Real Estate Research provides analysis of topical research and current issues in the fields of housing and real estate economics. Authors for the blog include the Atlanta Fed's Kristopher Gerardi, Carl Hudson, and analysts, as well as the Boston Fed's Christopher Foote and Paul Willen.

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April 20, 2015

Income Growth, Credit Growth, and Lending Standards: Revisiting the Evidence

Almost a decade has passed since the peak of the housing boom, and a handful of economics papers have emerged as fundamental influences on the way that economists think about the boom—and the ensuing bust. One example is a paper by Atif Mian and Amir Sufi that appeared in the Quarterly Journal of Economics in 2009 (MS2009 hereafter). A key part of this paper is an analysis of income growth and mortgage-credit growth in individual U.S. ZIP codes. The authors find that from 2002 to 2005, ZIP codes with relatively low growth in incomes experienced high growth in mortgage credit; that is, income growth and credit growth were negatively correlated during this period.

Economists often cite this negative correlation as evidence of improper lending practices during the housing boom. The thinking is that prudent lenders would have generated a positive correlation between area-level growth in income and mortgage credit, because borrowers in ZIP codes with high income growth would be in the best position to repay their loans. A negative correlation suggests that lenders instead channeled credit to borrowers who couldn't repay.

Some of the MS2009 results are now being reexamined in a new paper by Manuel Adelino, Antoinette Schoar, and Felipe Severino (A2S hereafter). The A2S paper argues that the statistical evidence in MS2009 is not robust and that using borrower-level data, rather than data aggregated up to the ZIP-code level, is the best way to investigate lending patterns. The A2S paper has already received a lot of attention, which has centered primarily on the quality of the alternative individual-level data that A2S sometimes employ.1 To understand the relevant issues in this debate, it's helpful to go back to MS2009's original statistical work that uses data aggregated to the ZIP-code level to get a sense of what it does and doesn't show.

Chart 1: Measures of the Relationship between within-County Income Growth and Credit Growth for U.S. ZIP Codes

Chart 1 summarizes the central MS2009 result. We generated this chart from information we found in either MS2009 or its supplementary online appendix. The dark blue bars depict the coefficients from separate regressions of ZIP-code level growth in new purchase mortgages on growth in ZIP-code level incomes.2 (These regressions also include county fixed effects, which we discuss further below.) Each regression corresponds to a different sample period. The first regression projects ZIP-level changes in credit between 1991 and 1998 on ZIP-level changes in income between these two years. The second uses growth between 1998 and 2001, and so on.3 During the three earliest periods, ZIP-level income growth enters positively in the regressions, but in 2002–04 and 2004–05, the coefficients become negative. A key claim of MS2009 is that this flip signals an important and unwelcome change in the behavior of lenders. Moreover, the abstract points out that the negative coefficients are anomalous: "2002 to 2005 is the only period in the past eighteen years in which income and mortgage credit growth are negatively correlated."

Chart 2: Serious Delinquency Rates by Loan Vintage

There are, however, at least three reasons to doubt that the MS2009 coefficients tell us anything about lending standards. First of all, the coefficients for the 2005–06 and 2006–07 regressions are positive—for the latter period, strongly so. By MS2009's logic, these positive coefficients indicate that lending standards improved after 2005, but in fact loans made in 2006 and 2007 were among the worst-performing loans in modern U.S. history. Chart 2 depicts the share of active loans that are 90-plus days delinquent or in foreclosure as a share of currently active loans, using data from Black Knight Financial Services. To be sure, loans made in 2005 did not perform well during the housing crisis, but the performance of loans made in 2006 and 2007 was even worse.4 This poor performance is not consistent with the improvement in lending standards implied by MS2009's methodology.

A second reason that sign changes among the MS2009 coefficients may not be informative is that these coefficients are not really comparable. The 1991–98 regression is based on growth in income and credit across seven years, while later regressions are based on growth over shorter intervals. This difference in time horizon matters, because area-level income and credit no doubt fluctuate from year to year while they also trend over longer periods. A "high-frequency" correlation calculated from year-to-year growth rates may therefore turn out to be very different from a "low-frequency" correlation calculated by comparing growth rates across more-distant years. One thing we can't do is think of a low-frequency correlation as an "average" of high-frequency correlations. Note that MS2009 also run a regression with growth rates calculated over the entire 2002–05 period, obtaining a coefficient of -0.662. This estimate, not pictured in our graph, is much larger in absolute value than either of the coefficients generated in the subperiods 2002–04 and 2004–05, which are pictured.

A third and perhaps more fundamental problem with the MS2009 exercise is that the authors do not report correlations between income growth and credit growth but rather regression coefficients.5 And while a correlation coefficient of 0.5 indicates that income growth and credit growth move closely together, a regression coefficient of the same magnitude could be generated with much less comovement. MS2009 supply the data needed to convert their regression coefficients into correlation coefficients, and we depict those correlations as green bars in chart 1.6 Most of the correlations are near 0.1 in absolute value or smaller. To calculate how much comovement these correlations imply, recall that the R-squared of a regression of one variable on another is equal to the square of their correlation coefficient. A correlation coefficient of 0.1 therefore indicates that a regression of credit growth deviated from county-level means on similarly transformed income growth would have an R-squared in the neighborhood of 1 percent. The reported R-squareds from the MS2009 regressions are much larger, but that is because the authors ran their regressions without demeaning the data first, letting the county fixed effects do the demeaning automatically. While this is standard practice, this specification forces the reported R-squared to encompass the explanatory power of the fixed effects. The correlation coefficients that we have calculated indicate that the explanatory power of within-county income growth for within-county credit growth is extremely low.7 Consequently, changes in the sign of this correlation are not very informative.

How do these arguments relate to A2S's paper? Part of that paper provides further evidence that the negative coefficients in the MS2009 regressions do not tell us much about lending standards. For example, A2S extend a point acknowledged in MS2009: expanding the sample of ZIP codes used for the regressions weakens the evidence of a negative correlation. The baseline income-credit regressions in MS2009 use less than 10 percent of the ZIP codes in the United States (approximately 3,000 out of more than 40,000 total U.S. ZIP codes). Omitted from the main sample are ZIP codes that do not have price-index data or that lack credit-bureau data.8 MS2009 acknowledge that if one relaxes the restriction related to house-price data, the negative correlations weaken. Our chart 1 conveys this information with the correlation coefficients depicted in red, which are even closer to zero. A2S go farther to show that if the data set also includes ZIP codes that lack credit-bureau data, the negative correlation and regression coefficients become positive.

But perhaps a deeper contribution of A2S is to remind the researchers that outstanding questions about the housing boom should be attacked with individual-level data. No one doubts that credit expanded during the boom, especially to subprime borrowers. But how much of the aggregate increase in credit went to subprime borrowers, and how did factors like income, credit scores, and expected house-price appreciation affect both borrowing and lending decisions? Even under the best of circumstances, it is hard to study these questions with aggregate data, as MS2009 did. People who take out new-purchase mortgages typically move across ZIP-code boundaries. Their incomes and credit scores may be different than those of the people who lived in their new neighborhoods one, two, or seven years before. A2S therefore argue for the use of HMDA individual-level income data so that credit allocation can be studied at the individual level. This use has been criticized by Mian and Sufi, who believe that fraud undermines the quality of the individual-level income data that appear in HMDA records. We should take these criticisms seriously. But the debate over whether lending standards are best studied with aggregate or individual-level data should take place with the understanding that aggregate data on incomes and credit may not be as informative as previously believed.

1 Mian and Sufi's contribution to the data-quality debate can be found here.

2 Data on new-purchase mortgage originations come from records generated by the Home Mortgage Disclosure Act (HMDA). Average income at the ZIP-code level is tabulated in the selected years by the Internal Revenue Service.

3 Growth rates used in the regressions are annualized. The uneven lengths of the sample periods are necessitated by the sporadic availability of the IRS income data, especially early on. The 1991 data are no longer available because IRS officials have concerns about their quality.

4 Chart 2 includes data for both prime and subprime loans. The representativeness of the Black Knight/LPS data improves markedly in 2005, so LPS loans originated before that year may not be representative of the universe of mortgages made at the same time. For other evidence specific to the performance of subprime loans made in 2006 and 2007, see Figure 2 of Christopher Mayer, Karen Pence, and Shane M. Sherlund, "The Rise in Mortgage Defaults," Journal of Economic Perspectives (2009), and Figure 1 of Yuliya Demyanyk and Otto Van Hemert, "Understanding the Subprime Mortgage Crisis," Review of Financial Studies (2009). For data on the performance of GSE loans made in 2006 and 2007, see Figure 8 of W. Scott Frame, Kristopher Gerardi, and Paul S. Willen, "The Failure of Supervisory Stress Testing: Fannie Mae, Freddie Mac, and OFHEO," Atlanta Fed Working Paper (2015).

5 MS2009 often refer to their regression coefficients as "correlations" in the text as well as in the relevant tables and figures, but these statistics are indeed regression coefficients. Note that in the fourth table of the supplemental online appendix, one of the "correlations" exceeds 1, which is impossible for an actual correlation coefficient.

6 Because a regression coefficient from a univariate regression is Cov(X,Y)/Var(X), multiplying this coefficient times StdDev(X)/StdDev(Y) gives Cov(X,Y)/StdDev(X)*StdDev(Y), which is the correlation coefficient. Here, the Y variable is ZIP-code–level credit growth, demeaned from county-level averages, while X is similarly demeaned income growth. As measures of the standard deviations, we use the within-county standard deviations displayed in Table I of MS2009. Specifically, we use the within-county standard deviation of "mortgage origination for home purchase annual growth" calculated over the 1996–02 and 2002–05 periods (0.067 and 0.15, respectively) and the within-county standard deviation of "income annualized growth" over the 1991–98, 1998–2002, 2002–05, and 2005–06 periods (0.022, 0.017, 0.031, and 0.04, respectively). Unfortunately, the time periods over which the standard deviations were calculated do not line up exactly with the time periods over which the regression coefficients were calculated, so our conversion to correlation coefficients is an approximation.

7 It is true that the regression coefficients in the MS2009 coefficients often have large t-statistics, so one may argue that ZIP-level income growth has sometimes been a statistically significant determinant of ZIP-level credit growth. But the low correlation coefficients indicate that income growth has never been economically significant determinant of credit allocation within counties. It is therefore hard to know what is driving the income-credit correlation featured in MS2009, or what may be causing its sign to fluctuate.

8 Though house prices and credit bureau data are not required to calculate a correlation between income growth and mortgage-credit growth, the authors use house prices and credit bureau data in other parts of their paper.

April 25, 2014

Two Views of the Involvement of Credit Rating Agencies in the Mortgage Crisis

A lot of people have blamed credit rating agencies (CRAs) for helping to cause the mortgage crisis. The report of the Financial Crisis Inquiry Commission (FCIC) labelled CRAs as "key enablers of the crisis," because the exploding mortgage-backed bonds that caused so much trouble could not have been sold without stamps of approval from the CRAs. Commentators often link CRA failings to the fact that they are paid by the issuers of the securities they rate, with the implication that CRAs are thus given incentive to award good ratings to securities that do not deserve them. Indeed, two recent articles by academic economists on this topic come to the same conclusion: financial markets would work better if we scrapped the issuer-pays model in favor of some other way to pay CRAs for their evaluations. But the two articles disagree on why this is so, and understanding the source of this disagreement sheds some harsh light on claims that CRAs should be even partly blamed for the financial crisis in the first place.

Grade inflation in the student-pays model
The first article is a Wall Street Journal op-ed piece by Princeton economist Alan Blinder. Blinder likens the awarding of credit ratings to mortgage-backed securities to his own awarding of letter grades to his Princeton students. "Suppose I proposed to grade my students by a 'student pays' model," Blinder suggests. Such a setup would encourage him to give easy As in hopes of attracting more students and higher pay, and the information in the grades would suffer as a result. "Yet that description comes pretty close to mimicking the way we pay rating agencies," Blinder writes. "Looking back, is it any wonder that so many securities were blessed with undeserved triple-A ratings?"

One interpretation of Blinder's analogy is that college grading works better than securities rating because universities have not adopted the student-pays model. That argument will seem curious to many college instructors, because this model approximates their own compensation arrangements pretty well. Students may not write checks to professors, but they (or their parents) write checks to colleges, who then pay the professors. Instructors whose grades are overly harsh in relation to other courses are likely to see their class sizes dwindle, to the dismay of department chairs facing hard budget constraints. Even if an instructor has no problem attracting students, she may not want grading disparities among courses to distort student decisions on what to study, so she might ease up in her own grading as well. Given the incentives of professors, it is not surprising that grade inflation is debated at many universities, even the very best ones. A December 2013 article in Harvard University's student newspaper, the Crimson, described a faculty meeting at which a professor bemoaned the fact that the most frequently awarded grade at Harvard College is an A-minus. A university dean corrected him: "The median grade in Harvard College is indeed an A-minus," the dean is quoted as saying. "The most frequently awarded grade in Harvard College is actually a straight A." (Disclosure: Harvard's grading policy is of personal interest to two authors of this blog post, who teach intermediate macroeconomics courses there in their spare time.)

Rational employers, rational investors
If the student-pays model leads to grade inflation, then don't we have even more ammunition that the bad incentives inherent in the investor-pays model for CRAs is partly responsible for the mortgage crisis? Not necessarily. For bad CRA incentives to have caused the crisis, two things must be true: one, the incentives must have caused inflated ratings, and two, the investors had to believe the inflated ratings. The second step in this causal chain is open to question. If the investors knew that the issuer-pays model gave incent to the rating agencies to inflate ratings, then rational investors would have taken that information into account when making investment decisions.

The college-grading analogy is again useful here. Consider an employer who is thinking about hiring a recent graduate who received a B-minus in a course that is highly relevant to what the firm does. How should the employer use this information? One option would be for the employer to look up how the student's official university documents define a B-minus—the documents are likely to define a grade in the B range as indicating a better-than-average understanding of the material. But a rational employer who knows the incentives facing American professors would also know that instructors are given cause to inflate grades. The firm could thus surmise that an applicant on the border between a B and a C may actually have a lower-than-average mastery of the subject. In the same way, rational mortgage investors who knew that CRAs had incentive to inflate ratings would have taken those ratings with a grain of salt when evaluating mortgage-backed investments.

Investor rationality plays a prominent role in a second recent piece on CRA incentives, a formal paper by the economists Anil Kashyap and Natalia Kovrijnykh (KK). Because this article is part of the academic economics literature, the authors adopt the fundamental assumption that all actors in the model are rational. As we might expect from our analogy of the job applicant, the rationality assumption makes a big difference when analyzing CRA payment regimes. Consider a situation in which CRAs are paid by the issues of securities, as they are today. Further assume that CRAs receive more money for good ratings than for bad ones. Rational investors in the KK model would realize the ratings are likely to be inflated under this set of incentives and would deflate the ratings accordingly. But if the CRAs are unable to fool investors who know both the CRAs' preferences and their opportunities, then the CRAs might as well tell the truth. KK therefore constrain their attention to equilibria where rating agencies are always truthful.

The revelation principle
In assuming truth-telling, KK are following a long tradition in the modeling of imperfect information. In fact, the assumption that actors with private information tell the truth shows up so often in models of imperfect information that it has a special name: the revelation principle. This principle is useful for modelers because it allows them to focus on equilibria in which the agent with private information has no reason to lie. To be clear, in this situation, the revelation principle does not mean that rating agencies never lie. Rather, it states that any equilibrium in which rating agencies lie is equivalent to one in which they tell the truth. The lying doesn't affect the actions of investors who know the incentives and opportunities of the CRAs, just as inflation of our B-minus student's grade does not lead the employer into an inappropriate hire. Because lying does not encourage agents to take inappropriate actions, it can safely be ignored when thinking through the fundamental aspects of the problem.

The appropriateness of the revelation principle in this context hinges on the ability of mortgage investors to analyze CRA incentives and opportunities and thereby back out the truth. Is this realistic? Ironically, the critics of CRAs provide evidence in support of this view. When Barney Frank alleged that CRA incentives led them to inflate ratings, he was doing exactly the sort of reverse engineering that lies behind the revelation principle. And if legislators could figure out that rating agencies had distorted incentives, why couldn't investors, who were putting up their own money? Indeed, investors should have had much better information about agency incentives than Barney Frank. It turns out that financial intermediaries lost enormous sums on the mortgage-related securities that they purchased and held on their balance sheets (more details on this in the next post). At the same time, they were also large issuers of these securities. Who would know better about the potential for corruption of rating agencies than the financial intermediaries that supposedly corrupted them?

Of course, if the KK model holds that rating agencies always tell the truth, then the model cannot rationalize arguments that CRAs helped cause the crisis by misleading investors. Indeed, the revelation principle makes it hard to rescue any story about untruthful CRAs. What if credit rating agencies had private information about their incentives, in addition to private information about their effort and the quality of the securities that they rated? Setting aside the fact that the issuer-pays model of credit ratings was common knowledge in the market, this change to the model has no effect on its outcome. Here again, the revelation principle would imply that CRAs truthfully reveal the private information about their incentives. For investors to be misled, they cannot simply be confused about incentives. Rather, they must believe that the CRAs' incentives were better aligned than they actually were. In our view, that is unlikely.

CRA payment arrangements
We began this post by noting that both of the recent articles on CRA incentives argued against the issuer-pays model. How can KK make this argument if investors in their model are not fooled? The reason involves some subtle implications of exactly how CRAs are paid in different states of the world. In all contracts in KK's issuer-pays regime, CRA pay is contingent on the outcome of the security. That means that if an AAA-rated security defaults, the CRA gets paid less than if the security pays off. To induce effort by the CRA, the spread between the payoffs must be large (that is, the CRA must be paid a lot more when the AAA security is successful compared to when it defaults). Because of limited liability, the CRA's compensation is bounded below by zero when a bond defaults—that is, investors can't demand payment from the CRAs in the default state—so high-powered incentives, which require high average pay, imply that compensation to the CRA in the good state has to be very high. As a result, paying the CRA for high effort can be prohibitively expensive for the issuer, causing the issuer to settle for low-powered incentives instead and thus receiving low effort from the CRA. Even in the low-effort equilibrium, however, CRAs increase the information set of investors and are socially useful.

Going farther, KK show that having the investor rather than the issuer pay the CRA solves the limited-liability problem and thereby raises social welfare. Particularly surprising about this finding is that the investor-pays model is not only good for society, but it is also good for the CRAs! The reason once again involves the revelation principle. In equilibrium, everyone knows both the amount and usefulness of the effort expended by the CRAs in evaluating securities. The larger the CRA's social benefit, the more the CRA gets paid. If KK's model is accurate, then CRAs themselves may lead the way to a better social outcome by encouraging the adoption of the investor-pays model.

While KK's paper includes many specific lessons about potential CRA payment arrangements, the bottom line to emerge from a comparison of the Blinder op-ed and the KK model involves their differing assumptions regarding investor rationality. The KK model illustrates how the revelation principle, which follows from investor rationality, works against the argument that CRAs helped cause the crisis by misleading investors. As long as investors understand the basic structure of the market, then standard models of asymmetric information—of which the KK model is an example— do not predict that investors will experience large and unexpected losses.

You can read the Harvard Crimson article on the magazine's website.

Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston,


Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, and


Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston

February 19, 2014

Asymmetric Information and the Financial Crisis

In describing the $13 billion settlement reached between JPMorgan and the Department of Justice last November, Attorney General Eric Holder said,

Without a doubt, the conduct uncovered in this investigation helped sow the seeds of the mortgage meltdown. JPMorgan was not the only financial institution during this period to knowingly bundle toxic loans and sell them to unsuspecting investors, but that is no excuse for the firm's behavior.

What Holder describes sounds like a textbook example of what economists call asymmetric information: JPMorgan knew something about the loans it was selling (that they were toxic) that they didn't reveal to investors. Specifically, the government alleged that JPMorgan reported facts to the investors that turned out to be wrong. For example, JPMorgan may have said that it made only 10 percent of the loans in a pool to investors (as opposed to owner-occupants) when the actual percentage was 20 percent. So it would seem as if economic theory, which has a lot to say about asymmetric information, should help us understand the crisis. Indeed, to many, asymmetric information and "bad incentives" are the leading explanations of the financial crisis. For example, a Reuters article that described the settlement made the following claim:

The behavior that the largest U.S. bank admitted to, authorities said, is at the heart of what inflated the housing bubble: lenders making bad mortgages and selling them to investors who thought they were relatively safe. When the loans started turning bad, investors lost faith in the banking system, and a housing crisis turned into a financial crisis.

In future posts, we will consider this seemingly intuitive idea, and argue that the economic theory of asymmetric information, in fact, provides very little aid in understanding the central questions of the crisis.

Let's focus on Holder's quote. The standard theory of asymmetric information implies that JPMorgan's misrepresentations could not cause significant losses to investors. That may seem surprising. Many may think that either we don't understand the economics of asymmetric information or it's just another example of the naïveté of economists regarding how the real world actually works. While there is certainly no shortage of examples of economists holding naïve opinions about the real world, in this case, we will argue that we are correctly characterizing the economist's view and that it is based on a common-sense argument.

Let's start with the economics. Let's assume that JPMorgan is selling a pool of loans, about which it knows the true quality, to a group of buyers who can't observe the true quality. What does economic theory say will happen?

A. Investors will overpay for the assets and lose money.
B. Investors will underpay for the assets and make money.
C. Investors will infer the true quality of the loans and pay accordingly.

The answer is C. To many, that may sound shocking, but the basic logic is simple: investors know that they cannot observe the true quality of the loans and they know that JPMorgan has an incentive to dump bad loans in the pool. Thus, they correctly infer that JPMorgan will dump bad loans in the pool. In other words, investors form correct beliefs about the quality of a loan,1 despite not being able to observe quality directly.2

"Knowingly bundl[ing] toxic loans" may be unethical or even illegal, but according to the economic theory of asymmetric information, it shouldn't cause unexpected financial losses to investors. The key to understanding the gap between Holder and economics is the word "unsuspecting." Economists assume that all market participants are inherently suspicious. Market participants understand that the people with whom they are doing business have an incentive to cheat them if those people know more about the products that they are selling.

Are economists naïve to think that market participants can figure out the incentives of their adversaries? We would argue that common sense says people are pretty suspicious. Take, for example, real estate agents. A cursory search on the internet yields the following table of "translations" of real estate listings:

Loaded with Potential: means loaded with problems the seller didn't want to tackle.
Cute: means they couldn't think of any other possible way to describe it.
Great Bones: means you're going to have to gut it and rebuild.
Wooded/Shaded Lot: means surrounded by trees and leaves on the ground.
Charming: means they couldn't think of a more appropriate word.
Needs a Little TLC: means it needs about $45,000 dollars or more in renovations and repairs.
Won't Last Long at This Price: means the price is so low it will compel you to see it but it will take a miracle for you to want to buy it.
No Disclosures: means you're going to have to find out all the problems with the home on your own.

Most people read this and chuckle, but no one is surprised that real estate agents stretch the truth. After all, it's their job to convince you to buy. And, in general, people view salespeople as among the least ethical of all occupations, only slightly above members of Congress. Perhaps the most egregious example of this, and in fact the example that motivated the seminal paper on the economics of asymmetric information, is used-car salespeople. Do used-car salespeople try to misrepresent the quality of the cars that they are trying to sell? Most people would likely answer this question with a resounding "Yes, of course." Does this cause injury to most used-car buyers? Not so much. Since the general public recognizes that "used-car salesman" is basically American slang for a fraudster, nobody really believes what they say.

In subsequent posts, we will answer questions about the crisis that turn on asymmetric information problems:

  1. Theory says investors should have guessed the quality of the loans. Did they?
  2. If investors knew the quality of the loans they were buying, why did JPMorgan pay $13 billion to settle accusations that it misrepresented the quality of the loans it was selling?
  3. Can't policymakers fix some of these incentive problems? Doesn't forcing issuers such as JPMorgan to retain a portion of the securities they issue align incentives and mitigate the asymmetric information problem?
  4. If asymmetric information didn't cause investor losses, does that mean it doesn't affect economic outcomes? (Spoiler: The answer is an emphatic no.)
  5. What about rating agencies? Didn't they know that deals were bad but lie to investors and say they were good?

Photo of Paul WillenBy Paul Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston, and


Photo of Kris GerardiKris Gerardi, associate economist and policy adviser at the Federal Reserve Bank of Atlanta.

1 In some situations, investors will hold beliefs that may be wrong on an individual asset-by-asset basis, but that are right on average. For example, they might not know which loans are the most likely to default, but their beliefs about the performance of the pool of loans will be, on average, right.

2 More generally, the revelation principle says that in any equilibrium of an asymmetric information game, we can confine our attention to equilibria in which all private information is fully revealed. For example, in Akerlof's (1970) example of equilibrium in the used car market, the seller knows whether the car is a peach or a lemon but only the lemons trade. Everyone knows which car is good (the one that the dealer doesn't sell), but the buyer doesn't buy it because he knows that the dealer would have an incentive to substitute a bad car.

January 22, 2014

Wall Street and the Housing Bubble

The conventional wisdom on the 2008 financial crisis is that finance industry insiders on Wall Street deceived naïve, uninformed mortgage borrowers into taking out unaffordable mortgages and mortgage-backed security (MBS) investors into purchasing securities backed by bad loans—mortgages and securities that had not been properly vetted and that would eventually default. This theory is on display front and center in the Academy Award-winning documentary Inside Job, and it has motivated new regulations aimed at realigning incentives among Wall Street insiders and their customers. (One such rule is the risk retention requirement in the Dodd-Frank Act, which we will discuss in some detail in a future post.)

We've written in support of an alternative hypothesis for the financial crisis—specifically, that overly optimistic views about house prices, not poorly designed incentives on Wall Street, are the better explanation for the crisis (for an example, see this 2012 paper). This alternative theory holds that investors lost money not because they were deceived by financial market insiders, but because they were instead misled by their own belief that housing-related investments could not lose money because house prices were sure to keep rising.

A new paper makes an important empirical contribution to this debate by inferring the beliefs of Wall Street insiders during the height of the bubble. The paper, titled "Wall Street and the Housing Bubble," performs a clever analysis of personal housing-related transactions (like home purchases) made by individuals who worked in the mortgage securitization business during the peak of the housing boom. The behavior of these mortgage insiders is compared with that of a control group of people who worked for similar institutions in the finance industry but did not have any obvious connection to the mortgage market. What the analysis finds should be an eye-opener for believers in the inside-job explanation of the crisis. There is no evidence that mortgage insiders believed there was a housing bubble in the 2004–06 period. In fact, mortgage insiders were actually more aggressive in increasing their personal exposure to housing at the peak of the boom. The increase in insider exposure contradicts the claim that insiders sold securities backed by loans that they knew would eventually go bad when the housing bubble burst.

The authors construct a random sample from the list of attendees of the 2006 American Securitization Forum, which is a large industry conference featuring employees of most of the major U.S. investment and commercial banks (as well as hedge funds and other boutique firms). The sample is mainly comprised of vice presidents, managing directors, and other nonexecutives in mid-managerial positions whose jobs focused on the structuring and trading of MBS. The authors refer to this group as "securitization agents." As a comparison group, they use a random sample of Wall Street equity analysts who covered firms that were in the S&P 500 in 2006 but did not have a strong connection to the housing market (in other words, the sample includes no homebuilders). These equity analysts worked for similar financial institutions, had similar skill sets, and likely experienced similar income shocks (in the form of bonuses during the boom) but did not have any experience in the securitization business and thus did not have access to any insider information. (As a second control group, the authors use a random sample of lawyers who did not specialize in real estate law.) The names of the securitization agents and the equity analysts are then matched to a database of publicly available information on property transactions. The final data set contains information on the number of housing transactions, the sale price of each transaction, some mortgage characteristics, and income at the time of origination for each individual in the sample spanning the period 2000–10.

Armed with this unique data set, the authors then implement a number of empirical tests to determine whether the securitization agents' beliefs about the likelihood of a housing crash differed from the beliefs of the control groups. The first test considers whether the securitization agents timed the housing market cycle better than the comparison groups by reducing their exposure to the market at the peak of the bubble (2004–06) by either selling their homes outright or downsizing. The second test is slightly weaker in that it simply tests whether the securitization agents were more cautious in their housing transactions by avoiding home purchases at the peak of the bubble to a greater extent than the control groups. The third test looks at whether the average return on housing transactions during the entire sample period was higher for the securitization agents. The final test considers a prediction of the permanent income hypothesis: if securitization agents were armed with superior knowledge of the impending collapse of the housing bubble, then through reductions in their expectations of permanent income, they should have decreased the size of their housing purchases relative to their current incomes by a greater amount than the comparison groups.

The results of these empirical tests show very little evidence to support the inside-job theory of the financial crisis. The authors conclude that there is "little systematic evidence that the average securitization exhibited awareness through their home transactions of problems in overall house markets and anticipated a broad-based crash earlier than others." If anything, the authors are being a little timid in their interpretation as the empirical results clearly show that securitization agents were significantly more aggressive in their housing transactions during the bubble period, which suggests that they held even more optimistic expectations of housing prices dynamics than did the control groups.

This is an important paper because it sheds light on one of the most striking aspects of the financial crisis, which the inside-job theory is unable to reconcile: the financial institutions involved in the creation of the subprime MBS and collateralized debt obligations (CDO)—the true "insiders," if you will—lost enormous amounts of money on those securities. The table clearly supports this observation. The firms that lost the most money from mortgage-related credit losses were the same investment and commercial banks that are being accused of profiting off of naïve investors by selling securities comprised of loans that they knew would eventually go bad. The table shows that these firms lost enormous sums of money, and the paper provides a simple answer to explain why: like the rest of the market, agents working at those firms believed that housing prices would continue to rise so that even the riskiest mortgages would continue to perform well.

Mortgage-Related Losses to Financial Institutions from the Subprime Crisis, as of June 18, 2008

Photo of Kris GerardiKris Gerardi, financial economist and associate policy adviser at the Federal Reserve Bank of Atlanta, with


Photo of Chris FooteChris Foote, senior economist and policy adviser at the Federal Reserve Bank of Boston.