A recently published Atlanta Fed working paper by economists Christopher Foote, Kristopher Gerardi, and Paul Willen addresses a central question in the foreclosure crisis: why did so many borrowers and investors make bad decisions?
The authors present two opposing narratives in response to that question. The first, which they term the "inside job," reflects conventional wisdom about the crisis—that well-informed market insiders took advantage of relatively uninformed outsiders. The paper goes on to describe 12 surprising facts that the authors say refute this popular story. Listed below are a few of those facts:
The crisis was not so much a story of misaligned incentives, the authors note. Instead, it was a crisis borne of overly optimistic expectations about the future path of house prices. According to this second narrative, which they call the "bubble theory," distorted beliefs about house prices "rationalize the decisions of borrowers, investors, and intermediaries," helping to explain why borrowers took on mortgages they couldn't afford, why investors funded those loans, and why lenders failed to verify income or assets before making the loans.
These two explanations—the inside job and the bubble theory—call for very different policy approaches in the postcrisis environment, they write. The former would require regulation aimed at correcting improper incentives. But if the crisis were indeed caused by overly optimistic expectations for house prices, these regulations would not work. According to the authors, asset bubbles are like earthquakes—they can't be predicted or prevented. However, just as building codes help mitigate the damage caused by an earthquake, policymakers can help make the financial system more robust to adverse shocks, they conclude.
To learn more, access the full text of the paper here.