops that we need and most would eventually go belly up.

That’s what happened with housing.  With these distorted signals, we wound up with many more homes than we needed.