‘The Real Estate and Credit Meltdown: How Did We Get Here and Where Do We Go?'

Moderator: What do you see as the chief cause of the current financial crisis?"

Rafael Bostic:

This is a really hard question because there are a lot of moving parts. If I had to highlight one cause, I would say it is mostly because of "party greed." We've had an environment where there is a lot of money to be made in a very short amount of time. As risks started changing, it was observable that through the things we were investing in and the strategies we were using, those risks started to rise. Even as those risks increased nobody made the changes necessary, and we didn't change because people were still making their money. I call it mostly "party greed" because we can't blame any one party. It comes down to potential homeowners that were buying homes, lenders, banks, investors, and also the regulators. Each of them had a role in failing to recognize that we were moving closer to a very, very high-risk environment and changing our behavior.

Brad Hintz: The thing that I would point to is securitization. It's a wonderful technology. Securitization allowed us to take credit card receivables and stuff that we charge on our MasterCards, and turn it into a bond, or take mortgages and turn them into a bond. One of the problems with securitization is that it broke the link between the guy who originated a loan, and the guy who holds that loan. As a result, the quality control in terms of that loan origination dropped. We originated more mortgages, made more money, and didn't worry about the risk of whether or not someone else was going to hold up their risk on the other end.

There is also the manufacturing process. We didn't really talk about the ingredients that go into those products. I would also say that we trusted the rating agencies too much. But, you know, the rating agencies put their pants on one leg at a time, just like you and I. They are not the most highly paid people. They were overwhelmed with the volume coming through, and after awhile they slowly began approving things a little higher and a little higher. Add to that the credit officers who have had their four-year boom. It's not career enhancing to say "no" to something. After awhile what has happened is that the goal posts have slowly moved. These weren't mortal sins; there were a boatload of venial sins that everybody committed, and we're now all paying for them.

Robert Rodriguez: If these aren't mortal sins, then I don't know what a financial mortal sin is. This is an utter, complete breakdown in the U.S. financial system, straight and simple. There was unsound lending, a total dereliction of responsibility, moral turpitude-we could go down the list. We deserve exactly what we're getting.

Do you want to know who is responsible? Look at yourselves. It is about excessive leverage in the U.S. financial system. The U.S. Federal Reserve and Alan Greenspan compounded it with an absolutely absurd, totally insane monetary policy that took rates down to a level that was irresponsible. As a result of that, we have the brokerage industry, the financial services industry, the Federal government, and also the American public, who all participated in this ungodly party. No one wanted to earn a low return. That allowed Wall Street to manufacture this abomination of a product that allowed people to buy homes that they couldn't afford.

My firm, more than three and a half years ago, started writing. We identified the exact problem areas, and we did it with a total of three people. When I look around at what the cause of this was, it was excessive leverage, an unsound monetary policy, and an American public who added more debt in six years than in the prior 40 years combined. Leverage is great on the upside. It's very painful on the downside.

Ken Winston: The financial system has gone in only one direction over the last 10 years, which is to create more and more complex products. There are more and more layers of intermediation between the users of capital, such as somebody buying a house, and the suppliers of capital, such as investors, hedge funds, or anyone with capital. Every step of the way there were perfectly good reasons for these increased levels of intermediation. The general idea was to provide more choices on how to choose your risk-reward trade-offs. You could take a slice of the reward pie and fine-tune your exposure. The general idea every step of the way seemed sort of reasonable, but the end result and unintended effect of this was to make the decision process much fuzzier.

First of all, bad decisions were made. That's plain and simple. But secondly, and probably more insidiously, there was a general lack of clarity. People were not sure about whether or not good decisions had been made. The result of that was the freezing of the credit system.

When it became apparent that bad decisions had been made, it caused fear that securities, which were very complex and very difficult to understand, may or may not be problematic. That fear led securities and credit to devalue. The fact that institutions that were providing credit held the securities caused that credit to devalue further. It was kind of a perfect storm-a perfect storm of negative feedback-where these two things interacted. The bad decisions caused fear, more fear caused more bad decisions, and we're still in the middle of that. All of that was caused by the complexity of the system.

Richard Green: This is no longer my number one reason, but I think it's a really important reason that we haven't mentioned: Proliferation of the 100 percent multi-value ratio of the mortgage. I'm a big fan of home ownership. I've written a lot of papers about home ownership. The interesting thing is that the papers I have written that say home ownership is good have gotten a lot of citation, with a lot of pointing out that there are a lot of downsides to it, like strained mobility. We love home ownership in this country. But if you have no equity in a house, you don't really own that house, because, by definition, you don't own something if you don't have equity. So what do you have with a zero percent down loan? You have two options. You have the ability to give the house back to the lender. If things go badly, that's what you're going to do. Or, as the value of the house increases you have an ability to refinance it with some equity at the time that you refinance. You buy back the loan from the lender, get another loan, and buy the house from the profit that you've made.

What is your cost in capital for doing something like this, if you've put nothing down? It is pretty much zero. So your bet is that either it goes well, or things go badly. What does that do to the demand for housing? It's going to get perverse. It's going to drive prices up because people are demanding houses because they are getting two free options. We saw areas like Modesto, California see its housing prices go up to a median approaching $400,000. Someone said to me the other day, "God put San Francisco on earth so there'd be an expensive housing market." I don't think God put Modesto on earth so there'd be an expensive housing market. You look at Florida, Nevada, Arizona, and the Inland Empire, these are markets where zero percent down loans made up more than 30 percent of the sub-prime loans in that market.

Larry Harris: We're in the mess that we're in today because too many people bought these over-priced securities and over-valued real estate properties. The interesting question is then, "Why did they do this?" There are a lot of reasons, some of which you have already heard, but the reason we haven't broken down enough yet, and it is not stressed enough in the wider debate that the country is now engaged in, is the following: Too often the people buying the securities and the people creating them will pay now for creating risky positions, the value of which will be discovered in the future. There were a lot of people who had an incentive to make deals, because they were paid to make deals, which created liabilities and future risks that other people bore. There are governance problems associated with the management of other people's money that will ultimately have to be addressed to ensure that we don't run into these problems again in the future.

Moderator: Since we're focusing right now on housing policies and prices, I'd like to start with a couple of questions on that. First, how long do you think it will take for home prices to stabilize, and go back to previous values? The other question, is what kind of risks are real estate buyers taking in today's market?

Rafael Bostic: I think a lot of the issue here has to do with the financial markets and what was mentioned earlier about credit having to flow. If people cannot get credit then very few of us can buy a house. Very few of us can buy a house with cash, so we need these credit markets to function. If we can't get mortgages, then demand for housing is going to take a hit. As long as that isn't happening, it is hard to say where the bottom is. One thing that is really interesting about this episode is that it started off, really, as a non-economic event. This was a capital markets credit event. What has happened in the past six months or so is that the real economy is starting to show some real cracks. That puts additional weakness on the demand for housing because if people are having a problem when they had a job, it will be much more difficult to sustain demand when we don't have jobs or when there is a fear of losing it. I'm not very optimistic at this point in terms of when stabilization will happen. Pricing is not so out of whack at this point, but there are real questions about the ability to get financing to be able to take advantage of that pricing.

Richard Green: Rafael has got it right. Prices came down so quickly, in Southern California in particular, that if you're going to live in a place for a long time, you're making the decision between owning and renting, and you can get a good loan, the finances of owning make reasonable sense relevant to the finances of renting. But that's only if you know you're going to be able to keep your job for a long time. You don't trade houses every year. (We hope that people stop doing that.) If you know you will live in a place for five to ten years, then you're fine. But most of us are not lucky enough to get tenure.

People are very worried about their jobs right now, and with very good reason. If you think there is a chance that you're going to have to move in the next year or two to find a job in a different part of the country, then buying a house is a very risky path. It's all about your horizons. Let's put if this way, if I were a new assistant professor and had no idea if I would have a job in six years, I'd be renting.

Robert Rodriguez: I'm a purveyor of capital for the capital markets. Our policy right now is that we will not buy any mortgage security with an origination date after 2004. We will not buy any new mortgage originations, period. Why? I don't trust what is going on. There has been a fundamental breakdown. The government is interfering with the mortgage contract. Politics have gotten involved. I don't know what my contract is going to be. We are experiencing a restructuring of the mortgage process-we've got to keep people in the home. I'm sorry, but that interferes with the contract again. Now, there is a whole level of securitization, and as you push out, or keep people in a property at a reorganized level, you're now transferring value. This is an influx that will not provide capital, so what we have here is an issue of trust. We've had a breakdown in that trust. Until that trust is reinstalled, the capital flow will remain disrupted. I will not convey capital into this area. My obligation is to the people who have entrusted their assets to me, to invest them in a professional, prudent, fiduciary, and responsible manner, and that is not the environment we have today.

If you would like to view the rest of this discussion, please go to http://www.marshall.usc.edu/news/all-articles/your-financial-future.htm.