Arnold Kling  

What Do Mortgage Lenders Want?

PRINT
Bartlett's Final Chapter... Group Solidarity and Survival...

Mike Konczal writes,


I think further deregulation would see something similar to what we see in the credit card market, where everyone's mortgage looks like whatever the laws of North Dakota say, and that the poorest homeowners (or "inept", if you prefer) cross-subsidize the richest. Like subprime, the whole thing would be characterized by interest rate jumps and penalties and a whole bad-faith expectation that someone can actually pay it off.

What this implies is that in the absence of regulation, lenders would prefer to issue mortgages that cannot be paid off. I disagree that the main goal of mortgage lenders is to create foreclosures. Lenders lose money on foreclosures, and the more foreclosures a lender has, the less likely it is that the lender will remain in business.

Mortgage brokers make money every time a mortgage loan closes. Mortgage brokers do not provide the funding for the loan, so any loss from a foreclosure is borne by someone else. Thus, a mortgage broker has no incentive whatsoever to worry about whether a borrower can repay the loan.

However, the "someone else" has a strong incentive to police mortgage brokers. Imagine that you are that "someone else," an investor in mortgage loans. If the broker is offering to sell you a loan that has a high probability of default, you do not buy it. And you do not give the broker the benefit of the doubt. On the contrary, you put in place anti-fraud and quality control procedures that are appropriate for dealing with cutthroats.

What people cannot seem to get their minds around about the subprime crisis is that the biggest losers were the big companies that took the credit risk on the loans, not the borrowers. I think that this reflects our deeply-ingrained folk Marxism, which divides the world into villain and victim classes. Our folk Marxism leads us to view low-income and minority home buyers as a victim class and to view corporations as a villain class. What's wrong with that picture is that the villain class wound up incurring the majority of the losses (I was going to say that the villain class wound up taking the losses, but that would be overlooking the fact that taxpayers wound up holding the bag.)

In a deregulated mortgage market, lenders would try to extract as much profit as possible from borrowers. Consumers would have to be wary. They might need to pay independent advisers to evaluate mortgage contracts, or they might have to stick to reliable brand names (think of what Carmax did for used cars). But it is not in the interest of private sector lenders to deliberately make loans that have a high probability of default.


Comments and Sharing





COMMENTS (12 to date)
Adam Ozimek writes:

Arnold,

I've been hoping fate would drag you into a debate with Felix Salmon and Mike Konczal over how bad the housing crash has been for people who get foreclosed on or are extremely underwater. You seem to suggest here and elsewhere that people essentially were allowed to take out an option on house values where heads they win, tails they walk away pretty easy. Felix and Mike have a much grimmer view where the outcomes of getting your home foreclosed on are so terrible that the risk of homeownership, even in normal times, is not be worth it for most people. I think this would be an elucidating debate, and it seems you are nibbling around the edges of it here.

Ted Craig writes:

I have yet to meet a lender who wants the asset rather than a payment. Maybe Konczal knows more lenders than I do, but I'll bet that he knows far fewer.

Fenn writes:
What people cannot seem to get their minds around about the subprime crisis is that the biggest losers were the big companies that took the credit risk on the loan

don't forget the suckers who had to bail these chumps out!

Boyd Klingler writes:

Mr. Kling,

You write:

However, the "someone else" has a strong incentive to police mortgage brokers. Imagine that you are that "someone else," an investor in mortgage loans. If the broker is offering to sell you a loan that has a high probability of default, you do not buy it. And you do not give the broker the benefit of the doubt. On the contrary, you put in place anti-fraud and quality control procedures that are appropriate for dealing with cutthroats.
One of the problems that government meddling created in the recent crisis was the pressure on Fan and Fred to accomodate subprime mortgages, so the buyers of brokered loans had a greater fool to sell to, thereby eliminating the need for careful policing. Bankers do one thing - they make money while the sun shines. If that federally mandated greater fool had not existed, the number of subprime mortgages would not have ballooned as it did between 2005 and 2007.
Lori writes:

If it were not in the interest of private sector lenders to deliberately make loans that have a high probability of default, then they wouldn't have such a penchant for pre-payment penalties. Sooner or later the inevitable pink slip or other type of rainy day will arrive, at which time default should be less likely if the borrower has amortized a bigger chunk of the balance due. Or so it would seem to me. In spite of my Generation-X age cohort, my parents started late, so I'm only one generation removed from the Depression. For this reason one of my biases is thinking of debt as a four-letter word.

To my outsider perspective it looks like the moneylenders' business model in the aughts (for some reason I don't quite get) focused on accumulating accounts receivable. Could have something to do with the rhetoric out of the economic elites in the wake of the '98 'Asian' crisis emphasizing 'creditors rights.' Maybe the moneylenders took that as a statement of what the future looks like.

Lord writes:

I think those who consider the borrowers worse off believe those increased prices represented real wealth the borrowers were entitled to rather than speculative excess that never existed in any real sense. Emotionally traumatic perhaps, but hardly financially devastating.

Ted Craig writes:

Lori, how is it advantageous to make loans that will default?

Mike M writes:

Ted, there are lenders that make loans they hope will default. But they are few and far between -- additionally, they have operating expertise.

If I'm normally a commercial real estate equity guy, I might be more than happy to make a bridge loan to you at a high rate for 90-95% of the value in the *hope* that I collect interest for a while and then seize the asset if you can't continue to pay. Again, because I'm an excellent owner / operator (hypothetically -- I'm not speaking about myself here), I'm comfortable letting you pay down my cost basis in the asset.

But I completely agree with you that, in standard practice, there are no commercial banks that want to foreclose on an asset. The cost of financial distress / the legal fees for taking the asset / the time it takes to actually foreclose make it extremely arduous to foreclose.

Lori writes:

Ted, it is udderly incomprehensible to me how it is advantageous to make loans that will default. That's why it's incomprehensible to me why moneylenders would pressure people into pre-payment penalties, negative amortization, balloon payment sc<strike>a</strike>hemes, etc., let alone underwrite so-called ninja loans.

Perhaps being owed is prized more highly than being paid, like with the loan sharks in the film On The Waterfront. As always, ability to pay off debts results from employability, but in this corrupt corner of the world employability results from willingness to take on debts. It's a well-known fact that employers reserve the right to check applicants' credit. The PR from HR says they're weeding out low-credit applicants, but is it entirely implausible that some are weeding out no-credit applicants, or even weeding out people who are in the black? I have no idea whether such a practice would be considered illegal. The motives seem plausible. Like most non-ec types I relate more easily to motives than to incentives. Maybe that's why I can't grok macro.

Ken writes:

Lori, it is "utterly", not "udderly".
Too early, maybe?

oakshott writes:

While there is clearly a conflict of interests between the mortgage brokers and the funding institutions, there is also a conflict of interest WITHIN the funding institution.

If incentives are not precisely aligned, the interests of agents within the funding institution may well be served by activities that (indirectly) encourage foreclosures in the medium/long term,

John Fast writes:

Lori wrote:

Ted, it is utterly incomprehensible to me how it is advantageous to make loans that will default. That's why it's incomprehensible to me why moneylenders would pressure people into pre-payment penalties, negative amortization, balloon payment schemes, etc., let alone underwrite so-called ninja loans.
Those things are designed to maximize the total profit of the loan (i.e. get the total amount of debt as high as possible) without causing the customer to either go elsewhere for his loan, or to default.

It's exactly the same when a shopkeeper or plumber or labor union tries to set *their* prices as high as possible without losing sales.

It's very much like playing blackjack or any other game (such as the final part of Trivial Pursuit) where you want to get as close as possible to a particular number without going over it.

It's a well-known fact that employers reserve the right to check applicants' credit. The PR from HR says they're weeding out low-credit applicants, but is it entirely implausible that some are weeding out no-credit applicants, or even weeding out people who are in the black? I have no idea whether such a practice would be considered illegal. The motives seem plausible.
Not to me. Why would an employer *want* to hire someone who had a lot of debt and/or who didn't pay it off regularly? The only explanation I can think of would be the assumption that someone who was in debt would be less likely to quit their job because they need the money more than a solid citizen, but that's just . . . Bizarro-world-style thinking.

Employers want employees who are reliable, who show up on time and follow orders and perform routine tasks. Paying debts regularly is a strong indicator of that, and so is not having a lot of debt (or even not having any debt). People who have a lot of debt and/or don't pay it off regularly probably have personalities that aren't particularly bothered by other reckless behavior like showing up drunk, or yelling obscenities at their supervisor if they're in a bad mood, or deciding to take the day off and go fishing or drinking, or to quit suddenly.


Like most non-ec types I relate more easily to motives than to incentives. Maybe that's why I can't grok macro.
No, you probably can't grok macro because it makes no sense. Heck, even Arnold Kling agrees with that!

Comments for this entry have been closed
Return to top