Economic Policy & Analysis

Week Three – Case Study:

Mortgage Market Meltdown

1. Does the logic of group behavior give us any insight into how lenders and borrowers may have behaved in the run-up of real estate values in the U.S.? What role has the secondary market (where the initiators of mortgages quickly sell them to other investors rather than holding them for the long term) played in potentially fueling "irrational" increases in real estate values and inevitable "adjustments" downward?

Lenders and borrowers behavior can be explained to some extent by the rational behavior exhibited by large groups. Lenders were being very lenient in who they lent to (Sloan 2007). They all have standards but they became more relaxed so that they could benefit from the astronomically rising home prices. There were large numbers of mortgage companies who looked around at others in the mortgage community and saw that each one was willing to exploit the market and take higher risk (lower credit scores) but gain more business (more mortgages). Even though for the mortgage industry, it was in their common (long term) interest to have good mortgages, there was little accountability. McKenzie and Lee (2006) state: “a [firm] may reason that although he agrees with the...common interest, his contribution will have no detectable effect in achieving it.” In short, the bystander effect will allow each individual to participate in the profits to be gained, but not stand up for the long term success of the mortgage industry because his individual effort will not noticeably help. The firm may see how his efforts can help, but there is not enough personal incentive to make it worth loosing the profits to be made in the short term.

Borrowers have a similar problem, using their home as an ATM (Coy 2008). It became the mindset of many home owners that the value of their home would always increase. So borrowing money against their homes was nearly free. Many people were caught in this trap and continued to borrow until recently when their homes started to decrease in value leaving them owing more on their homes than they are worth.

The secondary market has fueled the pricing inflation by creating a market for existing mortgages. If a mortgage turned out to be more risky than the originators had initially thought, there was a different market where they could sell them. Higher risk mortgages will have a lower value in the secondary market but there are firms willing to accept that risk in hopes of a higher payoff. Originators will lose less money by selling high risk mortgages to these entrepreneurs who are less risk averse than if the mortgage went into default. Effectively, the secondary markets reduce the risk for mortgage originators and creates money making opportunities for the third tier businesses.

2. Does government action to "bail out" borrowers or lenders who have been hurt by the adjustment in real estate and mortgage values have economic consequences for the future? Discuss the possible effects on incentives and prices when government offers implicit guarantees regarding private contracts.

Realistically, the question should be, what are the future consequences of the government bailout for lenders. Slone (2007) states that:

It's the "too big to fail" syndrome. In a world in which big players make incredibly large and complex deals with one another-that's what derivatives are-regulators don't dare let a big or important institution fail for fear that the collapse of one would lead to "cascading failures," and other institutions wouldn't be able to collect what the collapsed institution owed them.

To summarize, if nothing is done then the national (if not world) financial system may collapse without the bailout. Realistically, it is in essence removing the accountability of firms to be efficient in their business. It allows them to take more and more risk at the expense of the taxpayers and small businesses.

The incentive is for lenders to take more risk at the possibility of making more money. This added incentive increases the perceived benefit and allows more cost to be overcome in the cost-benefit analysis. This incentive is effectively the removal of risk for both lenders and borrowers.

Other policy actions that the government engages in (including one this week of increasing the lending caps of government/private entities) may be helpful to overcome short term problems of borrowers. There are always costs associated with bail-outs. For borrowers the policy changes may stabilize the market quicker, but it will artificially increase the demand for housing and allow prices to be artificially high. The best scenario would be to hold the market prices steady until they return to the long term trend line (Coy 2008).

3. What are the advantages and risks of large firms such as "Fannie Mae" and "Freddie Mac" (you may have to look these up to fully understand what they do) having a large role in the mortgage market? Does having lots of government involvement in the rules and regulations of mortgage lending have beneficial or harmful effects?

These types of companies, from what I understand, act as a middleman for lenders and Wall Street, they are part of the secondary markets (Freddy Mac). They provide a distinct advantage of improving liquidity of the mortgage market. They increase the supply of cash that can be lent to borrowers. Buy increasing supply of cash, they lower the cost of borrowing (McKenzie & Lee, p60). This enables more people to afford the cost of purchasing (or renting) a home.

One risk that is coming to the forefront of every market analyst is that the secondary market is now weakening because of poor understanding of actual risk of the securities that were purchased in the secondary market by Wall Street. The secondary markets are not performing well and that has in turn, made borrowing more costly. This additional cost reduces demand (McKenzie & Lee, p55) and drops the market price of housing. This is precisely what we are seeing today.

Government involvement helps reduce the effects of the large markets being inefficient and destroying all other markets. The government's responsibility is to “protect the financial system” (Sloan 2007). That does not mean that it should step into markets to protect individuals or firms. The competitive market deals with individuals and firms ruthlessly when mistakes are made, that is what makes them efficient. But when large markets (real estate for example) are failing because of lack of controls, the government has a responsibility to it's taxpayers and citizens to stabilize with as little negative impact as possible.

Coy, Peter (2008). Housing Meltdown: Why home prices could drop 25% more on average before the market finally hits bottom. Business Week. January 31, 2008. cover story.

Freddy Mac. Corporate Profile: Our role in the secondary market. Retrieved March 7, 2008 from: http://www.freddiemac.com/corporate/company_profile/our_role_secmkt/index.html

McKenzie and Lee (2006). Microeconomics for MBA's: the economic way of thinking for managers. New York: Cambridge University Press.

Sloan, Allan (2007). The Escape of the Enablers. Fortune 156, (5).