Rajan, Levitin/Wachter on the Demand for Credit

There’s been a lot of interesting commentary on a recent debate surrounding Raghuram Rajan arguments on inequality and the financial crisis at the American Financial Association – see this Economist article for the best writeup.  MIT economist Daron Acemoglu’s AFA slides are on his MIT website. Here’s Simon Johnson with commentary. From the Economist:

Governments, he argues, could not simply stand by as the poor and unskilled fell farther behind. Ideally, more should have been spent on education and training. But in the short run, credit was an easy way to prop up the living standards of those at the bottom of the economic pile. This was especially true in America, with its relatively puny welfare state.

Mr Rajan thinks, therefore, that it is no coincidence that America in the early 2000s saw a boom in lending to the poor, including those folks that banks used to sniff at. He points to the pressure the government put on the two state-backed housing giants, Fannie Mae and Freddie Mac, to lend more to poorer people. Affordable-housing targets, slacker underwriting guidelines and the creation of new “low down-payment” mortgages were all used as instruments of public policy.

I think there are two problems with Rajan’s argument.

1. If you look at the history of financial deregulation it’s not clear that it was done first and foremost to help increase access of credit to the poor and middle-class. This could really benefit from some examples. Increased access was often a post-hoc justification, indeed the justification used in the public sphere, but much of what we consider deregulation didn’t impact consumers. Much of the real change in consumer credit law came out of a 1978 Supreme Court ruling, Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp. Indeed if you look at the bankruptcy reform of 2005, it’s not clear that this was cover to keep a struggling middle-class alive at the expense of capital investors – one could read it as the opposite.

2. The bigger problem is that, in the Economics 101 language, Rajan says that we’ve had a demand-side problem. Why was there so much credit floating? Because people wanted it, their demand increased, to compensate themselves from income stagnation. But for those in the field, MBS looked like a supply-of-credit issue – the orders came in to fill so much paper, not that people were knocking down their doors demanding loans.

How does that fit the data? As always, we can look at loan volume, and prices. I don’t think this excellent paper, Explaining the Housing Bubble (Adam Levitin, Susan Wachter) gets enough attention. (James Kwak covers it here.)

Looking at securitization data, Levitin and Wachter find that the volume of debt increased while the price decreased. Economics 101 quiz: What does that mean? That means that the supply-curve has shifted out. From the paper:

We believe that the cause of the bubble is to be found in the changes in the structure of the housing finance market in 2003-2004, as the market moved from Agency securitization of traditional FRMs to private-label securitization of nontraditional ARMS. It is unquestioned that securitization was the funding mechanism for the housing bubble, but no previous work has examined its pricing in relation to the bubble. We examined the pricing of PLS deals from 2003-2007. Our examination reveals a remarkable trend: even as mortgage risk and PLS issuance volume increased, the spread on PLS over Treasuries that represents their additional risk premium decreased. (See Figures 12 and 13.)

What’s more, spreads on AAA-rated PLS fell during 2004-2007, even as yield spreads on AAA-rated corporate bonds held steady. (See Figure 14.) In other words, the change in spreads was specific to PLS, and did not reflect a general movement in the AAA-rated bond market.
Declining PLS spreads meant that investors were willing to accept more risk for lower returns. In other words, housing finance was becoming relatively cheaper, even as it became riskier. The risk-adjusted price was dropping and quantity was increasing during 2004-2007!…

The movement in PLS spreads and volume—that spreads fell and volume increased even as risk increased, that the spreads fell below corporate bond spreads, and that PLS spread fell while corporate bonds spreads remained static—points to a supply-side explanation of the housing bubble, rather than a demand-side explanation. Simultaneously falling price (spreads) and increasing quantity (volume) means that there had to be an outward (rightward) shift in the housing financing supply curve (from S1 to S2, in Figure 15).

There may also have been an outward (rightward) shift in the housing finance demand curve (from D1 to D2, in Figure 15), as irrationally exuberant consumers sought ever more financing to cope with escalating prices. Such a shift would have resulted in both greater supply (Q2a) and higher prices (P2a), and thus larger PLS spreads. But PLS spreads decreased, even as supply increased. This means that the housing finance supply curve must have shifted outwards (from S1 to S2) enough to offset any outward shift of the demand curve in terms of an effect on price (P2b<P2a). Put differently, even if there was an increase in housing finance demand, there was a greater increase in housing finance supply. Investors’ demand for PLS was outstripping the supply of mortgages.90

I take it for granted that prices are mechanisms for making sure supply finds demand. There’s a lot of morality talk about how American consumers overbinged on credit; but that makes no sense – they were rationally reacting to price mechanisms and increases in the supply of credit. The question is why did so much credit get lent out?

One way to link that back to inequality is through Michael Kumhof and Romain Rancière model in Inequality, Leverage and Crises, where huge gains at the top are lent out to people in the middle of the distribution, increasing their leverage to financial crisis level of instability. We’ll discuss this model and the Levitin paper more in the future.

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15 Responses to Rajan, Levitin/Wachter on the Demand for Credit

  1. ginsbu says:

    I agree the Levitin/Wachter article is very good — I use it in a class I teach — and unfortunately overlooked. I wonder whether being a law review article has hurt it (in term of recognition, it already made it far too long).

  2. Sue says:

    “American consumers .. were rationally reacting to price mechanisms and increases in the supply of credit”

    Any hypothesis has to explain why a subset of consumers rationally reacted to the very same phenomena by noticing that being told they could borrow $x did not mean they could afford to borrow $x and so they did not.

    • Patrick E. says:

      Easy. Increasing property values meant that if you could not afford the payment when the ARM reset, you could refinance at the time of reset when the value of the property would be greater.

      Thus, even if you could not afford to borrow $x at the time, if you could afford the low payment schedule at the beginning of the ARM, it would still be profitable for you to take the unaffordable mortgage and then refinance into something more affordable once the value of the house had gone up to $y. That’s an assumption that many people made in the real estate market.

  3. Mandrake says:


    You need a tweet button on your posts. It would make them much easier to share while I read them at work. Everyone should be reading this stuff.

  4. I tend to agree that property values ruled, and that to deny access to lower income families while those who had, were able to get more and more appreciation in their homes., LOOKS RACIST, even if it isn’t.

    The key stat to consider is homeowner equity to credit card debt. As homeowners from the 60’s and 70’s and up to the late 80’s were experiencing the tripling and quadrupling of their home equity to well above what they paid for their homes, (although property tax and home improvements should not be discounted), using a portion of the built up credit seemed like an ok thing to go.

    Especially when interest only HELOC’s were offered.

    Once property values sank, the ratio of credit card debt to actual equity has exploded in such a short time there is little left for main street to work with.

    Not wanting americans to reduce their credit card debt is a sign that our government and wall street is turning inherently evil.

  5. should I have said “imploded” instead of exploded?

  6. chris says:

    they were rationally reacting to price mechanisms and increases in the supply of credit

    I question this use of the word “rationally”. How can a borrower rationally expect to benefit from debt-financed consumption? By dropping dead before they have to actually undergo bankruptcy? Otherwise they get to pay back more than they ever received, or go through a bankruptcy that will probably immiserate them more than they could have benefited from the temporary high living, or even both.

    Debt-financed investment is a whole other beast, in theory, but in practice I think a lot of people get into that for irrational reasons, too. If a given investment were that much of a guaranteed return, there’d better be a damn convincing reason why it’s still sitting on the ground; and if you know the investment is speculative, levering up to invest in it is the financial equivalent of juggling lit dynamite.

    And for most homebuyers, a house is consumption, not an investment — they buy it to live in it. People duped into buying too much house because they *thought* it was an investment that would beat the interest rate are not acting rationally; they’re putting their other assets at risk to gamble on the continued inflation of an already overheated housing market.

  7. Altoid says:

    I haven’t read the article and apologize if this is naive, but doesn’t the first graph imply that an underlying process was really high demand for supposedly safe securities? If so, this is pretty much where Krugman and DeLong are, but the process started fairly early in the 2000s. Would that point back to artificially low interest rates and Greenspan-Fed policy?

  8. thewoda says:

    I just wanted to add to the discussion here – Mike, you asked “why did so much credit get lent out?”

    William Black has cogently and consistently argued that the extension of credit to the undeserving is a sure sign of control fraud: it is a way to make short-term accounting profits at the expense of the financial firm.

    While many (I can specifically remember David Harvey saying this) have noted that the massive credit spike helped keep effective demand artificially high in an era of wage stagnation, I think that may only explain why consumers were so willing to borrow. The short-term motivation for the bankers may indeed have been accounting profits in an effort to commit control fraud.

    Black’s blog post about it here:


    Best to everyone.

  9. Ebenezer Scrooge says:

    Sue and Chris have a very good point. Pricing is not the entire story. Part of the problem is that banks were able to induce demand, in ways that previous suppliers of credit to marginal risks were not. Banks can take out fancy ads extolling the virtues of debt; the Shylock & Kneecap Freelance Lending Consortium could not. Eliminating usury restrictions (which operate only on legal lenders) is a key part of the story. Banks can also hire psychologists and marketers who can make the cost of borrowing near-invisible until the borrower is on the treadmill. Shylock & Kneecap is a bit more–uh–up-front. Banks can enact BAPCA; Shylock & Kneecap can’t do much to improve their debt-collection technology.

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  11. Barry Ickes says:

    The Levitin Wachter finding says nothing about the Rajan hypothesis. Rajan says that increasing inequality was a political problem. The authorities needed to do something about it. To enable those with lagging incomes to maintain their consumption the authorities could increase the supply of credit or loosen standards so that more is available. That is policies could be implemented to lead to shocks to the supply curve that cause the price of credit to decline. That is not inconsistent with a story that rising inequality caused politicians to weaken credit standards so that consumption could be maintained. It is not proof of it, but it is not proof against either.

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