Monday, April 21, 2008

How Historians Caused the Subprime Mortgage Mess

A hopeful sign that the credit crisis precipitated by the subprime mortgage disaster of ‘aught seven’ has run its course is that the blame game has begun in earnest. With typical abandon, liberals cast aspersions on the market while conservatives chastise the government. Poor Alan Greenspan, a conservative who long served as chairman of the government’s primary monetary policy instrument, the Federal Reserve, has been forced to walk a tenuous tightrope as he tries to vindicate both himself and the financial system. Almost simultaneously, The Economist ran an article suggesting that the root cause of the subprime debacle was a deficient educational system. Apparently, Americans, Brits, and the citizens of most of the world’s nations know so little about money they can’t be trusted with any, especially their own. Economists strenuously demur, preaching to an increasingly incredulous audience that humans are innately rational beings.

I want to join the blame game because it looks like such great fun. It doesn’t take much effort to concoct some controversial yet plausible-sounding monocausal explanation for our economic ills. All of us chiming in can get on television and talk past each other in short, vacuous, but strangely alluring sound bites. Nothing of value will come out of it, but we’ll have a grand time defending the indefensible while distracting people from ‘slightly’ more important topics like the war in Iraq, the burgeoning national debt, and global climate change. So here goes …

Historians caused the subprime mortgage mess. They did so by spending the last umpteen years studying increasingly narrow cultural topics to the exclusion of important stuff. Broad concerns about race, ethnicity, class, and gender devolved into minute studies of if not nothing then next to nothing. Those who preferred to stay off the cultural bandwagon were marginalized, shunted aside, and barred from the profession’s most important associations and laurels. One by one, the great pillars of the discipline’s once mighty edifice crumbled. Political, diplomatic, military, and economic historians fled for the greener pastures of retirement or professional schools. The Queen of the Social Sciences, as History was once known, abdicated her throne.

Few outside of academe knew, or cared, much about this strange transformation. It did not take long, however, for them to lose faith in the new cultural historians, who tended to be either ivory tower types with obvious, and often radical, political agendas or glib public intellectuals who supplied gobs of edutainment but little depth. Both quickly sank into irrelevance; policymakers public and private increasingly turned to political scientists, economists, and other non-historians for guidance about the past. Though adept with statistics and mathematical models, social scientists of the past often lacked skills that historians exude in ample quantities, especially archival research skills and the ability to think contextually. Largely devoid of those crucial skills, the social scientist of the past also proved insufficient to the task of providing deep historical insights relevant to major policy questions but clouds of fancy math and jargon delayed recognition of the fact.

While historians stood in the corner talking to themselves about next to nothing and social scientists of the past obsessed over their numbers and models, American investment banks blindly stumbled onto a ‘new’ idea, securitization, or the packaging of mortgages into bundles for resale to institutional investors throughout the world. The idea appeared brilliant because it took the risk of a mortgage default and spread it out, ostensibly to the point of eliminating it. Predicting whether in a given year a particular mortgage would go bust was as difficult as predicting whether a specific individual would die. But thanks to the law of large numbers, the percentage of a population that will die in a year can be known with great precision. So, too, it was thought, could the number of mortgage defaults. Investors could therefore buy even the riskiest mortgages so long as they diversified their portfolios by buying a lot of them offered together in a single security or bond.

One problem with that reasoning is that people usually do not want to die, but their desire and ability to pay their mortgage can change over time, and quite dramatically at that. Another problem is that life insurance agents typically receive their commissions over a period of years in order to give them incentives to sign up healthy people with safe occupations and lifestyles. Mortgage originators, by contrast, receive their payments upfront, at closing. They therefore have no reason to concern themselves with borrowers’ ability to repay their mortgages and in fact had incentives to help weak applicants to borrow the most they possibly could. NINJA loans (no income, no job or assets) and other absurdities are the result.

The most damning evidence against securitization, however, was purely historically. Between the Civil War and World War II, six America mortgage securitization schemes went belly up. None caused as much economic heartache as the current one but they nonetheless left ample evidence in the historical record. Each centered on a profitable-looking new market, eastern, western, rural, urban, local, and national. And each failed after a few years for precisely the same reason the subprime market was bound to, the skewed incentive scheme discussed above. A few scholars, those conversant with Kenneth Snowden’s chapter on the topic in Anglo-American Financial Systems (Michael Bordo and Richard Sylla, eds., 1995), knew about those foreboding precedents. It was difficult for them to get a word in edgewise, however, because they were few and not well respected by their historian or social science colleagues. That, in turn, rendered it impossible for them to gain the ear of regulators and investment bank executives. The rest is, or rather will be, history. Or will it? If the lessons of securitization are allowed to slip out of our historical consciousness again, our children or grandchildren could suffer a similar debacle, perhaps involving Artic beachfront property.

Historians need not drop what they are doing and rush off to study financial institutions and markets. It would be helpful, though, if they recognized the importance of their own discipline and unique scholarly skills to all aspects of contemporary life, not just culture. That might entail rendering their journals fairer and more inclusive, giving awards and other laurels to a wider group than hitherto, and occasionally hiring someone whose research might help save the nation from its next political, military, diplomatic, or economic crisis.


David R said...

Excellent article. Very interesting how the "diversification" of our society led to true knowledge being marginalized to society's detriment. Especially interesting was the historical tidbit regarding past mortgage securitization schemes.

Dr. T said...

I think your point is very fair and deserves the attention of people in my discipline, Geography, where there has been the same scholarly trend. - Eliot M. Tretter, PhD

John said...

Good Article!!!

khighland said...

I applaud you for being the only one that I could find online who brings History to light. We are such a soundbite society, and history started the day we first voted. What is the old addage, "those who don't know their history are doomed to repeat it." here in living color for all to see, but unfortunately, few see it. Thank you for your article.