A Stitch in Haste

Think the Democratic presidential candidates would pay attention to this?

While some degree of early defaults are to be expected in subprime mortgage pools, the extraordinarily high level of defaults encountered by the 2006 vintage cannot be explained by home price declines alone. It has become increasingly evident that loans originated with lax underwriting and higher instances of fraud can have a material impact on a securitization.

They're not called "no income verification" mortgages for nothing:

BasePoint Analytics LLC, a recognized fraud analytics and consulting firm, analyzed over 3 million loans originated between 1997 and 2006[.] ... Their research found that as much as 70% of early payment default loans contained fraud misrepresentations on the application.

No one laments how the unethical borrowers who lie on the mortgage applications "exploited" the unfortunate bank. Nor should they: If you lend down with dogs, you wake up with fleas.

But that should work both ways: What is so "cruel" about being unsympathetic to those who deserve no sympathy? Competent consenting adults, hoping to game the system, got burned -- not by any "predatory lender" but by their own miscalculation (dare one say "their own greed"?). They could have stayed out of the housing market. They could have waited until their finances and credit improved. They could have done their homework before they signed the forms. They could have been, forgive the repetition, competent consenting adults.

Instead they try to cry foul and play victim of imagined Silas Barnabys -- and succeed? That simply cannot be right.

This is comparable (worse, in fact) to the "exploited" college student who opens up her first credit card account, promptly buys $1,000 worth of DVDs, pizza and airfare to Daytona for Spring Break, none of which she can afford, and subsequently becomes fodder for bill collectors. The pesky fact that she got to enjoy the money while the bank is out $1,000 doesn't stop malcontents from insisting that the student is somehow the "victim" and the bank is the "predator." It makes no sense at all.

You're probably familiar with the old joke about two explorers in the jungle who stumble upon a hungry tiger.* As they run for their lives, one explorer shouts to the other, "Why bother? We can't possibly outrun the tiger!"

"I don't need to outrun the tiger," the other explorer replies. "I only need to outrun you!"

That joke crossed my mind as I came across another joke: Paul Krugman's latest column —

In a 1963 essay for [Ayn] Rand's newsletter, Mr. Greenspan dismissed as a "collectivist" myth the idea that businessmen, left to their own devices, "would attempt to sell unsafe food and drugs, fraudulent securities, and shoddy buildings." On the contrary, he declared, "it is in the self-interest of every businessman to have a reputation for honest dealings and a quality product."
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In Mr. Greenspan's world, predatory lending — like attempts to sell consumers poison toys and tainted seafood — just doesn't happen.
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Of course, now that it has all gone bad, people with ties to the financial industry are rethinking their belief in the perfection of free markets.

A few hasty stitches:

--It hasn't "all gone bad." The subprime "catastrophe" represents a subset of a subset of a subset of the securities markets. Ripple effects are, thus far, noticeably lacking.

--As I asked yesterday, what about "predatory borrowers"? Are they to bear no responsibility for their willful and in many cases flagrantly unethical contribution to this situation?

--Who was selling "poisoned toys"? Oh right, Communists. Anti-freedom charlatans pretending that "centrally planned capitalism" could possibly exist. Remind me again what the read-through is likely to be for mortgage lending (or socialized medicine or energy policy or education or ...)?

--Krugman is rebutting not Greenspan but a straw man. Capitalists don't "believe in the perfection of free markets." We only believe in the superiority of free markets over the prognostications and prescriptions of central planner wannabes. We don't believe we can outrun the tiger, but we know we can outrun Krugman.

It's quite simple really: The "greed" of Wall Street will never be more dangerous than the hubris of Washington or its apologist op-ed writers.

(Via no third solution.)

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*I suppose today it's a polar bear. Or a smoke monster. Or something.

On why any central planner worth his salt should advocate banning subprime mortgages:

The welfare harms caused by subprime mortgage lending are readily measurable. They include the direct impact of more than two million foreclosures on families, the resulting property value losses, the social and fiscal impact on cities where subprime mortgages were concentrated, the price discrimination resulting in black and Latino homeowners paying unnecessarily high rates, and the broader impacts on the credit markets and the economy.

The disastrous consequences of subprime mortgage lending were in part the result of deregulating mortgage interest rates. Similar harms can be prevented in the future by reimposing reasonable interest rate limits on first-lien mortgages.

Of course, the utilitarian gobbledygook term "welfare harms" conveniently blanks out the fact that the overwhelming majority of subprime mortgages are not only not in foreclosure but also not even in default.

And the fact that not every foreclosure "victim" is a family (in fact many or most are speculators with multiple loans covering multiple properties, many of which are empty or even unfinished). Indeed, as I noted previously, often the borrower is not the victim but the victimizer.

And, most importantly, the fact that if even one competent consenting adult wants to take out a subprime loan, and even one lender wants to offer a subprime loan, then both ought to left alone to do so.

--All the loans that are not in default? Blank out.

--All the properties not in foreclosure? Blank out.

--All the property values not declining? Blank out.

--"Social and fiscal impact"? Impact to whom? Defined how? By what standard?

--"Unnecessarily" high rates? Unnecessary to whom? By what standard?

--"Reasonable" interest rate limits? Reasonable to whom? By what standard?

No, all that matters is that some nebulous, arbitrary, subjective measure of "welfare harms" should give politicians, bureaucrats -- and their codependent law professor enablers -- sanction to restrict freedom of contract for all.

Kip's Law: Every advocate of central planning always -- always -- envisions himself as the central planner.

I was saving this recent Dilbert strip for a future Sidebar Sidetrack, but I'm going to post it now instead:


(Click to enlarge.)
Armed with that:

Just why investment bankers and traders out-earn, say, doctors or computer engineers is a question I've never heard convincingly answered. Are they smarter? Unlikely. Do they contribute more to the economy? Questionable. True, Wall Street often performs a vital function. It channels savings into productive investments. It helps provide access to capital and credit. In 2006, U.S. companies raised nearly $4 trillion through new stocks and bonds. Many financial innovations, including mortgage-backed securities, have benefited individuals and companies.

But Wall Street also frequently misallocates capital and credit. The "tech bubble" of the late 1990s was one episode. Now we have subprime mortgages. Why? Well, the herd mentality of financial crazes has a long history. But compensation practices skewed so heavily toward bonuses based on annual profits make matters worse.

Apparently Robert Samuelson, like Paul Krugman, isn't really an economist but just plays one on TV. Nevertheless, he knows full well what drives Wall Street salaries: supply and demand, just like any other market. He can barely go two sentences without explaining his own concocted paradox: In a sector that creates $4 trillion of new financial products (let alone the secondary markets) every year, is an annual bonus that reflects a fraction of a fraction of a percent of that enormity really such an outrage?

Typically we see this sophomoric, flunk-the-final screeching in the context of celebrity salaries: Does Alex Rodriguez "deserve" $275 million? Did Bon Jovi really "contribute" $67 million of value to society in 2006? Should Johnny Depp ($92 million in 2006) out-earn a computer engineer?

The answer to all those questions is: Yes, if that's what the free market concludes. Rodriguez' compensation package, for example, is not a single financially "obscene" transaction, but the aggregation of perhaps a million de minimis transactions or more: ticket sales, endorsements, broadcasting rights, media stories, etc. All of which, bit by bit, aggregate into a voluntary* arrangement that — by definition — is correct, justified and entirely moral. (*Ignoring side issues such as baseball's antitrust exemption, FCC licenses to television and radio stations, taxpayer subsidies to stadiums, and other ancillary considerations.)

And remember that, despite being the most heavily regulated industry in the universe, finance is an entirely voluntary domain. No one is forced to buy a stock or bond (or, it bears repeating, a subprime mortgage via a fraudulent application). Can the "noble" politicians who refuse, for example, to consider even the most modest Social Security reform say the same about their "vital function"? And the fact that we don't let supply and demand work its wonders in medical salaries the way we do on Wall Street is precisely why we are running out of doctors. Go figure.

If Samuelson thinks that Rodriguez is overpaid (or, more proximately, that a Yankees ticket is overpriced), then he is free not to enter into that transaction. If he thinks that Johnny Depp is "exploiting" moviegoers, then he is free to protest by staying home. And if he doesn't like the subprime market, then he can opt not to borrow through it. Beyond that, he has no standing to complain — and neither does any politician, bureaucrat or other malcontent. Move along folks, no externalities to see here...

Meanwhile, Samuelson claims that "Wall Street also frequently misallocates capital and credit." Misallocates — by what standard? If I go to a movie that I end up disliking, did I "misallocate my capital"? Would I be "crazed" to ever go to a movie again after seeing a bad one? Of course not. Bad outcomes do not automatically prove bad decisions. "It made sense at the time" is not always a rationalization.

Finally, remember my parable in this post: Wall Street specifically, and the free market generally, are not required to prove that they are perfect. They merely need to prove that they are better than the only available alternative: command-and-control statism by people who think exactly like Samuelson (or worse).

That would be an investment guaranteed to prove worthless.

More thoughts at EconLog, Rolling Doughnut.

If mortgage lenders are all so "greedy," then why should the federal government try to emulate them?

Sen. Christopher Dodd said he envisioned an entity with an initial capitalization of $10 billion to $20 billion that would buy distressed mortgages and pass on the "discounts ... to homeowners in the form of new, lower-balance mortgages."
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"The difference between the old mortgage and the new mortgage would be sufficient, after initial capitalization, to fund the program and cover possible losses," the Connecticut Democrat said in the letter.
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Dodd's proposal is aimed at helping millions of Americans facing the risk of foreclosure.

This is, of course, utter nonsense.

Buying, selling, repackaging and servicing mortgages is precisely what all those "reckless" financial companies (i.e., the ones that Democrats love to damn nowadays) have been doing all this time. The notion that the federal government needs to get in on the action, to the tune of $20 billion, has no rational basis -- especially from a Democratic worldview.

If there is a way to buy up distressed mortgages and restructure them to avoid foreclosure, then the private sector can and will do so. (Remember, contrary to the "Silas Barnaby" stereotype, banks do not enjoy foreclosing on properties -- they enjoy getting mortgage payments, even restructured ones, in full and on time. Banks will in fact bend over backwards to avoid foreclosure -- assuming that the debtor isn't a predatory borrower or other deadbeat and is actually interested in "working something out.") If there is no way to do this profitably, meanwhile, then Dodd is lying and his scheme becomes just a more complicated form of bailout for defaulters.

It's Amtrak all over again: Politicians using the fact that not enough people want a service as grounds for going right ahead and providing it anyway. The mind reels.

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On the other hand, there are worse ideas than Dodd's.

The latest data on the mortgage and housing situation:

Nearly 1 in 10 American homeowners with a mortgage faced foreclosure or fell behind in their payments in the first three months of the year, according to a report released Thursday, a figure that offers a look into the toll caused by the collapse of the housing market.

Of course, this means that the Times' headline — "Nearly 1 in 10 American Homeowners Face Problems With Loans" — is flat-out wrong: Do we really need a remedial course in the difference between "homeowners" and "homeowners with a mortgage"?

Similarly, do we really need a remedial course in arithmetic? If 10% of homeowners with a mortgage "face a problem with their mortgage," then by definition 90% do not.

And of course, not every mortgage "problem" (i.e., foreclosure, late payments or missed payments) maps to a unique homeowner problem: speculators — sometimes with 5, 10 or 15 properties — surely explain some if not many of these occurrences (the report, by the Mortgage Bankers Association, is based on all residential mortgages, including by speculators financing multiple properties). By the same token, many of these loans represent just-completed or even unfinished properties in new housing developments (i.e., no one has ever lived in them and no one is being forced out of them).

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Which leads to the other rarely-discussed fact about the "crisis" —

Four states — Arizona, California, Florida and Nevada — accounted for about 89 percent of the foreclosures, a disproportionately high amount of the newly reported figures.

I have seen first-hand the situation in the Las Vegas suburbs, where my parents now reside in a new-build community (with no mortgage, incidentally).

The mindset has been, and continues to be, "build first, sell later." Of course there is a housing collapse there: Why would anyone buy a "used" house when they're still building brand new ones on the other side of the development for basically the same price?

(And, to make matters worse, why buy a foreclosed property that you are prohibited, by law, from entering and inspecting? It's bizarre: you literally have to bid on the property sight unseen. But that's how it works in Nevada, or at least where my parents live.)

At least four houses on my parents' street have foreclosure notices taped to the garage door. Not a single one was ever occupied (at least not by owners — some were briefly rented). No Mother Peep, no Silas Barnaby, no evil conspiracies, certainly no "predatory" lending. Just gamblers who lost — a phenomenon not unusual in Nevada.

Speaking of my parents: What do Nevada, Florida and Arizona have in common? That's right: They are retirement destinations; my parents are a prime (no pun intended) example. Who really believes that legions of middle-class (or wealthier) retirees are selling their homes and setting up shop in a new state — armed with their sold-house proceeds, their pensions, their IRAs and their Social Security checks — and then blowing it all on a subprime mortgage? Of course that's not what's happening. The people who had the common sense and the modesty to simply buy one house and live in it are not the ones caught up in all this.

So I ask again: How do 5% of mortgage-encumbered owner-residents (again, not mere "homeowners"), mostly speculators, in four states constitute a "national" crisis?