My AEI colleague Stan Veuger cables from Holland to alert me to a fascinating academic economics paper. Here’s how the authors open the paper:
Did Wall Street foresee the recent crash of the US housing bubble? Given the role played by Wall Street in facilitating the credit expansion that precipitated the housing market boom, understanding this question is important for systematically understanding the causes of the worst financial crisis since the Great Depression. With the benefit of hindsight, many find it hard to imagine that Wall Street missed seeing large-scale problems in housing markets before others. For example, the Financial Crisis Inquiry Commission wrote in its report that, in the years preceding the collapse, “Alarm bells were clanging inside financial institutions” (Financial Crisis Inquiry Commission 2011). If Wall Street was aware that the process of securitization was generating a national housing bubble that would lead to a deep financial crisis yet proceeded to securitize mortgage loans of dubious quality, this would reveal far more severe incentive problems on Wall Street than many have recognized—and confirm many of the worst fears underlying outrage from the public and policymakers. On the other hand, if Wall Street employees involved in securitization systematically missed seeing the housing bubble, despite having better information than others, this raises fundamental questions regarding how Wall Street employees process information and form their beliefs.
The authors attempt to answer this fundamentally important question — “Did Wall Street foresee the recent crash of the US housing bubble?” — by looking to see whether Wall Street employees avoided financial losses on their own real estate transactions. As the authors put it:
Because a home typically exposes its owner to substantial house price risk, midlevel employees in the financial industry, even with relatively high incomes, should have maximum incentives to make informed home-transaction decisions on their own accounts. Individual home transactions thus reveal beliefs regarding their own housing markets in isolation of any distortions arising from job incentives.
We find little systematic evidence that the average securitization agent exhibited awareness through their home transactions of problems in overall house markets and anticipated a broad-based crash earlier than others.
Securitization agents neither managed to time the market nor exhibited cautiousness in their home transactions. They increased, rather than decreased, their housing exposure during the boom period, particularly through second home purchases and swaps of existing homes into more expensive homes. This difference is not explained by differences in financing terms such as interest rates or financing, and is more pronounced in the relatively bubblier Southern California region compared to the New York metro region. Our securitization agents’ overall home portfolio performance was significantly worse than that of control groups. Agents working on the sell side and for firms which had poor stock price performance through the crisis did particularly poorly themselves.
The paper, by economists Ing-Haw Cheng, Sahil Raina, and Wei Xiong, can be found here.
— Michael R. Strain is a resident scholar and economist at the American Enterprise Institute. You can write to him on Twitter at twitter.com/MichaelRStrain.