Lecture 20: Fallout: The Housing Crisis and its Aftermath

Lecture 20: Fallout: The Housing Crisis and its Aftermath

– Okay, good morning, everybody. Today, we are going to talk
about the housing crisis and its aftermath, which
could've been subtitled the tragedy of errors. And we're gonna work our way
through the various errors and the tragedy of it
over the next hour or so. I want to start with President Clinton speaking in the East
Room of the White House at a session with his then Secretary of Housing and Urban Development,
Henry Cisneros in 1995. – One of the great successes
of the United States in this century has been
the partnership forged by the national government
and the private sector to steadily expand the dream of home ownership to all Americans.

In 1934, President Roosevelt created the Federal Housing Administration and made home ownership available to millions of Americans who
couldn't afford it before that. 51 years ago, just this month, Harry Truman rewarded servicemen and women with the G.I. Bill of
Rights, which created the VA home loan guarantee program. That extended the dream of home ownership to a whole new generation of Americans. For four decades after
that, in the greatest period of expansion of middle class dreams any country has ever seen
anywhere in human history, home ownership expanded as incomes rose, jobs increased, the educational level of the American people improved. But in the 1980s, as
the vice president said, that dream began to slip away. I ran for president in large measure because I wanted to restore that dream to grow the middle class,
shrink the underclass, promote the mainstream values
of work and responsibility, family and community,
and reform government in a way that would enhance opportunity and shrink bureaucracy. We made good progress, but
we have to do a lot more.

I ask all of you just one more time to look at that chart, and I wish I had a lot of other chart to show you that would reinforce that. Home ownership declines then
stabilizes at a lower level. At the same time, more
and more American families working harder for the same
or lower wages every year under new and difficult stresses. It seems to me that we have a serious, serious unmet obligation to
try to reverse these trend. – So there you have
President Clinton in 1995 bemoaning the decline in home ownership that has set in over the
previous several decades and pledging his
administration to increase it.

And we will see that Clinton was not alone that the desire to expand home ownership, which is closely
associated, as you can tell, from his comments there,
with mainstream accounts of the American dream has been bipartisan and pursued by administrations
over a number of decades. Our agenda today is to
think about what produced the subprime mortgage
crisis that played out in the financial crisis that
we talked about on Tuesday. Think about the results of
the subprime mortgage crisis.

And what are the lessons
that we should draw, given the larger narrative
and concerns in our course. And you really, in order
to get an understanding of the housing crisis and how it played, has played itself out,
we really have to go back and understand the place of housing in fights about justice and particularly racial justice in America
back to the 1930s. And what I'm calling here the transition from hard to soft
apartheid, or if you like, from legalistic to market-based
apartheid in America, is something that really
occurred over the course of a number of decades after the 1930s.

If you go back to the 1930s,
it would not have been unusual to see signs like this in neighborhoods, particularly, but not
exclusively in the south. And this is what I, this
is the height of Jim Crow and the era in which
explicit racial segregation was the order of the day. When people bought and sold houses, they would often contain
so-called restrictive covenants. Here's a passage from a
deed transferring some land. It says: None of the said
lands, interests therein or improvements thereon shall be sold, resold, conveyed, leased, rented, or in any way used, occupied, or acquired by any person of Negro
blood or to any person of the Semitic race, blood, or origin, which racial description shall be deemed to include Armenians, Jews,
Hebrews, Persians, or Syrians.

So this is a notion of
restrictive covenants and they were, by the way,
perfectly legal until 1948, famous Supreme Court decision
Shelley versus Kraemer, a five to zero decision with
three justices abstaining because they all own houses
that had restrictive covenants, and what the court said in that opinion was that while it was a violation of the Equal Protection
Clause of the 14th Amendment for states to enforce these
restrictive covenants, it was no violation of the Constitution for people to put them
in the deeds of houses and voluntary abide by them.

So if you were, wanted to signal to buyers that this is a Whites only neighborhood and we shouldn't allow
non-White to come in, that was not illegal. And so, and that of course goes back to something I mentioned to
you in an earlier lecture, namely after Reconstruction, we had very restrictive readings of the civil right, Civil War Amendments by the Supreme Court and in particular they
said of the 14th Amendment that it didn't apply to private action but only state action. So Shelley versus Kraemer in 1948 said these restrictive covenants could no longer be enforced, but that didn't mean that they went away and they didn't for some time thereafter. This is something called
the 8 Mile Wall in Detroit. Anyone here from Detroit? Anyone know what the 8 Mile Wall was? It was actually half a mile long, it's not eight miles long,
it's half a mile long, but it's on something called 8 Mile Road, and 8 Mile Road was a physical barrier between White and non-White neighborhoods.

So the idea was to keep African American, presumably principally
African American children from going into White neighborhoods and it since, you can see, has
had been covered in graffiti, but it's still there as a kind of monument to the physical segregation, what I'm calling hard
apartheid of the Jim Crow era. That was actually, the 8
Mile Wall was built in 1941. Anyone know what this is? It's a map, yeah,
(students mumbling) what's all the scribbling on it? – Redlining.
– This is so-called redlining, and you can see this saying, this is an OK place to write mortgages, this is OK, this is
super, this is the hood, and this is don't even think about writing mortgages
in this neighborhood.

And so actually the history of redlining goes all the way back to the 1930s and initially the government
was in fact behind it. In 1934, we got the National Housing Act which created the Federal
Housing Administration, and the following year, they commissioned the Federal Loan Bank Board
to run studies in 239 cities in the service of underwriting. They wanted to help underwriters know where these risky loans actually were. And so the idea was that
mortgage underwriters would know what to charge and whether,
and what circumstances underwriting would be warranted.

But of course, it soon became a proxy for denying loans, mortgages in minority neighborhoods and to minority lenders. So redlining became used for that purpose. And as you can see, just if you Google up redlining on Google Images, you can find maps of
virtually any American, and by the way, also Canadian
cities from this period. This is one from Seattle,
and you can see there from the color code, the green is best, the blue is still desirable, the yellow is the declining neighborhoods, and the red, hence
redlining, was hazardous. And so that's one from Seattle, I've just put a few up here, one from San Francisco, Buffalo, New York, Austin, Texas, and I could've put many, many more, many more of these.

And so this practice of
redlining reinforced, of course, racial and class-based
segregation of neighborhoods, because banks would only
want to lend in the areas that were least risky and most desirable. In 1968, the Fair Housing
Act prohibited discrimination in lending based on race
and also by neighborhood. This was reinforced by even more stringent legislation a decade later, the 1977 Community Re-investment
Act, reiterated these bans, but they're extremely
difficult to actually enforce. This is what I'm calling
the era of soft apartheid, you don't necessarily
need restrictive covenants and we'll see this play
out in four-part harmony and in the rest of today's lecture. But even though redlining and
loans based on discrimination either against particular
neighborhoods or by race has been illegal since the 1960s, as recently as 2015, there were
huge settlements with banks who had been caught in this practice.

For instance, Hudson City Savings Bank, which services New York,
New Jersey, and Pennsylvania reached the largest settlement ever with the Department of
Justice, $33 million settlement for denying loans to African
American and Latino borrowers and were required as
part of that settlement to open branches in
minority neighborhoods. And in that same year, there
was actually a $200 million settlement with HUD, the
Department of Housing and Urban Development, between, for a bank called Associated Bank for doing the same thing
in Chicago and Milwaukee. And again, they were
required to open branches. So even though redlining
is no longer legal, that doesn't mean it doesn't occur. And so this is one of the ways in which it's become possible for markets and market practices essentially to underwrite the
segregation of neighborhoods. So I asked you to spend
a little bit of time with the Parable of the
Polygons, the Schelling, which is a user-friendly version of Schelling neighborhood tipping game.

Who did, did you spend some time with it? What did you take away from it? – [Student] I found it a little depressing when I got toward the end.
– What's depressing about it? – [Student] Well, that
in most of the scenarios, you end up with very
segregated neighborhoods and you have–
– But how do we get to segregated neighborhood? – [Student] Well, there was,
a lot of the rules were about, you're only happy if, they
came down with the 1/3 rule, so if it went down–
– Just back up a little bit and explain how it works
for anybody who didn't– – [Student] All right, so
there's two types of polygons. There's the triangles and the squares. And basically the point of
the game was to show you at what point, by looking at the map, when all the triangles and
all the polygons were happy based on who their neighbors were.

And what you discovered was that the more you played around with it, you needed to have
segregated neighborhoods for people to be happy or generally happy with their environment. – Okay, anyone want to add a point that was taken away to what he said? Yeah? – [Student] Yeah, I was
just really surprised by how little personal bias it takes in order to get–
– Okay, sorry, elaborate on that.
– Collective bias. Because even though one square or triangle might only need to be
surrounded by like 1/3 of people who are like them to be happy, the way that that ends up playing out is that in order for everyone to be happy it reconfigures so that you're
actually really surrounded by people who are mostly like you. It doesn't actually factor out to that 1/3 in like a collective way. – Exactly, so he's, just to
summarize what you're saying, very mild levels of prejudice, where mild is understood to mean, I just want some of my
neighbors to be like me, 20% to 1/3 is enough to, of course, entire neighborhoods to
segregate completely. So very low levels of prejudice
will segregate neighborhoods simply by the voluntary
choices that people make.

You don't need restrictive covenants, you don't need all this
other stuff to get it, that's what I'm calling soft apartheid. And not only that, it's
very difficult to undo, it's very difficult to reverse, and less people have an
active desire to integrate. That we have to change their preferences, otherwise, with very
low levels of discomfort at having large numbers of
your neighbors be unlike you is gonna be enough to
segregate neighborhoods. And so this is a very famous, Schelling was a brilliant economist, most of his works is on arms races, but this neighborhood tipping game tells you that if you start off with a neighborhood that looks like that and people have these
very low levels of desire to be surrounded by some
people like themselves, it's gonna wind up in pretty
short order like that.

And of course, we don't start off with something like that
in most American cities, so it's even tougher. What we really start off is something much more like this, this is a map of Chicago
with neighborhoods are already heavily segregated. And what would be required
would be to desegregate them and that's taking Schelling to heart is not going to happen unless you have pretty radical changes in the population. And so in some ways, it
might be said that actually soft apartheid is harder to combat than hard apartheid or Jim Crow. I've given you one reason already, first of all, you would really have to have active changes
in people's preferences, positive desires to
desegregate the neighborhoods, not just absence of resistance
to the desires of others.

Any other reasons why soft apartheid might actually be harder to fight against than hard apartheid? By hard apartheid, I'm
talking about de jure, restrictive covenants,
laws outlawing people living in certain neighborhoods and so on. Yeah? – [Student] Is it more
unconscious, like unconscious bias? – It could be, there could be
issues of unconscious bias, that might be part of it. Anything else, what were you gonna, yeah? – [Student] There's an
economic factor now, housing prices have gone
so much that it's difficult to actually, even though you enforce it, to have people move in if
they have lower incomes. – So people are gonna self-segregate by socioeconomic status, yep, okay.

Anything else? – It's much harder to prove.
– Pardon? – It's much harder to prove.
– It's harder to prove, and it's harder to identify. If you think about hard
apartheid, it provides targets. If you wanna get rid of
restrictive covenants, let's say, we can have a campaign to get rid of restrictive covenants, gives you a kind of a proximate
goal to organize around and to get rid of and
I'm gonna come back more and talk about the importance
of proximate goals. There's also a literature in psychology about so-called boundary permeability. Academics never say in
words of one syllable what can be said in
words of five syllables. But here, this is the basic idea. If there's a law which
says no Blacks and Jews can join a New Haven Lawn Club, there will be a campaign
to get rid of that rule.

There will be a campaign
to have Blacks and Jews allowed to join the New Haven Lawn Club. If there's no rule, but one Black family and one Jewish family is
allowed to join every 15 years, there won't be a campaign. Similarly, if you have a rule which says no junior faculty will get tenure. Then you'll get a junior faculty union. If you don't have a rule, but in fact, only one in eight of the
junior faculty gets tenure, which has been a Yale
equilibrium for many decades, then you don't get a
junior faculty union, why? It's not entirely clear,
but it may well be, and this is claim in the
boundary permeability literature, everybody thinks I'm gonna be the one, I'm gonna be the one, so if you have norms or practices that function
so as to produce exclusion without actually having formal exclusion, it becomes much more difficult to get people to organize, to change them.

And so this is, if you look at something like the Civil Rights Act, and you say this is 1964 and
the Voting Rights Act of 1965, what has been, what's been achieved? It's mostly that the de jure,
rather that the de facto forms of racial discrimination
that have been stamped out. It's much harder to
stamped out the de facto. So we have inherited a world
in which the hard apartheid of the Jim Crow era has been replaced by the much more nebulous,
but in some ways, more difficult to deal
with, soft apartheid, that gets generated as a byproduct of the lack of proximate goals, the tipping phenomenon
that Schelling describes, and the very big obstacles to
organizing collective action in circumstances where you have high levels of boundary permeability.

So that's something to bear in mind and we'll come back as we
see how this played out. People attempting to combat
the effects of soft apartheid played out in the housing crisis. Now, if you said, what was the
cause of the housing crisis, there's no single answer, it
was really a perfect storm. A number of factors came
together to produce this result. And I wanna mention four. The first one we've already heard from President Clinton's mouth, and here I, this he wrote
the year before that speech, but here you can see, "More Americans "should own their own homes, "for reasons that are
economic and tangible, "and reasons that are
emotional and intangible, "but go to the heart of
what it means to harbor, "to nourish, and to expand
the American dream." Home ownership is part of what people who want to realize the
American dream aspire to, and a big part of the housing crisis grew out of the agenda of extending home ownership to previously excluded racial and ethnic minorities, exactly the people who are
being discriminated against as a result of soft apartheid.

And this graph sort of
reflects the numbers that Clinton was talking about, you can see that in March of the, starting actually at the
beginning of the post-war period, you see big increases in home ownership, and then it levels off and
successive administrations do take actions to increase it. Now we're gonna talk about till it finally reaches a peak in 2008. Second is securitization of
the subprime mortgage market. So just to be clear, a
subprime mortgage is, we're talking about the
subprime mortgage crisis, what is a subprime mortgage? A subprime mortgage is a
mortgage that is risky to hold.

It is risky because it is
being given to somebody who either has not a
very good credit history or it's being given with
a very low down payment so that the home owner doesn't
have a lot of incentive to keep paying the mortgage, we're looking at more about that later. It's a mortgage that it's
risky for a lender to hold. It's subprime and so
normally, in a market system, subprime mortgages charge higher interest rates than regular mortgages precisely because they have
to bear the cost of that risk. So that's what a subprime mortgage is. Now, securitization of subprime mortgages, what securitization of
subprime mortgages refers to is the following, (coughs) if I had wanted to buy a
house, say, in the 1970s, I would have gone down to the local bank, they would've said, "You want a mortgage? "Well, give us your credit history," I would've had an interview
with the bank manager and I would have had to put 20% down on the house,
the bank would have, probably the bank manager
would have known me, it would have been, I lived in Guilford, that would be in the Guilford Savings Bank as it in fact was, but they
would run their credit history, they would become comfortable
with lending me the money, I would take out a 30-year mortgage and they would then hold that mortgage and service that mortgage
and I would spend the next several decades
paying off that mortgage back to the Guilford Savings Bank, that is basically how
mortgages used to work.

Securitization is the
process whereby banks not only sell, once
they give the mortgage, they sell it to another bank
or another financial entity and those mortgages then become chopped up and sold off in pieces and traded. So they start, they become securities. And it's important to understand that the securitization of mortgages actually begins with
the federal government. Fannie Mae, Fannie Mae is so-called government sponsored entity. It was established in basically the 1938 as part of the second new deal in the wake of the depression, more than 25% of America's home owners had their homes foreclosed
on in the depression, and it was extremely difficult for people to get mortgages, to buy homes. And so the Roosevelt administration wanted to make it easier. And so what the Freddie, Fannie Mae quickly got involved in doing was essentially two things. One was buying up mortgages from banks, and secondly, creating liquidity, because if you think about,
if Guilford Savings Bank is holding that mortgage for 30 years, they can't use that, they can't give another mortgage with that same money, but if they sell that
mortgage to Fannie Mae, they can then use the money
to give out more mortgages.

So Fannie, starting way back in the 30s, but much more in recent decades began buying up mortgages to create liquidity in
the mortgage market. And then they also wanted more money with which to do this. So they began the process
of securitization. Fannie Mae actually started chopping these mortgages up and selling them and then they would become
traded as securities. And it's, it was a government entity, but eventually it became
partially privatized. So you can trade Fannie Mae stocks on the stock exchange now, it's a public-private
partnership, if you like, and that is part of the
source of its problems. But the securitization of mortgages essentially got going
because Fannie started selling them off and
then they would be resold and repackaged and resold and repackaged, and more and more finely sliced.

And they got the great book about this is "The Big Short" which
some of you might have read, but people had very little understanding about internal composition
of these buckets of mortgages that were being traded. Another thing that nobody
was aware of at the time but became obvious in hindsight was people had generally
thought of real estate as a hedge against the stock market, because you don't wanna have
all your eggs in one basket.

But the more you had the
securitization and trading of these mortgages on Wall Street, the more actually they
were operating in tandem, and so when the real
estate markets crashed, so did the stock market. The government started to do this, but then private banks
also started to do this, and the big investment
banks got into their own securitization and indeed
after 2002, 2003, 2004, when regulators were
finally getting nervous and started pulling back the government's activity in securitization, that's when the private sector
securitization ramped up. And so the good news was that more and more liquidity was being created, it was getting easier and
easier to write these mortgages, the bad news was that there
was more and more vulnerability in the system and people
started to lose the incentive to conduct the sort of due diligence that you would otherwise
conduct in giving out a loan.

If the Guilford Savings Bank
is gonna give me a loan, they need to be confident that I'm gonna be able
to pay that loan back. If the Guilford Savings
Bank is gonna sell the loan they give me to somebody
else the next day, then it doesn't matter to them whether two years from now I'm not gonna be able to pay my mortgage. So they don't have the same incentive to do the due diligence
in giving out the loans. And it's not just in giving out the loans. If you think about appraisals, if the Guilford Savings
Bank is giving me a loan, they wanna be sure that when they're told the house is worth $150,000,
it is worth $150,000. If they're gonna sell that
loan, it doesn't really matter, and so you started to get
not only the phenomenon of drive-by appraisals, but
what the appraisal company soon discovered was that if
they didn't give the appraisal, that the borrower and lender wanted in order to facilitate the transaction, they would just go to
another appraisal company.

And so the appraisal
company's also were complicit, and indeed, I can remember refinancing a mortgage
in about 2006, 2007, I wanted to borrow out the
equity to do this and that, and I needed the appraisal
to be some number, I've forgotten what it was, $850,000, and we got the drive-by appraisal, it said it was worth $900,000, and I remember sitting
there in signing the papers looking around the room,
the guy from the bank, from the attorney, and so on, I thought, nobody in this room believes
this house is worth $850,000. And indeed, it turned
out later it was not. (students laughing) But there it was, nobody had the incentive to do the kind of due diligence. So the securitization of
subprime mortgages is, and we'll see why we got more and more subprime mortgages in a minute, but there were a lot of these
very high risk mortgages that were being securitized
and being traded and there was nobody with enough
so-called skin in the game to have the incentive to
do their own due diligence.

The third component of the crisis was what we talked about last time, the behavior of the banks,
the relentless drive to deregulate them and make it easier for investment banks in particular to get involved in this activity. But the fourth and most
important in many ways piece that I wanna emphasize was politics. And so the idea that the government should get involved in
addressing soft apartheid goes back at least to the 1980s. This is Jack Kemp, quarterback
for the Buffalo Bills. He was actually in 1996,
Bob Dole's running mate in his failed attempt to
unseat President Clinton, but before that, sorry, after that, before that, 1989, he was Secretary of Housing and Human Development in the George Herbert
Walker Bush administration and he called himself a
bleeding heart conservative, and he came up with this
idea of HOPE programs, Home Ownership for People
Everywhere is what HOPE stood for, Home Ownership for People Everywhere. And he had this idea that the government should sell off, this was
like Margaret Thatcher's privatization of council houses in London. The government should sell off all its public housing to the owners and he was beating the drum to do this, he actually ran into huge opposition within the Bush administration from people like Darman
who's managing the budget, and Congress was not very
excited about funding it and it turned out that just to get one of these government owned houses sold was gonna cost close to $100,000, so it kind of crashed and burn but it didn't really work as a policy.

But Bush did it about
whether to get behind it, then we have already seen that in the Clinton administration, there was a lot of effort
to get behind this. And it didn't just come from Clinton, it came from the left
of the Democratic Party and from minorities in
the Democratic Party. This is Barney Frank,
as in Dodd-Frank Frank. He was considered a
very liberal congressman and he was a huge champion
for saying to Fannie Mae that you have to put
pressure on these private loan originators to give mortgages to low income neighborhoods,
to minority neighborhoods. Maxine Waters, congresswoman
from California was part of this same group of people, and so essentially, what
happened was that Congress started putting pressure
on Fannie and Freddie Mac, which is a, Freddie Mac is a
younger and smaller Fannie Mae created in 1970 to have some
competition in this market, but essentially, Congress, under pressure from these kinds of people in Congress was saying that you have only to make, you have only to make
Fannie Mae funds available in subprime mortgage markets.

That is what bankers would
call subprime mortgage markets in minority neighborhoods,
in poorer neighborhoods, and then came relentless pressure to make the subprime more and more sub, so reducing down payments
from 20% to 10% to 5%, eventually to next to nothing. And again, using non-traditional criteria for granting people mortgages in terms of evaluations
of their credit and so on. And when people say, oh, so
it's actually the government that caused the financial crisis, which conservative sometimes argue, this is what they're talking about. Because they're essentially saying that these practices by Fannie and Freddie distorted the whole mortgage market because they, after all, even though they are publicly traded, are underwritten by the taxpayer. So they can take more risk than they would if they were not
underwritten by the taxpayer. But that means that private sector lenders have to do the same thing if
they're gonna be competitive. So the argument gets
made that these practices distorted the entire mortgage market and create and even as the government started to get out of the business of securitizing subprime mortgages in the new millennium, nonetheless, they had already created this world in which the only way in which lenders could compete was by giving
more and more risky loans and further because of the
process of securitization, everybody underprice the risk because everybody was passing them on.

It's one of the reasons
I think Alan Blinder called his book that I
was referring to last time "After the Music Stopped,"
you don't find out who doesn't have a chair to sit on until the music actually stops. And so that is what they,
that became the game. And there was enormous pressure in the Clinton administration
and it continued into the George W. Bush
administration as well. Again, pressure to reduce
underwriting standards and so on. And it was heralded just
as Clinton had heralded it and Bush had also heralded it as expanding the American dream into
minority communities and making home ownership available on a more equitable basis. So let's talk about the aftermath when it all came crashing
down for a minute. And I wanna have you listen
to a colleague of mine in economics department for a few minutes by the name of John Geanakoplos. He is one of the most
brilliant people at Yale. He's one of those people, if he's giving a paper, you just go. You know you'll learn something. He also happens to, he
happens to have a hedge fund that invests in mortgage
backed securities, so he knows whereof he speaks, and this is his post-mortem on
the subprime mortgage crisis.


– Some errors. So what we did right, I guess, is we averted a complete
collapse of the banking sector, but that is also the source
of what we did wrong, because we were so obsessed with the banks that we forgot what caused the crisis, which was the subprime mortgage market and the mortgage market in general, home owners and what would
happen to home owners. So we've lost about four million
or five million households to the crisis who've been
thrown out of their houses, and another couple million
more that are on the way out that still haven't finished
with the foreclosure process. So altogether, they're gonna be something like six million or more, maybe even will get to
seven million households that will have lost their houses. If you're thinking three
people per household, maybe some people had multiple houses, so it might be a slight exaggeration, but we're talking about 20
million people lost their homes and who would've thought
that America would ever have to deal with 20 million
people losing their homes? And who would have had to deal with this long period of
stagnation and growth, which I think is related
to the housing crisis.

So I think the biggest mistake we made was concentrating too much on the banks and recapitalizing the banks both during the crisis and still now and too little on helping the home owners, who I think were the heart of the crisis. So to give you an example,
we have a lot of data now on what happen to people
who lost their homes and what happen to the lenders. So a typical subprime loan might have been for say $160,000 and the house originally was worth a
little more than $160,000. But during the crisis, housing prices fell quite dramatically and that kind of house conceivably could have fallen to $100,000. So think of yourself
as a subprime borrower with a bad credit rating to begin with, that's why he is or she
is a subprime borrower, who owes 160,000 on a house
that's only worth 100,000 in a time period where the future looks very bleak for
earning money, for example.

It would be almost crazy for
such a person to keep paying. And in fact, most of the
people didn't continue paying for a while in 2008 and 2009. Six or, people now
position six or 7% a month, not a year, six or 7% a month were defaulting on their mortgages. So every month, there'd
be a new and different set of 6% or so who defaulted
on their mortgages. So what we did in most cases was tell them they'd stop paying. The Obama administration
might have lept in and said, "Oh, it must be
because you don't have a job, "we'll try to reduce your interest "payments for a little while." But so, imagine again you're that person who still owes 160,000, instead of paying 8% a month, you now pay 4% a month.

Your house is still worth only 100,000. So what happened was 50
to 80% of those people after about a year re-defaulted. So the plan of helping the homeowners by reducing their interest
payments for a while till they got over the bad times was completely unsuccessful. They defaulted. And what happened to the
lenders after the default? The homeowner didn't just
walk away from his house, he sat there until he was thrown out, which took on average almost three years, during which time the homeowner
didn't pay his mortgage, after he found he was
gonna lose his house, he didn't pay his mortgage,
he didn't pay his taxes, he didn't fix the house, and
on the way out of the house, maybe some things got taken or the house got ruined on the way out. So we have the data now, the
recovery in such a situation was in fact, on all the
subprime loans was under 25%. So the lender would've gotten
back 40,000 out of the 160.

Had we forgiven some of the debt, had the lenders gotten
together and reduce the debt from 160 to 90 and maybe
even slightly subtle, more subtly said, "We'll
reduce your debt to 90, "but in case the house
goes back up in price, "we'll raise the debt, 50%
of the increase in the house "we'll add to the debt again." Had they done that, they
probably would've gotten their 90 because the home owner now could've seen that his house was worth
more than the debt. At worse, the home owner
could've sold the house and pay back the 90 and kept 10. And so the home owner
would've been better off, the lenders would've been better off, because they would've
gotten 90 instead of 40, and the economy would've
been immeasurably better off, and by the way, the banks,
would've been better off, because that's where they were losing all their money in those kinds of loans.

So I think our biggest
mistake was that we focused on the banking sector and
trying to recapitalize it and find enough money for the banks, and we didn't focus on the home owners whose debts were actually
owned by the banks and who were gonna determine the fate of the banks at the end anyway. And we would've done much better concentrating on the home owners. I think that is the major mistake, major policy blunder that the
Obama administration made.

And they made it not because
it never occurred to them, because people like
me, and I wasn't alone, went and talk to them and said, "This is what you should do." I even testified in Congress a few times. And it's not just academics like me who were saying things like that, it was the business people who
were making the investments and who effectively owned the loans who also wanted to see the debt forgiven. This isn't some pie in
the sky, academic idea, there were a number of hedge funds, these mortgages, they're
not done individually. A bank may give the mortgage, but the banks then sells
the mortgage into a pool, and it's the shareholders of the pool who are effectively lending the money, the bank is just the middle man.

So a bunch of, but these bondholders, shareholders of the pools,
they don't know each other, so it's very difficult for them
to coordinate any activity. That's why we need the
government to coordinate things that are difficult to
coordinate otherwise. So a bunch of those hedge
funds and other investors also testified in Congress
that they would like to see the debt forgiven not
because they were good guys but because it would help them as well as helping the economy. And we just weren't
willing to be bold enough to listen to those voices
and we didn't take, I think, the most important
step we could have to make the ensuing
recession less dramatic. – So why didn't the politicians
take Geanakoplos's advice? He's saying it would've
been an all around win. The banks, the home owners, the investors would all
have been better off.

Why didn't the government do that? Any, any thoughts about why? Yeah? – [Student] I just feel
that everyone thought that they had a good
thing going at that point, and they didn't want to put
a monkey wrench in there. – Well, but this is when
we were having mortgages defaulting at a very alarming rate. So that can't be the story. Any, yeah? – [Student] For me, this is akin to getting away with murder. So if you know that you can taken a loan and they'll cut it to half, then why pay the loan at all, 'cause you know you can get away with it.

– So you're worried about
the moral hazard problem. Well, let's hear elaboration of the moral hazard problem here. – I tell you what, I have an idea. The new administration's big
on computers and technology, how about this, President,
new administration, why don't you put up a
website to have people vote on the internet as a referendum to see if we really wanna
subsidize the loser's mortgages or would we like to at least
buy cars and buy houses in foreclosure and give 'em to people that might have a chance to
actually prosper down the road and reward people that
could carry the water instead of drink the water.

– Hey Rick, it's a novel idea. – Hey, Rick–
(others mumbling) They're like putty in your hands. Did you hear–
– No, they're not, Joe. They're not like putty in our hands. This is America, how many of you people wanna pay for your neighbor's mortgage that has an extra bathroom
and can't pay their bills, raise their hand, hello, we all. (others booing) President Obama, are you listening? – How about we all stop
paying our mortgage? It's a moral hazard. – Hey, Rick, how about the notion that Will reported that
you can go down to 2% on the mortgage–
– You could go down to minus 2%, they can't afford the house.

– And still have 40% not be able to do it, so why are they in the house? Why are we trying to
keep 'em in the house? – I know Mr. Summers is a great economist, but boy, I love the answer to that one. – Jason, Jason–
– You're thinking of having a Chicago Tea Party in July, all you capitalists that wanna show up at the Lake Michigan, I'm
gonna start organizing. (someone whistling)
– What are you jumping– – So that is so-called
Rick Santelli's rant. He is a financial commentator, that was a morning on the
Chicago Mercantile Exchange in February of 2009,
the Obama administration had just taken office
and it's a famous rant because you've heard him
calling for a tea party in July and that is often
credited with galvanizing what became the Tea Party
movement, Rick Santelli's rant.

Although some people dispute and say his influence has been exaggerated, but it's become emblematic of
the scorched earth resistance to doing anything remotely like that. And so one argument he's making there is the moral hazard argument. Now, people like Geanakoplos and others, they weren't entirely
ignorant of such things, and there were ways to address it, namely first of all,
to point out to people that if you didn't write down these loans, say of your neighbor's home, your house has become even worse, even, it's gonna lose value, because it's gonna be
next to a decrepit house. And secondly, the people who
did get mortgage assistance, for example, what the government,
as John Geanakoplos said, they would give them a lower
interest rate for a while, it didn't work because of the underlying incentives didn't line up, but they were put
through humiliating hell.

It wasn't like you just filled out a form and said, now I get my mortgage reduced, or my interest rate reduced, you went through endless interviews with people that made you prove your need, this is like the sorts
of humiliating things people have to go through to get out of government assistance. So the argument was that there are ways to manage the moral hazard, if you like, even if you can't make
it entirely go away. But the Rick Santelli's
rant, I think is instructive for other reasons, which is, go back to, remember our discussion
of the Capuchin monkeys when I said that the researcher misinterpreted the
result of his experiment when he said that the angry monkey was like a Wall Street protester, and it's really people make
much more local comparisons, and it's the idea even if
you're gonna be worse off because your house is
gonna get less valuable being next to a dilapidated house, you make the local comparison and that becomes the
source of your resentment. And so for this reason,
the kind of proposal that Geanakoplos and others
were pushing is dead on arrival.

Even though people are
gonna have to actually take an absolute hit for refusing this kind of assistance, it's not gonna possible to
mobilize them behind that. And it might not surprise
you to know that, you maybe can guess from his name that John Geanakoplos has
over the last number of years be in acting for the Greek government in its dealings with the
IMF and the European banks where he's made exactly the same argument. He said the Greeks cannot pay their debts and you should write the principal down because all we're doing by, they just keep rescheduling
it into the future, they're not solving the problem.

What they should be doing is
saying for every euro you pay, we will forgive the principal
you owe by two euros, or something like that. And it won't surprise
you to know that he's got no further defending the Greek government than he got defending the home owners during the mortgage crisis. And that is because
brilliant economist as he is, he's not paying enough attention to the politics of the situation and the resentment that
would get generated if the government did do
this on a significant scale. So even though it makes
pristine economic sense and Geanakoplos is right that everybody would have been better off, it was something that was
politically was dead on arrival. And that's scarcely surprising. It should also just be said that the banks were divided about this. They were not as united
as that clip suggests. Some of them actually preferred the wholesale buyouts,
bailouts of the banks rather than worrying
about the home owners, partly because there would've
been quite substantial transaction cost to doing
it they would have had, because the mortgages
are owned by many people and so how you're actually
coordinate the writing down.

At the end of the day, the
really simple way to do it would be even harder politically, which namely the government
would've just given the money to the home owners, written them a check, but again, I think, for reasons we're gonna go into next week, for government to give people checks is politically very difficult. There's also, was also
some sunk cost fallacy, so this is related to loss aversion that I've talked to you about, which is if a lender writes down a debt, you're admitting you made a bad loan.

Whereas if you hope against hope that the market's gonna come back, you will not have to own the
fact that you made a bad loan. So you see this all the time, an economist will tell you if you're trying to decide whether or not to sell a stock, the only
important question is what is it gonna be worth in the future if I don't sell it today. But nine of 10 people will focus on what did I pay for this stock. It's the wrong question. For an economist, it's a
completely irrelevant question what I paid for the stock, but Kahneman inference, a
psychologist who understands the human psychic cost
of internalizing the fact that you've lost something means that you will irrationally ignore the data that you should
be paying attention to, which is not what did I pay for it, but whether, what, if
I don't sell it today, what will I be able to
sell it for tomorrow.

So it wasn't only the
issue that Geanakoplos was speaking about, but certainly, that was a significant part of it. So what do we to make of all of this. So here, we've had this long history, as I said, the transition
from hard to soft apartheid did not get rid of class-based and race-based discrimination
in housing markets, it just made it more
difficult to deal with. Here we had decades where
success of administrations, Democratic, Republican,
Democratic, Republican, sought to address this problem by first outlawing discrimination based on neighborhood and discrimination in who you would give mortgages to.

This created all this
pressure on Fannie Mae from the federal government to restructure mortgage markets to make them
more friendly to minorities, but when we look at how
this all played out, it's not a happy story, if you look here, the run up to the financial crisis here, you can see that African
Americans and Hispanics received a great majority of the increase in subprime mortgages. And if you look into the
aftermath of the crisis, when everything came crashing down, Blacks were 47% more likely to be facing foreclosure than Whites, Latinos were 45% more likely
to be facing foreclosure. If you look at the loss of property, you see from 2007 to nine, nearly 8% of both African
Americans and Latinos lost their homes to foreclosures, basically double the rate of Whites. African Americans were 80% more likely to lose their homes compared
to similarly situated Whites and Latinos was 70% more,
and if you look, more likely. And if you look at the recovery after the, that I ended with last time, you can see again that
this is household wealth.

By 2009, it was starting
already to turn around for Whites but not so
for African Americans. If you look at changes in home equity, you can see that in the
run-up to the crisis, Whites represented there by the blue bar, their increase in equity
slowed relative to Blacks, but in the crash, the Whites lost less and turned around more quickly, turned around more quickly than it did for African Americans. So not entirely a straightforward story. In fact, in 2016, right at the end of the Obama administration, they did start doing a little bit of what Geanakoplos had been advocating. Fannie and Freddie
approved a one-time plan to reduce mortgage balances with unpaid principal
balances of 250,000 or less, but 33,000 home owners
were expected to qualify, many fewer than that actually
took advantage of it.

They also, in their
settlements with banks, the government gave the
banks some incentives to write down principal. In 2013, they gave JP
Morgan Chase $1.15 credit towards its huge settlement for every dollar of loan forgiveness that they offered home owners. So they did, and they did a
similar thing with Goldman. So they did do a little
bit of this at the margin, but nothing on the scale that would have made
a dent in the problem. And if you look at
projections of the effect that this has had on the creation
of wealth into the future, you can again see that this big wallop that African Americans have taken during the collapse is gonna cost them and their children for many
decades into the future, I'm not sure projections
this far out worth that much and so I wouldn't put too much stock by the absolute numbers, but the general trend is clear.

If you look, this is
the peak to the trough. You can see African
Americans and Hispanics lost more value in their homes, and then the trough to the
peak, they gained back less. And we see, if you look at
home ownership rights by race, you can see that African Americans, again, the pink line on that graph have fallen to levels that
hadn't existed for many decades. And this has produced a new
rounds of outrage in people, you could be saying, here we go again. These are some headlines
from newspapers last year complaining that Black home
ownership is as low as it was when housing discrimination was legal and Black home ownership rates are where they were 50 years ago.

The Urban Institute, a
liberal think tank says, "We've made important progress, "but we can't claim to have
vanished housing discrimination "and its pernicious effects." And so here we are again, we
are starting to see pressure to make home ownership available
to less advantaged groups. Now you might say, well why is
home ownership so important, why is it centrally associated
with the American dream? And anyone wanna take a shot at that? Why do we, why do people care
about home ownership so much? Why is it important
that people own a home? – [Student] Financial security.

– Financial security is one answer. We'll see how much financial
security it really gives them. – [Student] It's a major
avenue for wealth creation. – Pardon?
– Wealth creation. – Okay, so let's start with that. People think that home, it's
a way of creating wealth because most people believe that the value of homes always goes up. People believe that, that's one reason, but Shiller's book
"Irrational Exuberance", this is Robert Shiller, our colleague in the Economic Department,
a Nobel Prize winner, he wrote a book, this book
"Irrational Exuberance" in 2000 right before the dot com bubble burst and predicted the dot
com bubble would burst. He then wrote a second edition in 2006 about the mortgage market saying they're gonna collapse, and they did. You might say, "Why don't
people listen to Shiller?" I did hear one economist opine once the trouble with Shiller
is that he's predicted nine of the last three recessions.

(students laughing)
But the most famous, the most famous graph in
Shiller's book is this one where he points out that if you
deflate nominal prices from, you control for inflation and you, basically the story is that the real value of homes does not change, they've been flagged for over a century. So people think it's gonna go up, you might say why would people
think they're gonna go up, the price of nothing else just goes up, and people would have theories like, well, populations are growing and so on, but as Shiller points out, you've also got a factory and
cost of building comes down, all sorts of things, but
so it's just not true.

It's just not true that assets keep, that homes, that real
estate keeps appreciating. Goes up and down like other things and the actual deflated value by inflation is more or less flat
over the last century. Another reason you might
think it would lead to building up security is
that people are forced to save. Americans are notoriously bad savers, and if you spend, every month, you're sending in your mortgage payment, you're paying, you're
building up that nest egg, it's forced saving,
so-called the third leg in the three legged stool that you're gonna need for retirement. The other being social security
and your private pension. So you build up the nest egg. The trouble with this theory
is that it's no longer true. And it's no longer true principally because of the 1986 Tax Reform. The 1986 Tax Reform
was, tax simplification was the big issue in
the 1986 Tax Reform law. So they were trying to, this
is the Reagan administration, they were trying to
greatly simplify the code and among other things, they
sought to get rid of the home, deductions off your taxes
for paying interest on debts.

And so they were gonna get rid
of all interest deductions. They rapidly ran into the buzzsaw, which is that the mortgage, the banking lobby is extremely powerful and the real estate
industry's extremely powerful, and they were strongly
opposed to getting rid of the deductibility of home
interest mortgage deduction. But the '86 Act did get rid of credit card interest deduction. Used to be until '86, you could have, whatever interest you were paying on your Visa card was deductible, just like your mortgage
interest is deductible. And so the '86 Act got rid
of deduction for credit cards and not for home owners, for mortgages. Well, enter the HELOC, HELOC, you could all remember HELOCs, right. The home equity loans. So what people would
then do is essentially borrow out the equity in their house, pay off their credit cards with it or spend it on vacations
in the south of France or whatever it was, and then
the HELOC would be deductible. And so what people started to do was to, if you like, the government
gave them a big incentive to raid the nest egg, and so
the net result of this was, after '86, people would regularly
refinance their mortgages, borrow out the equity, and so in effect, there wasn't gonna be a, there isn't gonna be a nest egg there whenever you finally sell the house, people essentially were financing this.

And of course, it should be said, going back to what I said right at the beginning of the course, and forward to what I'm gonna
be talking about next week, that as wages stagnated
and people were going from one income to two incomes to keep the same amount of
money coming in the door, the pressure to finance
current consumption out of one's home equity
would get ever stronger. And this is the source of Rosner, he teamed up with Gretchen
Morgenson to write that book "Reckless Endangerment" in 2011, that's the best political
book on the politics of the financial crisis, I think, and certainly the best book
on the mortgage crisis. He had predicted in that
piece I posted in 2001 that this market was gonna
become unsustainable.

In that piece, the subtitle of which is called "Housing in the New Millennium" and the subtitle is "A Home Without Equity "Is Just a Mortgage with Debt." so it doesn't give you
any appreciating asset. A source of security. Not in an era of permanent
employment insecurity. So just, let's just listen to
John Travolta for a minute. – How many of you work
jobs that just pay the rent no matter how many hours you put in? I see. My momma worked jobs like
that after my daddy died. I remember her coming home from work just bummed, weary, you know what I mean. And I know she wanted to play with me and ask me about school, but sometimes you're just
too tired to do anything but heat up a TV dinner,
blob out in front of tube. – You got that one right.
– There you go. And I don't have to
tell you how hard it is to be looking for work. Hey, I don't have to tell you
anything about hard times.

So you know what I'm gonna do? I'm gonna do something really outrageous. I'm gonna tell the truth. (audience applauding) I know, I know what you're thinking. You're thinking he must really
be desperate to do that, but if you had to swallow enough garbage– – You can say shit, we're X-rated. (audience laughing) – Yeah, me too, if you believe
what you read in the paper. (audience laughing and applauding) All right, here's the truth. No politician can reopen this factory or bring back the shipyard jobs or make your union strong again.

No politician can make it
be the way it used to be because we're living in a new world now, a world without economic borders. A guy can push a button in New York and move a billion dollars in Tokyo in the blink of an eye, and in that world, muscle jobs go where muscle labor is
cheap and that is not here. So if you wanna compete,
you're gonna have to exercise a different set of muscles,
the one between your ears. – So that is "Primary Colors," an anonymous book, it turned out later was written by Joe Klein
about the Clinton candidacy. And the reason I put that up there is because of the
contrast between Clinton, and he did actually say that, I couldn't find an actual clip
of the New Hampshire Primary, so I took it from the movie, but it's a radical contradiction between his claim in the clip I showed you from 1995 saying he wants
to expand home ownership to his argument in the
New Hampshire Primary three years earlier that
the era of long term permanent employment is gone.

And if you look, this is data
released earlier this year by the Bureau of Labor Statistics looking at baby boomers
and the takeaway point here is that they change jobs 12
times during their lifetimes. And only the first five
or so could be explained by summer college employment
or something like that. So people are looking at long
term employment insecurity, and if you're not gonna
know whether and when you're gonna be in a position
to service a mortgage, then a home without equity is indeed nothing more than a rental with debt. Okay, so next we will talk
about backlash, 2016 and beyond. (slow music).

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