Were mid-level managers who essentially ran mortgage securitization during the housing boom aware of the systemic risks occurring in subprime portion of that market?  Three researchers have looked at the home-buying behavior of a group of these analysts and determined that, whatever the level of their awareness, they typically did not expect those risks to lead to problems in the wider housing market.

Ing-Haw Cheng and Sahil Raina of the Ross School of Business, University of Michigan and Wei Xiong of  Department of Economics and Bendheim Center for Finance, Princeton University have published the findings of their research in a paper titled Wall Street and the Housing Bubble.

There have been two distinct theories about the meltdown in mortgage securitization.  The larger body of literature looks at whether the incentives for Wall Street agents were misaligned with those of outside stakeholders such as shareholders, creditors, taxpayers, and society at large.  A smaller body of study surmises that over-optimistic beliefs about house prices may have arisen due to behavioral biases, cognitive dissonance and/or money illusion.

These researchers say the two schools of thought are very much related, in that distorted beliefs about the wider housing market and bad incentives to lend to unqualified borrowers may interact and reinforce each other. For example, any weakened incentives to screen subprime borrowers would be exacerbated if lenders expected prices in overall house markets would never fall.

Despite its simplicity, disagreement about whether Wall Street was fully aware of broad-based problems in housing has remained relatively unresolved, owing to the difficulty in disentangling behavior motivated by beliefs from behavior motivated by job incentives. The authors sought to resolve this by studying the individual home purchase behavior of Wall Street mid-level managers who worked directly in the mortgage securitization business.  They argue that individual home transaction behavior reveals information about whether these employees believed there were problems in housing markets, as a home typically exposes its owner to substantial house price risk. Even employees in the financial industry, despite their relatively high incomes, should have maximum incentives to make informed home-transaction decisions on their own accounts, particularly mid-level managers.

The study group was composed of securitization investors and issuers culled from a publicly available list of attendees at the 2006 American Securitization Forum comprised of vice presidents, senior vice presidents, managing directors, and other non-executives working at major investment houses and boutique firms.  The researchers then collected information from the public record about the personal home transaction history of these securitization agents.

The study used two control groups which arguably had no private information about housing and securitization markets.  The first group consisted of S&P 500 equity analysts who do not cover homebuilding companies but who, by nature of their employment, had similar self-selection biases and were subject to similar income shocks.  The second control group consists of a random sample of lawyers not specializing in real estate law.

The researchers also controlled for a number of extraneous factors such as effects specific to individual firms, the location of the property particularly as affected by the housing boom and bust; financing considerations such as interest rates, the type of property, and whether the purchases attempted to limit exposure by refinancing or purchasing in non-recourse states.

The authors focused on testing whether securitization agents were more aware of the housing bubble than the control groups and relied on the cross-sectional variation in home purchase and sale behavior across the groups during the boom and bust periods.  They first tested for awareness in a strong "market timing" form, i.e. were the securitization agents better able to time the housing markets than others?  Caveats there are that market timing is a strong form of awareness because of the high cost of moving out of one's home and because mere knowledge of a housing bubble would not necessarily allow precise timing.  Neither of these however should impact the sale of second homes nor prevent securitization agents from avoiding home purchases if they were indeed aware of problems in housing.  

A second empirical test for a weaker, "cautious" form of awareness posited that securitization agents knew enough to avoid increasing their housing exposure - by avoiding purchases of primary homes, second homes, and moves into more expensive houses - during the bubble period of 2004-2006.

A third test focused on the net trading performance to see whether securitization agents' observed transactions improved or hurt their financial performance. Researchers benchmarked the observed strategies against a static buy-and-hold strategy and compared whether securitization agents did better against their benchmark than control groups.  

The analysis showed little evidence of the test group's awareness of a housing bubble and impending crash in their own home transactions.  Securitization agents neither managed to time the market nor exhibited cautiousness in their home transactions and increased, rather than decreased, their housing exposure during the boom period through second home purchases and swaps into more expensive homes. This difference is not explained by differences in financing terms such as interest rates, or refinancing activity, and is more pronounced in the relatively bubblier Southern California region compared to the New York metro region. The 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.

This is broadly inconsistent with systematic awareness of broad- based problems in housing among mid-level managers in securitized finance based on a revealed beliefs approach. However, a home purchase provides a consumption stream that may not be easily found in the rental market, and thus may reflect a consumption motive in addition to beliefs about the future path of asset prices.

It is difficult to rationalize why securitization agents endowed with income risk tied to housing would purchase additional second homes and swap into larger homes in 2005 if they simultaneously anticipated an imminent broad-based collapse in housing markets. There was also little evidence that securitization agents were conservative in the value-to-income ratios of their purchases, and that homes purchased in 2004-2006 were among those most aggressively sold in 2007-2009, relative to both control groups. This suggests that securitization agents overestimated the persistence of their incomes and that any consumption stream in these houses was short-lived.

The researchers stressed that none of these conclusions contradict the existing evidence that bad incentives caused loan officers and securitization agents to relax lending standards in the subprime borrower market.  Those in the study group were not subprime borrowers themselves.  "If Wall Street was complicit in relaxing lending standards in the subprime borrower market, our evidence suggests they did so without expecting it to lead to a wider crash in housing markets."

This distinction has important implications for post-crisis policy reform and future research. Regulators and academia should devote more attention to understanding whether agents working in the securitization finance industry had ex ante distorted beliefs or whether these beliefs only seem distorted ex post.   "It seems that certain groups of agents - those living in bubblier areas, working on the sell side, or at firms with greater exposure to subprime mortgages - may have been particularly subject to potential sources of belief distortions, such as job environments that foster group think, cognitive dissonance, or other sources of over-optimism. Changing the compensation contracts of Wall Street agents alone, for example through increased restricted stock holdings or more shareholder say on pay, may be insufficient to prevent the next financial market crisis."