The housing bubble: who knew what when?


There’s a really interesting post by James Hamilton at Econbrowser that explores a central question of the housing bust: did those who were primarily responsible for making bad loans realize that they were making bad loans?

In other words, did they have so many incentives to make bad loans that they made them anyway? Or were those who made, secured, packaged, and bought and sold the bad loans as clueless as the rest of society?

Those two views are touched upon in Hamilton’s Understanding the housing bubble:

One interpretation emphasizes misaligned incentives. Money managers earned bonuses while others were left holding the bag. Institutions like Fannie, Freddie, and AIG profited handsomely during the run-up, but the government picked up the tab when things went bad. These kinds of explanations come very naturally to most economists, whose models are usually built on the assumption that economic decision-makers are responding in a rational way to the incentives they face.

But an alternative view is that the key players were simply mistaken as a group, lulled into a misunderstanding of what was going on through social and institutional feedback that sustained a misguided groupthink. This view is hard for many economists to embrace, though there is a good case to be made that this is an important part of the story of what we just went through.

Hamilton cites a new paper that looks at the investments and purchases of “securitization investors and issuers” to determine whether they made moves with a clear knowledge of actual conditions. From that paper:

In particular, it is difficult to rationalize why securitization agents endowed with income risk tied to housing would purchase additional second homes and swap into larger homes in 2005 if they simultaneously anticipated an imminent broad-based collapse in housing markets. We also find little evidence that securitization agents were conservative in the value-to-income ratios of their purchases, and that homes purchased in 2004-2006 were among those most aggressively sold in 2007-2009, relative to both control groups. This suggests that securitization agents overestimated the persistence of their incomes and that any consumption stream in these houses was short-lived.

In other words, they find that the agents were as oblivious of the housing bubble as the buyers they loaned to.

There are obviously other questions worth asking about this, some of which are raised in the comments. It’s a provocative post.