Who put the “liar” in “liar loans”?

Megan McArdle has a fine post up at the Daily Beast on the housing market collapse. I’ve read far too much about how the big banks caused the problem. That’s true in a sense; they certainly rode a bubble all the way up, then presented us all with a scary prospect when it seemed they might all fail at once, precipitating a liquidity crisis.

But I find too few articles looking closely at how fraud happened. Most writers completely miss the function of interest rates in allocating risk in a lending market. You can stop reading right away if an author starts talking about interest rates and monthly payments that give borrowers a “fair” chance of buying the house we all think they deserve as a human right.

Likewise, there’s almost no talking to anyone who thinks that someday there’s going to be discovered a substitute for people actually repaying the debts they incur. This problem is particularly acute in the home mortgage context, because most buyers don’t seem to understand that the bank didn’t loan them a house; it loaned them cash to pay to the seller of the house. The seller walked away with the cash. The bank is out the cash. It is not fundamentally the bank’s problem if the house later drops in value, any more than the bank is entitled to a windfall if the house rockets up in price. The buyer/borrower really, truly owes the cash to the bank, even if he’s disappointed in his expectations of a flourishing housing market, even if he loses his job, and even if he has to move to another city. Am I unsympathetic to a homeowner in this situation? Of course not. But I’m not inclined to say it’s the bank’s problem to bear the cost, either. That’s just another way of saying we’re so tender-hearted that we want charity for a guy in a tough spot, but we want someone else to pay for it. (This is my nomination for the social-policy error that creates the great confusion and damage while permitting the maximum preening by people who want to look and feel altruistic at no personal expense.)

Anyway, I liked McArdle’s article because she looked carefully at the incentives for writing the garbage loans to begin with. Her commenters chimed in with more clear thinking about the incentives further down the chain of investment, all the way to the government-sponsored entities (GSEs) whose limitless appetite served as the vacuum pressure back up through the supply pipe, to the would-be homeowner.

Now, if the GSEs had been purely private investors, all that would have happened is that they would have gone broke when it turned out they had been buying garbage loans in a bubble market. But the GSEs weren’t quite private. They had powerful friends in Congress who implied all along that they could count ultimately on taxpayer bailouts, because we have to ensure stability, and everyone (in both parties) knows that homeownership is part of the American Dream. Those same friends in Congress never missed a chance to bully banks into loaning money to whatever members of their constituencies weren’t actually qualified for a big loan in the harsh light of soulless financial calculations (a/k/a “the Man”). Without the GSEs standing at the far end of the pipeline ready to soak up whatever came through the spigot, Congress would have had limited ability to force banks to make loans that were unlikely to be repaid (or to be more accurate, to buy packages of bad loans that independent “originators” put together). Yes, the banks could bundle the bad loans up and sell them off in strips to investors of greater or lesser sophistication, but the investors in turn had a big appetite only because of the GSEs standing down at the end of the pipe.

Wait, you say, wasn’t it the fault of the rating agencies? Shouldn’t they be accused of fraud for rating garbage as triple-A? Well, what are the odds they would have stuck to the triple-A ratings without the presence of the GSEs, with their implied (and later actual) taxpayer underwriting?  Look at the abuse they took when they finally started to hedge about the wisdom of giving a triple-A rating to anything that could be said to have U.S. government support.

But although this is a big, multifacted picture, the fraud element is not as complicated as much of the press over the last five years would lead you to believe. The fraud all boiled down to lying about the ability of homeowners to repay their loans. Buyers fudged their creditworthiness so they could get a loan.  Originators fudged the buyers’ creditworthiness so they could qualify the loan. When the originators sold the loans in bundles, they lied to the banks about the same thing. Buyers of the loan packages theoretically shouldn’t have lied to themselves about it, but individuals within buyer institutions had a big motive to lie to other individuals within the same institutions, to close the deal, get the annual bonus, keep the job, and so on. It wasn’t their personal money, right? And then those buyers bundled up the packages of loans and sliced them various ways and sold them again — and at that stage the same kind of lying occurred again.  By the time the pipeline had grown really long and the investment instruments had grown really intricate, investors simply persuaded themselves that the risk couldn’t possibly be that great, and boy, look at those yields!

At some point, you’re supposed to reach a buyer whose own skin is in the game, and who is motivated to stop listening to lies and stop lying to himself about whether all those homeowners could repay, because that’s what the risk boils down to at every stage in this domino structure. The beauty in this system is that you never reached that person with skin in the game until you came to the taxpayers. And then the taxpayers (not an outstanding bunch in the area of financial acuity) were persuaded that the problem lay almost anywhere you can imagine except with the practice of lying about the homeowners’ credit.  Because who wants to be mean to people who are being thrown out of their houses?

The McArdle article goes further than most, by identifying some empirical investigation into just who knew the most about homeowner creditworthiness, and how they let it affect either their willingness to close or their willingness to set a low interest rate.  She was also lucky enough to attract this intelligent commenter, “circleglider”:

People follow rules because those rules are congruent with their morals or because the risk/reward ratio of any sanction is unfavorable.

When governments regulate otherwise private economic transactions, they necessarily create principal-agent problems.  Rules – especially arbitrary ones – only exacerbate agency costs.

This is one of the many reasons why command and control economies fail.  And the diversion of ever more resources into rule enforcement is a signal step in their decline.

In those rare cases where true market failures exist, the most effective interventions are those that minimally impact incentives and consequences.  The U.S. housing finance system operates almost entirely contrary to these principals.

. . .

The vast majority of markets work just fine.  “Economic crashes” are separate from market failures and may or may not be exacerbated by them; government intervention is almost always the causative factor.  There are few true monopolies or oligopolies outside of those created by government (hint: try naming any that constitute even 10% of the U.S. economy).  Asymmetric information, while technically a type market failure, can be and is often rectified by private actors.  And by definition, the Tragedy of the Commons only occurs where market forces are not allowed to operate – otherwise, the commons could not exist.

Throughout history and across the globe today, there is an inescapable inverse relationship between economic growth rates and government interference in private economic affairs.

Most alleged market failures are simply outcomes that some person or group finds objectionable.  Indeed, some of the most often decried outcomes are those that represent markets doing what they do best — facilitating mutually beneficial trade and allocating resources to their best and highest uses. Markets are where people come together to do what they do best:  self-organize.

Those who work and live in the private economy rarely see markets fail.  Those who work and live in the public sector rarely seem them work.

This sorry spectacle should make us take especially careful note of what California public entities are getting up to lately in the way of issuing bonds.  They really need the money, and they really don’t have it.  They’ve already tried borrowing it, but they need to commandeer more than the resources of the the next few years of taxpayers.  What they really need is the resources of taxpayers forty years from now.  But they’d be thrown out of office if they tried to get next year’s taxpayers to start paying on a forty-year obligation for this year’s schools or pension obligations, so they came up with a brainstorm:  balloon bonds!  Pay nothing now, and then the payments will mushroom later, much later, don’t even worry about it.  Sound familiar?  When that structure crashes, will people remember that the problem was that the public entities should have known right from the start that they were borrowing more than they could possibly afford to repay?  Or will there be a confused scramble to sue the Big Banks that helped structure the deals?

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