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December 04, 2007
Are The Borrowers At Fault?
Ryan Avent argues that, though some loan officers may have been unscrupulous, the real cause of the housing crash was stupid, greedy, borrowers, who wanted more loan in order to buy more house. This, Ryan says, is why so many ended up in the subprime market when they qualified for fixed rate mortgages. And maybe so.
Neither Ryan nor I have any data on how these conversations actually went. But whether it was the loan officer pushing the borrower off the variable-rate cliff or the borrower begging for a bit more rope with which to hang herself or, most likely, a bit of both, doesn't much matter. It is perfectly well understood that borrowers, by and large, know nothing of loans. It's a market that operates with a huge asymmetry of information. And though we know that loan officers are, in fact, loan salesmen, they are not presented that way -- instead, they're offered up as helpful experts waiting to guide you to a safe and secure financial solution. They're presented, in other words, like loan doctors.
What's supposed to govern their behavior isn't merely basic morals and business ethics, but a sense of concern for their company. If too many individuals enter into loans they can't afford, defaults will rise and the bank will suffer. Which is exactly what's happened. The loan officers, and above them, the banks, and above them, the regulators, were the ones with the knowledge, power, and authority to head off this mess. This market works, it exists, because we trust them to run it in such a way that does not massively exploit the ignorance of individuals, and does not put the entire economy at risk. They failed. But, unlike with the individual borrowers, they failed when their whole mission in life was to not fail, when they were paid to have the tools and information to not fail, and now, in reconstructing this market, we need to figure out what regulations will keep them from failing again. The behavior of the borrowers, financially stupid though it may have been, is simply not equivalent. This whole banking superstructure has supposedly evolved to help them -- to suddenly turn and say that it was a self-interested enterprise they had to outthink the whole time is quite strange.
December 4, 2007 in Economics | Permalink
Comments
It is perfectly well understood that borrowers, by and large, know nothing of loans. It's a market that operates with a huge asymmetry of information.
Where is the asymmetry of information? You get money, you have to pay it back, either at a fixed rate or some floating rate. If it's a floating rate loan, you don't know what will happen to interest rates, but neither does your lender.
I think it is probable that lenders are generally more rational than borrowers (who are unduly optimistic about what will happen with interest rates, their ability to repay, etc.) but I don't see what the information gap is.
Posted by: alkali | Dec 4, 2007 11:16:47 AM
oh give it up. Your trolls will be arriving in a few seconds to argue that its "personal responsibility" only if the average person assumes it. Renters, workers, poor people, aspiring middle class people, buyers, loan takers, etc...--they all have, or should have, "personal responsibility" that amounts to an impossible level of understanding of the risks involved in their own economic choices and in the economy at large.
Corporations and their paid employees can't have "personal responsibility" and certainly not level of "accountability" because...well...it would conflict with the majesty of capitalism and the slavish romance with the idea of the free market.
aimai
Posted by: aimai | Dec 4, 2007 11:18:43 AM
alkali is a perfect example:
Lenders and borrowers both rely on a large number of proxies to help them determine what their own risk is in lending and borrowing, and what the assets they are lending and borrowing *against* are worth at the moment of the transaction and for the foreseeable future. There are mortgage brokers, house appraisers, credit agencies, lawyers, etc...etc...etc... All of these other parties are involved in determining what the asset is and what the loan should be. But all of these are what are called *repeat players* or in some cases *witting investors* compared to a first or second time home buyer/loan getter. By definition a repeat player has more *information* and more understanding than a first timer. Both groups are certainly relying on projections into the future--projections that jobs will be steady or income going up, projections that the asset class won't degrade, that the asset itself won't degrade, blah, blah, blah. But of the two groups--lenders or borrowers--only one makes money *off the transaction itself* and also *whether the transaction goes well or ill* and that is the professional end, the professional mortgage maker. That sometimes buyers do ok doesn't mean that they weren't a leg down in the whole transaction. And that sometimes lenders get burned before they can offload their loans onto the next fool doesn't mean that they don't, as a rule, make their profit off the deal.
aimai
Posted by: aimai | Dec 4, 2007 11:24:41 AM
And though we know that loan officers are, in fact, loan salesmen, they are not presented that way -- instead, they're offered up as helpful experts waiting to guide you to a safe and secure financial solution. They're presented, in other words, like loan doctors.
Very interesting analogy... I'd love to see some really well-thought-out arguments (IOW, the kind I'm too lazy to make) about how we're all salespeople & shills now, how the service economy seems to have reached a tipping point at which even traditionally conservative business models are less trustworthy than those old-fashioned door-to-door salesmen. People sense that being a consumer is too damned much work these days, IME, at least in part because there are so few ethical sellers.
Also, what aimai said re: "personal responsibility" and who is actually expected to display same.
Posted by: latts | Dec 4, 2007 11:32:53 AM
There's no asymmetry of information but there certainly is an asymmetry of education. All the information is public and available but interpreting what it means requires financial expertise.
But this isn't really the problem. The problem is that the market fell victim to one of its classic idiosyncracies: bubble mentality. All bubbles ultimately involve a consensus understatement of the risk associated with an investment. If lenders had adequately quantified the risk, they wouldn't have qualified a lot of borrowers. If derivative issuers had quantified the risk properly, they would have priced their products accordingly and buyers would have better hedged their investments. When the risk was properly appreciated, the market became unstable.
By and large, I don't think there's anything predatory going on in this whole mess. It's a screwup. They happen in hot markets. They correct themselves, sometimes painfully. Usually, the same problem won't happen again, because the participants in the market are smart and have institutional memory.
Of course, the upside of the bubble was that a lot of borrowers got houses when they wouldn't otherwise have gotten them, which will accrue to the benefit of the majority of borrowers that don't default on their loans. But the downside of having the bubble burst is that there will be less capital available for future borrowers. That downside can be mitigated by a certain amount of bailout, which appears to be happening. The downside can also be greatly exacerbated by over-regulating the loan industry, which will also happen.
Posted by: TheRadicalModerate | Dec 4, 2007 11:33:13 AM
i'm not going to bother to read ryan avent's comments, which, for all i know, are more intelligent that ezra made them sound.
i am going to note that no one walked into a mortgage office with a gun and insisted upon being given a mortgage on the spot. if mortgage companies were offering no-doc, no-downpayment loans and prospective buyers took advantage, i don't really care which of those prospective buyers were scumbags and which were simply taken in by the bias towards higher rates of home ownership that is part of our public discourse: none of them granted themselves the mortgage.
Posted by: howard | Dec 4, 2007 11:34:00 AM
Federal and state regulators are taking up this issue.
The Massachusetts AG recently developed new regulations governing mortgage lenders and brokers that (1) prohibit mortgage brokers from processing, making or arranging a loan that is “not in the borrower’s best interest” and 2) where the broker’s interest conflicts with the borrower’s (i.e. where the broker’s compensation depends on securing a higher interest rate or other terms less favorable to the borrower), the broker must disclose the conflict and cannot process, make or arrange the loan so long as the conflict exists.
Similarly, the Mortgage Reform and Anti-Predatory Lending Act of 2007 contains an "Anti-steering" provisions which instructs the FTC and other regulators to develop regulations to "prohibit mortgage originators from steering any consumer to a mortgage loan that is not in the consumer's interest."
These seem designed to prevent brokers and lenders from taking advantage of the information asymmetry. There are additional measures that require lenders and brokers to make certain disclosures to the borrowers that serve to balance out the information asymmetry problem.
Posted by: Dungheap | Dec 4, 2007 11:35:23 AM
Wow!
aimai is in rare form in defense of the poor, poor borrowers. And without any evidence.
The truth is borrowers will borrow whatever you allow them to borrow because they want houses, cars, clothes and it's easy to put off paying to the future. If this were not the nature of borrowers, there wouldn't be the need for credit bureaus to tattle on the bad ones. Guess which is greater: People who use credit responsibly or those who have terrible credit?
Borrowers are ultimately responsible for their debts. That's why they are the ones signing the forms. It's just the left's "duty" to always believe that corporations are evil and the poor poor consumer is always the innocent lamb, let to slaughter.
Give it up, already
Posted by: El viajero | Dec 4, 2007 11:35:58 AM
There's no asymmetry of information but there certainly is an asymmetry of education. All the information is public and available but interpreting what it means requires financial expertise.
But this isn't really the problem. The problem is that the market fell victim to one of its classic idiosyncracies: bubble mentality. All bubbles ultimately involve a consensus understatement of the risk associated with an investment. If lenders had adequately quantified the risk, they wouldn't have qualified a lot of borrowers. If derivative issuers had quantified the risk properly, they would have priced their products accordingly and buyers would have better hedged their investments. When the risk was properly appreciated, the market became unstable.
By and large, I don't think there's anything predatory going on in this whole mess. It's a screwup. They happen in hot markets. They correct themselves, sometimes painfully. Usually, the same problem won't happen again, because the participants in the market are smart and have institutional memory.
Of course, the upside of the bubble was that a lot of borrowers got houses when they wouldn't otherwise have gotten them, which will accrue to the benefit of the majority of borrowers that don't default on their loans. But the downside of having the bubble burst is that there will be less capital available for future borrowers. That downside can be mitigated by a certain amount of bailout, which appears to be happening. The downside can also be greatly exacerbated by over-regulating the loan industry, which will also happen.
Posted by: TheRadicalModerate | Dec 4, 2007 11:36:29 AM
Sorry for the double post. Either Typepad or IE went temporarily insane.
Posted by: TheRadicalModerate | Dec 4, 2007 11:40:38 AM
aimai: I asked a real question. I was not trolling. You are being rude.
I still don't see that the issue is one of asymmetric infirmation. The mortgage borrower typically has lots of information that the lender doesn't have; he/she's been through the house, probably knows the neighborhood, knows his/her own financial situation and job prospects. The mortgage lender has, as you say, access to a huge set of databases that the borrower doesn't, but those databases are at best proxies for the specific information that the buyer has.
Put another way, it does not seem to me that the problem with the subprime lending situation could have been averted if only the borrowers had been told fact "X" which the lenders already knew.
Posted by: alkali | Dec 4, 2007 11:41:23 AM
Let's not forget the role of realtors and home sellers in this whole fiasco as well. I was shopping for my first home just a couple years ago straight out of college, and I had multiple realtors tell me that homes prices were way up but such and such bank is willing to work with us to make sure that I'm going to be approved for a mortgage that we can use to buy whatever home I want! The home market was hot hot hot!
I fortunately never purchased a house during this time (I'd certainly be in dire straits if I had), but let me assure you, it's almost drunkenly empowering to hear that a freshly graduated kid such as myself could be approved for a $300,000 home loan based on a decent credit record and a $60,000 salary. Knowing that I had that kind of purchasing power made me want to go out and find a house that cost every penny that I could possibly borrow, just so I could have it.
I know now that I was being lured into a trap. Let me assure all of you, I never heard the phrase "adjustable rate" during any of my conversations with any realtor or lender. It was always referred to as "your home loan." Sometimes the homier ones would call it "your nest egg." Based on my experience at the time, I know that I could have just as easily wound up becoming as much of a statistic as so many Americans have today.
In the end, there is always some responsibility with the borrower. They should have paid more attention to the tiny print. Sometimes though it's a lot easier to move forward with something if you're being, to a degree, willfully ignorant. This is why it's called predatory lending--a lot of flash, a lot of cash, an easy signature, and suddenly a mountain of debt with a dangerous adjustable interest rate.
Posted by: Clayton | Dec 4, 2007 11:43:52 AM
> There's no asymmetry of information but there
> certainly is an asymmetry of education. All the
> information is public and available but interpreting
> what it means requires financial expertise.
Multi-hundred billion dollar financial institutions with hundreds of people on staff dedicated to analyzing these issues got caught short. Multi-billion dollar municipal funds with access to high-powered advice got caught short. Very large banks with staffs and experts got caught short. One of the US' largest mortgage brokers got caught short.
But Joe * Jane Citizen are supposed to collect all the necessary information (most of which is hidden in agave type on paper documents that you aren't allowed to see) and do a better job of analysis than Goldman Sachs. Sure.
Cranky
Posted by: Cranky Observer | Dec 4, 2007 11:44:24 AM
“It is perfectly well understood that borrowers, by and large, know nothing of loans.”
Is it? Where? Let’s not go overboard here.
“a market that operates with a huge asymmetry of information.”
Sit down at the closing table and tell me this again, with a straight face. Everything is disclosed. The problem isn’t that the borrower doesn’t have enough information; it’s that they have too much. The closing process is a race to the end because a borrower must sign 50 documents. Within the closing package is a statement of the fees, the ARM disclosure (if applicable), and everything else one needs to understand the transaction they’re entering. You even get 3 days to pull out!
“And though we know that loan officers are, in fact, loan salesmen, they are not presented that way -- instead, they're offered up as helpful experts waiting to guide you to a safe and secure financial solution. They're presented, in other words, like loan doctors.”
This I agree with. Loan Officers, back in the days Krugmen remembers so fondly, were more salesman AND underwriter; they were key to one getting a loan. Today, they’re all salesman and customer manager while underwriting is done via technology or a back office underwriter. If you put too much faith in your loan officer, you open yourself up to getting into a deal that benefit the LO more than yourself.
I’m still not sure this market failed to the extent reported in the media. There was massive overreach in the subprime world, but that overreach has been punished. Banks are again reverting back to more stringent underwriting standards and prime loans are going strong, though volumes are down. The overall impact on the economy has been overstated (there’s some good data on this at Marginal Revolution); the housing market is the bigger issue.
The real questions are: what could regulators have done to prevent this? What can they do to prevent this from happening again? Remember, all the information a borrower needs is laid out before them already. This is a highly regulated industry today. It’s easy to say the market needs more regulation; it’s harder to pinpoint the new regulation that will mitigate the risk of this happening again.
Posted by: DM | Dec 4, 2007 11:45:08 AM
The loan officers didn't fail. They generated the loans, which were packaged and sold to investors. Their employers made an immediate profit. They didn't work for and had no duty to look out for the investors who bought the debt. The entity generating the loan was taking on no risk, and so had no incentive to turn down risky deals. The entities taking on the risk, the investors, had no ability to evaluate the risk and simply didn't bother to do so, being lulled into complacency by years of high returns.
As you point out, the historical model was that the bank retained the risk and therefore the loan officer was a gatekeeper who would not loan to poor risks (we all know the stereotype of the banker who refuses to give the poor farmer a loan). But in the modern era the lender is not concerned with whether you can pay the whole loan, only that you can pay the first few months.
Except in cases of actual fraud, which no doubt did happen, the problem is not one of asymmetry of information. It is one of asymmetry of expertise. The lender, who has the expertise, used to have an incentive to use it in a way that kept the eager homebuyer out of trouble (and often, out of a house). No longer. The ordinary home buyer is given all the information, but does not have the training and experience that allows him or her to process it intelligently.
Labelling a desire for a nicer house in a better a neighborhood as a moral failing ("greedy") and sneering at ordinary people's optimism untempered by professional expertise ("stupid") is the usual libertarian way of justifying predictable injustices.
Posted by: Bloix | Dec 4, 2007 11:46:48 AM
I've got a good job, my wife has a good job, and we have one kid. We've been renting a crappy duplex for a while because it's cheap, and now we're ready to buy our first home.
So we talk to our credit union, a couple of banks (local/regional and national) and a couple of mortgage companies. We read about fixed-rate and ARMs, about mortgage insurance, title insurance, inspections, home insurance, property taxes, what "escrow" really means, etc. etc. etc. We shop around for realtors that seem trustworthy.
We do all this and more, right, but when it comes down to it, when trying to figure out how much we can afford to pay, we go to the mortgage person, give them our SS numbers & other information, and they come back and tell us that our credit rating and income are such that we can borrow $XXX,XXX from them.
What possible reason would we have to not trust that figure?
As far as the wisdom of getting an ARM, we get a whole bunch of bullshit about how the interest rate on the loan is "locked in" for 5 years, and then only goes to prime + 2% or some other thing, and the prime rate is only .05% right now, there's no way it could go up that much. The person telling me this is the professional I go to for the loan. Why should I automatically distrust what they say?
If I take my car to a mechanic and they purposefully damage my car's engine beyond the original problem, is that my fault? If I need a double-bypass done and the surgeon removes my appendix, is that my fault?
The credit industry as a whole has been on a rampage for years now, reworking loans, coming up with new ways to extend credit, hiding their fees and terms in esoteric language, getting compliant Congressional Democrats to join the Republicans in passing bankruptcy legislation written by the credit companies themselves, convincing every company out their that they need to see a person's credit rating before doing business with them - cell phone companies, insurance companies, etc.
Thousands of highly-educated, highly-paid professionals have been working full-time for years in order to create credit agreements that meet the letter of the law while completely obscuring the actual terms of the loan. But when millions of people find themselves in trouble because of all this, it's supposed to be the consumers' fault. It's always the consumers' fault for those idiots who reflexively defend the corporation against all proof.
Sure, some people tried to take advantage of the system. But the majority of the people in trouble with this just went to their bank or a mortgage broker and asked for a loan. Then they got covered in a mound of bullshit but it's supposed to be all their own fault that they stink now.
And for the record, we got a 30-year fixed mortgage and borrowed way less than they said we could.
Posted by: Stephen | Dec 4, 2007 11:51:24 AM
"All bubbles ultimately involve a consensus understatement of the risk associated with an investment."
Bingo. In this case, it was the risk to the value of the collateral, the home. When home values starting falling, loans started going bad. The bubble mentality lead people to believe housing was a high growth investment with no downside risk; but all return come with risk, and this was lost on everyone.
Posted by: DM | Dec 4, 2007 11:54:38 AM
I recommend you take a look at this article from 2004:
>One of these spells flared up during the last week in February, when Greenspan recommended that the home-owning public take a good hard look at switching from fixed-rate mortgages ... to adjustable rate mortgages (ARMs), where payments fluctuate along with interest rates--which, right now, makes close to zero sense.
>But sometimes wacko ideas can betray deeper truths. It is tempting to ask what stake the chairman might have in trying to convince millions of people to do something so contrary to their own interest. One theory floated by Fed-watchers is that the chairman is trying to help out his classic institutional constituency, the big banks, which hold trillions of dollars in fixed-rate mortgage paper. There may be something to that theory, but there is almost certainly a deeper and more important motive behind this curious advice. Quite simply, Greenspan is trying to keep a wobbly and fragile recovery alive--and using mortgage refinancing to do it.
http://www.washingtonmonthly.com/features/2004/0404.wallace-wells.html
Posted by: Tangurena | Dec 4, 2007 12:18:29 PM
There was certainly asymmetrical information when my wife and I bought our house 5 years ago (with a fixed-rate mortgage). I thought I should probably read and understand the papers I was signing. After a half hour, the mortgage broker and title people told me that while I had every right to read it, most people don't, so they had allotted only an hour for the meeting. I wound up just scanning a lot of it, and signed reluctantly, knowing that there could be unwelcome details I missed.
To be fair, the loan people seemed pretty ignorant too. I asked about the necessity of one form that seemed entirely pointless. The mortgage broker just read me the title of the form. I asked for more detail and she repeated the title and said it was needed to complete the process.
Posted by: hohum | Dec 4, 2007 12:27:06 PM
So, let's go with the "borrowers got fucked" mentality and also regulate the stock market, bond market and certainly the commodities markets and blame those who sold other leveraged investments on margin that have performed poorly and were hit with margin calls. After all, isn't that REALLY what we're talking about?
Posted by: El viajero | Dec 4, 2007 12:27:32 PM
I had this discussion with my boss well-nigh 15 years ago when I was getting ready to buy my first house. He'd already owned a house for 10 years. He was envious of me because the underwriting standard across the industry had changed from the time he bought his first (early 80s) to the time I was buying mine (early 90s). When he bought, he said, you were qualified to buy a house selling for no more than 2x your annual family pretax income, and generally needed 20 percent down. When I bought mine, the standard was you could afford a house for 3x income, and for first-time buyers making less than 80,000 a year, you could buy for just 5 percent down.
Fact of the matter is, few of us are underwriters and actuaries, and words-folk like me and my boss are a looooong way from that, despite respectable educations and a good level of common sense. We trust what the experts tell us. Luckily, I bought in Michigan, where the disclosure laws are very strict. Some would call them onerous. Looking back, I call them smart.
Posted by: Rick | Dec 4, 2007 12:34:20 PM
I bought in 2004 after looking for a long time (not a bad decision for us) and having gone to innumerible open houses, the thing that surprised me was the number of open houses WITH A MORTGAGE BROKER THERE. Someone for Countrywide or Joe's Mortgage Shop or whathaveyou would be standing there beeming next to the realtor telling you how low your payments would be with his ARM, and on your way out he'd be pawning off cards for when you DO find that prefect house....
It was the slickness that turned me off and put in the chair of the local bank for a fixed rate mortgage...
Posted by: random | Dec 4, 2007 12:46:58 PM
the problem is not one of asymmetry of information. It is one of asymmetry of expertise.
Yes. Fortunately, there is an easy way for the individual home buyer to make up at least some of their expertise deficit: hire a real estate lawyer before you close on a house. You will get someone with lots of expertise in these transactions who, as your employee, is legally bound to advocate for your interests and to ensure you fully understand what you are signing.
I know people are reluctant to shell out the extra money for this representation, but in my view it's well worth the cost to prevent yourself from being screwed in the long term by disadvantageous loan terms. Think of it as a cheap form of financial insurance.
No, I'm not a lwayer myself, but there are several in my family, so I was taught to appreciate the value of having expert advocacy. Whenever I hear descriptions of high-pressure closing situations where people sign documents they don't fully understand, I cringe and think, "Why didn't your attorney warn you? Oh, yeah. you didn't have one."
I am not trying to blame the victims here. Everyone else involved in a real estate transaction has a vested interest in the buyer being the least informed person in the room, so nobody is likely to recommend that the buyer get legal representation. Given the bad reputation lawyers have had at least since Shakespeare's time, few people hire one when they don't have to. So we can't really blame home buyers (especially first-time home buyers) for not wanting to go to this extra, up-front expense. But a home closing is really one of times when, for self preservation, you really need to suck it up and hire a lawyer. Now you know.
Posted by: Dyon | Dec 4, 2007 12:52:24 PM
Borrowers do have their share of blame. I don't think any of this mess is going to comfortably fit into any world view. There is a ton of blame to go around. A post 9/11 government policy designed to encoruage spending and increased liquidity to the point of actually encoraging risky investments (borrowers did what government wanted them to do) , lenders all too willing to make crappy loans to people who had no bsuiness getting them, brokers all too willing to generate them, realtors (do i really need to say anything?), financial institutions that bought into the notion that somehow housing prices were immune from typical market forces, institutional investors who blindly purchased debt, and greedy and/or stupid borrowers.
There are simply way too many resources available to consumers to absolve them of any responsibility. The vast majority of people still manage to navigate their way through the process without fucking themselves over. I'm not sure the home buying process could be dumbed down anymore than it already is.
I agree with an earlier commenter that markets will correct themsleves and that it is often painful. However, the correction in this case came damn close to a meltdown and there is speculation that 2008 will be worse. If you never took a subprime, never even considered one, and in every way have no culpability for the current mess, you still stand to suffer mightily from a global collapse in credit. I can't believe I'm about to say this, and I doubt I'll agree with his proposed remedy, but Barney Frank has a point. We cannot confuse capitalism with financial anarchy.
Posted by: Alex | Dec 4, 2007 1:09:20 PM
Bloix, it's more than that. Brokers were INCENTIVIZED to generate higher-rate loans for their borrowers. I remember walking into a mortgage office with perfect credit and being told that the best option available was an interest-only ARM. Yield spread premiums are a powerful factor in this. I'm not absolving borrowers of blame (I didn't take the interest-only loan), but I think stopping lenders from financially gaining from screwing their customers is a reasonable proposal.
Posted by: dday | Dec 4, 2007 1:25:15 PM
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