Greed, Gullibility, and Optimism
Lessons from the Subprime Mortgage Fiasco
RETSINAS: Too many people began to regard their homes as a guaranteed high-return investment.
Photo by MARK ALCAREZ
We just got carried away,” observes Nicolas Retsinas, a lecturer in real estate at HBS, whose distinguished career in housing, community development, and banking informs his levelheaded assessment of the causes and impact of the country’s mortgage meltdown. Serving since 1998 as director of Harvard University’s Joint Center for Housing Studies, Retsinas also teaches at the Graduate School of Design and the Kennedy School of Government.
A veteran of several high-level housing and finance posts in Washington, D.C., Retsinas believes all parties in the housing mess were coconspirators — from lenders that hawked subprime finance deals with microprint caveats, to brokers that turned a blind eye to borrowers’ long-term solvency, to borrowers that viewed home buying as a foolproof investment. A more reasonable view of home ownership will return, Retsinas predicts, but if the pendulum swings too far, he is concerned that worthy borrowers with modest incomes could be shut out of the market.
Could you place the U.S. mortgage crisis in historical perspective?
Home ownership is a fairly recent phenomenon in the United States. In the years leading up to the Great Depression and World War II, there was a very high percentage of recent immigrants in the United States, and home ownership was beyond the means of most. Before World War II, the term of a home loan was typically five years, with a 50 percent down payment. Not many of our grand- parents or great-grandparents could save that much.
Under Roosevelt’s New Deal, the Federal Housing Administration institutionalized the long-term, fixed-rate mortgage, opening the door to home purchases for many. The GI Bill, which offered much easier access to financing for veterans, accelerated suburban development and helped make the American dream of home ownership a reality for the middle class.
What happened to turn that dream into such a nightmare?
Not only in America but also around the world, a home traditionally has been regarded as a stake in the community — a safe place to settle down and raise a family. But in the U.S., particularly in the first half of this decade, the balance shifted pretty radically from viewing a home as a place to live in to seeing it, instead, as an almost guaranteed high-return investment. That, of course, was folly.
Should lenders and borrowers have known that the house of cards would fall?
Yes and no. If you believe that eventually what goes up must come down, then we should have known. But with five or six years of double-digit appreciation in real estate prices, we were seduced by a phenomenon I call “extreme extrapolation comfort,” which is the belief that if something happens for a little while, it will happen forever. There were times when we should have known we were approaching the subprime debacle, but when, exactly, the bubble would burst was always difficult to say.
You’ve written that the subprime problem was the result of “greed, gullibility, and optimism.” Do those terms apply equally to borrowers and lenders?
Oh yes. Borrowers overborrowed, lenders overloaned, and builders overbuilt. If you think about it, that behavior is not uncommon in any kind of environment where the underlying price of the asset is increasing. It lures people to overextend credit and to overinvest on the prospect that they too will benefit before the music stops. In this case, the music stopped, and as we know, people are falling off the carousel.
Was the problem made worse because so many mortgages are now held by institutions with little connection to local communities?
It obscured the risk that is inherent in lending and in owning. We have developed such a sophisticated housing-finance system that we were able to layer the risk, to pass it on. We fooled ourselves into thinking that passing on the risk would mean eliminating it, and of course, we woke up to find that very few people had much of a stake. We had effectively eliminated the down payment, so the borrower had no equity invested in the home. The lender was just an intermediary that sold the loan to some distant investor. And the investor was lured into thinking that if the underlying asset was appreciating so quickly, any mistake would be camouflaged by that increase in value.
What is your view of proposed remedies, such as freezing interest rates on some subprime loans or establishing a moratorium on foreclosures, for those whose adjustable rates have skyrocketed?
These are small steps in the right direction, but they do not address the problems of those whose impaired credit is keeping them from refinancing or exiting from troubled mortgages. To be honest, I’m somewhat surprised that government involvement has been so limited. I can make an argument that the market may be overreacting to the problems, but I can make an even more persuasive argument that the government is underreacting. The ideas put forward by Treasury Secretary Henry Paulson [MBA ’70] are good, but they are modest and essentially voluntary. They are the kinds of ideas that, if they are in the interest of the lender and borrower, should be done anyway.
The result of this too cautious intervention on the part of the government is that we will see a wave of foreclosures, and in the next 18 to 24 months, I’m afraid it’s not unlikely that up to 2 million people will lose their homes. The good news is that more recent proposals to license mortgage brokers and to require more disclosure by credit rating agencies and investment bankers will reduce the likelihood that we will make the same mistakes in the future.
Are there lessons in this for rethinking the kinds of mortgage products that should be offered in the future?
Our challenge is to develop new mortgage products that extend credit that is reasonably priced, and where the risk is understood and not unduly placed on the borrower.
Should financial institutions provide borrowers with more guidance when it comes to managing family finances?
No one would argue against better consumer education and more financial literacy for Americans, in general. But the system itself caused many of these problems. We were paying intermediaries to transact, to close sales. Mortgage brokers closed upon execution of the loan, not whether the loan performed. Lenders were paid for originating the loan, not, again, whether the loan performed. The incentives that were in place encouraged behavior that led to extremes, and the outcome was the situation we’re in today.
Earlier you mentioned the possibility that financial markets are overreacting to the subprime situation. In what way?
There has been a contagion effect beyond the housing market that has caused an across-the-board reassessment of risk. Risk was not appropriately priced in the past, but now people are questioning fundamentals. If the word “mortgage” is on a security, that now automatically means some discount. The erosion of trust in the subprime arena has affected the entire market.
Are there other spillover effects?
The corrosive impact of foreclosures is becoming more and more visible in terms of lost tax revenues, falling property prices, and increases in crime, since many foreclosures are clumped in certain neighborhoods. One of the reasons the housing market will be slow to recover is that foreclosures have added to the glut on the market. Until that inventory is cleared, it will be hard to reestablish equilibrium. And until equilibrium is reestablished, there is little prospect of stable or modestly increasing prices.
Is the future as bleak as it sounds?
There’s always hope. Markets do correct, eventually. There will always be some investment value in a home, but in the future, perhaps buyers will resist the urge to think of that little bungalow as a place to fix up and put back on the market in a year, and instead look at it as a good place to live.
