Category Archives: Financial Crisis of 2008

Conflict of Interest in Mortgage Lending and the Role of Regulation

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I received some pushback on this post. This is a response.

There is a narrative of the housing bubble/crash which tries to fit it into a neat oppressor-oppressed model. Greedy banks exploited naive borrowers in an era of libertarian deregulation. Emotionally, it as a satisfying story. Analytically, it is not. Here is why.

There are conflicts of interest between borrowers and mortgage originators, and there are conflicts between originators and investors. The financial crisis was created by the latter, not the former.

The main conflict of interest between borrowers and originators is that it is almost always in the interest of the mortgage originator to induce the borrower to pay an excessive fee and/or interest rate.

In my view, this conflict was not much of a factor in the housing crisis. The vast majority of the defaults were the result of the collapse of house prices, not the cost of mortgage loans.

Nonetheless, I have spent a lot of time thinking about this conflict and how to deal with it, because it bothers me that the most vulnerable people are the ones who are most likely to get ripped off. I do not think that market competition works very well to protect consumers, because a sophisticated lender can make it appear that he is offering the most competitive rate and then turn around and rip off the consumer. I do not think that letter-of-law regulation works very well, because you can never close all of the loopholes.

One possibility would be reputation systems. If an entity like Consumer Reports were to rate lenders and loan offerings, and enough consumers use that entity, then bad actors would be driven out of the lending market. Unfortunately, the most vulnerable consumers do not use these sorts of consumer rating services, so I do not think that solution will work.

The other possibility is principles-based regulation. Audit firms to ensure that their products, policies, procedures, and internal incentives are designed not to exploit vulnerable consumers.

The oppressor-oppressed narrative has lenders giving loans to borrowers when the lenders should know better but the naive borrower does not realize that he or she should not be getting the loan. Some comments on this.

1. Lenders are not omniscient. They make mistakes. A Type I error is making a loan that you think will be repaid, and it turns out to default. A Type II error is turning down a loan that would have been repaid. Until 2007, the main oppressor-oppressed narrative was that lenders were making Type II errors, particularly with respect to minorities. That is, the evil lenders were turning down too many good borrowers. When the crisis hit, the oppressor-oppressed narrative suddenly became the opposite. Lenders supposedly forced loans on unwitting borrowers who could not pay them, and we need to regulate lenders to make sure this never happens again. That is, originators deliberately committed Type I errors.

2. Under the old-fashioned originate-to-hold model, there is never an incentive for lenders to make loans that will not be repaid. You lose money on those loans. In this model, the bank pays its loan origination staff not on sheer volume, but on quality decisions, including rejecting loans as warranted.

3. On the other hand, with securitization, the originator’s idea of a good loan is any loan that can be sold to an investor, without regard to whether it can be repaid. When you deny a loan application, you cannot possibly make money on it. If you approve the loan and it cannot be repaid, that is someone else’s problem. This is primarily a conflict of interest between originators and investors, not between borrowers and lenders. At Freddie Mac, this conflict of interest occupied us constantly. Trying to keep originators from funneling bad loans to us drove enormous amounts of our staff time, business functions, policies, procedures, and contractual arrangements.

4. One of the illustrations of the conflict between originators and investors is that loan applications often include fraud and misrepresentation. The most common examples include over-stating the borrower’s income and/or lying about whether the borrower is going to occupy the home. Income misrepresentation is often initiated by the originator, trying to “help” the borrower get a loan. Occupancy fraud, on the other hand, is almost always initiated by the borrower. It can be hard for the originator to prevent this fraud, because it only becomes clear after the loan has been sold that the borrower never intended to occupy the home and instead is a speculator.

Taking all this together, I do not find the story of deregulation leading to the housing crisis to be very compelling. The main conflict of interest that caused the problem was the conflict between originators and investors. Basically, originators were able to foist bad loans on investors. This is not a case of the rich and sophisticated taking advantage of the poor and naive. On the contrary, the typical originator is a low-class guy working for a poorly-capitalized company in a highly competitive business. The typical investor is a sophisticated money manager.

Regulation was part of the problem, not part of the solution. The regulators’ perverse risk-based capital requirements encouraged the risk-laundering AAA-rated tranche business. And their attack on Type II errors prior to the crisis was at worst a major cause of the crisis and at best spectacularly poorly timed.

Private Securitization and the Housing Bubble

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Adam J. Levitin and Susan M. Wachter write,

We argue that the bubble was, in fact, primarily a supply-side phenomenon, meaning that it was caused by excessive supply of housing finance. The supply glut was not due to monetary policy or government housing finance. The supply glut was not due to monetary policy or government affordable-housing policy, although the former did play a role in the development of the bubble. Instead, the supply glut was the result of a fundamental shift in the structure of the mortgage-finance market from regulated to unregulated securitization.

Pointer from Reihan Salam.

The implication is that if government regulates securitization, things will be fine. Some problems I have with this analysis:

1. They do not examine how the market for “unregulated” securitization was in fact bolstered by capital market regulations. Take away the regulatory advantage for AAA-rated and AA-rated securities, and I do not think that the securitization market is able to take off. Remember that capital requirements for banks were so perverse that holding a tranche in a pool backed by sub-prime mortgages required more less capital than originating and holding a low-risk mortgage.

2. The “regulated” sector, namely Freddie and Fannie, lowered its standards at exactly the wrong time, in 2005 through 2007. Several private players, including AIG, either exited the market or tightened standards before the bubble burst.

3. The problem with private securities is not that they lack standardization. It is that the whole securitization model is flawed. It introduces more costs than benefits into the mortgage finance system. That fact has been obscured by all of the support that government has given to securitization, including the “too big to fail” status of Freddie and Fannie and the perverse capital requirements noted in (1) above.

The Voice of Authority

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Either Google “Charlie Rose Stanley Fischer” or try this link.

I am particularly interested in Fischer’s view that (a) the financial crisis had the potential to cause another Great Depression and (b) that the policy responses of the United States worked quite well and (c) fiscal expansion was needed, because monetary policy could not do enough. He does not offer a list of evidence on these points. Instead, he says, in effect, that experts agree on these points. Some possibilities:

1. There is a lot of evidence, but in an oral interview he could not give footnotes.

2. Fischer’s circle is an echo chamber that takes these views, without much need for evidence.

3. Fischer formulated an opinion early on in the crisis, and he has seen no need to change his views, because hypotheses about the financial crisis are untestable (we cannot undertake controlled experiments in macro).

I am particularly curious about (1), and where one could find the list of observations that supports the view that we were headed toward another Great Depression without the bank bailouts and fiscal stimulus.

The Cochrane Tax

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John Cochrane proposes,

I think a simple tax is the answer – though since “tax” is a dirty word, let’s call it a “systemic externality fee” – on debt, and especially on short-term debt or any other contract where the investor has the right to demand payment, and fail the firm if not received. Every dollar of such funding will cost, say, a 10 cent fee. Payments due later generate smaller fees.

The idea is that all short-term debt contracts end up being implicitly insured by taxpayers. So from the standpoint of incentives and fairness, those contracts ought to be taxed.

Keith Hennessey and Edward P.Lazear on the Financial Crisis

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They write,

The best evidence suggests that the financial crisis was caused in large part by an unprecedented flow of funds into the United States and other developed economies.

Thanks to Michael Barone for the pointer.

Their essay is very well organized and well written. That does not mean that I agree with it. It is true that there is a tendency for large capital inflows to end badly (think of Latin America in the 1980s or Asia in the 1990s). However, we could have used those capital inflows to finance something other than a consumption binge funded by unsound mortgage loans.

One of their arguments is that the financial crisis was more like popcorn (a lot of institutions faltering for the same reason) than like dominoes (one institutional failure leading to another). They say that this argues against case-by-case rescues, and I agree with that. But they say it argues in favor of TARP, which they describe as a systemic solution. But a solution to what? How does transferring the real losses from the owners and creditors of distressed firms to the taxpayers solve anything? They write,

Five years later, TARP and the other policy actions taken during the financial crisis nevertheless remain widely unpopular. This tension between a policy success and intense political unpopularity is a defining feature of the actions taking during the financial crisis.

Of course, we do not have the counterfactual, so they can say that all they want. Just as proponents of the stimulus can say that it saved lots of jobs. Both TARP and the stimulus were followed by horrible economic performance, but you can always argue that it would have been worse without them.

The authors, both of whom were important officials under President Bush in 2008, also defend the GM and Chrysler bailouts.

If [Bush] chose not to extend the loans, he was advised that these firms would likely liquidate within weeks. Private sources of debtor-in-possession financing that would have been necessary to allow GM and Chrysler to continue absent government aid were simply unavailable.

What Would Keynes Have Done?

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Bradley Bateman writes,

He never said that the government could exactly hit some target. This is an idea that came from one of the first great Keynesian texts published in the late 1940s, Functional Finance by Abba Lerner

Bateman writes in a collection of essays called The Economic Crisis in Retrospect, which tries to ask what great economists of the past might have said about the financial crisis of 2008. It is published by Edward Elgar, which typically prices its products for libraries as opposed to the mass public. I was sent a review copy.

Bateman also claims that Keynes did not believe in running government budget deficits. “In many ways he was Libertarian.” Of course, he was always in favor of public works as a stimulus package, but Bateman claims that Keynes proposed using the government’s sinking fund to finance this. It is not clear to me why this is not deficit spending.

In another essay, on Joseph Schumpeter, Richard N. Langlois quotes from Capitalism, Socialism, and Democracy.

Capitalism, then, is by nature a form or method of economic change and not only never is but never can be stationary. And this evolutionary character of the capitalist process is not merely due to the…social and natural environment…The fundamental impulse that sets and keeps the capitalist engine in motion comes from new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization that capitalist enterprise creates.

Langlois says that Schumpeter explained the business cycle by saying that it takes a while for signals of obsolescence to reach the firms that are affected. Langlois writes,

They do not stop making carbon paper right away. So there is an economic boom that starts as the new technology spreads. It creates what Schumpeter calls a secondary boom that is artificial. Because what should be happening is that resources should be being withdrawn from carbon paper at the same time they are being put into computers. But that does not happen. The carbon paper is still there because those signals have not yet reached those who finance carbon paper. Yet there is a boom in computers. The whole process is not sustainable.

The book has other interesting essays including one by Perry Mehrling, who gives his view that we need to extend government protection to shadow banking, as well as one by Thomas Sargent, who raises some doubts about that approach.

Although I found the book worth reading, and I may re-read Sargent’s essay (I found a video of Sargent delivering his essay, and I passed it along to Scott Sumner, who seems to have had as much difficulty as I did following it.), I would not put it at the top of your wish list.

A Question

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From the comments on this post.

if it were made clear that in the event of a crisis the shareholders would be wiped out and the bondholders would take whatever loss was required, then why should anyone care what financial structure an institution chooses?

This approach could have been taken in 2008. Several economists argued that Citigroup could have been handed over to the bondholders. Why wasn’t this done? Here are some possible adverse consequences:

1. Depositors will hear “Citigroup is bankrupt” and rush to pull deposits out, even though they are safe.

2. Holders of bonds at other banks will sell those bonds in order to buy safer assets.

Of course, these concerns can always be raised about bank debt. If the government will never allow bank debtholders to take a loss, then in effect we have 100 percent government guarantees to bank debtholders. Russ Roberts has argued vociferously that this is in fact the regime we have been under, and the consequence is that banks have the incentive to maximize their debt financing.

It appears that the government cannot credibly commit to letting bank creditors bear some of the losses from an insolvency. If that is the case, then it would seem that taxpayers have an interest in forcing banks to have a capital structure with less debt and more equity.

Outlaw Private Short-term Debt?

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That seems to be what John Cochrane is advocating.

In the 19th century, private banks issued currency. A few crises later, we stopped that and gave the federal government a monopoly on currency issue. Now that short-term debt is our money, we should treat it the same way, and for exactly the same reasons.

Read the whole thing. He argues against the conventional approach to financial regulation, which is to allow banks to issue risk-free liabilities with an explicit or implicit government guarantee and try to regulate their risk-taking on the asset side.

While I agree with those who favor a financial system with more equity and less debt, I would prefer a different approach to getting from here to there. I would like to phase out the subsidies to debt finance. These subsidies include deposit insurance, too-big-to-fail, and the favorable tax treatment of debt. All of these ideas are fairly drastic relative to current policy, but they are less drastic than outlawing outright the contracts that create short-term debt.

Consider this recent paper by Harry DeAngelo and Rene M. Stulz.

Debt and equity are not equally attractive sources of bank capital. Debt has a strict advantage because it has the informational insensitivity property – immediacy, safety, and ease of valuation – desired by those seeking liquidity. High bank leverage is accordingly optimal when the MM model is modified to include a price premium to induce (socially valuable) liquidity production.

Or, in my terms, the nonfinancial sector wants to issue risky liabilities and hold safe assets, and the financial sector accommodates this by doing the reverse.

Another recent essay, Taming the Megabanks, comes from James Pethokoukis.

The Home Borrowership Crisis

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Christopher L. Foote, Kristopher S. Gerardi, and Paul S. Willen of the Boston Fed write,

the facts refute the popular story that the crisis resulted from financial industry insiders deceiving uninformed mortgage borrowers and investors. Instead, they argue that borrowers and investors made decisions that were rational and logical given their ex post overly optimistic beliefs about house prices

This paper from last year was cited the other day by Scott Sumner.

One quibble I have is that the paper makes it sound as if the only variable that shifted during the run-up to the crisis was house price expectations. In fact, the proportion of loans with down payments less than 10 percent shot up (even the authors have a figure showing that the market share of loans with down payments under 5 percent nearly doubled, to almost 30 percent of loans, in just four years–from 2002 to 2006), the proportion of loans backed by non-owner-occupied properties (i.e., speculative investments) went from roughly 5 percent to roughly 15 percent, and the proportion of loans that went to borrowers with lower credit scores also rose.

Of course, the expectations of rising home prices helped fuel the decline in lending standards, because you cannot be punished for making a bad loan in a rising market. And the deterioration in lending standards helped fuel rising home prices, because it broadened the market to buy homes. Hence the bubble.

Basel and the So-Called Savings Glut

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Thomas Hoenig and I have new commentaries expressing similar thoughts. Hoenig said,

We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights. The objective is to maximize a firm’s return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management. This creates the illusion that banking organizations have adequate capital to absorb unexpected losses. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets. This “leveraging up” has served world economies poorly.

Read the whole thing. Then read my latest essay.

So what accounts for the low interest rate on long-term bonds, particularly those of the U.S. government? It is not “quantitative easing.” It is not a mysterious shift in preferences among savers. It is that banks, which enjoy enormous advantages in attracting funds from savers due to actual and perceived protection offered by governments, have a strong incentive to direct these savings into financial instruments that their regulators have designated as having little or no risk. Risk-based capital regulations may be ineffective at promoting bank safety. But they are plenty effective at allocating capital away from productive private investments and toward government bonds.

I also thought the Hoenig quote worth including in the essay.