Capitalism: Success, Crisis, and Reform

PLSC 270 - Lecture 11 - Guest Lecture by Will Goetzmann: Institutions and Incentives in Mortgages and Mortgage-Backed Securities

Chapter 1. Financial History, with Will Goetzmann [00:00:00]

Professor Douglas W. Rae: Okay let's begin. We've got a terrific guest today and I'm just going to briefly introduce him and then leave forty-eight minutes for you to enjoy what he has to say. Will Goetzmann, a graduate of this college in what year?

Will Goetzmann: 1978.

Professor Douglas W. Rae: The class of 1978, with a professional and grown up career in art history and in finance, and that's not an easy combination. He does it with grace and with ease. He, like Sharon Oster, is a standout teacher in the School of Management MBA program. He directs The International Center for Finance and is — the catholicity of his interests, which we'll see in his slides and in his analysis is truly impressive. Please help me welcome Will Goetzmann.

Will Goetzmann: Well, thanks a lot for the introduction, and I'm — I was thrilled with the idea of this course so was really looking forward, as Doug was describing, the idea of the course and his plans for it and what you all have been doing. It seems like a fantastic thing. So the question in my mind was, what could I add today that would be of interest to you, and I thought what I would do is focus a little bit on the historical background to the current crisis. I know you've been doing some reading about the current crisis and its relationship to ideas of capitalism and so forth. I thought a little bit of historical foundation would be a good thing to lead off with and give you an idea of how old these financial crises are.

This is a cuneiform tablet from the old Babylonian period, roughly 1600 B.C. It's a loan, so that it was created with the terms of the loan on one side, and typically, although you can't see it from this side, you'll have people that are witnesses to the loan on the other side. So debt has been around for a long time. One interesting feature about debt is that usually when you — if you're a lender, you like to have some collateral. The collateral for debts in this time period often were human capital. In other words, if you defaulted on your loan, the borrower could seize you for three years and your family and you'd have to work the loan off. That sort of debt slavery was something that began quite early in human culture.

You had — when you had — with that debt slavery there would be periods when people would get themselves into a terrible mess, and let's say crops failed and lots of farmers wouldn't be able to pay off their loans, you would have lots of the society in deep debt. And the king, periodically, would decree all debts null and void, so wiping the slate clean. So here is a fragment by edict Samsuiluna, who was the son of Hammurabi, who, by the way, lived in the city that Yale has had a long time expedition to excavate called Tal Alon.

Anyway this is releasing everybody from bankruptcy in the form of debt slavery. But the issue there, of course, is where you draw the line? Which debts do you release, and if you just want to take people out of slavery, but you want to maintain a financial system, how do you differentiate? The solution to that problem, at least from the view of writers in antiquity, particularly Aristotle, who wrote about Solon, comes in the form of another major debt crisis. When Solon of Athens became the autarch, or whatever you want to call it, the leader of Athens, it was about 600 B.C. or so, somewhere in that timeframe, and he was brought in because there was a terrible crisis, much like the crises in the Middle East — it was a period when Athenian citizens had been seized for debts, and these were debts incurred typically by farmers, and then they'd be sold off outside of Athens, they'd just sell them offshore and export these debt slaves, and it created terrible crisis.

So, Solon was from a wealthy family, he was elected by the — sort of the rich people in Athens, they thought that he would stand up for property rights and he wouldn't let the financial system go to hell just because of the pain inflicted on the poor portion of society. What he did made nobody happy. He said, "We're going to preserve property rights, we're going to preserve the right to contract, but the only thing we're going to forbid is the right to sell yourself into slavery," so he drew the line at that debt slavery point. Ever afterwards, people — Athenians would look at him, he sort of was like the George Washington of Athens, and 200 years later, people would write about this moment in time when he made the differentiation between the financial system and the system of human slavery. It was not to say that slaves didn't exist, but the ability to contract on your freedom was not allowed after Solon.

I'm going to skip forward through a lot of exciting financial history. Those of you that like that kind of stuff might consider taking — I teach a course seminar, senior seminar on financial history in the spring, so if you are interested in those topics, I would love to have you participate. I'm going to skip forward to our debt crisis because I worry — I stay up late nights worrying that we're getting ourselves back into a debt slavery situation, and the recent code that we — the bankruptcy code has made it hard for people to shift off their debts, or shake off their debts, which is the term that Solon used. It was called seisachtheia or something like this, a shaking off, like an earthquake.

But I'm going to skip forward to 1892 and have you read this quote because it lets you have some sense of where the policy for real estate, mortgage lending in the United States might have come from. The occasion for this was a big festive dinner. It might have been at Delmonico's Restaurant, I'm not sure exactly where, I don't think it says here, but in New York and a bunch of guys in the real estate business in New York were getting together and they were really kicking off an attempt to create a real estate exchange in New York City. And the exchange — there had been something like a real estate exchange where properties were listed and brokers were admitted and so forth — the idea that they were coming to was that they needed an exchange for real estate securities.

The real estate securities that we have now are — a lot of them are things like — you've heard lots about Fannie Mae and Freddie Mac, and subprime loans and commercial mortgage backed securities and things like that, well these guys were thinking about setting up exchange to trade debt, maybe some equity too actually, in New York. And New York would be the center of real estate trading. What were they going to trade? Well here's a picture, just a piece of a bond of the kind they were going to trade. These things are incredibly beautiful. The New York — the U.S. Bank Note Company made bonds for — made stocks and bonds and money for all the countries in the world, and they had incredibly detailed filigrees and these beautiful motifs and so forth. It wasn't to make these things more attractive to customers. All of this detail was really to prevent counterfeiting, because if you could counterfeit a bond like this you could take it in and get coupons.

So what's this bond? It's a $500 bond, it's issued to finance something called 44 Wall Street Corporation, and it's The Manhattan Company building. Well, 44 Wall Street is still a building in Manhattan. I don't know if anybody here might have worked there during the summer, but there was a corporation that was set up to build and operate one single building, and there was some equity capital in the corporation and there was some debt in the corporation. The debt was issued to the public in bonds. You and I could go out and we could buy these bonds and then the coupons, the money that would come in from the bonds is money that would come in based upon the rents that were being paid by people that leased space in this 44 Wall Street building. This is a fairly extraordinary kind of security, particularly because we don't have securities like this anymore. I mean there are some bonds that have been issued against buildings, and I'm thinking now of things like — in London you had this vast project in the Canary Wharf, and that was financed with some really interesting debt. But one to one, building to bond, really we don't have in the modern day. This one, by the way, was issued one month or so, right after — not long after the great crash.

Here's a little bit about this market. The market was nothing much — this is the total cumulated amount of outstanding debt based on the face values. The face value of that one was $500, you'd multiply that times the total number of bonds, you add all of those bonds that existed up in this — these are the numbers you're getting: $100 million, $200 million and so on. You see that even in 1913 there were some of these bonds being issued and then there are two companies here that we're tracking, New York Title & Mortgage Company and Lawyer's Mortgage Company. These two companies actually served as guarantors for debt. In particular, actually, what they would do, about eight companies got together — or didn't get together, but eight companies offered a service. They would take a residential mortgage, put a guarantee on it, and then sell that mortgage to somebody else. Just like you have bond — one commercial building offered through bonds, you also had one mortgage for one house then guaranteed and offered for sale. These firms also began to pool these mortgages, and you'd pool together 100 or so of these mortgages, or a thousand of these mortgages, put a guarantee on them and then sell those pooled claims out as bonds. So this picture represents not just those commercial bonds that I showed you, but also residential securities. And you can see what happened is that they were coming along doing fine, small part of the business, and then in the '20s both of them picked up dramatically.

As a matter of fact the First World War was an important hinge point in the history of this particular kind of financial innovation. The First World War was the first U.S. war that was financed by massive issues of war bonds, and it became your patriotic duty to buy war bonds to finance the effort. When the war was over and those bonds were reclaimed by the government, they were paid off by the government, people had been used to owning securities. A whole operation to sell these securities had existed, a sales operation, so then the brokers said, "What else are we going to sell?" Real estate bonds became a really important new product. So you can see this might have been driven by demand, actually, for investment product in a marketing system that had grown for savings bonds earlier during the war. Nevertheless, you could see this stuff really take off and peak around 19 — late '20s.

That was cumulative, this is just new issues. There you see the drop around the crash time even more dramatically. This is a picture of those — plotting those number of new issues for commercial bond — for commercial properties, against new buildings. Here we only took a look at new buildings that were seventy meters high or so, so we're looking at really tall buildings. This is a time period when — the skyscraper was really born in the 1890s, and really got going in the early part of the twentieth century. So a question that we've begun to ask ourselves is, maybe the skyscraper was a response to the emergence of a new capital market for fixed income securities. Maybe the financing drove the desire for big buildings rather than the other way around. I mean New York and other cities had existed for a long time without skyscrapers and there's a lot of interesting theory about how skyscrapers were kind of a result of changes in zoning laws in some places and so forth. But if you think about it, London did fine without skyscrapers for many years. Paris, London, other great capitals of the world did fine without skyscrapers. Why would you suddenly have these sort of immediate blossoming of skyscrapers largely coincident with an emergence of a capital market and ability to sell these bonds?

By the way how would — is there any way you can think of testing that theory about which — if my theory was finance made skyscrapers or finance led to big buildings, how would you test that theory if you had some data?

Professor Douglas W. Rae: Come on guys, let's take a shot.

Will Goetzmann: Anybody? I'm going to cold call on somebody, but your chance of being cold called — yes, back there.

Student: Maybe you could do a comparison, look at other countries where for some reason — perhaps there is a case where there's another country where the capital markets didn't mature in the same way. I mean there's going to be some endogeneity issues anyway with this study, but that's a start, and in comparing if — how their timing was with their — the start of skyscrapers.

Will Goetzmann: Yeah, so look across country, and cross-sectionally, you'd like to find conditions that maybe didn't have this financial explosion.

Student: Perhaps you might find some exogenous reason why they didn't have the capital markets that are completely independent of the other factors, but that's hard to do.

Will Goetzmann: Okay, does everybody know what endogeneity is? Everybody who is an Econ. major and you're a senior or a junior you probably know. Other than that you probably think it's some kind of horrible skin disease. Endogeneity means that the factors that you're studying could actually be — it could be some reverse causality going on, or there could be some — a common unidentified factor that could be driving both of them, and you have to find some way of sorting this out. The question is — so the one way to do this is to find some independent phenomena to observe. That's what's being proposed. Any other suggestions? Here's some college —

Student: I was just going to say that you could always not only look at the rest of the world but look at, in the United States, the development of these types of bonds and the number of skyscrapers like with this, and I would wager that probably the first skyscrapers were not financed with these types of bonds, which would seem to indicate that there was some other factor at least initially driving skyscraper construction.

Will Goetzmann: Okay, so if you can find a skyscraper that was — the first skyscraper was — if you can show that it wasn't financed by these bonds than you could prove that it's possible to have skyscrapers without the financing, so that's a way to test the basic proposition. It may be — it may not — you can prove that it's not a necessary condition if you find one example. One more idea — who's an SOM student? Got one here — no. You here in the — yes, gray — charcoal t-shirt.

Student: Other than taking a survey looking at multiple cities and how — when skyscrapers started to be built, and when this capital market developed, I don't think I can really add anything else other —

Will Goetzmann: That's good. Take a look cross-sectionally at the different cities, see if they have, maybe, access to capital markets differently across the cities, and see what the timing is. That's a good idea. I'll tell you what we have been doing. We figured that one interesting issue here is — has to do with the size of the bond issue. If you have a really — if you have a tiny building and you want to go to the public capital markets, do you think an investment bank is going to give you the time of day? Absolutely not; there are basic issues of economies of scale that have to do with financing. So what we did is we said, "Let's take a look at the size of the bond issue," we also looked at the height of the building, but the size of the bond issue is the legitimate thing to look at, and presuming that the bigger the bond issue, the bigger the building. Then we asked, "Is the interest rate on the bond, that is the rate at which the bond was issued, was that lower or higher for bigger buildings?" What we found pretty strikingly is that the bigger the building the lower the yield, the lower the cost of capital. So if you're thinking about — if you're a developer and you've got a plot, and you could build two small buildings or one big building, or you could finance it all at once or one at a time and you know that you're going to be able to have a lower cost of capital, what are you going to do? You're going to build one really big building. You can see finance has this potential, maybe to possibly even distort the way that the — the way that cities develop, because of simple issues like the cost of capital, and those guys sitting around the — toasting themselves that we saw in 1892, the creation of that market for those securities, may have had an influence on the New York skyline during that time period.

Here's just a picture, by the way, of the tall buildings in New York and when they were all constructed. You see huge boom during this period, and than a long malaise during the middle of the century, during wartime, and then the market picked back up. I'll tell you one sort of shocking thing to me is that the residential mortgage backed security market completely disappeared in the '30s and that commercial one building/one bond market completely disappeared at least by 1940 or so. I mean there's still bonds that may exist, but when I say disappeared, they stopped new issues and you couldn't easily trade these things, they didn't change hands. So there are bonds that are still paying out. I have a friend whose mother — whose family has some securities that were used to build the Empire State Building, they're still paying them money and they're proud to own these things, but these are the fossils of the financial world. What you had is this extraordinary period of innovation in financing of real estate. The shift in the way that people were able to access mortgage money, and a change in the way the developers thought about how they would build buildings, and all of it came to a grinding horrible end as a result of The Great Depression.

Did that market cause the crash or was it — did the fallout from the crash destroy that market? That's the question we're asking ourselves today, right? We're saying, "Well, subprime obviously caused the big problem that we're in and so the foolish bankers, idiots that wanted to own their own home and were willing to borrow to the hilt, this horrible evil brew of people that couldn't plan ahead and bankers that were willing to give them enough rope that they could hang themselves," that's sort of the theme, the drumbeat we're hearing. You know sort of wonder, maybe the mortgage market is a casualty rather than a cause of this crash.

Chapter 2. Current Financial Crisis [00:24:20]

Doug has given you some readings that — kind of a hard reading to slog through, but because — although, again, if you're an Econ major you should be able to snap your way right through this thing because it's got a bunch of regressions, and tables, and plots. Let me just tell you a little bit about the idea of this paper. I'm doing it with Liang Peng, who is a colleague of mine, he's now at Colorado and Jackie Yen, who is a doctoral student at Yale. Jackie is studying to be a finance professor but she also worked in Wall Street for quite some time and knows a lot about these capital markets, particularly about mortgage data. The question we're asking is a simple one, like many scholars right now, we want to try and help the world understand what the causes of this crisis are. We're in a position that we don't — I'm not quite sure I know what the causes are, and so the way that we're dealing with that is we're gathering some data and we're looking at it and putting questions to this data.

The data that we got are housing indexes. Those come from Bob Shiller and Chip Case who developed these when I was a graduate student here, Bob and Chip Case had just started building these indexes of housing. We really have data going back, I think they stretch back — their data start from about, well, late '80s or so. What they do is they take sales of housing; they take houses that have been sold twice in a given city, and they get thousands of those, and you can sort of figure out what's the best measure of return to explain all of those repeated sales, so it's actually transactions based measures of housing. We've got those for all the city — the big cities in the country, and metropolitan statistical areas, about 320 or 330 of these. Then we have some additional city level information we can compare that to, then we've got mortgage issuance by city, and finally, and this is pretty amazing, for one year for 2006 we took all the mortgages that were issued in the entire country and we have detailed data about those mortgages. We figured somewhere buried in this data we're going to be able to get some sense of what the problem was.

Chapter 3. Price Growth vs. Subprime Approvals [00:26:56]

Here's a chart. On this axis is past price growth from 1999 to 2005 — end of 2005. What did we do? We took each one of those cities, we look at that index that Bob Shiller had created, and we said — we just plotted the total growth that that index had undergone over the period — over the 2000s, up through 2005. We wanted to look at the hot markets. Which were the really hot markets? Which ones had really grown a lot? You could see some of them had grown by almost a factor of three; Las Vegas, there are parts of California and Nevada, and Florida that were just off the charts, having grown an amazing amount. By the way there are a lot of cities where there wasn't much growth at all, the whole cluster here of cities that had grown by a factor of — well, they had grown 30% but that was over a long length of time. They're probably growing at less than 10% per year.

Well 10% per year over this time period was actually a pretty good investment when you think about it. The stock market was doing terribly. We had just gotten off this horrible bender from the tech bubble. People said, "Stocks are terrible, I don't want to invest in them anymore," bonds were a decent investment, but they were — people were really wondering what are we going to put my money in. A lot of people thought housing, although a modest growth in many of these cities, housing might not be such a bad thing. When you think about it, if you're sitting in the year 2000 having just been burned by the tech bubble, and you're saying, "How am I going to save for myself and my family?" You know, why not put your money in your house? At least you can watch the asset, you can take care of it, you can improve it, granted you have to pay takes on it and you have to fix it up, and it's not very liquid. But you balance these things off, it might be — it was the new asset class of the era. It was an idea — it was not a speculative asset, it was a savings related asset.

Okay, how about this other axis? Subprime approvals in 2006; the log of the dollar amount in thousands. We looked at all of these — we looked at the rates city by city of subprime approvals. That is, people that had applied for a subprime mortgage and then been approved. A subprime mortgage means you don't qualify to get a prime mortgage. To qualify for a prime mortgage you have to have steady source of income, you have to have a good credit rating, there has to be a good loan to value ratio, that means you aren't trying to borrow too much, you have to have a house that's appraised in such a way that the loan to value ratio is a legitimate measure that a bank can trust. If you're not in that circumstance then you're in sub — the world of subprime. What we see here is subprime approvals were more frequent in markets where the prices had gone up. Why would that be? Okay I'll ask this as a general question. Why would you expect that? Yes.

Student: When you have — when the prices are higher more people are going to have — when the prices are higher, assuming that incomes in the cities didn't go up with that, you're going to have people that have lower incomes relative to the value of the house that they're buying because the average price is higher and the amount they're going to borrow is also going to need to be higher relative to the price of the house, so it's going to be a higher ratio.

Will Goetzmann: Okay. This sounds like endogeneity; good. People — the houses would go up too fast, they — a normal loan — they can't get a normal loan to buy a house they might not have been able to buy ten years ago with a prime loan, so therefore you've got necessity of more demand for subprime loans. These are approvals though. That means the bankers had to say yes, so bankers had to go along with this to get this graph. Yeah.

Student: When prices are rising there's this almost — there's a market contagion that prices can't fall down, they can just go upwards, so people in general just start taking more risks and financial institutions which grant these subprime loans also become overly optimistic. They all feel that prices have to go up, and they feel that the real value of houses have increased, and that is —

Will Goetzmann: That sounds like irrational exuberance. Okay. It's easy to say that they're irrational. It's harder to say that they're rational. It would be nice to know if — first of all Bob Shiller is a good friend of mine, and I love his book, and I love his wonderful intuition about when the cart is going off the track. He tends to be right so it's hard to deny that irrational exuberance is behind a lot of the big messes we're in. However, as an economist, you sort of want to see how much you can get with the rational stories first, and then have the remainder be the exuberance. We're going to push on that a little bit — yeah.

Student: Yeah, I interpret this chart as, if prices of asset values are going up and subprime approvals are going up at the same time that means the structure has to be increasingly leveraged, that's the only way to fill the gap. You're not saying that subprime incomes are going up, but you're saying the approvals are going up, so something has to fill that gap in the purchase price and that means they're being more heavily leveraged.

Will Goetzmann: Yeah, I think that there's some evidence consistent with your observation. It's amazing how much you can get off staring at a graph like that because buried behind it are a whole bunch of decisions by individuals applying and by bankers deciding. I'm going to show you a picture just from one city, this is from Seattle, and what we've done here is we've gone from 2006 — what we've done is we've said, "Let's extrapolate the housing price in 2006, let's extrapolate it and then use some econometrics to figure out how far down we think it could go and how far up could go." Those are those two lines there, and then there's wiggly line which shows you exactly what housing prices did.

Actually I'm going to show you more in just a second. I want you to understand the geography of this first. These are confidence bands and if you're thinking — if you're a banker and you're going to make a loan the first thing you want to know is, is this loan to value ratio going to change a lot over the time period of the loan? A lot of subprime loans sort of reset after three years and so forth. You'd like to have some confidence, or at least know how far down the value could go, so that you — because you're worried about the loan value being higher — the loan being higher than the house value. That's called underwater. So you're worried about the value of the asset, so this picture is really putting confidence bounds on the value of the asset, and what this is saying is that, in 2006, if you just extrapolated the prices from that time you'd get kind of a flat line, and then you didn't — you wouldn't find any reason to expect that over the next three years prices could drop more than 20% or so. Only one time out of twenty would you get a shock of more than 20%. How would you get that? Here we are.

Chapter 4. Estimating the Relationship between Past Growth and Future Growth in Mortgage Prices [00:35:12]

Now here's a whole — here are a whole bunch of these — the same exercise. I'll tell you a little bit about the exercise. Here's where the econometrics comes in. We take those indexes that Shiller gave us for all the different cities, these major cities, and than we did something that any red-blooded econometrician would do. We did an auto-regression which estimates the relationship between past growth and future growth. What you see from all these housing indexes is that past trends seem to be followed — there seems to be a huge amount of momentum and inertia in these movements of these markets, even when they're going down. Once they start — here's Minneapolis, it was going up like this, incredible auto correlation in past trends, and then of course once it starts going down it just keeps going down. This is not a random walk. Housing doesn't follow a random walk by any stretch of the imagination. It's very, very predictable. You could predict, the models tell you that you could predict the housing prices, with a huge degree of confidence for three years out just given about twenty — fifteen or twenty years worth of past data.

All of these pictures show you that for each city there is a line which is the past price increase. That's the — not Las Vegas — went up like crazy at one point. Then there are the two confidence bands, then there's the orange bar saying what do we expect the price trend to be? But it's not the expectation that's so important, it's this lower bound; how bad can it get? If you're a banker that's the thing that tells you, "Is this loan going to be a disaster?" Every single one of these cities, virtually, the actual price just plunged right through the banker's confidence bands. If you've got a model that's an econometric model that's based on past price trends, and you ran that model in 2006 you wouldn't have been able to predict any of this crash. You would have felt pretty confident that when you were writing those mortgages, even the subprime mortgage, that those were good bonds, that was a good loan. A subprime loan doesn't mean that the house is bad; it just means a borrower is bad. It's a subprime borrower, not a subprime house. So you say, "Look, what's the worst that could happen? My borrower can't — we get into some trouble, my borrower can't make the payments on the house, then the bank has to repossess the house, but if the house price isn't going to move much, then what the heck, we'll just turn around and sell the house so we've got good collateral."

We all know what happened. That model turned out — that econometric model turned out to be a complete disaster. Actually one more point on this. What do you need for an econometric model aside from an econometrics textbook? SAS, I use R, I did this from R, Stata — some people use that. What else do you need to run an econometric model? This isn't a trick question. You have a blue scarf on, what do you need to estimate a model like this?

Student: Data.

Will Goetzmann: Data. Okay. You need data, and so the data come from Robert Shiller. The fact is, unless you have those housing indexes you can't run this model. The irony of these indexes is that although they opened a world to us of what housing prices do, they also made econometricians believe that they could estimate the risk associated with the housing. Before we had those indexes we couldn't do any prediction, we couldn't do any of this sophisticated mathematical calculations. We couldn't walk into the president of the bank and say, "Look, we've done a value at risk calculation using these fantastic indexes that tell us that the probability of us losing more than 20% of our capital is .005." You couldn't do it. Suddenly, with this data, a little bit of information is a really dangerous thing when you put it in front of somebody that knows how to crank through a regression. It's a terrible thing to blame Bob Shiller, the person that forecast this crash, to blame him on the other hand, for providing the matches that allowed people to burn down the house. It was a failure of models but you can't run the models without the data.

Chapter 5. 2006 Mortgage Regressions [00:40:27]

I'll just give you a little bit more flavor for what we do. We run a whole bunch of regressions. We're looking for relationships, but mainly what we do is we divide things up into the world of the demand side for loans and the supply side for loans. What we want to ask is, was it the stupid or avaricious banker that drove the crash? Or was it the stupid and avaricious homeowner, borrower that drove the crash, neither, or both. Here we have subprime mortgages and prime mortgages. Roughly when we look at relationships, here's what we find. We find for both subprime and prime, the numbers of applications and measured by — dollars and numbers of applications were increasing in those home prices. So when the home price goes up you make your forecast of what the worst scenario might be, and if you had a positive trend, you would think that lenders would be more comfortable with the bottom line, that they'd be able to get their money out. And borrowers, if they think, "Hey look, I'm buying a house, I'm putting every dime I have into it, but the trends look pretty good, I should be able to get my money out at the other end," then you ought to see a positive relationship between past price increases and applications, however you want to slice it.

Somebody mentioned — you mentioned leverage. That's exactly what happened. There was a greater loan to income requests for — higher leverage requests for both of those two. People actually also tended to — this is loan to income, measure of leverage, not loan to value. The loan to value actually also — the value to loan went up. Why is that? People felt comfortable putting more of their money into houses and than people bought more expensive houses, but the endogeneity issue — who mentioned that? That was a really important point. There were more expensive houses so that was inevitable.

So were people being foolish? Well that's a hard thing to say. They looked at it as a savings opportunity. You could say this was a crisis driven by over too much demand for savings. It's just that they didn't save in — just that the savings vehicle was the house. Were they irrationally exuberant? Well if you look at those trends maybe I would have been fooled by the same trend as well. How about on the banker's side? Now the banker's job is to say no, to reject loans. What do we find here? Now the weirdest thing that we completely — that completely shocked us is that approvals didn't really — the rate of approvals for subprime, once we controlled for a lot of things, didn't change as much as we had expected. In fact the rate for approvals for prime actually went down, which is strange. That means bankers were getting tougher. Well, they were only getting tougher because the demands were increasing. You have to look at this as, the environment was changing because the demand for loans was increasing a lot, but so that there were — their approval rates were actually going down. It really doesn't look like that — it doesn't look like irrational exuberance on the bankers' part for prime loans.

Mostly on the prime side, bankers appeared to be behaving really pretty rationally, less so on the subprime side. The loan-to-income ratio, that was going up; the value-to-loan ratio was going down; in other words, people were having to put up less of their own cash to own the home, and people were getting higher loans with lower incomes. If anything I think what we're beginning to convince ourselves, using this loan data, that the subprime market and the prime market were two kind of slightly disjointed markets with different decision processes in operation. Both sides had securitization going on and we haven't attacked the question of whether securitizable loans were driving all of this, but other people have been asking that question.

Chapter 6. Evidence for Three Demand Effects and Loan Level Likelihood of Approval [00:45:44]

We certainly found evidence of high — of increasing demand in prices. It could be that people are chasing after — chasing the trends. But it could be also that the expectation of the liquidation value of the house was going up and made them feel safer about the borrowing. The riskiness of mortgage applications is increasing in past price. Everybody wants to buy more expensive homes, but — that we documented, and as I mentioned, there's this disjunction between the two. That's sort of a — kind of a flavor for how a professor and some graduate students look at the crisis. You've been reading Posner and you see how somebody tries to put the whole thing together; well, our goal was to kind of deconstruct it. Let me see if there's — that's just a — kind of more documentary evidence of what I was talking about. I don't know, I've looked at history, been interested in that, and looked at current data, so with that — I don't know if we have time for questions or not but —

Professor Douglas W. Rae: Yeah I think there's time for one or two questions.

Will Goetzmann: Back there — Notre Dame.

Student: On one of your previous slides, you mentioned that the supply side seemed to be almost constrained, and you seem to attribute that to, I guess, potentially greater responsibility on the part of the bankers in not approving the increased number of applications, and I was wondering if you think that that is the case, or if there's evidence that it could just be that there was a constraint on the supply where banks just were not able to issue more loans due to capital requirements or other financial regulation.

Will Goetzmann: The beautiful part about this work is that we're taking as given that people — everybody, the banks and the borrowers are operating in their own best interests. So that we're looking at this as sort of a equilibrium outcome where they've taken into account the potential for the capital constraints and what have you, so that negative coefficient actually — you see it here, this negative coefficient on approvals for prime versus subprime. My tone of voice may have led you to believe that I thought that was a foolish thing. It certainly no evidence that it's foolish at all, but it's an interesting puzzle. I mean, we expected to see everybody lifting the floodgates and make — writing all these loans. The notion that the prime lenders were actually clamping down suggests that they were exercising some judgment about quality of loan that resulted in this negative rate.

Professor Douglas W. Rae: One last question.

Will Goetzmann: Question here?

Student: On the same slide you also implied that the supply side, the bankers, were not accepting these overleveraged mortgage applications as much as you would expect, but does your research indicate anything about how overleveraged the banks were themselves in how much capital they were taking out of the market?

Will Goetzmann: The question you're asking really implies a point of view about bank capital requirements. Certainly, I'll just use the data that I showed you, so we didn't use that — any information. As you know, this is a big spider web of different relationships that scales all the way up to the world, the government, and the role of capital requirements and regulators. We just didn't — we didn't pay attention to all of that. Our job is not to put the thing together but to see if we can find certain pieces that help us understand whether decisions were good or bad.

Professor Douglas W. Rae: Thanks, Will, it was a terrific lecture.

[end of transcript]