Who Burst Our Beautiful Bubble?


Was it beauty killed the beast or was it readjustments? If you have not passed out during our review of the respective roles of adjustable rates and subprime lending in the housing debt bust, here's some detail from Edward Pinto.

Pinto, a mortgage-finance industry consultant and chief credit officer at Fannie Mae in the late 1980s, explains that default risk on an original loan increases geometrically the closer you get to no money down. A default propensity of 1 on a property bought with 80 percent financing increases to 2 at 90 percent financing, 4 at 95 percent, and 8 at 100 percent.

It's the rapid growth of these low/no-money-down purchases that Pinto has tracked back to the passage of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. Most of that growth took place not through the Federal Housing Authority but through private lenders guaranteed by the government-sponsored entities Fannie Mae and Freddie Mac.

Fannie bought a lot of crapola debt.

Why did the GSEs count so many high loan-to-value mortgages as prime on their books? Because they were relying on shady measures of loan quality. "Fannie and Freddie consider subprime a certain classification: If it's a lender that traditionally does subprime, or has a division that does subprime, they'd count it as that." So as loan originators passed along low-down-payment loans as prime, Fannie and Freddie (which were required by the 1992 act to provide more support for low-income and underserved purchasers) played along with the fiction. The GSEs finally revealed their exposure to alt-A, subprime, negative amortization loans and other junk in Fannie Mae's 10Q from the third quarter of 2008. (If this link [pdf] doesn't work, the relevant disclosure from page 182-183 is at right.

"Through the end of 2003, self-denominated subprime, impaired credit, as a percentage of the overall mortgage market, didn't change," Pinto says. "The rapid growth in the loan portfolio came from low down-payment debt and other mortgages based on flexible underwriting. There were more flexible definitions of income, such as including an energy tax credit as income. There were people proving their credit history by rental receipts."

Reason: where horrible seventies powerpop never died.

In Pinto's view, self-described subprime lending, which increased rapidly in 2004, was the "third stage." First D.C. used relaxed underwriting to nudge up the national rate of homeownership (which grew more than 5 percent between 1993 and 2005, when it peaked at 69.2 percent and began dropping quickly). Next came a period of equity extraction, as owners of overpriced houses began refinancing at artificially depressed interest rates and getting green money from their home equity. ("Cash-out refi appraisals tend to be inflated," Pinto notes.) Actual subprime lending was kind of the last gasp, demonstrating Robert Shiller's point that the bubble caused subprime, not the other way around.

What does this mean for the original point of this discussion: that adjustable-rate mortgages across all loan-quality classes correlate with defaults more reliably than does any particular class? It's true that ARMs continue to lead the default curve, and one of the weird wrinkles of the last decade is that the popularity of ARMs mushroomed during a time of relatively low interest rates. But Pinto's larger view is that de facto subprime lending has been going on for so long, with Fannie and Freddie's connivance, that by the time the default wave hit, already it was impossible to say which was which.

NEXT: Don't Worry, America. You're Still Paying to Bail Out Second Mortgages.

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  1. Love the alt-text on the Boston pic. Full of win.

  2. Who Burst Our Beautiful Bubble?

    Please, I said a million times – don’t run with scissors!

  3. Don’t look at me!

  4. At some point, it seems that all of these pernicious trends reinforced each other. At the core was the Fed’s easy money and the GSEs’ almost insatiable greed and irresponsibility. Fannie and Freddie need to be shuttered, post-haste.

  5. Increases “geometrically”? WTF does that mean? I like the stuff you make up, Tim, but “geometrically” is not a stand-in for “exponentially”. I suggest you leave the math to Asians and Jews. OMG RACIST

    1. I’ve always used geometric and exponential growth as the same thing. Pretty sure they are. Can we get some math genius up in here to confirm or deny.

      1. X increases geometrically with Y if X = k * Y ^ p where k and p are constant.

        X increases exponentially with Y if X = k * p ^ Y where k and p are constant.

        So with exponential growth, the variable is in the exponent, while with geometric growth, the variable is raised to a constant exponent. Thus exponential growth is much faster.

        1. If you do their homework for them they never learn. Best to give them a link to read.

      2. Geometric is just exponential growth with equal intervals? I think the problem lies with which discipline it is being applied to.

        1. No, that’s not it. The sequence

          1, 2, 4, 8, 16, 32, 64, 128, 256, 512, 1024, …

          is an example of exponential growth, while

          1, 4, 9, 16, 25, 36, 49, 64, 81, 100, 121, …

          is geometric growth.

          1. Those are sequences or progressions and I wouldn’t argue. When discussing growth and not a sequence a geometric growth has equal intervals.

            Again the discipline it is being applied to appears to be important. You are giving the pure mathematical examples of geometric progression and exponential growth. Two different things. Geometric growth and exponential growth are the same, the latter being of equal intervals.

            1. *the former not latter

              1. Unlimited growth: y = ce^(kt)

                Limited Growth: y = c[1 – e ^(-kt)]

                Logistic Growth: y = M / [1 + ce(-kt)]

                e = 2.718281828459…, c = constant, t = time, k increases without bound.

                1. * Precalculus: Functions and Graphs; Barnett, Ziegler 1989

                  1. The question isn’t the equations, its the semantics between disciplines. I already agreed with your examples, I just disagree that your examples are the only commonly used semantics to describe your examples.

                    1. What is common and what is correct are two different things. “Increases geometrically” can mean anything regarding rate of growth. A Geometric sequence is just a progression of numbers if there exists a nonzero constant (r) or “common ratio”.

                      a sub(n) = ra sub (n-1) for every n>1

                      I can’t see a “geometric increase” being anything other than a mathematical term without definition. To say something grows geometrically could mean it grows by 1s or 2s or 1,000s. It is a completely arbitrary term.

                    2. Damn, I must be dense tonight. There’s no relationship to time with a geometric series. Duh. Anyway, the Eagles are on.

                2. Sorry, k = rate

            2. But back to your original question. Is addition and subtraction different in, say, Biology than in Chemistry? Different terms can mean the same thing as with interest compounded continuously is the same as biological growth rates, but the function, f(x), is the same. The same terminology cannot define different functions regardless of what discipline it is being applied to. Mathematics is universal.

          2. 1,4,9,16,25 …. isn’t geometric. Its quadratic.

            1. 1,1,2,3,5,8,13… but is it Fibonaccial?

      1. Er, those are the silly biology definitions. Basically the same for exponential, but their definition of geometric growth is vague and unmathematical.

          1. Suki forgot her life rule: stay out of the deep water!

        1. How about a link to graphs in math terms?

      2. Log growth is just the opposite of exponential growth, a shallower curve. I’m not unfamiliar with either. I just don’t think the term is being misused in the article.

        1. Me neither. Let’s watch Epi and Tulpa hash this out and bond.

        2. I thought “Log growth” was what Barney was doing with Freddie and Fannie.

    2. Epi — Tim uses words for their snarkiness, for the way the electrons trippingly roll off Teh Interboobs — precision means nada in that context. A sound and fury indicating laughter.

      Just substitute exponentially for geometrically in that sentence and move on.

      1. Shhhh! Can’t you ever play along?

      2. Hey, I just wanted to bust Tim’s balls. Nothing I say has any substance either.

    3. The phrase “close enough for government work” comes to mind.

    4. I always thought when a thing keeps doubling in size you say it’s growing geometrically. I looked it up on the wikis, and that definition seemed to be supported. Sorry if that was wrong.

      1. Never back down! Never apologize! Never surrender!

        Plus, I’m learning a lot from the pedants.

  6. Do you have a link to Pinto’s original comments? You quote him, but I don’t see a link to that.

    1. This is all from a phone interview. He has a lot of this material online in various forms.

      1. Gotcha. I’ll use this article as my reference, then. Congrats, you’re “[Cavanaugh 2010]”.

  7. As a Pinto-related teaser concerning my epic takedown of the CRA, take a look at this:

    Statement of Edward J Pinto Before the Financial Services Committee United States House of Representatives, September 16, 2009…..timony.pdf

  8. So basically if you get rid of the retarded notion that sub-prime is this fixed and absolute number and not a scale of correlated measures you notice that people putting 5% down on a 250K home and make 35K with perfect credit are basically sub-prime.

    The incentives to go into default are pretty interesting to me. Low equity has to be one. Immediate recognition of benefit is another. There seems to be a real disconnect between default and actually getting tossed out of your house, a sort of hurdle on the time horizon or even the actual act of being homeless.

  9. It used to be when a borrower entered a business agreement with a bank involving a loan, the bank insisted the borrower have a stake in the successful outcome of the business agreement. Typically, that stake was a down payment.

    Down payments motivate people to avoid default because you lose your down payment along with whatever it was you borrowed money to buy. People used to starve rather than miss a mortgage payment.

    Additionally, saving the money to put toward a down payment demonstrates to lenders a potential borrower has the discipline to properly manage money.

    Somewhere along the line, the government decided if we give people houses via loans without down payments they’ll automatically BECOME disciplined enough to properly manage their money, and when times get tough, they’ll starve rather than miss those mortgage payments for a loan in which they have no stake.

    Let’s see… No demonstrated money management skills and no incentive to avoid default. Only government could possibly see an upside in such a lopsided business arrangement…

  10. Low down payment; no down payment; cashing out accumulated equity; what do these things have in common? “I’m living in a free house.”

    This is why am overwhelmed by the urge to strangle anybody who says, “Never use your own money.”

    These deadbeats should be in debtors prison, and the people who wrote the mortgages should be in jail. There- I said it.

    1. There’s something to be said for debt in any capital structure, individual included. Of course, driving the default risk into the netherworld tends to have market ramifications unless government or something else eases those ramifications.

  11. From Johnnie’s reference.

    “Bank of America noted on its Q3:08 earnings call with equity analysts that while its CRA loans constituted 7% or $18 billion of its owned residential mortgage portfolio, they represented 29% of net losses, with an annualized loss rate of 1.26%.

    See, it was that 29% of losses that almost sank the former Bank of Italy. The other 71% has no effect at all.

    Which means, thankfully, that the bankers at bear no responsibility at all for making, buying and selling the bad mortages themselves or for making, buying and selling mortgage backed securities. Thank God it was all due to the government and the stupid poor people who took the CRA loans.

    1. From Johnnie’s reference.: “Bank of America noted on its Q3:08 earnings call with equity analysts that while its CRA loans constituted 7% or $18 billion[…etc, etc,] government and the stupid poor people who took the CRA loans.
      You’ve managed to include internal contradictions, begging the question and assuming strawmen all in one post. Impressive!

  12. See, it was that 29% of losses that almost sank the former Bank of Italy. The other 71% has no effect at all.

    From my upcoming epic CRA beatdown:

    “Some on the left might complain that [this] leaves out 71% of Bank of America’s losses. Reverse the situation and pretend a government mandate resulted in 7% of Bank of America’s residential portfolio, which was 29% of its hypothetical profits. Would the same liberals ignore that or make that a huge point in favor of the mandate?”

  13. Third Stage, Boston’s third album, was released in 1986. It sucked hard. It didn’t have Sib Hashian on drums. It didn’t have Barry Goudreau on guitar. It didn’t have Fran Sheehan on bass. Tom Sholtz spent six years over producing it until it finally escaped his colon.
    The first two Boston albums were, IMHO, damn good so-called seventies power pop.

    1. Tom Sholtz spent six years over producing it until it finally escaped his colon.

      For this sentence alone you deserve a paid gig reviewing music somewhere.

    2. I think I like it.

  14. Dont you just hate it when someone comes along and pops your buble!


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