Complex Loans Didn’t Cause Crisis? Bull!
Courtesy of Karl Denninger at The Market TIcker
The WSJ carried an interesting (and misleading) opinion piece today:
Regulatory reform that can improve competition and consumer choice in financial services is long overdue. But no new federal bureaucracy such as the Obama administration’s proposed Consumer Financial Protection Agency (CFPA) is needed to bring that about.
More importantly, the administration is incorrect in claiming that such an agency would have prevented the present financial crisis and is necessary to prevent the next crisis. On the contrary, such an agency might be the first step toward more problems.
How does forcing lenders to reduce a credit card or mortgage agreement to language that can fit on both sides of an 8-1/2 x 11" page in 10 point courier type constitute "a first step toward more problems?"
During the housing boom bankers made a raft of extraordinarily foolish loans. Some were the result of lenders defrauding borrowers; probably at least as many were the product of borrowers defrauding lenders. But there is no evidence, as Elizabeth Warren (a champion of CFPA and chair of the TARP Congressional Oversight Panel) recently asserted on these pages, that lender fraud was the overriding cause of the crisis.
The bank loans were not foolish because borrowers didn’t realize what they were doing. They were foolish because of the incentives they created for borrowers, especially when housing prices turned south.
No, the bank loans were foolish because the banks lied about what they were selling, to some degree to consumers but to a much larger degree to investors.
My own research confirms the analysis provided by University of Texas economist Stan Leibowitz on these pages last July: The initial onset of the foreclosure crisis was a problem of adjustable-rate mortgages, whether prime or subprime. It was not initially a subprime problem.
Who wrote loans without qualifying the borrower on the fully-indexed (that is, the highest rate the loan could reach) rather than (as they did) qualifying them on teaser rates that were known to have a short expiration date, sometimes as short as two years post-initiation?
That would be the banks, who created not a mortgage product but instead a product for asset-stripping the consumer, in that they wrote paper that theyknew the consumer could not "pay as agreed" through the entire term.
The intent was to force the consumer to come back and get a new loan in a couple of years. This was insanely productive for the banks for two reasons: it gave them another set of fees they could strip off from the consumer, and in addition virtually the entire payment stream during those first two years on an amortized note is interest, with almost none of it principal.
That is, the intent of such a note was not a "mortgage" – an amortizing loan contemplated to be retired at maturity. The essence of these "loans" was in fact more akin to a typical commercial real-estate loan where amortization is not the prime purpose; these are typically written as interest-only balloons and refinanced, with the interest payments made from tenant leases. In this case the interest payment is made from the "home tenant’s" employment cashflow. A Consumer Financial Protection Agency could and should bar the marketing of such loans as "mortgages" and instead demand they be called what they are – a complex financial transaction that effectively amounts to a lease!
The error of course in the bank’s thinking was that home prices could never go down. In fact, their bet was that home prices would always appreciate fast enough to accommodate both the paid interest and the fee to refinance after two years.
Again, we get down to my favorite graph:
It doesn’t matter how you slice the pie here. House prices cannot expand faster than wages forever, just as debt cannot expand faster than GDP forever. The compound function of exponents makes all such claims and expectations false and dangerous.
The proliferation of mortgages with minimal downpayments, interest-only or even negative amoritzation terms, and cash-out refinances meant that many consumers fell into negative equity territory much more rapidly than they would have otherwise.
Those mortgages were made available only because the banks willfully and intentionally ignored warnings by The FBI, HUD and private credit analytical firms that these loans were not as represented. They packaged them up and sold them to investors either knowing (or willfully blind) that the credit quality of the paper inside those MBS (and the more-complex securities structured upon them, including the partially and fully-synthetic versions) were not as represented.
This was not an accident it was a scam.
Regulators may want to limit mortgages that provide so many borrowers with such strong incentives to walk away when housing prices fall. They may want to prohibit lenders from making loans with minimal downpayments or interest-only loans that result in consumers having minimal equity in their homes. But that’s an issue of safety and soundness, not protection against fraud.
If regulators prosecuted and jailed those executives who misrepresented the credit quality contained in these securities then the loans could not have been made. Without the ability to obtain funds you can’t loan funds.
The bank that has $100 million to loan out must sell its loans to be able to make more loans. If it cannot sell them at a price representing the risk and make money (because it allowed people to take out loans on "prime" terms when they were poor credit risks, and upon disclosing this honestly to buyers nobody will pay anything close to "par" for that paper) then they are immediately restrained from continuing this conduct and the fuel for the bubble is immediately removed.
Without that free-flowing and fraudulently-granted credit there is no price appreciation spiral that drives the bubble. The bubble does not inflate. The price appreciation does not happen. The mania is quelled before it begins and the damage to the economy does not happen.
The financial crisis resulted primarily from the rational behavior of borrowers and lenders responding to misaligned incentives, not fraud or borrower stupidity. Policies that fail to appreciate the difference will not protect, and may hurt, the very consumers they are intended to protect.
Bah. The financial crisis resulted primarily from promises by lenders (on both the funding and lending side) that were knowingly false and in some cases maliciously so. Borrowers were flatly told they could come back and refinance before any "payment shocks" happened – not that they might be able to, but that they would be able to. They were led to believe by the statements of what amounted to con men that they were getting not only a great deal but that they could come back at any time and continue to get a new great deal.
At the same time buyers of the paper emitted by these lenders and their cronies on Wall Street failed to disclose that as early as 2004 The FBI was warning of an epidemic of falsehoods in mortgage applications – that is, that the paper contained in those securities was trash. Despite having authorization to verify the statements of borrowers (via 1003s and 4506-Ts) the lenders willfully did not do so and issued paper with reps and warranties that were issued as statements but which they intentionally failed to verify. Ratings agencies accepted data submitted without verification and filled in "blank" data with unsubstantiated guesses, along with running computer models that presumed there would never be a home price decline (a mathematical impossibility given the flat income curve for the median citizen since 2000.) All of these assumptions were made by "wise people" who either factually knew or, had they actually exercised their claimed wisdom and knowledge, should have known.
Synthetics were then created at the behest of hedge funds and others through the purchase of a naked credit-default swap – a bet that the reference securities would default – while not owning the reference security. Those synthetic CDOs were then sold to investors, rated on the underlying (bogus) credit of the reference instruments. The outrageously-overrated credit quality claimed for these reference instruments came to light almost immediately, in many cases mere months after these synthetics were created, with the buyers taking heavy and in some cases total losses. Was it disclosed to the buyers of these synthetics that they came into existence only because someone bet that the purchaser would lose all their money? Would you buy a security that came into existence only because the person at who’s behest it was created believed that it was in fact worthless, if that fact was disclosed to you up front?
The essence of the crisis was, as Mr. Zywicki notes, the three-cycle collapse of the housing market first by adjustable-rate loans, second by price declines and now by unemployment.
Mr. Zywicki acknowledges (in a phone call I just completed with him) that but for the price increases caused by these fraudulent misrepresentations the bubble would not have happened – and thus neither would the collapse.
BUT what he refuses to recognize is that the essence of the Consumer Financial Protection Agency is to prohibit practices that amount to fraudulent and misleading conduct on the part of lenders in their dealing with consumers. That is, promising that you "will be able to refinance" before that teaser expires, qualifying borrowers on other than fully-amortized and fully-indexed rates and other abusive practices that lead consumers to believe that the fundamental mathematical laws that govern all exponential functions have somehow been repealed, even if temporarily.
Fraud in all it’s forms was the essence of this crisis. It could not and would not have occurred but for that fraud, as the home price increases seen in the 2000 decade could not have occurred without the money flow necessary to fund the spiral, and that money flow could not have happened without misrepresentations by both omission and commission up and down the line.
Each and every part of the flow of funds was involved – lenders, borrowers and investors.
Even those who were not involved in the fraud in any way – who took out traditional, fixed-rate 30 year mortgages during these years – were harmed by this fraud. They were induced to pay a price that was fraudulently inflated for the property they purchased – a price that was not supported by the fundamentals of the market – that is, free action by informed buyers and sellers – but rather a price that was inflated by the fraudulent loan originated, made and securitized to the person who bought a house down the street. That fraudulent loan presented itself in the marketplace as false demand in that the "buyer" was incapable of affording the home he allegedly "purchased." Each and every buyer of a home from 2003 to 2007 was thus harmed by these practices, irrespective of whether their loan was honestly represented to them or not.
Resolving the crisis demands prosecution for all those involved in the myriad frauds, starting from the top down. We have done exactly none of what has to happen to clear the system of this fraud, nor have we punished the perpetrators, even though intentional misrepresentation by omission or commission is, in nearly all cases where financial injury results, already illegal.
Preventing this from happening again requires not only that the financial industry be subject to true oversight and enforcement to keep it from defrauding investors, but that consumers be protected from the misrepresentations perpetrated upon them by the financial industry in the lending products offered and that it be made clear that consumer misrepresentations and frauds perpetrated upon lenders will not be tolerated either.
Mr. Zywicki is a law professor at George Mason University and a senior scholar at the Mercatus Center. This op-ed is based in part on a Mercatus working paper, "The Housing Market Crash."
Mr. Zywicki claims in his areas of expertise consumer credit and consumer lending. It is clear from his piece (and my phone call) that in point of fact his position is that anything a consumer gets themselves into is a function not of deception and defective understanding (due to omissions or commissions by the lending industry) but rather simply a matter of "efficient markets."
I strenuously disagree, and submit that if you’re attending George Mason University to become versed in how to claim that it’s all the consumer’s fault (even when actively misled) or perhaps even to defend against allegations of these misrepresentations and omissions while working for a financial institution, you’ll do well to attend his classes. He’ll fill your head with everything you need to recite in a puerile attempt to defend the indefensible.
I’ll take a pass as that’s the sort of lawyering that leads me to recall my Shakespeare – Henry VI, of course.
