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

In December 2020, content from Real Estate Research became part of Policy Hub. Future articles will be released in Policy Hub: Macroblog.

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November 17, 2011

Taking on the conventional wisdom about fixed rate mortgages

The long-term fixed rate mortgage (FRM) is a central part of the mortgage landscape in America. According to recent data, the FRM accounts for 81 percent of all outstanding mortgages and 85 percent of new originations.1 Why is it so common? The conventional wisdom is that the FRM is a great product created during the Great Depression to bring some stability to the housing market. Homeowners were defaulting in record numbers, the story goes, because their adjustable rate mortgages (ARMs) adjusted upward and caused payment shocks they could not absorb.

In a Senate Committee on Banking, Housing, and Urban Affairs hearing on October 20, some experts presented testimony that followed this conventional wisdom. As John Fenton, president and CEO, Affinity Federal Credit Union, who testified on behalf of the National Association of Federal Credit Unions, laid out in his written testimony:

Prior to the introduction of the 30-year FRM, U.S. homeowners were at the mercy of adjustable interest rates. After making payments on a loan at a fluctuating rate for a certain period, the borrower would be liable for the repayment of the remainder of the loan (balloon payment). Before the innovation of the 30-year FRM, borrowers could also be subject to the "call in" of the loan, meaning the lender could demand an immediate payment of the full remainder. The 30-year FRM was an innovative measure for the banking industry, with lasting significance that enabled mass home ownership through its predictability.

Of course, this picture of the 30-year FRM as bringing stability to the housing market has profound implications for recent history. Many critics attribute the problems in the mortgage market that started in 2007 to the proliferation of ARMs. According to the narrative, lenders, after 70 years of stability and success with FRMs, started experimenting with ARMs again in the 2000s, exposing borrowers to payment shocks that inevitably led to defaults and the housing crisis. Indeed, one of the other panelists at the hearing, Janis Bowdler, senior policy analyst for the National Council of La Raza, argued in her written testimony that "when the toxic mortgages began to reset and brokers and lenders could no longer maintain their refinance schemes, a recession ushered in record-high foreclosure rates."

I argue, on the other hand—both in my testimony at the hearing and in this post—that the narrative of the fixed rate mortgage as an inherently safe product invented during the Depression that would have mitigated the subprime crisis because it

eliminated payment shocks does not fit the facts.

Parsing the myths around the fixed rate mortgage
First, the FRM has been around far longer than most people realize. Most people attribute the FRM's introduction to the Federal Housing Administration (FHA) in the 1930s.2 But it was the building and loan societies (B&Ls), later known as savings and loans, that created them, and they created them a full hundred years earlier. Starting with the very first B&L—the Oxford Provident Building Society in Frankfort, Pennsylvania, in 1831—the FRM accounted for almost every mortgage B&Ls originated. By the time of the Depression, B&Ls were not a niche player in the U.S. housing market. They were, rather, the largest single source of funding for residential mortgages, and the FRM was central to their business model.

As Table 2 of my testimony shows, B&Ls made about 40 percent of new residential mortgage originations in 1929 and 95 percent of those loans were long-term, fixed-rate, fully amortized mortgages. Importantly, B&Ls suffered mightily during the Depression, so the facts simply do not support the idea that the widespread use of FRMs would have prevented the housing crisis of the 1930s.

Source: Grebler, Blank and Winnick (1956)
Note: Market percentage is dollar-weighted. Building and loan societies were the main source of funds for residential mortgages and almost exclusively used long-term, fixed-rate, fully amortizing instruments.

To be sure, at 15–20 years, the terms on the FRMs the FHA insured were somewhat longer than those of pre-Depression FRMs, which typically had 10–15 year maturities.3 The 30-year FRM did not emerge into widespread use until later. It must be stressed that none of the arguments that Fenton made hinge on the length of the contract. Furthermore, the argument that Bowdler made in her testimony—that by delaying amortization, a 30-year maturity lowers the monthly payment as compared to a loan with shorter maturity—applies as much to ARMs as it does to FRMs.

But even though the ARMs may not have caused the Depression, FRM supporters might ask, didn't the payment shocks from the exotic ARMs cause the most recent crisis? Again, the data say no. Table 1 of my Senate testimony shows that payment shocks actually played little role in the crisis.

Source: Lender Processing Services and author's calculations.
Note: Sample is all first-lien mortgages originated after 2005 on which lenders initiated foreclosure proceedings from 2007 to 2010.

Of the large sample of borrowers who lost their homes, only 12 percent had a payment amount at the time they defaulted that exceeded the amount of the first scheduled monthly payment on the loan. The reason there were so few is that almost 60 percent of the borrowers who lost their homes had, in fact, FRMs. But even the defaulters who did have ARMs typically had either the same or a lower payment amount due to policy-related cuts in short-term interest rates.

To be absolutely clear here, my discussion so far focuses entirely on the question of whether the design of the FRM is inherently safe and eliminates a major cause of foreclosures. The data say it does not, but that does not necessarily mean that the FRM does not have benefits. As I discussed in my testimony, all else being equal, ARMs do default more than FRMs, but since defaults occur even when the payments stay the same or fall, the higher rate is most likely connected to the type of borrower who chooses an ARM, not to the design of the mortgage itself.

The difficulty of measuring the systemic value of fixed rate mortgages
One common response to my claim that the payment shocks from ARMs did not cause the crisis is that ARMs caused the bubble and thus indirectly caused the foreclosure crisis. However, it is important to understand that this argument, which suggests that the FRM has some systemic benefit, is fundamentally different from the argument that the FRM is inherently safe. This difference is as significant as that between arguing that airbags reduce fatalities by preventing traumatic injuries and arguing that they somehow prevent car accidents.

Measuring the systemic contribution of the FRM is exceedingly difficult because the use of different mortgage products is endogenous. Theory predicts that home buyers in places where house price appreciation is high would try to get the biggest mortgage possible, conditional on their income, something that an ARM typically facilitates. When the yield-curve has a positive slope (in most cases) and short-term interest rates are lower than long-term interest rates, ARMs loans offer lower initial payments compared to FRMs. Thus, it is very difficult to disentangle the causal effect of the housing boom on mortgage choice from the effect of mortgage choice on the housing boom.

In addition, there is evidence from overseas that suggests that the FRM is not essential for price stability. As Anthony B. Sanders, professor of finance at the George Mason School of Management, points out in his written testimony, FRMs are rare outside the United States. A theory of the stabilizing properties of FRMs would have to explain why Canadian borrowers emerged more or less unscathed from the global property bubble of the 2000s, despite almost exclusively using ARMs.

By Paul Willen, senior economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kristopher Gerardi)

1 First liens in LPS data for May 2011.

2 See the testimony of Susan Woodward for a discussion.

3 See the discussion in chapter XV of Leo Grebler, David M. Blank, and Louis Winnick (Princeton, NJ: Princeton University Press, 1956), 218–235; available on the website of the National Bureau of Economic Research.

August 10, 2010

Part 2: A closer look at Michael Lewis's "The Big Short"

In the first part of our discussion of The Big Short, we argued that the bet against subprime mortgages that the book title refers to was not a sure thing, as the book's protagonists claimed, but a highly risky bet that just happened to turn out well. In this post, we focus on the logic of the "sure thing" claim, which is that the subprime bears were exploiting the ignorance of the subprime bulls. The idea that subprime bulls were ignorant is central to the thesis of the book, because it explains both why investors made such huge errors and why it was possible for the subprime bears to exploit, with little risk, the collapse of the mortgage market.

Lewis argues that the ignorance of the subprime bulls resulted from a combination of laziness and obfuscation by issuers of the securities they were buying. We argue, however, that the evidence, including some in the book itself, shows this claim to be patently incorrect. Issuers provided staggering amounts of information about mortgage securities and there was a whole industry of analysts on Wall Street who pored over that data and published literally thousands of reports.

The question, then, is this: if there was so much research going on and so much information available, why did so few investors get it right? The answer comes back to the same issue we discussed in the previous post: house prices. Investors bought subprime bonds not because they were too stupid or lazy to do research, or because issuers prevented them from getting relevant information, or because the securities were so complex that they couldn't figure out that a subprime borrower was a risky proposition. Subprime bulls bought the bonds because careful research based on vast amounts of loan-level data using state-of-the-art models (which, as we will show, was and still is largely correct) showed that if house prices continued to behave as they had for the previous ten years, the bonds would perform well. The research also showed that if house prices collapsed, investors would lose big, but, after ten years of solid appreciation in house prices, researchers viewed a big fall as unlikely.

Lewis's portrayal of those who lost money on subprime as bumbling and ignorant and those who made money as prescient is wrong and it is not a mere detail, it is the heart of the book. Lewis writes:

…a smaller number of people—more than ten, fewer than twenty—made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market and, by extension, the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed. (p. 105)

What we argue here is that to "foresee" the crisis, one had to explore something to which the subprime bears paid little attention: the evolution of house prices. Whether the fall in house prices that ultimately caused all subprime bonds to default was itself foreseeable is a question that we will return to in subsequent posts, but even the most outspoken subprime bear, Michael Burry, would have a hard time explaining how the main focus of his research—"reading dozens of prospectuses [of subprime mortgage bonds] and scour[ing] hundreds more"—gave any special insight into the dynamics of house prices.

Was the market opaque?
Lewis argues that the issuers of mortgage-related securities "had a special talent for obscuring what needed to be clarified." But to outsiders, specialist terminology often sounds deliberately obscure: why do doctors say the results are "negative" when an X-ray shows good news? The typical buyer in the mortgage marketplace was a specialist, and those who weren't specialists were spending hundreds of millions of dollars and could afford to, and usually did, hire experts to explain to them what was going on.

In the end, Lewis's examples mostly demonstrate his ignorance of the market, not anybody's deliberate attempts to deceive investors. For example, he claims that "a bond backed entirely by subprime mortgages, for example, wasn't called a subprime mortgage bond. It was called an ABS, or asset-backed security" (p. 127). As Lewis himself says, ABS is a class of securities that included "bonds backed by credit card loans, auto loans and other, wackier collateral…" (p. 95n). As such, these securities historically had been characterized by default rates that were literally orders of magnitude bigger than those on mortgage-backed securities (MBS), which were composed of prime residential mortgages. Thus, to the typical buyer of securities, the ABS designation did precisely the opposite of what Lewis claims—it actually drew attention to the credit risk inherent in subprime mortgages.

Another major error along these lines concerns Lewis's discussion of the Alt-A market. Lewis writes that:

Alt-A was just what they called crappy mortgage loans for which they hadn't even bothered to acquire the proper documents—to verify the borrower's income, say. "A" was the designation attached to the most creditworthy borrowers; Alt-A, which stood for "Alternative A-paper," meant an alternative to the most creditworthy, which of course sounds a lot more fishy once it is put that way. (p. 127)

This is just wrong. Alt-A loans were made to borrowers with impeccable credit who, for various and perfectly valid reasons (self-employment being the most common one) could not document income in the standard way. If a borrower had several years' worth of income in the bank, no other debt, and a credit score that indicated that he or she had not missed a payment on anything for years, lenders would rationally overlook his or her inability to provide a letter from an employer documenting income. By calling the loans Alt-A and not A, the lender drew attention to the fact that the loan did not have traditional documentation. The historical credit performance of Alt-A loans was very, very close to that of prime loans and vastly better than that of subprime, so to call Alt-A loans subprime would be completely misleading. As far as investors were concerned, the main difference between Alt-A and A paper involved prepayment risk: Alt-A loans prepaid less and thus were more valuable to investors.1

Were the "shorters" the only people to do serious research on subprime mortgages?
Another central claim of the book is that Wall Street analysts did not seriously research the market. The following passage suggests that until March of 2007, researchers on Wall Street did not pay attention to the details of the pools of loans they were trading.

On March 19 his salesman at Citigroup sent [Michael Burry], for the first time, serious analysis on a pool of mortgages. The mortgages were not subprime but Alt-A.* Still, the guy was trying to explain how much of the pool consisted of interest-only loans, what percentage was owner-occupied, and so on—the way a person might do who actually was thinking about the creditworthiness of the borrowers. "When I was analyzing these back in 2005," Burry wrote in an e-mail, sounding like Stanley watching tourists march through the jungle on a path he had himself hacked, "there was nothing even remotely close to this sort of analysis coming out of brokerage houses. I glommed onto ‘silent seconds'* as an indicator of a stretched buyer and made it a high-value criterion in my selection process, but at the time no one trading derivatives had any idea what I was talking about and no one thought they mattered." (p. 194)

In fact, researchers had done exactly that sort of detailed analysis for years. This paper provides a detailed discussion of the state of mortgage research in the years 2003–2006, reviewing a relatively small sample of the contemporary literature, which still amounts to dozens of reports. Burry's claim to be the only person doing standard credit analysis–"In doing so, [Burry] likely also became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made (p. 50)"—is fatuous.

In fact, some of the quotes in the book suggest that the subprime bears, and not the bulls, were the ones who had little understanding of the details. Lewis writes:

As early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry's view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. (p. 28)

A loan cannot simultaneously be "interest only" and "negative amortizing." Interest only means you pay only the interest every month and "negative amortizing" means you pay less than the interest so that the principal balance of the loan actually increases over time. Unlike the distinction between ABS and MBS, the distinction between these two terms is easy to understand, even for a nonspecialist, and a self-proclaimed expert like Michael Burry should have understood it. But a careful student of prospectuses like Michael Burry should also have a hard time digging up a subprime negatively amortizing loan. "Option-ARMs," largely the only loans that allowed negative amortization in the United States, rarely ever appeared in subprime deals; they were generally considered Alt-A or prime and most were held in the portfolios of banks and never securitized.

In fact, Lewis erodes his own case by providing compelling evidence that other investors were trying to exploit subtle differences between pools and must have done exactly the sort of detailed loan-level analysis that Burry claims was not going on:

A smaller group used credit default swaps to make what often turned out to be spectacularly disastrous gambles on the relative value of subprime mortgage bonds—buying one subprime mortgage bond while simultaneously selling another. They would bet, for instance, that bonds with large numbers of loans made in California would underperform bonds with very little of California in them. Or that the upper triple-A-rated floor of some subprime mortgage bond would outperform the lower, triple-B-rated, floor. Or that bonds issued by Lehman Brothers or Goldman Sachs (both notorious for packaging America's worst home loans) would underperform bonds packaged by J.P. Morgan or Wells Fargo (which actually seemed to care a bit about which loans it packaged into bonds). (p. 105)

The fact that investors who had done such detailed research made "spectacularly disastrous gambles" refutes the idea that the success of the subprime bulls reflected their willingness to do research.

Why did the subprime bulls believe in the market?
If so many investors did so much research, why didn't they bet against subprime? Lewis hears and reports the right answer over and over again. They didn't believe that house prices were going to fall. On page 89, he quotes one participant: "For the bonds to default, he now said, U.S. house prices had to fall, and Joe Cassano didn't believe house prices could ever fall everywhere in the country at once."

On page 157, he quotes another:

"We asked everyone the same two questions," said Vinny. "What is your assumption about home prices, and what is your assumption about loan losses." Both rating agencies said they expected home prices to rise and loan losses to be around 5 percent—which, if true, meant that even the lowest-rated, triple-B, subprime mortgage bonds crafted from them were money-good.

To me, the most compelling piece of evidence about what the subprime bulls got wrong, the smoking gun that makes sense of what happened, is the following table from a Lehman Brothers report from August of 2005 titled "HEL Bond Profile across HPA Scenarios."

Scenario #







11% HPA over the life of the pool




8% HPA for the life of the pool





HPA slows to 5% by end-2005





0% HPA for the next 3 years, 5% thereafter





-5% for the next 3 years, 5% thereafter



Source: Lehman Brothers 2005

Lehman Brothers analysts used a default model to predict losses for deals made up of mortgages originated in the second half of 2005 under different scenarios for house prices.

There are two key things to notice in the table. The first is the researchers predict catastrophic losses for the "meltdown" scenario of 5 percent annual house price declines. A 17 percent loss means that anything below a AAA-rated bond was essentially wiped out. Because the collateralized debt obligations (CDO) were composed of BBB-rated bonds from these deals, the meltdown scenario implies complete default on the CDOs. The actual price fall that took place was roughly twice as bad as the meltdown—annual declines of 10 percent rather than 5 percent—but the predictions of the model were largely correct: the deals based on these loans should rack up losses of about 23 percent. Thus, this table completely and utterly invalidates the argument that researchers at the top investment banks did no research and were completely ignorant of what they were buying or selling and had no idea that there was any possible scenario in which the bonds might lose.

The second thing to notice about the table is in the last column. The researchers assigned the meltdown scenario a 5 percent probability—a better outcome than the one that actually obtained. More importantly, they assigned 80 percent probability to house price appreciation of 5 percent or more, scenarios where the losses were sufficiently small that even the BBB-rated bonds were "money-good," scenarios in which the heroes of The Big Short would have seen their bets expire worthless.

In a sense, the subprime bears, the heroes of The Big Short, profited from their own ignorance. Their basic thesis was that making loans to people with poor credit histories was dumb and massive losses were inevitable under any circumstances. But what subprime bears failed to understand was that making unsecured loans to borrowers with poor credit histories generally leads to large credit losses—it's called payday lending—but making loans secured by an asset with a rising price is a low-risk business. The subprime bear logic that making mortgages to borrowers with problematic credit histories was guaranteed to fail would have generated massive losses between 1995 and 2004, as actual outcomes resembled scenarios 1, 2, and 3 from the Lehman Brothers' report chart year in and year out. It was their good fortune, not their astuteness, to make the bets in 2006.

By Paul Willen, research economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kris Gerardi)

1For an extensive discussion of the Alt-A market, written in 2003, see the Nomura report.

July 6, 2010

The Big View of Michael Lewis's "The Big Short"

Author's note: This is the first of two posts on The Big Short. This one addresses the overall theme of the book. The next will focus on the book's details—in particular, the question of whether issuers obfuscated or even deliberately misled investors about subprime mortgage securities.

In The Big Short (Norton, W. W. & Company, 2010), Michael Lewis provides a narrative of the subprime mortgage crisis through the stories of a set of unconnected investors, including Michael Burry of Scion Capital, Steve Eisman of Frontpoint, and Jamie Mai and Charlie Ledley of Cornwall Capital, all of whom made a common bet against subprime mortgage bonds and won big. The book is a treasure trove of anecdotes about the crisis and deserves the wide audience it has received. But, in terms of reforming Wall Street or preventing another crisis, The Big Short—the title refers to the controversial Wall Street practice of short selling—could do more harm than good because it perpetuates the idea that it is possible to make large amounts of money in financial markets while taking little or no risk.

A reader might get the impression that the protagonists of The Big Short went to the roulette table knowing exactly where the ball would land. But they actually took a huge gamble when they bet against subprime bonds in 2006. In fact, had they tried their bet in 2005, The Big Short would not have been written.

Composition of pre- and post-2005 mortgages were not dissimilar
To understand the extent of the risk that characterized the bets these investors made, one needs to realize that the high levels of defaults on the loans in the deals that the investors bet against were not inevitable and were, in fact, unprecedented. The difference in performance between subprime loans originated before 2005 and after 2005 is like night and day. Loans originated before 2005 were only half as likely to default as the loans in the pools that Burry and his cohorts invested in. More importantly, while none of the BBB-rated bonds in the deals that originated in 2004 and 2005 defaulted, virtually all did for the deals that The Big Short investors traded on.

What accounts for the differences in performance between pre-2005 and post-2005 loans? None of the variables that Burry or any of the traders in The Big Short focus on. For example, while it's true that 35 percent of subprime loans originated in 2005 and 2006 had reduced documentation, that percentage is only marginally higher than the 30 percent with reduced documentation before 2005. Yes, it's true that 78 percent of the subprime loans originated after 2005 had "teaser rates" that would expire two or three years after origination—but 67 percent of the loans originated before 2005 had the same feature. Sure, 73 percent of the loans originated after 2005 had prepayment penalties, but that was down from the 74 percent that had them before 2004. Plus, the average FICO score had actually risen to 615 from 607.

House prices are the difference
So if the composition of mortgages did not change dramatically between 2004 and 2006, what explains the completely different outcomes? The answer is house prices. House prices are central to mortgage performance. When they are rising, few mortgages default because borrowers who can't make their payments can profitably sell to avoid foreclosure. Lewis's statement that a "person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place" (p. 100) is misleading. In fact, in the pre-2005 pools in which the average FICO score was 607, fewer than 5 percent of borrowers missed a payment in the first year of the loan.

The point here is that the timing of the bet was crucial. Simply betting against deals because they contained loans that were incompletely documented or because the FICO scores were low would have been a losing strategy in 2001 or 2002 or 2003 or 2004 or 2005. Nor was there anything inevitable about the timing of the fall in house prices. By 2003, standard measures of the relationship of house prices to income or to rents already showed overvaluation, and yet house prices continued to rise and even accelerate for the next three years.

In short, the success of the traders in The Big Short was not based on logic and skill but on their willingness to gamble that house prices would fall dramatically in 2006. It's not clear that they understood how much their bet depended on the evolution of house prices.1

Subprime bulls had an extraordinarily successful run
There is a kind of irony here in that in writing The Big Short, Michael Lewis falls for precisely the same logic that created the subprime crisis in the first place. The logic is that investors who make money are smart and investors who lose money are dumb. The problem is that someone writing in 2005 could and did tell an identical story about the subprime bulls.2 Then the smart people were the investors in subprime bonds who made huge returns because the high interest rates on the loans more than compensated them for the surprisingly small credit losses. The dumb ones were the suckers who invested in prime mortgages. What Lewis forgets is that in 2006, the subprime bulls were coming off a string of successful investments no less impressive than that of the heroes of his book. These subprime bulls were the smart ones at that time.

This dissonance is perfectly illustrated in one of the high points of the book when Lewis tells the story of Howie Hubler, a trader at Morgan Stanley:

Some people enjoyed Hubler, some people didn't, but, by early 2004, what others thought didn't really matter anymore, because for nearly a decade Howie Hubler had made money trading bonds for Morgan Stanley (p. 200).

Lewis understands the dangers of Hubler's logic:

Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency (p. 215).

Hubler's subprime bets end up going grievously wrong and he ends up causing the biggest single trading loss, $9 billion, in Wall Street history. Yet in many ways, the heroes of the book have a lot in common with Howie Hubler. Like Hubler, they took big bets. Like Hubler, they thought they were exploiting the stupidity of others. And like Hubler, they made a lot of money. Hubler ended up losing big, which may eventually happen to the stars of The Big Short.

The lesson of the crisis really is that one should be skeptical of any trader or fund manager promising high returns without risk. But for many who read The Big Short, the book will only make them look harder for that big score.

By Paul Willen, research economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kris Gerardi)

1 John Paulson, who also bet against subprime and actually made far more money than the characters in The Big Short, did understand the centrality of house prices to his wager. But his story is told in Gregory Zuckerman's The Greatest Trade Ever (Random House, 2009), not in The Big Short.

2 See "Making sense of the subprime crisis," by Kristopher Gerardi, Andreas Lehnert, Shane Sherlund, and Paul Willen, Brookings Papers on Economic Activity, Fall 2008: 69–145.