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.