Arnold Kling  

What I Think About Financial Reform

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My instinct is to call the proposed legislation a "blame deflection bill" rather than financial reform. But I admit that I have not read the whole bill. Has anyone?

My impression is that the following things are not in it.

1. No exit strategy from government support for subsidized, lenient mortgage credit. No curbs on Freddie and Fannie, whose market share has skyrocketed in the past year and a half. No increase in down payment requirements for FHA, which is in deep doo-doo.

2. No change to the role of credit rating agencies, as far as I know. It seems to me that one thing that everyone, left and right, can agree on is that the regulators outsourced their function to the credit rating agencies, and this worked out badly. As far as I know, the bill does not correct this flaw. Perhaps it tries to, but other provisions have gotten more attention.

3. Nothing to address the issue of "cognitive capture." The regulators will still get their analysis of the financial sector from the CEO's of the largest banks.

Finally--and this will get me in big trouble--I have to rant about the notion of a consumer financial protection agency. I know that it's axiomatic that poor people are helpless victims. But in the case of these mortgages, that is a really hard sell. The banks did not take from poor people. They gave to poor people. If you were lucky enough to get one of these exotic mortgages when house prices were still going up, then you got to reap a nice profit on your house. If you were not so lucky, you lost...close to nothing. I'm sorry, but if you borrowed up to 100 percent of the value of the house or more, then all you really lost were your moving expenses.

What about predatory lending? As I understand it, the idea of predatory lending is to saddle the borrower with an expensive mortgage so that you can foreclose on the property and sell it at a profit. How many times did that happen? Have you read of a single instance in the past three years where the bank made a profit on a foreclosure?

I am always ready to feel sorry for poor people because of their poverty. But I cannot feel sorry for somebody who was given a basically free option on a house and the option didn't happen to come into the money.

The reason that those of us on the right are left somewhat speechless by the financial reform bill is that it seems to us to be based on premises that strike us as preposterous.


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The author at Pileus in a related article titled Kling on Predatory Lending writes:
    Arnold Kling at EconLog echoes my skepticism a few days ago about predatory lending.  This is from his post on the proposed financial reform legislation: Finally–and this will get me in big trouble–I have to rant about the notion of a consu... [Tracked on April 22, 2010 10:02 PM]
COMMENTS (16 to date)
Doc Merlin writes:

If only, it was a blame deflection bill.
Its even worse than that, it actually makes a lot of the problems worse. It also increases the cognitive capture problem and encodes bailout powers into law.

silvermine writes:

There must be something unpleasant in it because USAA is emailing me telling me to write to my representatives. And USAA does *not* get all political. Like, ever that I've seen. But they seem genuinely convinced that this bill may totally screw up their business model. Which I have to say, has worked great for me. I can't think of a company I trust and enjoy dealing with more. I'd be really irritated if that goes away. (Heck, I'm ready to get health insurance from them if anything happens to my husband's job... Of course, I'm sure that will be screwed up by the stupid healthcare bill.)

fmb writes:

Perhaps the predatory behavior was on the part of mortgage brokers. I imagine some buyers took unsuitable refinancing risk and lost their downpayment as a result. This was not good for the bank, either, of course.

I suspect, of course, that the brokers often didn't really understand this risk, either, and in fact were incentivized to have their customer come back to refinance down the road.

[N.B. This is a re-post of a comment originally posted on Apr 22, 2010 that got overwritten because of many comments being submitted at once. We apologize for the inconvenience.]

mark writes:

I agree with you and I also agree (unusually so) with Mark Thoma who identified one additional problem, the lack of clear strong debt to equity ratios.

Finally I would add the suggestion of many people, Greenspan being the most famous, of requiring every financial institution over a certain size to have a layer of debt that regulators can convert to equity. This is really key and far more constructive and important than a "resolution authority".

[N.B. This is a re-post of a comment originally posted on Apr 22, 2010 that got overwritten because of many comments being submitted at once. We apologize for the inconvenience.]

Noah Yetter writes:

Just to play devil's advocate for a minute, some of the impetus for a consumer financial protection agency comes from (potential) abuses in the areas of bank fees and credit card agreements, rather than mortgages.

[N.B. This is a re-post of a comment originally posted on Apr 22, 2010 that got overwritten because of many comments being submitted at once. We apologize for the inconvenience.]

Biagio Mazzi writes:

I have never seen my thoughts on the subject so well and concisely expressed as in the last four paragraphs of this post.
I know that a lot of people in the US share this view but it is really hard to see it take a well structured expression.

matt writes:

I also have not read the bill but the cynic in me leads me to believe that compliance costs of the regulation will create a barrier to entry for the 2nd tier banks - cementing the largest banks in place. The second effect will be stifling innovation at smaller institutions - Goldman fights/insinuates itself into the FCPA much more effectivly than a mom and pop shop can and is able to set the bars of what does and does not protect. You can safely invest in the largest banks - they will be on top and very profitable for a long time to come.

Dan Weber writes:

I think the "pre-funded bailout bill" may be a good idea. I can definitely conceive of how it could backfire, but it doesn't strike me that the risks of making it are more than the risks of not making one.

I'm probably not going to state this clearly, but I think it can create a good incentive for banks to police themselves. If the other bank down the street ends up needing a bailout, under the old rules this was good for you, because it dumped more money into the banking system. Under the new rules, banks may see the fund as "theirs" and be reluctant to let their neighbors fail and get it, because it will cost them part of "their" fund.

Boonton writes:

Arnold,

Makes me wonder where your economic rationality is here? If banks thought home prices were going up then why go through the convoluted process of recuriting poor people to take out mortgages, buy homes, then sell them and pocket a nice profit while the bank only gets its mortgage paid off early? Instead of, say, loaning $1M to people to buy ten homes simply buy ten homes directly and sell six months or a year later and score all the profit for the bank rather than the interest.

What about predatory lending? As I understand it, the idea of predatory lending is to saddle the borrower with an expensive mortgage so that you can foreclose on the property and sell it at a profit. How many times did that happen? Have you read of a single instance in the past three years where the bank made a profit on a foreclosure?

The idea of predatory lending is to saddle someone with an unmanageable loan. This was done by selling them on the idea that they would 'establish good credit' during the teaser periods at which point they would be able to refinance again easily. I'd have no problem with this if:

1. The mortgage company provided the new home owner a gurantee that they would refinance him after said period of good payment history.

2. They warn the homeowner that this is just a prediction and he may very well discover he cannot refinance and will have to pay the onerous amounts after the teaser period ended.

Seems like there was/is a very clear agency problem going on here. The borrower is relying on the mortgage broker or banker as a 'professional' to give him guidence and help. In reality he perceives himself as an agent of the bank 'selling' a product.

Of course we can come up with other victims here. The Wall Street firms that brought these mortgages thinking the brokers were doing due dilligence. The various investors who then brought the repackaged bonds from Wall Street thinking they were made up of only fresh, grade A, ground beef when in fact they had a lot of past due low grade meat in them and so on. But I think we do agree that if you're going to do transactions in excess of $10M you should either know what you're doing or hire people who do so. For the poor and even middle class a home purchase is a once in a life transaction (or few times in a life) that many lack expertise in and are vulnerable.

Your argument seems to be that because this scheme didn't work and the banks and companies playing this game got burned badly when they were suddenly left with lots of debts and plenty of dubious mortgages they could not longer sell to Wall Street it proves everything was ok. In reality it's not. The information balance here was out of whack and the easiest and most efficient way to resolve it, IMO, is to prohibit egregious rip offs against the 'average person' as well as require full and comprehensible disclosure about risks, conflicts of interests and other relevant data.

Boonton writes:

I think the "pre-funded bailout bill" may be a good idea. I can definitely conceive of how it could backfire, but it doesn't strike me that the risks of making it are more than the risks of not making one.

From what I understand there is no 'pre-funded bailout bill' on the table. Institutions that are insolvent have their shareholders wiped out to zero. The cries of 'bailout' are political spin premised on the idea that in theory nothing actually prohibits bailouts.

But the problem is no law passed today could prohibit bailouts in reality. Back in 2007 if you said Congress, in less than a month, would approve over half a trillion dollars to go directly to Wall Street firms you would have been called crazy (ohhh if only there was an Intrade contract on that!) No matter what law is passed today, there is no way to really know what would happen at some future point if Company A was insolvent and the cries went up that letting it go under would send the entire world into crises.....especially if those cries seemed quite plausible.

ColoComment writes:

This is another bill with lots of traps and unknowns (i.e., let's pass it in a hurry, so we can then find out what's in it?)

I, too, heard from USAA (of which I have been a member since the 70s.) I don't think it has EVER before solicited political lobbying efforts from its members (I almost deleted the email, fearing it was spam), so I take its concern very seriously. However, it failed to clearly explain just HOW it would be adversely affected by the bill, which severely weakened its plea.

Nonetheless, I figured it wouldn't hurt to add that to my continuous string of "VOTE NO" emails to my representatives and senators (for all the good it does - I am not convinced that they count them much less have their aides read them....)

Boonton writes:

I am always ready to feel sorry for poor people because of their poverty. But I cannot feel sorry for somebody who was given a basically free option on a house and the option didn't happen to come into the money.

Suppose I swipped your wallet right after pay day and replaced all the cash you had in it to pay the mortgage (let's just say you decided to pay your mortgage in cash this month for inexplicable reasons) with $1 scratch off lottery tickets.

Most people would feel sorry for you and feel that you were wronged somehow even though, technically, you have an even swap of $1 bills with $1 lottery tickets. If one of those tickets happened to win you five times the cash you had in that wallet people would feel less sorry for you but would hardly approve of what I did.

People weren't looking for an option on a house and it wasn't for free. They were sold on a house with a solid way to build credit. The cost came at their credit plus whatever they sunk into the deal. Maybe, being poor, it wasn't rational for them to value good credit so much (after all, good credit still means you have to pay off what you borrow and if you don't have a lot of income that's hard). Maybe taking a 'free' option on a house was actually not too bad a gamble given their circumstances. But as an enemy of paternalism you should recognize that this isn't your decision to make on their behalf. If the deal was they'd risk their credit for a 'free option' on a house then that should be made up front and clearly.

But phrasing it this way reveals just how socially useless this all was. Certainly if the market was really for 'house options' we have the intelligence to create instruments that are just that, just as we have options on stocks, bonds, commodities etc. that anyone can buy and sell just by opening a simple brokerage account. Why the great deception with mortgages, closings, dubious statements of income etc? The shennigans were needed because people were not buying and didn't want 'house options'.

Boonton writes:

This is another bill with lots of traps and unknowns (i.e., let's pass it in a hurry, so we can then find out what's in it?)

Lots of unknowns? How can that be? Not too long ago I heard a long analysis on the news about public perception of the bill....if the Republicans said it was a 'bailout bill' would the public believe them or not? Certainly if the media has time to report so intensively about how the bill is perceived its actual details must have been extensively and exhaustively covered!

In all seriousness this, like that other bill, has been talked about for nearly a year. Just because you started paying attention to it on Wednesday doesn't mean it came into existence on Tuesday!

buermann writes:

What predatory lending? Lost nothing? Ameriquest? The higher interest rates charged to one in five prime borrowers that made up the subprime market? The hidden fees, balloon payments, the destruction of credit ratings? I agree with you often enough and enjoy the blog, but this sounds like you've been living under a rock.


Josh Fulton writes:

I said the same thing about the Consumer "Protection" Agency. It's another regulatory agency. Boooo to regulatory agencies.

http://joshfulton.blogspot.com/2010/03/consumer-protection-agency.html

als writes:

What about predatory lending? As I understand it, the idea of predatory lending is to saddle the borrower with an expensive mortgage so that you can foreclose on the property and sell it at a profit. How many times did that happen? Have you read of a single instance in the past three years where the bank made a profit on a foreclosure?

I don't think this is the idea at all. Most banks saddled the the borrower with an expensive mortgage, then packaged these loans into mortgage backed securities and sold them off. So the predatory lenders assumed none of the risks created by their predation.

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