The Financial Crisis - What happened and why

The current crisis is catalyzing an array of responses, including searching
for causes, reworking regulatory frameworks, searching for scapegoats, and
a massive injection of capital.

Without a clear understanding of the cause, the remedies may do more harm than
good, innocent participants may be unfairly scapegoated, and valuable progress
in financial tools may be reversed or curtailed. Even more importantly, there
is grave risk that a similar crisis could occur again in the future.

On the basis of a simple mathematical model of the underlying economics, I first
predicted this crisis in July of 2004. An economic dynamic relating very
low interest rates to the structure of the demand curve in the housing market
made this outcome foreseeable, indeed inevitable. The current crisis had a
mathematical cause.

First, let's consider some of the alternate suspects. The chorus we hear fixes
blame on Wall Street greed, irresponsible home buyers, lack of regulatory
oversight. Dr. Allen Greenspan blames it on a flaw in the workings of the
market.


In every downturn there is a bezzle. Corrupt practices are easier to hide in
good times; in bad times there are far fewer options for juggling and
concealing. When this bezzle is revealed, the customary error is to confuse
cause with effect, and think the corruption caused the downturn. And this time
is no exception.

Focus instead on the proximate cause of the problem - an epidemic level of
mortgage defaults and foreclosures. The cause of these is also clear - a rise
in interest rates from historically low levels, making the monthly payments
attached to variable-rate mortgages balloon. While the rise was small in
absolute terms, it was huge in relative terms, which made the monthly payment
change quite large, too large for the mortgagee to absorb. That alone need not
have caused the catastrophically high level of default, however. What caused the
defaults was the simultaneous drop in values, which made it financially
impossible for all but a few of these homeowners to sell their house to get out
from under the burden of unsustainable monthly payments. In fact the rise in
interest rates, which caused the rise in monthly payments, also caused the drop
in real estate values. The simultaneous plummet in property values is what made
default the only option.

This is the effect which we must understand - why do low interest rates cause a
bubble in real estate value, and why do rising interest rates burst that bubble?

Classical economics nicely explains equilibrium pricing, in terms of the
concepts of supply and demand. These concepts capture the intuitive notion
that if the price of something rises slightly, while everything else stays the
same, then buyers become less willing to buy, while suppliers become more
willing to sell. Conversely, if the price falls slightly, buyers become more
willing to buy, while suppliers become less willing to sell. This causes the
price to tend to reach the point where the willingness to supply matches the
willingness to buy, or more precisely where the quantity that suppliers supply
matches the quantity that buyers buy.

Like all equilibrium pricing, there is a supply curve and a demand curve for
housing. Over the short term, the housing supply is effectively constant. It
takes time to build new houses, so over short time periods there's no way to
increase or decrease the quantity of housing available. So it's the demand curve
that's crucial. And here the two central facts are these - for reasons we'll
discuss in a moment, buyers buy a monthly payment, not a house price, and buyers
buy as much house as they can afford.
Each of these phenomena is worth a moment's reflection, because each has
something to tell us about the dynamics and limitations of classical economics,
but let's postpone that discussion long enough to understand how those two
behaviors generate the inverse proportion.

Which brings us to the heart of the matter: mortgages which require no down
payment, and which require only interest payments, alter the structure of the
demand curve for real estate, in a way which is harmless enough when interest
rates are high, but which drives a bubble at low interest rates. Specifically,
they make housing prices inversely proportional to the interest rate. If
interest rates are cut in half, house prices double. When those rates double,
house prices are slashed in half. When interest rates are large, they are not
likely to double or halve, but when interest rates are small, a small adjustment
can be a big percentage change, and the danger of big swings in housing prices
is appreciable, even inevitable.

How does this happen?

If buyers buy as much house as they can afford, and decide on what they can
afford based on the monthly payment, that implies that they first set a monthly
payment budget, based on a substantial fraction of their monthly income, and
then look at houses priced at that monthly payment.

With no down payment, no amortization, and closing costs folded into the loan,
the only issue in affording a house is the monthly payment, which is the house
price multiplied by the interest rate.

To say that another way, the house price you can afford is the monthly payment
you can afford, divided by the interest rate. As interest rates change, the
affordable monthly payment doesn't change, nor does the housing stock, the
income distribution, or any of the other factors affecting the real estate
market, as measured in monthly payments. A house that is worth a given monthly
payment when interest rates are high will be worth that same monthly payment
when interest rates are low.

What does change, therefore, is the house prices themselves.
As interest rates drop, the monthly payment on the house drops. If interest
rates are cut in half, the house you can buy with a given monthly payment costs
twice as much. But the same number of people with the same income distribution
as before is competing for a fixed stock of housing. Because of the
distribution of incomes, vastly more buyers can now afford that house. But the
housing stock is essentially fixed. Only one of those buyers can buy the house,
and it will be the buyer who makes the largest offer. What will that winning
offer be? The house price is bid up until the new monthly payment at the new
interest rate matches the old monthly payment at the old interest rate. It will
be the old, constant monthly payment, divided by the new lower interest rate.
The house price varies inversely with the interest rate.

That won't be a problem, if interest rates don't radically change. The kind of
change that matters here is a multiplier change. If interest rates are cut in
half, house prices will double. If interest rates double, house prices will
be cut in half. There's no danger of interest rates doubling or being cut in
half, unless those interest rates are small to begin with. If they're near zero,
then that danger is appreciable, even inevitable.

The effect is somewhat mitigated, ironically, by property taxes, which
effectively raise the interest rate, but it's no accident that the bubble
occurred during a time of historically low rates, and burst when those rates
rose again.

This perfect storm required the confluence of a number of factors, each one of
which was at worst innocuous and at best virtuous. Let's consider them one by
one.

Interest rates were low for valid economic reasons, which we'll discuss at
greater length below.

The traditional mortgage had several features which have recently been relaxed.

The traditional mortgage required careful income verification. Modern
computerized database-driven statistical scoring technologies have provided
much more reliable ways of extending credit to vastly greater numbers of
deserving, credit-worthy people. On many levels that's a very good thing.

The traditional mortgage required a down payment. This provided a safeguard
against default, in two ways. It increased the chances that the house could
be sold for enough money to cover the loan, after all the transaction costs,
such as legal fees, sales commissions, taxes, etc., were paid. It also increased
the cost to the homeowner of defaulting and mailing in the keys, since the down
payment would likely disappear completely in those transaction costs. The value
of this safeguard, however, largely vanishes in a housing boom. The equity in
the house is supplied by the rising market, and within a year or two the down
payment is no longer relevant. It simply becomes a barrier to buying a home,
and eliminating a pointless barrier is a very good thing.

The traditional mortgage had a fixed interest rate. This, recall, was what
caused the savings and loan collapse which fueled the rise of Charlotte as a
national banking center. Fixed interest rates can only work when inflation rates
are highly predictable. The development of variable rate loans was a key
adaptation to the runaway inflation of the 70's. They work as long as the rate
on the loan matches the rate of wage inflation. As the inflated monthly payment
rises, inflated wages keep pace, and no default results. When there is a rise
in interest rates that is not paced by a rise in wages, then there are two
conceivable outcomes. Default is one, but if the value of the house is rising
or even just stable, an orderly exit is possible. Selling the house pays off the
loan and leaves the homeowner whole, if not exactly happy.

The traditional mortgage amortizes the loan, which is to say that every payment
pays not just interest on the loan, but a portion of the loan balance is
reduced every month. However, very little reduction occurs in the early years
of the loan. Constantly fluctuating interest rates, together with other
financing needs, not to mention mobility, create recurrent incentives for
refinancing, with the result that the benefits of amortization are of more
theoretical than practical value.

Each of these innovations, in isolation, represents a significant advance in
making home ownership affordable and available.

Taken together, however, they arm a trap which springs when interest rates dip
by a significant factor, and then rise again.

But that raises significant issues. Why would homeowners walk into that trap?
Why would mortgage lenders? Dr. Alan Greenspan recently testified that he
discovered a flaw in the model of how the world works, that he had relied on
the self-interest of lenders to act rationally.

The market worked, however. Supply met demand.

To fully understand what did happen, and why, we need to answer three questions:
Why do buyers buy a monthly payment? Why do buyers buy as much house as they can
afford? Why didn't lenders see the trap, and avoid it?

All three of these questions have a context. The usual context of classical
economics is the concept of supply and demand. As prices rise, suppliers are
more willing to supply, and buyers are less willing to buy. As prices fall,
suppliers are less willing to supply, and buyers are more willing to buy. But
why? The larger context is provided by the concept of utility, that people act
in a way that maximizes something called utility, and this act of maximizing
creates the supply and demand dynamic. But why? What is the larger context?

Economic activity is human activity, and human activity is biological activity.
Biological activity is physical activity. And physics, the body of knowledge,
is simply a collection of technologies for calculating probabilities, with the
key insight being the Principle of Selection, that whatever is more probable
probably happens more. In biological systems, the Principle of Selection occurs
in at least two distinct forms, the Principle of Natural Selection, and the less
familiar, but more important Principle of Sexual Selection.

The Principle of Natural Selection, recall, states that a heritable trait which
confers a higher degree of probability of survival to an individual, has a
higher probability of surviving in a population, while the Principle of Sexual
Selection states that a heritable trait which confers a higher degree of
probability of having offspring, has a higher probability of surviving in a
population.

Seen in this light, maximizing utility, which drives both supply and demand,
means neither more nor less than maximizing the long run number of surviving
offspring. Any economic behavior that raises the probability of survival, or of
offspring, which is also heritable, will predominate. Heritable, of course,
means not just DNA and cell structure, but also ideas and concepts. This makes
supply meet demand, and forces the time value of money, as we'll revisit.

But nobody knows the future. Biological Selection can't (or at any rate hasn't)
given us the power to formulate decisions based on perfect knowledge of the
future. Rather it gives us tendencies and faculties that have, on average,
worked better in the past than the alternatives did.


Why do buyers buy as much house as they can afford? Sexual selection forces it,
as does natural selection. You don't want your kids exposed to drive-by
shootings or gang violence. You do want your kids to be attractive, and you know
that your display of wealth will have a real impact on their attractiveness.
Don't shoot the messenger - I'm not lauding that fact, but it is undeniably a
fact.

Why do buyers buy a monthly payment? There are two, related reasons. It reduces
what is at heart a very complicated transaction full of unknowable future
uncertainties to a single, knowable, comprehensible number. You don't know what
will happen to property values, to neighborhoods, to interest rates, to zoning
laws, to taxes. You do know how much you make a month. And you are compelled to
act, with the gun of Selection held to your head.

The other reason has to do with personality, itself a manifestation of Sexual
Selection. Estimates vary, but around 40% of the population of the United
States has the temperament that Dr. Linda Behrens has labeled "Improviser", an
insightful re-characterization of Dr. David Keirsey's comprehensive study of
temperament. What characterizes improvisers is a preferred reliance on the
cognitive function that Jung labeled "extroverted sensing", which is profound
awareness of sensory input from the external world. This creates a strong
orientation to the "here and now", and a relative blindness to the past or the
future. For such a person, the monthly payment is the "here and now", and their
tactical strengths give them great confidence that whatever arises in the
future, they'll be able to deal with when the time comes. Those tactical
strengths, however, tend not to extend to strategic strength.

Another approximately 40% of the population of the United States has the
temperament of "Stabilizer", characterized by a preferred reliance on
"introverted sensing", which is a deep awareness of sensory memory. This creates
a strong orientation to the past, and a keen awareness of standards and
tradition, as well as a strong bias that whatever used to work is going to
continue to work, and a high level of trust in "the system". For such a person,
the fact that a mortgage product contains innovative elements would be
counterbalanced by the source of those products - (in some cases formerly) large
rich prestigious established institutions. Their strengths tend to be logistic,
rather than strategic.

Both Stabilizers and Improvisers share a strength, in noticing details, as well
as a vulnerability, in sometimes missing patterns, and in being relatively
unaware of the future.

The two other temperaments - Conceptualizers and Catalysts, share a
strength in noticing patterns, as well as a vulnerability, in sometimes missing
details, and in being overly future focused.

Which brings us to why lenders failed to see the trap. Wall Street has a strong
bias for detail-focused rather than pattern-focused people. Businesses do in
general. The mathematical component of the GMAT, for example, tests heavily
your knowledge of Euclidean geometry, which has been essentially useless since
the days of Descartes. However, it draws much more heavily on your "extraverted
thinking" faculties, largely ignoring your analytic "introverted thinking"
capabilities. As such it is largely a test for identifying smart Stabilizers.
Quant Interviews lean heavily on "fact sheet" questions, or tricky problem
solving. Einstein, who when asked what the speed of sound was, replied by asking
why he would bother to memorize something he could look up in an encyclopedia,
need not apply! In the modern world of rapid technical advance, businesses
which rely solely on the Improviser's here-and-now real-time response have
become just as vulnerable as those which rely solely on the Stabilizer's
resistance to innovation.

The good news is that businesses are developing an awareness of the need for
balanced teams of personalities, while the study of personality is, itself,
maturing. Dr. Keirsey's work, for example, has nicely unified the Jungian based
Myers-Briggs co-ordinate system for describing personality, with classic
observations on temperament, and elucidated the role of an externally observable
interaction style in sorting the members of each temperament into the
Myers-Briggs system. An interesting reformulation of this body of knowledge in
terms of a computational system balancing multiple brain processing centers is
described in dramw.blogspot.com, while a nice discussion of personality theory
can be found at

We mention in passing that these temperaments are striking examples of Sexual
Selection - each clusters with a distinct core need - to demonstrate competence,
or responsibility, or impact, or authenticity, traits that have much less to do
with survival per se and everything to do with being well thought of, which is
to say, attractive.

One last insight afforded by this line of reasoning has to do with the time
value of money, which has a biological basis, the subject of our next post.