Who Led Us into the Financial Crisis?

The New Republic's Zubin Jelveh writes up some intriguing findings calling into question the notion that securitization was at the heart of the financial crisis:

Instead of a smooth curve, at certain FICO scores there are big jumps in the number of people with mortgages.

The reason? Rules of thumb observed by those in the mortgage industry for judging the chances a borrower will default. In the 1990's, Fannie and Freddie released research showing that about 50% of defaults are associated with borrowers who have FICO scores below 620. That happens to be where the biggest jump in the graph above takes place, suggesting that the industry looks far more kindly on a borrower with a score of 621 than a borrower with a nearly identical score of 619.

But who used this rule-of-thumb?

The economists -- Benjamin Keys, Tanmoy Mukherjee, Amit Seru, and Vikrant Vig -- assert that securitizers followed the rule in deciding whether to buy a loan from an originator. Problem is, that meant the originator then knew he didn't have to spend much time vetting someone with a FICO score above 620, since there was a good chance the loan would be securitized and off his books. For the opposite reason, the originator would be more likely to put in the proper due diligence when considering lending to a borrower with a score below 620.

What we should then see is borrowers with FICOs just above 620 defaulting more often than nearly identical borrowers with scores just below 620. And lo and behold, when the economists looked at the data, that's exactly what they found.

Case closed, right? Not quite.

In a new paper, two Harvard PhD candidates -- Ryan Bubb and Alex Kaufman -- take an academic swipe at the big boys and point out the following: Although there is a big jump in mortgages at the 620 credit score, there isn't a commensurate jump in mortgages that get securitized at that score.

Meanwhile, Tyler Cowen points to some evidence that banker pay wasn't at fault, either:

This "executive compensation" theory of the crisis is now the keystone of the conventional wisdom, having been embraced by President Obama, the leaders of France and Germany, and virtually the entire financial press. But if anyone has evidence for the executive-compensation thesis, they have yet to produce it. It's a great theory. It "makes sense"--we all know how greedy bankers are! But is it true?

The evidence that has been produced suggests that it is false.

For one thing, bankers were often compensated in stock as well as with bonuses, and the value of this stock was wiped out because of the investments in question. Richard Fuld of Lehman Brothers lost $1 billion this way; Sanford Weill of Citigroup lost half that amount. A study by René Stulz and Rüdiger Fahlenbrach[3] showed that banks with CEOs who held a lot of stock in the bank did worse than banks with CEOs who held less stock, suggesting that the bankers were simply ignorant of the risks their institutions were taking. Journalists' and insiders' books about individual banks[4] bear out this hypothesis: At Bear Stearns and Lehman Brothers, for example, the decision makers did not recognize the risks until it was too late, despite their personal investments in the banks' stock.

The evidence I presented in my latest article, which deals in part with banker pay, also suggests that banker pay doesn't cause risk; rather, as the financial system gets more complicated (and therefore riskier, because it's harder to properly understand), there are more profits to be earned, because the returns to knowledge/skill are higher.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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