Wednesday, August 29, 2007

Making Political Hay From Sub-Prime Loans

What lessons did we learn from the Savings and Loan crisis that came to a head during the 1980s? Please bear in mind that this whole fiasco directly cost us taxpayers about $125 billion. Other indirect costs, including funding of the resulting federal deficits of the 1990s pin the total cost at a much higher figure. But did we learn anything from it?

I hope the S&L crisis hasn’t dimmed or become fuzzy in the minds of Americans, because one of the lessons we should have learned is that government intervention to rescue lenders from poor business practices causes far more problems that it solves. The S&L crisis was made worse by several orders of magnitude by government meddling that prevented the market from appropriately responding. But it seems that today we are on the threshold of wanting to repeat some of the same mistakes that significantly contributed to the S&L crisis.

S&Ls had a long history of performing well in the mortgage industry for a century. During the 1960s more Americans bought homes than ever before, financing them at rates of 5% and less. Life was good. And then we experienced rampant inflation and skyrocketing interest rates in the 1970s. To be competitive with other investment instruments, S&Ls had to offer higher rates to their investors than they were receiving from their debtors.

It was obvious that in the long haul this business model was completely unsustainable. How did S&Ls end up in this situation? After WWII, the government implemented regulations intended to increase home ownership. While this produced many salutary effects, it also led to S&Ls being too deep in fixed low-rate assets, and therefore, insufficiently flexible to deal with market changes. In effect, S&Ls were encouraged to act as if the economic conditions of the late 50s and early 60s would go on unchanged forever. S&Ls ignored common business sense by accepting this wonderland scenario.

When interest rates went up in the 1970s, S&Ls started writing mortgage loans at the higher rate, but the bulk of their assets were locked up in 30-year mortgages written at much lower rates. Investors naturally expected to earn interest at the new market rates immediately. S&Ls could either figure out ways to keep investors on board or risk losing enough investors that they would go out of business. Either way, insolvency was going to be the end result. It was only a question of how much time would transpire before that happened.

Seeing the looming problem, politicians came to the rescue in an attempt to save the floundering S&Ls. Over the next few years, laws and regulations were passed that artificially kept failing S&Ls in business. Had the market been allowed to deal with the crisis early on, there would have been pain, but ultimately the market would have corrected itself. Politicians put off the pain — and made the crisis many times worse — by intervening and shielding S&Ls from natural market pressures.

But all the king’s horses and all the king’s men couldn’t stop the S&L Humpty-Dumpty from falling, nor could they put him back together again. By the time the S&L collapse could no longer be stopped by politicians, Humpty-Dumpty was much larger and sat much higher, so his fall was much greater. Once again, Congress rushed in to pick up the pieces and save the market from dealing with the natural consequences of bad business decisions, resulting in the taxpayers forking out many billions of Dollars. Players learned that if business mistakes are big enough, they will ultimately not have to bear the full cost. Thus, Congress ended up encouraging riskier business behavior.

Fast forward to 2007. In recent years, mortgage lenders have climbed over each other in an effort to attract increasing numbers of Americans to their loan products. Home builders have been in on the take as well, working hard to attract buyers that have marginal repayment capacity. This has led to a significant increase in sub-prime lending. But common business sense dictates that making high risk loans will inevitably lead to a high default rate. This all hit the fan recently, when there was a sharp rise in the number of foreclosures in the sub-prime mortgage market between 2006 and 2007, resulting in what is being called the 2007 sub-prime mortgage crisis.

Politicians, ever eager for votes and ever eager to expand power, are licking their chops and planning increased regulation that would have the effect of overreacting, punishing some, and shielding the market from the natural consequences of shoddy lending practices. As Jerry Bowyer reports in this NRO article, mortgage lenders are not lending at the moment because they fear the congressional backlash that is about to be unleashed, even as the market is effectively responding to correct the excesses that led to the “crisis.”

The ironic thing is that, as Bowyer notes here, this whole issue is really just a tempest in a teapot. He cites the fact that “only about 0.6 percent of U.S. mortgages are currently in foreclosure. That’s up a hair from roughly 0.5 percent last year.” But since these additional 35,000 foreclosures are ostensibly for lower cost homes, “the recent increase in sub-prime foreclosures amounts to 0.01 percent of net U.S. household wealth.

In other words, the sub-prime “crisis” has been blown way out of proportion, making headlines in a slow news cycle. The market is already correcting the problem. But none of this will stop politicians from grandstanding on and trying to make political hay with this issue. And just about anything they are assaying to do will only make matters worse. Here’s hoping that Congress will take its most usual course of action and end up blathering a lot while doing nothing. Sometimes it’s good when politicians can’t accomplish anything.


y-intercept said...

The group really getting crunched are those who bought into the get rich quick real-estate hype and who leverage themselves red buying up speculative real estate.

The funny thing is that the folks who fail at the get rich quick schemes become the biggest critics of the free market when the schemes fail. They also tend to run to the government to beg for a bailout.

Come to think of it. I wonder if DL has a garage full of MLM Miracle Skin Cream that he could never sell.

Democracy Lover said...

It's interesting that we now the the Bush administration's plan for solving the sub-prime loan crisis:

First, they propose to have the FHA waive the current 3% equity requirement and insure mortgages that exceed the market value of the home. That's sounds like a surefire plan - borrow $200,000 on your $180,000 home! Essentially that means paying off the bondholder with taxpayer money while leaving the homeowner in even deeper debt.

Second, they want to temporarily waive the income tax on forgiven debt. If you are at a lower income level this is a bit of a help, but if you are in the 33% bracket and part of your MacMansion with the jumbo mortgage is foreclosed, you'll get a very nice tax break.

Home ownership has for a long time been part of the American Dream (a myth but a very powerful one). If a reputable lender who bombards the airwaves with expensive TV spots is offering you a mortgage on that dream house, you have to assume they think its a good investment. We can blame the poor sap who falls for this all we want, but this is a system created by the near-total relaxation of banking regulation over the last 25 years.

I don't have any Miracle Skin Cream, but I also don't have a huge McMansion with 2 SUV's in front that is 15 miles from the nearest store and an hour commute from my job. I think we are making a mistake to believe the mortgage crisis is all about the dumb working stiff who is over-extended on his "manufactured home". A lot of middle-class people I know have ARMs or balloon payments and if we have an economic downturn for whatever reason, lots of them will be hard pressed to keep their homes.

Reach Upward said...

About 25 years ago there was this big craze going around Northern Utah of "investing" in diamonds. Of course, this was all done through sales meetings held in people's homes. Every meeting featured people that had bought diamonds and re-sold them within a few weeks at a huge profit. People were falling all over themselves to engage in this investment.

Although I was a callow youth at the time, I refused invitations to attend any of these meetings. It seemed obvious that the whole thing was a scheme. Within a few months the whole thing came crashing down. It had been a Ponzi pyramid scheme (duh). All of the diamonds were sold to "investors" way above market resale value. Promoters had used some funds to buy back diamonds at even higher prices so that they would have people that could offer testimonials. Promoters had pocketed the rest of the cash.

In the end, a lot of angry people were left with diamonds that were worth far less than they had paid for them. Although the promoters were prosecuted, almost nobody got any of their money back. There were cries for government intervention and new laws. But the simple fact of the matter was that people had behaved stupidly and had paid the price for it. That provided a tremendous lesson to any that were willing to pay attention.

We do people a great disservice when we relieve them of the responsibilities of their own poor choices. I'm not arguing that we shouldn't help people, but there are good ways to do that and bad ways to do that.

Today, as DL notes, President Bush is talking about his plan to bail out the fools that are getting burned in the sub-prime mortgage kerfuffle. Senators and Representatives have already been noising their plans as well. Relieving these folks of the responsibility of their foolish behavior will only beget more foolish behavior; kind of like rebuilding New Orleans.

y-intercept said...

There is some merit to Bush's plan. When you have hard and fast laws set by the regulators, you will always find people schrunched against the rules when prices change. A homeowner's real equity is the selling price minus the mortgage. Since time is linear, a homeowner does not know their real equity. The same is true of all investments.

A person with 3% equity when they bought the house last year might have -3% equity today because a drop in price.

This situation happens regardless of the equity requirements of the FHA. If the regulators set a 25% equity requirement, then you would have a large number of people thrown into foreclosure when the prices drop because their 25% equity fell to an 18% with the housing drop.

Whatever policies are put in place by the government will become a magnifier.

Democracy Lover said...

Y doesn't seem to recall that while we did have "hard and fast rules set by regulators" over the banking and mortgage markets, those regulations were removed, largely making way for both the S&L crisis and now the mortgage lending crisis.

It seems to me that while it is true that many consumers should have been more wary, the burden of responsibility is on mortgage lenders and the investment banks that repackaged mortgage securities as investment vehicles. The financial industry knew they were playing with fire. The mortgage lenders were aware that they were approving borrowers who did not have verified income or who were bad credit risks. They knew the true value of the homes they were financing.

Responsibility and fore-knowledge are connected here. If I am a first-time home buyer being offered a great deal by professionals, I should be wary. If I am a knowledgeable, trained, licensed professional intentionally misleading my customer and knowingly inflating my client's income, home value or credit rating, then I am criminally liable. There's a big difference.

Reach Upward said...

Lenders and buyers share the blame. And they should share the pain as well.

Democracy Lover said...

I think you have to make a clear difference between the mistake of an uninformed buyer and the deliberate fraud of an informed seller.

We should not assume that it is perfectly OK for businesses to lie, cheat and steal because that is "how it is", and then blame the consumer for not having been sufficiently wary.

Reach Upward said...

I agree that a pure "buyer beware" policy places too much responsibility on the shoulders of the consumers. However, we must be extremely careful to not go overboard in the name of protecting people from the consequences of their own choices, because this only results in incentivizing poor choices. It's a delicate balancing act.

Democracy Lover said...

Incentivizing poor choices? We would have to go a long way to get there - I doubt that's a rational danger in the financial marketplace.

Certainly I would not advocate the government setting up some kind of policy that prevented a person from buying a home they could not afford or one that did not have a decent potential resale value - those are personal decisions. I do believe we should punish realtors who knowingly mislead customers, and mortgage bankers who are so greedy for loans they do not use generally accepted standards for measuring the security of their loans.

Again, we need to make a difference between a stupid decision and an intentional fraud. That's not too difficult, we have cases like that every day.

Moreover, I think it is very important that politicians who hold themselves up as moral "values" leaders do not permit a distinction between persons and corporations when it comes to illegal or immoral activity. If it is wrong when you do it to me, it is wrong when General Electric does it to you.

Reach Upward said...

I agree that fraud should be punished. Fradulent activity not only hurts its specific victims, it also hurts everyone in the market: producers, sellers, and consumers.