Why are nearly 10 million people still out of work today? Was it because in September 2008, the U.S. government failed to bail out the insolvent investment bank Lehmann Brothers? Was it because the two U.S. housing finance giants Fannie Mae and Freddie Mac guaranteed too many mortgages securitized by Lehman and other Wall Street firms to low-income borrowers in the run up to the housing and financial crises? Or does blame rest with the Federal Reserve’s too-easy-money policies in the wake of the brief dotcom recession in the early 2000s?
Princeton University professor Atif Mian and University of Chicago Booth School of Business professor Amir Sufi pin the blame squarely on policymakers, but not for any of these three reasons, all of which are variously popular with policymakers on different sides of the political divide in Washington. Instead, in their just-released book, House of Debt, they argue that the Great Recession was the result of a sharp fall-off in consumption due to the unevenly accumulated household debt in the first six years of the 21st century. In that period, mortgage-credit grew more than twice as fast in neighborhoods with low credit scores than in neighborhoods with high credit scores, a marked departure from the experience of previous decades. When the housing bubble popped, the economic consequences were sharply magnified by the way debt was distributed across households and communities.
How did this happen? Why did lenders suddenly shower less-creditworthy borrowers with trillions of dollars of credit? Mian and Sufi demonstrate this was enabled by the securitization of home mortgages by investment banks that did not seek federal guarantees from Fannie and Freddie—so called private-label securities, made possible by financial deregulation and the glut of cash in world markets in the wake of the Asian financial crisis of the late 1990s. That private-label mortgage-backed securities were at the core of the housing meltdown is no longer in doubt, but what Mian and Sufi bring to the debate is how an unequal distribution of debt magnified the economic risks—based on their path-breaking microeconomic research—and a new framework for considering who is to blame among policymakers for the still reverberating debacle.
Unfortunately, the two authors don’t provide answers for why so many households took on so much debt, but they do paint a cautionary tale. This is a critically important contribution to the policy debate now raging over what Congress and the Obama administration should do in the way of reforms to the housing-finance industry. And, it’s important to our understanding of whether and how inequality affects economic growth and stability. What they demonstrate is that as the U.S. housing bubble burst and home prices began to fall in late 2006, the unequal distribution of debt amplified the decline in consumer spending and the consequence was an economic disaster. Mian and Sufi’s research leads them to conclude that the crisis was avoidable if only economists had used the right framework to see what was happening around them at the time.
“Economic disasters are man-made,” they write in the opening pages, “and the right framework can help us understand how to prevent them.” By the end of the book, the reader cannot but be left appalled at the sheer enormity of the policy failures. It’s not just that 7.4 million workers lost their job during the years of the Great Recession of 2007-2009 but also that the employment crisis continues to this day. While jobs are no longer being shed at the rate of 20,000 a day, the share of the U.S. population with a job fell to a low of 58.2 percent in November 2010 from a high of 63.4 percent in December 2006, but has only increased by a fraction of a percentage since then, hitting just 58.9 percent in April 2014.
Missing the housing bubble was a massive failure on the part of policymakers. As a result, our new normal is one where there are nearly 10 million fewer people at work. This book's contribution helps us understand the important mechanisms through which this occurred.
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I watched the housing and financial crises unfold from my perch as staff for the U.S. Congressional Joint Economic Committee. By the time Lehman Brothers failed, the mantra on Capitol Hill had been articulated by former Treasury Secretary Lawrence Summers, who said that any recovery package had to be “timely, targeted, and temporary.” But the stimulus that emerged was not specifically targeted at homeowners in foreclosure. If Mian and Sufi are correct, the biggest failure was—and continues to be—leaving families struggling with mortgages they cannot afford because of the fall in home prices.
The federal government has provided assistance to a paltry 940,000 struggling homeowners through the Homeowners Assistance Mortgage Program, in a nation where 5 million homes have been foreclosed on. This lack of help hasn’t just hurt those homeowners. Also caught in the downdraft are now destroyed neighborhoods, ruined communities, and thwarted lives of far too many. Protecting banks does not necessarily make the economy strong.
So, how did we get here? That’s the focus of House of Debt. Mian and Sufi spent the past decade compiling and analyzing microeconomic data to test theories about how the macroeconomy works. They conclude that inequality in wealth and debt combined with greater availability of credit to marginal borrowers are a toxic macro-economic combination. They call this the “levered losses” view, arguing that severe recessions occur when “asset prices collapse and households sharply pull back on spending,” even with “no obvious destruction of productive capacity occurs."
Their story starts with an accumulation of debt—lots of it. After the Asian financial crisis in 1997, investors were looking for safe havens to park their money. What they wanted were AAA-rated bonds. What they got were mortgage-backed securities that were rated AAA but turned out to be junk. As we all now know—but most of us didn’t know at the time—Wall Street firms in the early 2000s began slicing and dicing and then reassembling mortgage debt into more and more exotic and risky mortgage-backed securities in ways that made them look risk-free.
But, it wasn’t just that there was more securitization. It was that loans made to riskier borrowers were more likely to be securitized. This both drove the housing bubble and made the consequences of it popping all the worse. Mian and Sufi point out that between 2002 and 2005, the growth in mortgage credit and household incomes became negatively correlated, that is, credit expanded in areas where incomes were declining. This makes no sense: How can you pay back a loan if your income is falling? They point to academic research by Yuliya Demyanyk and Otto Van Hemert showing the profound consequences: By 2006, loans had become so disconnected from prudent business practices that “an unusually large fraction of subprime mortgages originated in 2006 and 2007 [became] delinquent or in foreclosure only months later.”
As these foreclosures began to pile up, affected households cut back sharply on spending. Thus, the catalyst for Great Recession had begun two years before the dramatic demise of Lehman Brothers. In the second quarter of 2006, the collapse in consumption started with residential investment, which fell by a 17 percent annual rate. Non-residential investment didn’t begin to fall until late in 2008, but by then households had already pared back spending sharply.