Can Someone Tell the Washington Post About the Housing Bubble Already?

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The Post has a lengthy front page article today about how the Fed under Alan Greenspan and Ben Bernanke missed the problems developing in the subprime mortgage market. The piece makes many good points, but it missed the real story: the housing bubble. Yes, bad subprime and Alt-A loans were a problem, but the only reason that they shook the financial system was that we had an $8 trillion housing bubble. If house prices had not diverged from trend values then the default rates and losses on each default would not have been a big deal. Let's put this so that even a Washington Post editor can understand it. Suppose someone gets a garbage mortgage for $200k on a $200k home. Suppose the mortgage resets to a level that they cannot pay. The homeowner then loses the home. if the bank then has to resell the home, then it will lose roughly 25 percent, or $50k, on its investment, if the home is still worth $200k. This is bad news, but loses of this magnitude on $1.6 trillion or so of subprime and perhaps another $800 billion of Alt A would not have been that big deal. They certainly would not have sank the economy. The reason that the economy and the financial system sank is that the homes plummeted in value as the bubble collapsed. This meant that the $200k home might be worth $150k or even $100k in some markets. The loses in these cases could easily be 50 percent or even 75 percent of the initial mortgage. More importantly, there were huge losses even on prime loans as tens of millions of prime borrowers also fell underwater. It is important to keep saying that the problem was the bubble, both so that we have a clear understanding going forward and also so that everyone understands how badly Greenspan and Bernanke messed up. There was no need for any sophisticated understanding of complex financing on their parts. They just needed to know simple arithmetic to recognize a bubble and then to act on this knowledge. Apparently they either lacked arithmetic skills or the willingness to act based on the implications of this arithmetic. It is not clear what the Post's problem is.

--Dean Baker

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