Study Suggests Mortgage Market Insiders Just as Oblivious to Housing Crash as Rest of Wall Street
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
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
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.
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
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.
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
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.
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
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."