Foreclosure crisis: it is not about irrationality and sneaky bankers

Why has there been a foreclosure crisis in the United States? Two popular explanations are that 1) evil mortgage brokers forced people to take mortgages they could not possibly honor, and 2) those taking the mortgages did not understand what they were doing. As an economist who insists on logic and rationality, it is difficult to adopt these points of view, except that a point could be made about perverse incentives in the mortgage industry where the risk is masked and pushed unto unsuspecting people. But were mortgage holders really that stupid to think they would be able to make it? After all, I know several PhD economists who are still underwater, and they do not look stupid to me.

Christopher Foote, Kristopher Gerardi and Paul Willen come to the rescue. They argue that market participants made perfectly rational decisions given the information they had a the time, and in particular given the beliefs they had. The latter turned out to be too optimistic in retrospect though. Foote, Gerardi and Willen come to this conclusion with an interesting data analysis. They draw 12 "facts" that together contradict the popular explanations. Foremost, it does not appear that there is any correlation between exploding mortgage rates and mounting foreclosures. Also, even borrowers with spotty credit have had a remarkably good repayment history. One should thus not conclude that mortgages were designed to fail. Furthermore, all the instruments and innovations in the mortgage industry were introduced well before the past decade, and there was no significant regulatory change. Market participants knew what they were doing, had plenty of information and understood the risks. They were too optimistic though. Finally, no top-rated mortgage-backed security turned out to be toxic. The same cannot be said about similar bond-based securities.

All in all, there was nothing really wrong with the mortgage market apart from being too optimistic. In other words, there was a bubble, which can be a perfectly rational outcome. So there. But we still need to better cope with the eventuality of a bubble.