Book Review: The Rise and Fall of the U.S. Mortgage and Credit Markets

Just over a year ago, the Lehman Brothers collapse trip-wired the global financial crisis into high gear. At this juncture, not surprisingly, analyses and polemics are beginning to cascade onto the scene, a development that no doubt will deepen our understanding of causes, consequences, and policy options. Nevertheless, the handful of very early entrants into the analytic arena, including this book (originally published this past spring), deserve our attention, in part because doing so can help us assess how far and in what direction our accumulated wisdom has progressed since the onset of the crisis.

As the title indicates, Barth et al. concentrate on the boom-to-bubble-to-bust dynamics of the U.S. mortgage market, commonly agreed to be the hothouse for the now worldwide jungle of financial and macroeconomic turmoil. The analysis ends in late 2008 at a time when the mortgage market meltdown was morphing pell-mell into the global financial crisis. At first blush, one wonders if, analytically-speaking, that demarcation does not make the book obsolescent. In fact, however, even as newer analyses have now focused primarily on the worldwide financial conflagration, there is substantial value in having a clear record of the original forest fire that engulfed the U.S. mortgage market. This book makes a substantial contribution in that vein. Indeed, its biggest contribution is its detailed coverage of the over-leveraging process in the U.S. home mortgage market. The wealth of descriptive data woven into the analyses in the first half of the book, as well as the book’s exhaustive Appendix, constitute a substantial resource for future analyses of both the U.S. mortgage market catastrophe and the subsequent worldwide credit market crisis.

Promotion of homeownership has been a bedrock public policy objective in the U.S. at least since the end of the Second World War. Under these circumstances, the growth in the proportion of families owning their own homes, as well as the substantial increase in the stock of housing wealth in the early part of this decade, were universally regarded as desirable outcomes, the many dimensions of which are detailed in the book. From the vantage point of that historical perspective, the authors ask a series of questions.

Firstly: what happened in the U.S. home mortgage market – that is what, exactly, are the relevant facts on which analysis should focus? The book’s biggest contribution is here, in its detailed illumination of the mortgage market landscape over the past decade. The sharp increase in the homeownership rate between 2000 and 2007, which had inched up modestly over the previous three decades, as well as the surge in housing wealth, are juxtaposed to the equally rapid rise in mortgage debt. Moving from these macro dimensions, the authors examine in detail the steady increase in the proportion of securitized pools of home mortgages compared to mortgages held on the balance sheets of banks and other financial institutions. A turning point of note – in hindsight – came in 2006, when private label issuance of mortgage-backed securities (MBSs) exceeded MBS issuance by the government-sponsored entities (GSEs) by proportions of 55.3 percent to 44.7 percent, respectively, of all MBS issuance. That was significant, because of the composition of private label MBS: 40 percent of private label MBSs in 2006 were backed by subprime mortgages, and almost one-third of private label MBSs were backed by Alt-A mortgages. More broadly, over the 2003 to 2006 period, there was a rapid increase in the proportion of increasingly complex nontraditional mortgages, including in particular multiple variations on payment option adjustable-rate mortgages which allowed (some would say, encouraged) borrowers not to amortize their mortgage debt. While such instruments can be useful financing choices for a select group of borrowers (those with highly variable income flows and/or a high probability of substantial near-term increases in income), it should have been obvious that the world had not suddenly changed so much that such a “select” group had suddenly become a larger proportion of the borrowing population. Indeed, the authors suggest that clear-sighted monitoring of quantitative information such as this by regulatory authorities, market participants, and market observers should have served to set off credit extension alarm bells sooner.

The second question the authors address is what was the public policy context in which the mortgage market bubble developed. Two dimensions in particular deserve emphasis. First is the underlying role played by macro/monetary policy, which became strongly accommodative as a result of the desire to insulate the real economy from, first, the bursting of the tech stock bubble, and second – perhaps as importantly – the disruptions and uncertainty following 9/11. The second broad public policy dimension of note is the deregulatory tilt toward the supervision of financial services firms. One wishes that the authors had chosen to elaborate upon this observation in greater detail, but undoubtedly broad-based faith in the ability of financial markets to price risk effectively contributed to what many now cite as the slow-motion reaction by financial services regulatory authorities to the seismic shifts in mortgage market credit extension practices.

The third question the book poses is what, precisely, were the factors responsible for the change from housing market boom to housing market bubble in the 2004–2006 period. Chapter 5 – “What Went Wrong (with) …” – is probably mis-entitled, in that the authors do not in fact explain the exact operative effect of the factors they single out. However, this section’s contribution is in codifying a list of specific factors upon which subsequent analyses should focus or, alternatively, from which subsequent analyses should justify their decision to diverge. Included are the securitization process, ratings agencies, the GSEs, and regulation and supervision, especially of the banking industry. Less convincing are the inclusion and discussion of tax benefits for homeownership (which have been in place for decades and which did not change appreciably over the course of the housing boom-bubble-bust), and what the authors call “the Greed Factor” without a clear definition or analytic framework. One improvement in the overall discussion that would be worthwhile: a clearer description of the role of shadow banking system financial service firms in the propagation of high risk mortgage products.

An additional question posed by the authors probably would have been better left unasked: “When Will the Crisis End?” Given that this question was posed in late 2008, ahead of the early-2009 publication of the book, the analysis clearly was destined for a short shelf-life. As well, the subsection on the “Damage Scorecard to Date” details crisis consequences that have subsequently been vastly exceeded, in dollar terms, in loss of real economic output, and in the globalization of the fallout. In a related manner, the judgment that policy responses through November 2008 were “piecemeal” surely is a case of issuing a verdict before all the evidence was in. Even so, the delineation of early policy responses to, first, the bursting of the mortgage market bubble, and subsequently to the mortgage market meltdown-cum-financial system crisis makes interesting historical reading.

The final question posed by the book is “Where Should We Go from Here?” The focus in this concluding section is on the key factors the authors believe should drive longer-term policy responses, most particularly the overhauling of financial market regulation and supervision. The authors discuss nine “key factors.” The data presented in the discussion of each factor are wide-ranging and interesting. However, the overall structure of the discussion is somewhat disappointing: in particular, one might reasonably expect that the discussion of policy “solutions” would parallel, and indeed flow directly from, the early discussion of “what went wrong with…” In addition, it would have been helpful if, in their (too-brief) wrap-up, the authors had provided readers with a weighting of the relative importance of one factor compared with another. For example, one of the issues the authors raise is whether supervision should be organized around types of financial products (regardless of the nature of the firms offering given products), or (as is currently the case) on the basis of the nature of the types of firms (i.e., banks versus securities firms versus insurance companies, etc.) regardless of the range of products offered by distinct financial services “industries,” and irrespective of the fact that some of the same financial products are offered by firms in different financial services industries – and so are currently regulated differently. How urgent is it that this thorny issue be addressed as compared to, say, the issue of how concentrated the banking industry should be allowed to become? Or are these (and the seven other issues) equally important? Prioritizing the issues would have enriched the discussion. Nevertheless, as an early entrant in the literature on the nature and scope of the financial crisis, the delineation of specific dimensions of the financial marketplace most in need of policy rethink is a contribution to the still on-going debate.

Ultimately, this volume is likely to be judged not on the basis of how closely it tracks with either more seasoned postmortems, nor with actual financial services reforms once enacted. Rather, it will continue to serve in future the role it currently serves: as a useful description of the many facets of the historic overleveraging of the U.S. housing market, and the rapid bursting of the housing bubble.