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10 of 11 people found the following review helpful
5.0 out of 5 stars A Sledgehammer, 11 July 2014
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This review is from: House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent it from Happening Again (Hardcover)
In this very short and extremely readable book two young professors prove with mathematical rigor (and in plain English) that the recent "Great Recession" was caused by the overindebtedness of America's poorest homeowners. It is truly incredible how much economics they pack into this 187 page book and how much of it you can absorb without stretching yourself. Brief summary of the argument:

1. Always quoting relevant research, but never attempting to talk over your head, they start by explaining how the poorest 20% of homeowners on average lost their entire net worth in the crisis, all while the richest 20% came out unscathed. How come? Simple: 1. The top 20% mainly hold financial assets that were protected by the Fed 2. The top 20% are indirectly the guys holding on to the mortgages that the poorest 20% are still paying or alternatively the US government guaranteed by taking over the obligations of Fannie and Freddie. All the recent talk about inequality? Go no further. The authors have it covered by page 40. Next!

2. They then explain that the poorest 20% have a marginal propensity to consume that is a large multiple of that of the richest 20%, an effect that also works in reverse and explains most of the fall in consumption (and thus aggregate demand) in the economy once their home equity had wiped out their lifetime savings. Yes, I'm confusing wealth effects with income effects here, but only for the sake of brevity. The authors do not! In short, the way you lose your house is you lose your income first (for example, divorce cuts it in half or illness in the family keeps you from working), next you miss payments, then you lose the house, which represented all your wealth to cap it all off. Alternatively, it's all set off when your monthly payment rockets up. And that's how the spending stopped! Charts are provided that measure this impact and irrefutably demonstrate that this process was in full swing, with spending on cars, furniture etc. on its knees a good 2 years before anybody knew the word Lehman.

3. It does not end there. Banks sell foreclosed homes into a weak market, forcing prices lower, which drives everybody's house price down, forcing people's home equity down to below zero who have done nothing wrong. These are people who can make their mortgage payment, and indeed mostly carry on doing so. Meantime, however, they are in negative wealth, with the inevitable negative effects on spending, especially among the poor.

4. Lots of lower spending all-round then forces companies to trim production and triggers unemployment. This was to me the most fascinating part of the book. Through little parables about countries linked through trading etc. the authors demonstrate how lower spending in conjunction with three distinct inflexibilities in the labor market (1. It's easier to fire people than to cut pay 2. It's difficult to move labor around, especially when it's wedded to a house it cannot sell 3. Retraining does not happen instantly) inevitably leads to job losses even in parts of the country or indeed the whole planet where no overleveraging and no housing bubble ever occurred.

I'm probably making a total hash of explaining this here, but the authors don't; they totally rock.

5. Next, they explain how debt not only doomed the poor, it actually triggered the whole housing bubble to begin with. Their work here is, for lack of a better word, forensic. They go state-by-state, nay, ZIP code by ZIP code splitting America by (i) high/low leverage (ii) high/low constraints in expanding city limits (iii) high/low credit score and demonstrate that credit expansion led price house appreciation. NOT the other way round. The analysis is fascinating and totally convincing. Leverage came first, house price appreciation followed. Page 83 is where to look. But, needless to say, higher house prices of course subsequently also led to further borrowing by households who famously "used their house as an ATM."

6. My second-favorite part of the book comes next. It explains how even those who believe homes are overpriced are left with no choice other than to get involved if irrational buyers use leverage: It's pages 110 to 113 and I won't spoil it for you here, it's a total gem of an argument. And it's followed by an equally elegant argument (originally by Andrei Shleifer, the man who best refuted the efficient market hypothesis AFAIC) on who would lend into this type of boom: investors who are misled into doing so by investing in securities specifically designed by the banking sector that provide enhanced yield by dint of over-exposing them to "neglected risks." Like -10% HPA, for example.

And so on... I still can't believe how much they've managed to pack in. In summary, the Great Recession was not caused by the Lehman incident. Contrary to the literature about the "breakdown in financial intermediation" theory promoted by our self-styled saviours, it was caused by debt, and in particular by the overindebtedness of the poor.


Next, they train their laser onto the inadequate response of policy makers. In one sentence, the most efficient thing to have done would have been partial debt foregiveness. Period. A chapter is dedicated to how hopeless all other policies (fiscal response, monetary response, you name it) are in comparison. And the blame is laid at the feet of those in charge.

This is so persuasive, that in response Larry Summers took it upon himself to review the book in the FT, lavishing it with praise, but also pointing out 5 (count'em) reasons his hands were tied.

Double QED

All in the space of 187 pages.

Admittedly, the book could have been even shorter. The authors dedicate a fair few pages to the purpose of debunking the "save the banks, save the economy" theory that informed the policies of the Paulson / Bernanke / Geithner response to the crisis. They needn't have. More people believe in UFOs today than in the importance of Citibank, AIG or Goldman Sachs in our future prosperity, let alone their propensity to hold up the economy through the provision of credit. On the other hand, if you ever bump into somebody who chooses to defend the indefensible, you can always mail him his own personal copy of "House of Debt" and if he is remotely honest or open-minded that should settle the argument.

It's all capped by a rather lengthy proposal regarding Shared-Responsibility Mortgages. I work in the markets and I have no idea who will buy them, especially since the Fed has had to buy the much simpler paper that nobody wanted.

But from where I'm sitting the contribution of the book is elsewhere. It's both the definitive account of what happened to the American economy from 2006 to 2014+ and a powerful punch in the stomach for anyone who advocates the "democratization of debt" as a path to prosperity.

Buy it, read it and lend it to a friend. Spread the word!
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Showing 1-7 of 7 posts in this discussion
Initial post: 13 Jul 2014 12:42:26 BDT
NHOJ says:
" . . . prove with mathematical rigor (and in plain English) that the recent "Great Recession" was caused by the overindebtedness of America's poorest homeowners."

Yes, "America's poorest homeowners" issued trillions of dollars of CDO's?

In reply to an earlier post on 13 Jul 2014 14:37:40 BDT
Athan says:
They sure as hell provided the raw material, but the authors contend (and I mostly agree) that largely speaking they are the victims rather than the perpetrators of this financial crime. So the one word answer to your question is "yes," sadly. The longer answer is more nuanced.

In reply to an earlier post on 14 Jul 2014 21:03:27 BDT
JJA Kiefte says:
Oh come on. Banks developed mortgages for the lowest incomes, thus creating demand for these mortgages, not the other way round. It's nothing short of perverse to put ANY kind of blame on these consumers who were, if anything, tricked/misled/misinformed into taking out financial products they did not comprehend and were not meant to comprehend.

In reply to an earlier post on 15 Jul 2014 13:41:46 BDT
Athan says:
The beauty of this book is that it does not go into what's right and what's wrong. It just says "here's what happened: poor people took on debt they could not necessarily service at rates they could not necessarily afford," next it takes us through the cascading consequences on them, on the housing market, on their spending, on the economy and on unemployment and leaves the morals to one side. Next, it says "whether this is morally right or morally wrong, the quickest way out of this mess would have been to forgive some of this debt." That's the two-sentence summary of the book. I think it's a total triumph.

In reply to an earlier post on 15 Jul 2014 14:02:09 BDT
JJA Kiefte says:
Well, you sure make it sound as if the poor are to blame and whether the book leaves this squarely in the middle (where's beauty in that?) or not, it is the cynicism, the callousness even, of the bankers that saw a beautiful new market of people too ill-educated and too overawed to understand what they were 'advised' by greedy money-grabbing pin-stripe suited 'gentlemen'.

In reply to an earlier post on 16 Jul 2014 09:46:10 BDT
Last edited by the author on 16 Jul 2014 09:47:41 BDT
Athan says:
For what it's worth, I mostly agree with you. While my sympathy for the plight of the overleveraged poor is not unbounded (for example, I feel a lot worse for their neighbours from across the street who did not overborrow and lost everything regardless when their neighbourhoods were obliterated and their jobs were lost) one would have to have been on planet Mars not to notice that the banking system ACTIVELY TARGETED the poor because they pay higher rates. Elizabeth Warren's recent book details all of this extremely well.

But I insist that this book is not about morally right and morally wrong, it's about financially wrong and financially expedient: 1. It would have been better for the economy if the poor had not overborrowed. 2. Once that damage was done, it would have been better for the economy to partially forgive those loans.

This is, to my knowledge, the book that best explains these facts.

Posted on 1 Aug 2014 16:51:23 BDT
Schofield says:
What is amazing is how many people can think of government as evil inflationists but when it comes to private banks can't see that allowing banks to abandon house mortgage under-writing standards, actively encourage over-valued house price appraisals and then wash their hands of this greed and stupidity by the use of fraudulent mortgage securitisation will not ultimately result in the future that grossly inflated bubble bursting and recession ensuing.
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