by Calculated Risk on 1/09/2008 05:00:00 PM

St. Louis Fed President William Poole spoke this morning: Dollars and Sense.

Poole started by saying there are no new lessons here, we are just repeating old mistakes.

Will housing sector problems push the economy into recession? It is too early to tell right now, but what we can do is to examine the current situation closely and try to learn from it. Perhaps “relearn” is a better word, because the mistakes that brought us to this point have been made before. There are no new lessons here. The lessons are familiar ones that need to be more forcefully driven home and incorporated in standard financial practice in the future.

Usually I enjoy Poole's speeches, but I think he completely missed the mark with this one. First, here are Poole's Five Mistakes:

First, too many borrowers took on mortgages they could not afford. Nothing new there, except for the number of such borrowers. How could something seemingly so preventable happen? One of the main culprits was the adjustable rate mortgage, or ARM. Actually, the problem is not the ARM itself but grossly inadequate borrower understanding of this type of mortgage. The “Two/Twenty-Eight” ARM called for low initial payments for two years, which would then reset to higher levels for the remaining 28 years of the 30-year mortgage. Too many borrowers, though, did not insist on knowing just what the “higher level” would mean, and too many mortgage brokers did not provide that information in a way the borrower could understand. Other borrowers, wanting to take advantage of low initial payments, gave misleading or false information about their ability to repay. It is important to emphasize that there is nothing inherently wrong with adjustable rate mortgages, and they make sense for many borrowers. However, borrowers must be prepared for interest rate resets and able to pay higher rates. In recent years, too many borrowers were not prepared. Borrowers also need to understand prepayment penalties in their mortgage contracts. These can make refinancing ARMs into fixed-rate mortgages terribly expensive.

The problem with this "mistake" is that many of these borrowers acted rationally. They put little or no money down and basically obtained free put and call options on a house (with only their credit rating at risk). Was this really a mistake for these borrowers?

Second in our mistakes summary, mortgage brokers put too many borrowers into unsuitable mortgages. As I mentioned in a speech to a St. Louis real estate group last July, with widely held expectations of rising interest rates priced into the markets throughout the 2003-2005 period, it is difficult to avoid the judgment that these ARM loans were poorly underwritten. It was imprudent for mortgage bankers and lenders to approve borrowers who likely could not service the loans when rates rose. It is important to understand that rising interest rates were not just a risk but actually the market expectation. Poor underwriting not only jeopardized the borrowers put into unsuitable mortgages but also the brokers themselves. Numerous brokers are now bankrupt, and many survivors have suffered large losses and sullied reputations.

Third, it is surprising to me that investment banks jeopardized their reputations by securitizing these mortgages when the underlying loans were backed by inadequate or spurious information.

Damaged reputations are also casualties of the fourth major mistake: rating agencies that placed AAA ratings on many securities backed by subprime mortgages. The rating agencies seemed to have based their ratings on a backward look at default experience on similar mortgages before 2006, rather than on a forward look based on careful analysis of the likely ability of borrowers to repay in less favorable market circumstances. The reason default experience on subprime mortgages was relatively favorable before 2007 is that housing prices were rising, permitting stressed borrowers to sell their properties to repay the mortgages. The rating agencies, apparently, did not believe that house prices might stop rising, in which case the music would stop.

The final entry on our major mistake list is investors who bought those securities without conducting an adequate analysis of the underlying investments. Investors too readily accepted the AAA ratings at face value. As financial planners, you are very familiar with the cliché that “if something looks too good to be true, it probably is.” A reach for yield with inadequate attention to risk is another basic lesson that apparently cannot be relearned often enough.

It is interesting, and a bit depressing, that investment professionals made four of the five mistakes. I can understand the mistakes many financially naïve borrowers made but have a hard time understanding how so many investment professionals could have been so wrong. Many observers point to greed, but I prefer a different explanation. Shortsightedness rather than greed explains actions that led to losses of tens of billions of dollars and the failure of many financial firms.

I'd start any list of mistakes with lax underwriting standards and the lack of regulatory supervision. Why were underwriting standards so lax? Back in September, Fed Vice Chairman Donald L. Kohn addressed the causes of the housing bubble:

"... it is far too soon to pass judgment on what went wrong in the U.S. housing market and why. I suspect that, when studies are done with cooler reflection, the causes of the swing in house prices will be seen as less a consequence of monetary policy and more a result of the emotions of excessive optimism followed by fear experienced every so often in the marketplace through the ages. To some extent, too, the amplitude of the housing cycle was heightened by the newness of the subprime market, the fragmentation of regulatory oversight responsibility for that market, and the complexity and opacity of the newer instruments for transforming and distributing risk. Low policy interest rates early in this decade helped feed the initial rise in house prices. However, the worst excesses in the market probably occurred when short-term rates were already well on their way to more normal levels, but longer-term rates were held down by a variety of forces. And similar, sometimes even sharper, trajectories of house prices have been witnessed in some economies in which the central banks said they were paying more attention to asset prices."

Kohn raised three possible causes of the bubble: "fragmentation of regulatory oversight responsibility", "complexity and opacity of the newer instruments", and initially prices increased (in Kohn's view) due to "[l]ow policy interest rates".

The complexity and opacity of the new instruments (and methods of doing business) go a long way to explain the mistakes Poole lists for investment professionals. Each person - mortgage broker, rating agency, securitizer, investor - was only looking at their piece of the puzzle. I think Poole is focusing on the wrong mistakes. Kohn is much closer to the actual causes.

We can debate the impact of low policy interest rates, but a clear failure was the lack of oversight. A number of people saw the problem coming, see Fed Shrugged as Subprime Crisis Spread, but a few people in key positions failed to act, even when it was obvious that there was a systemic problem.

If we are relearning old lessons, perhaps we should remember that some oversight is good, and ideologues are dangerous to our economic health.