Barry Ritholtz emails to say that he disagrees with Paul Krugman's about the importance of lack of regulation in the subprime market in explaining the crisis:
Bubbles & Banks & Zero Lending Standard Loans, by Barry Ritholtz: Paul Krugman has an interesting OpEd in today’s NYT, one that I mostly agree with.
However, I take exception to his perspective on a few issues, one of which might ultimately prove to be crucial to understanding the crisis and putting the correct financial reform measures in place. ... The ... disagreement is over the impact of sub-prime loans on the entire US Housing market, and whether lending standards can be adequately enforced. Had then Fed Chairman Alan Greenspan done his job properly, and prevented Zero Lending Standard loans from infecting the real estate market, we would have been looking at a very different housing situation — to the upside as well as to the down side.
Let’s look at the impact Sub-Prime had, then see what could have been done about it.
First, we need to consider that markets typically are in balance — there are a roughly equal number of buyers and sellers. ... What happens when you drop mortgage rates significantly? Monthly carrying costs become lower, and this attracts more marginal buyers (demand) — at least until prices rise to the point where the balance between buyers and sellers stabilizes prices once more.
Without the explosion of subprime, but with ultra low rates, we very likely would have seen a rise in housing prices, followed by a plateau. But it would not have been nearly as severe relative to historic price relationships (as an example, median income to median home price).
What the newfangled lend-to-securitize subprime model did, however, was to bring millions of previous non-buyers — people otherwise known as renters — into the housing market. On top of the rise in prices caused by 1% Fed Funds rates (~6% mortgages), this added an additional level of pricing destabilization to the Real Estate market.
This is evident in the charts I’ve shown again and again: Median income to median home price; cost of renting to ownership; Housing stock as a percentage of GDP — all of these showed a housing market several standard deviations above its historic pricing mean.
With that in your mind, consider how this sub-prime driven boom played into the securitization market, and eventually the Derivatives market (CDOs, CDSs, etc). Look at the 10 steps detailed here on Monday regarding the forming of the credit crisis.
The inevitable conclusion is that sub-prime was a major driver of not only the Housing boom and bust, but of the entire financial crisis and credit freeze, and the subsequent bailouts . . .
Could it have been prevented? Only if the Fed would have enforced traditional lending standards, i.e., the borrowers ability to service the mortgage. They should have regulated those non-bank lenders whose model was based not upon the borrowers ability to service these loans, but upon the lender’s ability to subsequently sell the loan off top securetizers on Wall Street.
So, the answer is yes, appropriate regulation could have prevented the entire mess . . .
But the loan originators would not have made the subprime loans without the confidence that the securitizers would take them off their hands. So even if regulation failed as a first line of defense, and it did, I still think you have to ask (and understand) why securitizers were so willing to take this paper from the loan originators. What went wrong in their assessment of the risks of buying the securitized loans? Here, failures of the ratings agencies and the mathematical models or risk assessment both played a role, as did the feeling that this time was different so prices would continue to rise. Confidence among some investors that even if there was a bubble, once things turned downward they could get out of the market before realizing big losses was also a factor.
The point is that there wasn't just one failure at work, there were multiple lines of defense, any one of which could have prevented the bubble or made its consequences much less severe, that broke down. As I've said before, when I look at these markets, I see regulatory failures, market failures, and other problems creating bad incentives at just about every stage in the process. Home buyers, real estate agents, appraisers, mortgage brokers, securitizers, ratings agencies, compensation packages of executives, lack of transparency, and so on and so on all broke down and allowed the housing/credit bubble to inflate. If any one of these groups had held the line and not gone along with everyone else, e.g. if appraisers had not reported bubble prices, if ratings agencies had priced risk correctly, etc., then the bubble either doesn't happen at all, or does much less damage when it pops.
The problems in these markets were systemic. Maybe we can target one area, e.g. the regulation of subprime loans, and insulate the system going forward. But my view is that broad based failures require broad based solutions. That's why rather than trying to fix each problem individually, I've advocated solutions such as limiting leverage ratios that will insulate the system from large breakdowns in the event that another bubble occurs. Yes, we should try to fix all the individual problems that we can, including regulatory failures at each stage of the home loan process. But we shouldn't rest after that since that may not be enough to prevent bubbles in the future. We also need to do the things necessary to make the system much less vulnerable to a crash when the next one occurs (and it will).