Arnold Kling  

If Fish Had Wings

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Kevin Drum writes,


From a systemic point of view, the real issue is that predatory lending on a large scale helped to massively inflate the housing/credit bubble of the aughts. If the home loan market had been regulated stringently enough to keep mortgage lending relatively sober, the bubble most likely would have been half the size it ended up at...

Well, yes, if a regulator had stepped in and required 10 percent down payments, the bubble would have been much smaller. That is excellent hindsight. But in the real world, with real politicians, there is no way that a regulator would have done that. The result would have been to drive first-time homebuyers, particularly minorities, out of the market. That was an inconceivable policy decision in 2004 or 2005.

One of the assumptions about the "markets fail, use government" folks is that government always knows what it's doing. I guarantee you that the next financial bubble will be something that the regulators miss, just as they missed the last one.

I would also add that I am skeptical about a regulator's ability to keep smart financial firms from separating dumb investors from their money. As they say in software, you can't make a system that is idiot-proof. They will just build a better idiot.

But let me reiterate here that the people who were most taken advantage of in the housing bubble were not the folks who bought houses. They were the professional money managers who invested in AAA-rated securities. And ultimately the people most taken advantage of were the taxpayers who bailed out those investors.

Finally, on the issue of those taxpayer losses. We are seeing reports that TARP is costing less than expected. I hope that is the case, but the reports are premature. The housing market imbalances are not behind us yet. And I don't know how much of the reduction in losses at various banks merely represents a transfer of risk to the Fed (which, as far as I know, carries its mortgage securities at book value and does not hedge their interest-rate risk), Freddie Mac, and Fannie Mae.


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COMMENTS (17 to date)
Steve writes:

Why should the Fed hedge interest rate risk? If interest rates move against them, they can just move them back from whence they came!

Besides, I'd imagine the Fed is more worried about credit risk than interest rate risk. Prepayment risk at this point is pretty low for most MBS; those who would prepay in a low interest rate environment surely would have done so by now (there can't be many cuspy tranches left out there). The only interest-related risk now is extension risk.

ThomasL writes:

People used to remember little proverbs like, "A foole and his money is soone parted."

Apparently the modern ruling classes think that truism can be more wholesomely rewritten, "A foole and his money is soone parted -- unless we maintain a comprehensive, Federal consumer-protection agency."

Boonton writes:

I think that predatory lending is a problem but in itself it didn't cause the bubble, instead it was just some icing on the cake. It should be regulated because it is wrong.

Arnold asserts that it was the money managers who were the victims of predatory lending because they lost while many home owners at least gained an 'option' on a house. This is false.

Suppose I own a little store that sells lottery tickets. I swipe $100 from Arnold's wallet and replace it with 100 tickets. From his POV, I've done nothing wrong. He had $100 of value in his wallet before, and has $100 now. In fact, in a perfectly free and pure market he could instantly turn around and sell those tickets for $100 or he could enjoy having a 'free option' on winning the jackpot.

His argument continues along these lines, if one of those tickets happens to be the $100,000 winner, then I have lost. I could have kept that ticket myself and had $100,000. Instead I just have his lousy $100 bill!

But in the real world this would be illegal. Arnold had $100 cash in his wallet and he didn't want to buy an 'option on the jackpot'. I would be charged with theft even if one of those tickets won him $100K. Many were sold a bill of goods in the housing market. They were sold on the idea that by taking an outrageous mortgage they could:

1. Establish good credit.
2. Refinance into an even better mortgage before the resets hit.

As I said previously, I don't have a problem with this provided the mortgage lender:

1. Is required to guarantee that they will refinance the saps mortgage if he makes his payments on time.

2. Disclose fully and clearly to the guy that:
a. They are not 'on his side'. Their fiduciary obligations is to their financial interests and aren't giving him professional advice anymore than the used car salesman can be thought of as a consultant.
b. That there's a real change this won't happen, they will hit the reset without anyone to refinance them nor the ability to sell the house to pay it off and they should be prepared to pay the onerous payments on the other side of the reset.

By disclose I mean something more akin to what drug companies do with side effects and not "but its on page 36 in small type!". I would also require them to be liable if a reasonable person would conclude that even though the 'disclosure' was made the borrower could not reasonably have been expected to understand the risks being described.

Do I think this would have stopped the bubble? No. There were plenty of people willing to take those risks. But IMO it would have prevented some of the more innocent players from wasting their time, hopes and credit.

John Thacker writes:

Boonton:

But the entire concept of "predatory lending" doesn't make any sense. Either the lender and the borrower both made money or, in this case, they both lost money but the lender is losing more (though the borrower has less to lose.) Predators gain sustenance when the kill their prey; the banks are losing tons on people not able to pay their mortgages. Lenders want people to be able to pay them back, they just want to get as much money out of them as possible.

Even if you're going to criticize it, wouldn't "parasitic lending" make more sense?

Kevin writes:

It is not appropriate to compare voluntarily contracted loans and mortgages to swiping cash and handing over lottery tickets. The borrowers walked into the convenience store, asked the clerk if he has lottery tickets, pulled out their wallets, and bought the tickets. Lots of them actually left the store upset the clerk wouldn't sell them more. Voluntary/involuntary Boonton.

And home loan documentation isn't that complicated today. Most high school graduates can read it in an hour or less. The truth-in-lending forms simplify this further. I'll tangentially add that a lot of the small print that obfuscates the simple realities of many lending arrangements is a result of regulation.

Nick writes:

@John Thacker,

But the entire concept of "predatory lending" doesn't make any sense. Either the lender and the borrower both made money or, in this case, they both lost money

The "predators" were mainly mortgage brokers and mortgage originators who did make a killing on the fees charged on these loans. The disconnect of risk was a serious problem. The brokers/originators did not have long term risk exposure so they didn't care if the buyer lost money in the long run.

steve writes:

"Well, yes, if a regulator had stepped in and required 10 percent down payments, the bubble would have been much smaller. That is excellent hindsight. But in the real world, with real politicians, there is no way that a regulator would have done that. The result would have been to drive first-time homebuyers, particularly minorities, out of the market. That was an inconceivable policy decision in 2004 or 2005."

The investment banks and mortgage originators were making a fortune in 2004 and 2005. I would be willing to bet big bucks that they would have had more influence here than a few poor minorities. Sheesh! Every talking head on TV said we didnt need to worry about the economy and the middle class because their wealth was increasing due to home values. (Yes, some of us were worried about the slow job growth and stagnant wages.)

Steve

SydB writes:

"I guarantee you that the next financial bubble will be something that the regulators miss, just as they missed the last one."

If a building falls, and the reason is found, Mr Kling argues that building codes should not be updated to incorporate this new knowledge because in the future buildings will fall for other reasons.

Doc Merlin writes:

'One of the assumptions about the "markets fail, use government" folks is that government always knows what it's doing. I guarantee you that the next financial bubble will be something that the regulators miss, just as they missed the last one.'

This wasn't exactly 'missed' the bush administration pointed it out and tried to fix the rules. The problem was the political economy and incentive structure within the political system.

Boonton writes:

John

But the entire concept of "predatory lending" doesn't make any sense. Either the lender and the borrower both made money or, in this case, they both lost money but the lender is losing more (though the borrower has less to lose.) Predators gain sustenance when the kill their prey; the banks are losing tons on people not able to pay their mortgages.

You're telling me if a predator chases down a deer and slashes its throat but then trips on a stone and breaks its own neck it couldn't have been a predator!

In the normal sense predatory lending is a situation where a lender extracts onerous credit terms from a borrower by taking advantage of ignorance, lack of sophisciation or even outright deception. It doesn't require that the borrower technically loose anything.

Even if you're going to criticize it, wouldn't "parasitic lending" make more sense?

I suppose but I think the concept remains more or less the same.

Kevin

It is not appropriate to compare voluntarily contracted loans and mortgages to swiping cash and handing over lottery tickets. The borrowers walked into the convenience store, asked the clerk if he has lottery tickets, pulled out their wallets, and bought the tickets. Lots of them actually left the store upset the clerk wouldn't sell them more. Voluntary/involuntary Boonton.

True the analogy is extreme but it still works. Klings assertion is mostly wrong. Many borrowers were not thinking they were scoring an 'option on a house'. They thought the mortgage broker was acting as an adviser, someone 'on their side' rather than a salesman trying to hawk a product that is taking up inventory space and has to be cleared off the shelves.

I have no problem with them selling these types of loans but I think they should have the equivalent of a skull and cross bones on them and I think they should have to worry that the borrower has recourse in the courts if there's good evidence that the borrower was not aware he was buying a complicated and risky financial bet as opposed to a reasonably conservative investment.

Steve Sailer writes:

"But in the real world, with real politicians, there is no way that a regulator would have done that. The result would have been to drive first-time homebuyers, particularly minorities, out of the market. That was an inconceivable policy decision in 2004 or 2005."

Right. We can tell that's true because almost nobody wants to point out today the role that the bipartisan push for weakening credit standards in the name of increased minority lending played.

Markets are supposed to reflect the balance of Greed and Fear, but the government and our culture have relentlessly demonized for decades anybody who fears lending to minorities. So, Greed ran amok until the whole house of cards fell down.

George W. Bush's campaign in 2002-2004 for zero downpayment lending, highlighted by his October 15, 2002 White House Conference on Increasing Minority Homeownership, was explicitly rationalized as a way to close racial gaps in homeownership. In California, the % of first time home buyers putting zero down went from 7% under Clinton to 43% under Bush.

A majority of the defaulted dollars were lost in a single state, California. In 2006 in California, according to the federal Home Mortgage Disclosure Act data, 77% of the subprime and 56% of the total home purchase mortgage dollars were lent to minorities. According to a SF Federal Reserve Bank study, in California during this era, black borrowers were 3.3 times as likely to be foreclosed upon as white borrowers, Hispanics 2.5x, and Asians 1.6x. In other words, the great majority of defaulted dollars in California were lost by minority borrowers.

But nobody will mention that, so how can we expect to "reform" the system if we can't talk about what actually happened.

RPB writes:

The cost projections of bailing out the banks are an absolute sham if the Fed's interest rate exposure on their asset book is not included.

Because they are not hedged with respect to interest rate exposure, their book of securities retains a DV01 of 1.5 billion dollars per basis point rise in interests rates. Thereby, when rates do rise, which they will, they will have substantial losses on their portfolio of financial products.

Boonton writes:

Right. We can tell that's true because almost nobody wants to point out today the role that the bipartisan push for weakening credit standards in the name of increased minority lending played.

Please, the household wealth of blacks and Hispanics did not increase by $2T from, say, 1995-2007.

Boonton writes:

http://www.infoplease.com/ipa/A0883976.html has some helpful data.

Between 1996 and 2007 overall homeownership rates in the US went from 65.4% to 68.1%. White ownership rates went from 69.1% to 72%.

Black rates 44.1% to 47.2% and Hispanic 42.8% to 49.7%. Black ownership rates increased about as much as white's and as much as the US as a whole.

Hispanics make up about 15.4% of the US population so their increase was more dramatic at 6.9 points. But given their portion of the population their increased ownership rates only drove about 1 point of US ownership growth. Is this dramatic? Not really. Between 1960 and 1970 homeownership rates rose from 62.1 to 64.2, an increase of 2.1 points, not too shy of the 2.7 point increase from 1996 to 2007.

In contrast, 1945's rate was 45% and 1955 65%, an increase of ten points. Now you can attribute that to the post war boom but there does seem to be a problem here for those who would like to blame government first. Is the market so weak that a few politicians making speeches about minority ownership will cause it to waste $2Trillion?! Even more importantly, are we saying that for a lousy $2 Trillion and a bunch of supposedly Nobel Prize worthy financial innovations all we could do is increase the homeownership rate 3 points!!!!!

floccina writes:

But let me reiterate here that the people who were most taken advantage of in the housing bubble were not the folks who bought houses. They were the professional money managers who invested in AAA-rated securities.

Amen. The investment banks preyed mostly on investors not on borrowers. It is hard to prey on borrows as you are giving them your money.

floccina writes:

Boonton and Nick do you also hold the sellers of homes as guilty for gouging the buyers?

Boonton writes:

If you show me a seller of a home that was also handling the buyers mortgage, implying in a believable manner that he was on the 'buyers side' and making representations to the buyer on the consequences of such mortgages then sure I'd hold them guilty.

For the most part the sellers of the homes only have control over the price of the home. In many of the worse mortgages the problem wasn't price as much as the terms of the mortgage itself. There are situations where the seller can be guilty, for example if he hides or misrepresents serious defects in the house. This, though, is hardly new. Even first time home buyers are rarely first time buyers. They understand the seller's motivation is to sell and take off with the money. And there's plenty of case law that has developed over centuries to deal with various seller frauds.

Now here's something interesting. Considering how minor the actual increases were in home ownership rates by minorities and in general, I think its very clear the meltdown could not have been caused by high-risk first time home buyers getting loans because the Fed was pressuring banks. What is clear is that most of the loans had to have happened with pre-existing homeowners. Either home owners selling their current homes and upgrading to larger ones with new mortgages or refinancing current mortgages in order to take cash out, remodel or whatnot.

Since making these loans had nothing to do with increasing home ownership among the poor what's the 'blame gov't first' angle here? I'm sorry but I just can't recall any ACORN rallies in the 00's demanding more home equity loans for the propertied minority set.

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