Days before the government stepped in to rescue Fannie Mae and Freddie Mac, Knowledge at Wharton chatted with Mark Zandi, the chief economist and cofounder of what is now Moody’s, about his new book, Financial Shock: A 360-Degree Look at the Subprime Mortgage Explosion, and How to Avoid the Next Financial Crisis. With the book, Zandi aims to demystify the risky credit practices that preceded the string of front-page disasters in the still unfolding global financial meltdown.

Mark Zandi discusses the risky loans behind the meltdown

Knowledge at Wharton: Mark Zandi, chief economist, and founder of Moody’s, has a new book about the sub-prime mortgage crisis: Financial Shock. Knowledge at Wharton talked to Zandi about his findings, today’s economic conditions, and what should be done to get out of this crisis and avoid another. Welcome, Mr. Zandi.

Mark Zandi: It’s good to be here.

Knowledge at Wharton: The sub-prime crisis is one of those things that has unfolded piecemeal, and has taken over a year and a half. And some elements of it started much earlier. And now we have your book, which puts it all into one place, and describes it all, and provides a lot of additional data and insight that we haven’t had before. I’m curious that — in researching this book, what you ran across that really surprised you, beyond what you knew from having followed the whole story as it was unfolding.

Zandi: Right. Well, many things surprised me. But at the most fundamental level, it was just how egregious the lending had become at the peak of the housing boom. It wasn’t just simply making loans to people with low credit scores. It was making loans to people with low credit scores with no down payment, or down payment assistance. With no proof of income and just an enormous amount of risk layering that was going on. You know, I had a sense that obviously underwriting standards in the mortgage industry had fallen. I had no concept to what degree they had declined. And that’s a bit surprising to me, because many of my clients are in the industry. They’re mortgage companies, mortgage insurance companies; the Fannie Maes and Freddie Macs of the world. And I thought I had a pretty good understanding. I thought it was bad, but I had no understanding of how bad it really was.

Knowledge at Wharton: And this refers to things like the No-Doc loans, or Liar Loans, as people came to call them, and the 100% mortgages, and the sort of eroding of underwriting standards that were supposed to be the safety net that kept these things from collapsing.

Zandi: Yeah, exactly. I mean, if you go back early in the housing boom — say, 2004, maybe early ’05, the extent of the aggressive lending was just giving loans to people who had problems making payments on other kinds of credit. Bad credit scores. But lenders would require a pretty sizable down payment, and certainly proof of income and a stable job. By the end of 2005, and into 2006, all of that had just evaporated. And lenders weren’t checking anything. They weren’t even doing appraisals on the property. So it was really the wild, wild West, to a degree I did not know and could not have imagined.

Knowledge at Wharton: Just to go back a second. One of the things that happened in the build-up to all of this, that you mention in the book in some detail and that other people have talked about, is this period when risk seemed non-existent. And that risky securities like junk bonds and emerging market debt and some of these mortgage-backed securities were trading at prices that offered yields that provided almost no risk premium at all. And apparently that was mispricing. That we now know that they were much riskier than people thought. What caused people to be so sanguine about risk? And where do we stand now? Are we overestimating risk? Have we gotten too nervous? Or is it just impossible to tell what risks are?

Zandi: Well, in part, there was a fundamental reason for this optimism. And that goes to the global economy itself. The ups and downs in the economy seemed to be moderating. It’s called the Great Moderation. And there are some good reasons to believe that our economies are more stable than in the past. And so if you have a more stable economy, then it makes risk premiums for financial securities — it’s logical to expect that they would come in, and wouldn’t be quite as wide. You’re just not going to have big recessions, and big bankruptcies and lots of credit problems, so you don’t need as much of a risk premium. So there, I think, is a good sort of fundamental explanation for it. But I think it got carried to an extreme, and people started, in a sense, forecasting with a ruler. And, you know, most forecasting is done that way. If the price of something —

Knowledge at Wharton: If the line’s going like this, it’ll keep going like that.

Zandi: Yeah. If prices rose last year by 10% and they rose 10% the year before that, what do you think the price increase is gonna be next year? Ten percent. And so you start building that into your forecasting, and you tend to take more risk in response. The third thing is, there was just a lot of liquidity, a lot of cash. You can remember liquidity raining everywhere. And there’s a lot of discussion as to what drove that. Part of it was very aggressive monetary easing, back earlier in the decade. It was also related to the fact that we have this very large current account trade deficit. So we’re pumping out dollars, buying goods produced overseas. And that’s putting dollars out there to be invested. And that provided a lot of liquidity.

And so money managers, investors, had lots of cash, lots of liquidity. And they have to put that to work. They just simply can’t put it on the sidelines and wait for something bad to happen. They could do that maybe for a year. But if in that year, prices rose 10%, they can’t do that in year two, because no one will invest with them. They’ll say, “What the heck are you doing? I gave you my money to invest it in whatever it is you do. And now you’re not doing that.” So the professional money managers, the folks that were taking these global investor dollars and funneling it through these investments, really felt like they had no choice. They actually felt uncomfortable. I had many money managers as clients. They just knew that this wasn’t right. It didn’t feel right. You know, you’d go to conferences, and everyone’s hand-writing that, “This doesn’t make sense. But that doesn’t matter, because I’ve got cash to invest, and I’m going to have to invest it.”

Knowledge at Wharton: And so they were willing to accept an infinitesimal risk premium for buying emerging markets.

Zandi: They went from one asset class to the next, right? I mean, you look for — the first thing you’ve got —

Knowledge at Wharton: There’s a ripple effect.

Zandi: Yes. Because you buy one asset, the risk premiums come in, and you go, “Okay. Well, this asset has a higher risk premium. So let me go invest in that.” That risk premium comes in at the peak. You know, going back to the end of 2006, early 2007. Right before the financial shock. Risk premiums on everything. Junk corporate bonds, mortgage-backed securities. Commercial mortgage-backed securities. Direct investments in property. Everything — all the risk spreads were as narrow as they have ever been.

Knowledge at Wharton: It seems to me that a lot of people in this circumstance would kind of draw the line at what went wrong here as the innocent bystanders who were hurt. All of us who did not take out crazy mortgages and see our home prices fall, or see our stocks fall, and that sort of thing. So, where, along that continuum, should the proper amount of regulation be? What should its goal be? Just to protect the innocent, or to guide the markets in a deliberate fashion, in a certain direction?

Zandi: Well, you know, my view is that it’s important to set down some basic rules, that you need certain levels of capital. And these are the ways you measure capital. And these capital levels need to be equivalent across all financial institutions. That the entire credit risk in the financial system is at least being monitored, so that everyone can see it, and we have something palpable that we can measure and have an understanding of what was the level of risk rising, and the level of risk falling. We need to have rules that increase transparency. We talked about transparency in the trading of securities. But also, in terms of the balance sheets of the institutions that are in our financial system. So, you know, I think — it’s not saying that this is a bad mortgage loan, or this is a good credit card loan. There’s some basic things we might want to lay out with regard to that. Like, “Don’t make a mortgage loan to someone you don’t think who can repay you.” That makes sense to me. That’s pretty basic. But it’s not as much that as it is sort of the basic rules of the game, and have a regulator that can sort of watch over the entire system, as opposed to just a part of the system.

Knowledge at Wharton: And a better sense of knowing what’s going on.

Zandi: And just having the information. I mean, I’ll end it this way. We still don’t know — really don’t know — how many people are being foreclosed on. No one knows. And that’s not the fodder of good policy-making.

Knowledge at Wharton: Well, let’s come back next year and talk about it again.

Zandi: I would appreciate it. Thanks for the opportunity.

Knowledge at Wharton: Thank you very much. And good luck with the book.

Zandi: Thank you.