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12/23/2007

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a Duoist

Hmm. 'Doing nothing' about the imminent resetting of mortgage rates has a certain appeal to political conservatives, but the Fed's intervention to twice lower interest rates over the past few weeks is sending a different message: When a 'bubble' is now spotted, the Fed will respond. At the last do-nothing bubble burst, more than one trillion dollars of American wealth was wiped out and how many Americans lost their jobs? Doing nothing about bubbles with fiscal policy makes sense; but active management on the monetary side makes even better sense.

Jack

Duoist: Agreed, however the Fed's fairly puny efforts are not likely to "trickle down" to, or in the direction of, those most in trouble.

"Doing something" especially in the case of "2/28" loans (of 7% "teaser rates" and 11% rates for the other 28 years) will spread the losses from the debtor who can not handle the hit over the industry. Sure, those buying those instruments in anticipation of getting 11% returns for 5 to 7 years will take a hit, but their only other choice is that of taking the hits on foreclosures that are very likely to create a downward spiral as one unit is foreclosed that makes the neighbors unit unsaleable.

JEM

The theory of ignorance breaks down when the borrower is in fact ignorant and has something to lose. A common fact pattern in bankruptcy cases involves a debtor who refinanced a loan secured by his residences on less favorable terms than the one he had for not a lot in return relative to the total debt (as opposed to a "risk free" loan equal to the purchase price of a new home). In these situations, the lenders had relatively little risk, unlike the present situation in which the banks were if anything more reckless than their customers. Regulations requiring clear explanations of risks and a longer wait to close loans secured by residences might help some borrowers avoid making stupid mistakes, but I doubt it would be worth the cost. The extent of financial ignorance in general and in connection with mortgage loans in particular is truly astonishing. The 2005 amendments to the Bankruptcy Code require a debtor to take a financial management course as a condition to obtaining a discharge, but the course is too little, too late.

Sim

Judge Posner is spot-on in this week's installment. I would be very interested to see any other research on intelligence failures, but I think that is a particularly salient point in the discussion. Psychology played a huge role in the crisis as well, but I am shocked that no one put two and two together and said to themselves (or their boss at their investment bank, or any of the investors buying up the alphabet soup of mortgage securities) that a price rise in housing might also lead to a price fall, which would likely blow up the value of all of the derivatives involved in making a home sale as easy as it was. Extrapolation and psychology have a lot to do with it; worrying about missing out on the "action" does as well. I am interested in any suggestions Judge Posner might have in better aligning incentives for both executives at lending companies and investment houses in addition to the sales staffs that work under them. Aligning these may make no difference to the psychology of the market. But hopefully it would do more than the after-the-fact efforts of the regulators now underway.

Stephane

Economists of the austrian school do propose an explanation for such "clusters of errors". This theory points to the distorsion of production and fluctuation of interest rates caused by monetary policy. Too much has been invested in houses, and too much has been lended/borrowed on the subprime market. What do you think about the austrian business cycle theory?

ChinaCoalWatcher

I'm not sure I'm comfortable characterizing what is happening in the the mortgage market as an "intelligence failure", though I suppose any error in judgment (which always involves choices in information collection and analysis) can be described as such.

Still, with as much information as can be collected in a mortgage application and the tools and tables available to asses risks, this issue seems more of a problem of "willful blindness" on the part of all parties involved combined with counterproductive short-term bonus incentives to write as many mortgages as quickly as possible.

As a sub-prime adjustable-rate mortgagor myself (since I bought a house just before Law School with some savings, but no income) I find it hard to be sympathetic to either side in the "meltdown". I knew what might happen if I didn't sell my house before the rate-change, or if the housing market stalled and my home value went down instead of up at the time of sale. The bank knew they would have to foreclose if I ran into trouble because of my lack of income - and it was up to them to off-set that possibility as a risk-premium built into my rate. The risks and their burdens were well known by both parties in the simple contract.

My sympathies do lie with people in exactly the same position today as I was in over two years ago - but who today probably could not obtain a mortgage on similar terms despite the fact that the large majority of sub-prime are paying their bills just fine.

They certainly will not obtain those mortgages if the government decides that enough individuals are incompetent to read their future payments on the simple amortization table they automatically receive in their application, and that therefore anything but simple 30-year fixed-rate mortgages become de-fatco illegal.

mortgagewatcher

Of course, Judge Posner's comment deals with only one type of hypothetical borrower -- the nothing-down borrower. Because of the fact that mortgage loans in most states are non-recourse (i.e., the borrower's maximum liability is simply to turn over the property -- the creditor cannot reach other property), the nothing-down borrower is not really victimized even by most fraudulent mortgages and home appraisals. (Of course, that requires us to ignore the issue of fees and points.)

What about the many people who had substantial equity in their homes, but *refinanced* on adjustable-rate mortgages with low teaser introductory rates, extremely high (and perhaps inadequately disclosed) eventual rates, and extremely high fees (amounting to tens of thouseands of dollars -- "hidden" in a sense, because the fees are tacked on to the debt principal rather than paid out of pocket.) Those people faced substantial risks in their ARMs, and it may be *very* reasonable to assume that, behaving rationally, they would have avoided the refinancing had they understood the terms. This group of people may include a substantial number of the elderly (who lived long enough to build up substantial equity, but had not yet paid off their loans) in poor neighborhoods.

That's not to say that governmental regulation is the answer. But antiregulatory commentators such as Judge Posner must be prepared to move beyone the one hypothetical most favorable to their views if they want their analysis to have credibility.

Doug

"Suppose you have a low income... a mortgage broker offers (a 100% mortgage). What do you have to lose by accepting such a deal?"

Great point.

Jake

Judge Posner clears the bases with his comment on the so-called subprime lending crisis. His perspicaceous comment on the supposed "ignorance" of the supposed "victims" of subprime mortgage lending is a welcome note. Far and away, such "victims" got what they asked for -- consumption beyond what they could pay for in the near term (or at any time). Relaxing the ancient law of debtor-creditor relations in order to buy votes (i.e., Obama) is a very poor policy decision.

TANSTAAFL

JohnT

As a lawyer, I've met with actual people who are losing their homes. Many couples are both on anti-depressants or anti-anxiety meds. Some report that their kids are shoplifing or cutting themselves - acting out because they fear losing their homes.

I am angry at the pin-head regulators in Washington who allowed lenders to sell ARM loans to the public. These regulators are supposed to be the policemen - protecting the public. The regulators were somehow convinced that the bus drivers, carpenters and teachers on main street could weigh the risk of the LIBOR index going up.

Notice that the OCC, FTC, and OTS did nothing while the consumers were being misled by loan officers in the largest fraud perpetrated on the American public These agencies were neutered by political pressures. The California Congressional delegation would not allow any major action against Ameriquest or Countrywide. We were paying for Cadillac regulators and we got Yugo regulators.

For years while the FBI was telling Congress that there is massive fraud occuring in the mortgage industry. Congress did nothing - becaue Congress liked the campaign money the lenders were throwing around in Washington. Bush appointed Roland Arnall as our ambassador to the Netherlands, despite the fact Arnall could not find the Netherlands without Mapquest. Arnall purchased an ambassadorship. I thought those days were over.

Notice that none of the federal agencies did anything to stop Ameriquest. It took the 50 state attorneys general to put an end to that criminal enterprise. Notice too that Ameriquest closed their branches within months of signing the settlement with the Attorneys General promising to obey the law - showing that Ameriqeust could not make money unless they violated the law.

Still doubful? Well I represented a lady who was suffering from depression and was hospitalized in a mental ward. A national lender came into her lockup room in the mental hospital and closed her loan while she was juiced up on drugs.

Another lady refinanced her home by forging her husband's signature. But the lender falsely notarized the husband's signature and gave her the loan. After being hospitalized for depression, she shot and killed herself after being released from the hospital.

Want more? Call me.

A lawyer for a major law firm, representing a lender, tried to prove that my client knew what an ARM loan was. So he asked my client, "what is an index?" She resonded, "That's what at the end of a book." He continued .. "What is a margin?" She responded, "that's at the edge of a page." The lawyer immediately abandoned his line of questioning.

I have closed over 500 loans. I know how easy it is go get people to sign documents without explaining the terms.
I am absolutely convimced that few borrowers understood how the laons worked or the inherent risk.

I'd love to have each one of you in a closing room trying to refinance your home. I'd give you the opportunity to read your loan documents and I'll assure you that you could not understand the terms of your loan.

At some point in the past, some lending executive proposed that his company make loan to people who have not demonstrated the ability to repay loans. And he proposed that they not verify the borrowers income, but simply ask the borrowers how much they earned. Then he proposed that they loan 100 % of the value of a borrower's home.

That was a train wreck waiting to happen. I knew years ago that appraisers were grossly over-appraising homes.

The scandal is not that loan such as this were made. The scandal is that it went on for so long with no intervention. Too many were making money on this scam.

Finally, the subprime probem did not become front page news until some lenders were shutting down. Never mind that borrowers were being tossed out of their homes in record numbers for years. There appeared to be no concern about the borrowers.

I wrote to Ellen Steidman in 2003 and told her she was presiding over the biggest fraud ever perpetrated on the US public.

Now, the federal regulators feign concern about borrowers. Instead of acting like policemen protecting the public, the regulators have acted more like undertakers - showing up when the bodies are all room temperature.

I dread more phone calls from borrowers who are in dispair and at the edge. I can't deal with much more. You have no idea of the human carnage this has caused. Some divorce after the loss of the home.


John Tancabel
tbell@mm.com

Bill

A major depression, such as we last experienced in the 1930s, imposes immense social costs in the form of lost output.

There is a really big difference between 1929 and 2007. In 1929 social spending accounted for zero percent of the federal budget and the population was relatively independent.

In 2007, 65% of the federal budget is spent on social programs for a population that has developed a sense of entitlement.

Making things far more interesting.

Jack

Counselor Tancabel, Hats off for telling it like it is and helping to mop up after the frat boys have had their bash.

Jake, Hey, it's Christmas and they have movies about Scrooges with pencil thin mustaches. It's a great economic model isn't it? I assume you're targeting those whose wages have been pounded down to the point that their choices are those of raising their kids in two bedroom apartments that are "good cash cows" for someone or having faith that both jobs will last and making the leap to buy that first home.

Bill: I found your: "65% the federal budget is spent on social programs for a population that has developed a sense of entitlement." just a tad inconsistent, especially in 2007." Here's a site with a couple of interesting pie charts, neither of which fit with your estimates. And yes, your history is good as there was no safety net in the 30's and that is why such was invented.

Becker does well to mention "asymmetrical risk" which in the case of CEOs translates to...... gunning for huge bonuses for themselves means forgetting that they are bankers with fiduciary responsibilities to their depositors and stockholders. Should we wonder a bit about "the market?" that has pushed CEO gleanings up from 80 times worker pay circa 1980 to over 500 times worker pay today? When the Wharton alumni pleads ignorance it brings quickly to mind others such as Jeffrey Schilling.

Jack

Federal spending piecharts:

http://www.warresisters.org/piechart.htm

Stephane

"A recession involving some temporary unemployment may impose lower social costs than governmental interventions designed to head it off."

Also, as is rarely pointed out, a recession is the necessary outcome and cure of a real estate bubble caused by monetary inflation.

However, there is nothing "surprising" in the fact that market participants were "ignorant" of what was going on. When interest rates are set by the central bank and do not reflect time preferences of individuals, borrowers and lenders can no longer discover the clearing price on the lending market. They are then left trying to second-guess the Fed, an art in which one must always confess total ignorance...

See my post on Becker's article here.

Neuroscientist

I have experienced many booms and busts during my lifetime: the conglomerate merger wave of the 1960s and early 1970s; the junk bond and savings & loan crisis of the 1980s; and also IPO, biotech, Internet bubbles of the 1980s and 1990s. At any point in time, there is always a bubble of some type going on. At the time of each of these, any sentinent observer can clearly see that there is no economic justification to the transactions. They are very clearly driven by greed. Some people greedily make money on the transactions and others, just as greedy (but in a much worse position), try to take advantage of the situation as investors, knowing full well that they are "pulling a fast one." The current subprime crisis is no different. It is driven by greed on the part of the loan issuers, greed by real estate investors, and greed by home buyers seeking to acquire a more expensive home than they clearly can afford. There is no reason why the rest of us taxpayers should pay for the losses sustained by any of these parties driven by greed. I do not buy the argument that home buyers were duped by suprime issuers. These people knew full well that the could not affort the homes they were buying.

c&d

"There have always been bubbles. There will always be bubbles because of the factors that I have been discussing."

This statement is silly and wrong. Modest intervention could have prevented much of the housing loan problem. Limiting loan payment schedules to avoid large jumps in interest and payments would not constrict housing sales to prospective homeowner who could afford a house, but would reduce the number of irresponsible speculators and irrational optimists.

Reducing the number of home loan contract options would have an additional benefit of reducing transaction costs for borrowers.

One could also write "There have always been terrorists. There will always be terrorists." But Posner finds time to write lengthy books on how the government should intervene (heavily) into this aspect of society.


Burst bubbles are not something that simply affects the individuals to a transaction, but all participants in the economy. In other words, it produces negative externalities. Becker's talk about "the rights of both borrowers and lenders to make their own decisions" demonstrates a flawed view of economics and philosophy.

Diversity

A masterful piece from Posner; except for the conclusion.He is right that the measures which are being proposed are likely to do more harm than good (and he is too polite to mention the strong smell of shutting the stable door attached to them).However; -

the party who loses out when the bubble bursts, and leaves no money on the table earlier, is the central bank.
what the market lacks in a bubble is an authoritative early signal that the party is over.
Basel 2 offers the central bank a flexible and clear form for giving the market a timely signal:
"The Central Bank informs the financial institutions that in reviewing financial institutions' models for the assessment of the risk inherent in the institutions' portfolios, the Central Bank will not look favorably upon classifications of such and such an asset class as embodying less than X degree of risk."
Messages on these lines should be sufficient to prevent future bubbles in any type of asset. The asset will become less credit-worthy early rather than late.

That there always have been bubbles does not mean that there always will be bubbles. Bubbles are like apendicitis; treatable once we develop the technique.

corwin

Judge,
I certainly find your comments illuminating.Stll,few of us are immmune to greed and easy money.I remember(very well) in the late 90's when I tried to borrow 200K from my father for some more Microsoft.At that time,I was making quite a bit more-in paper profits than I was in real life.So,even though I'd been putting $6-8,ooo/month in the market, wanted MORE.I explained to my father why it was such a good loan.He sighe,and explained,"My Son,you're not making this money because you're so smart.You're making it because almost everyone else is as dumb as you.So,no loan,but I played margin...and you know how the story goes.
And Mr.Tanabell is right.Caveat emptor isn't enough when one side holds all the cards.
Merry Christmas to you and Dr. Becker

Austin Kelly

The major externality, not addressed here, is to the neighbors of the properties in foreclosure. When I was presenting a paper I wrote 2 years ago on the high rates of delinquency and foreclosure associated with zero down FHA mortgages (http://ideas.repec.org/p/pra/mprapa/4318.html), a member of the audience asked me "so the lesson is not to buy with nothing down?" I responded "No, the lesson is not to buy in a place where your neighbors have put nothing down." While I'm astounded that I can still drive around Chicago and see "0% Financing!" signs, as I would think by this point that they would drive away all but the most desperate buyers, in most cases it is almost impossible for a potential buyer to know the financing arrangements of their neighbors. There is a substantial risk that they will find themselves nailed by adjacent foreclosed eyesores (see the Charlotte Observer's map of one subdevelopment financed largely with 0 down loans at http://enterprise.star-telegram.com/ARCIms/Maps/clt/sc_2.asp),

ugly comps, and municipalities facing property tax shortfalls and half built infrastructure abandoned by bankrupt developers. And I don't see any really effective way for buyers or sellers to internalize that externality given present arrangements.

I was in the Chicago History Museum this week. At the Great Fire display they showed a letter from a German immigrant in 1872 complaining that the city was forcing him to build a brick house on his property, when wood would do just fine. I can see parallels.

charlie johnston

Maybe you would be interested in reading my book – No Such Thing as Luck – A Biblical Perspective You can find it at www.nosuchthingasluck.com Thank-you , Charlie Johnston

Richard

While the arguments against regulatory "solutions" offered by both Posner and Becker are valid, it is difficult to see that measures directed at enhancing transparency could do harm. I agree that the alleged lack of sufficient transparency in both mortgage origination and downstream investment activities is unpersuasive as a principal cause of current market events.

With respect to origination, I lean more toward the notion that adaptive expectations and rules-of-thumb, that are rational because they economize on calculation costs, led borrowers to anticipate that longstanding historical borrower-vetting procedures would assure that they were income/asset qualified borrowers. But changes in the mortgage products offered and in market disciplines, had radically altered the nature of borrower-vetting in mortgage origination. Now, once burned, however, there is no reason to anticipate that borrowers will make the same error twice (of course, there will always be the possibility of new errors . . .)

I suspect the story with respect to investor errors (underassesment of risk) is in some ways similar, though more complex. As Posner notes, these were not naive market participants, but there may have been hidden principal-agent imperfections that, in "normal" times were not severe, but when the products changed, became land mines waiting to go off.

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