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Some Thoughts On Our Present Economic Troubles
Brian D. Rude Sept. 2010
As I recall it was in the summer and fall of 2008 that it became apparent that the American economy was beginning to go bad. I remember my thinking at that time. The news reports said we had a housing crisis. A lot of bad loans had been made, and now that problem had reached a stage where it was bringing down the economy in general. It didn't take long at all for me to pull up a memory of the not too distant past, a memory of a mystery that I had not figured out to my satisfaction. It seemed like only a few years ago I would hear a lot of ads on TV for home mortgage refinancing. The first company name I remember was Ditech, but I think there were probably a lot of other companies doing the same thing. The gist of the ads was an appeal to homeowners, especially homeowners in financial trouble, to refinance the home loans. I suppose good interest rates were offered, and perhaps other inducements, but what really stuck in my mind was the implication that you could refinance beyond the usual 80% limit. Indeed after a time I think the ads made the explicit claim that you could finance up to 125% of the value of the home. That just didn't seem right. How could that be?
All my life time, so far as I have been aware, the figure of 80% has been considered the rule of thumb for borrowing. If you have a 20% down payment and good credit you won't have trouble borrowing the other 80% of the purchase price. It's always been true, I think, that there are many special cases in which 90% or even 95% loans are made, but they are not the rule. The 80% rule of thumb, I always assumed, came out of long experience. When people have less than 20% of their own money in a property problems develop. So isn't offering 100% loans, and more, an inducement to borrow recklessly? Isn't that financially unsound? Won't people dig themselves deep into more financial problems? And won't a company that makes such loans have a day of reckoning when people can't pay those reckless loans? And won't such a company bitterly regret their foolish actions?
I did have a tentative explanation at the time. I compared it to property insurance. I remembered that when my wife and I would buy a new house and get property insurance we would normally insure the house far above the market price we paid for it. I think the usual figure was 100% of replacement value. To replace an older home with a new home of the same size would cost a lot more than the market price of that older home. I assumed that usually when an older home burns down the insurance company doesn't have to rebuild the same size home on the same location. I always assumed the insurance company offers a settlement to the displaced homeowners, and then they go out and look for another suitable older home to buy. I have little knowledge and no experience on such things, but the important point is this: If we insure our house for 100% of replacement value, then don't we, the homeowners, have a motive to commit fraud, to burn our house down, claim it was accidental, and then enjoy a new home at the insurance company's expense? I concluded that of course we do have that motive, and indeed it is probably attempted once in a while. But I imagined that those attempts would be very rare. It would never occur to the vast majority of homeowners to think of committing insurance fraud, and if it did occur to them it would not be appealing. Cultural values, in other words, were sufficient to keep such fraud at a very low level, even though a perverse motive is allowed to exist. Insurance companies allow that perverse incentive to exist because it makes customers happy, and fraud is rare.
So, I surmised, maybe it's the same in refinancing. If you refinance at over 100% of the value of your home you do indeed have a motive to borrow the money, spend it foolishly, and then when you can't make the payments you just walk away from the home and let the bank deal with the problem. But maybe very few people would do this. Maybe cultural values are such that a bank can loan substantially over the traditional 80% limit, even over the 100% logical limit, absorb a certain percentage of bad loans, and still come out okay in the long run.
So when the news remained constant in the fall of 08 that we had a real problem with bad housing loans, I felt pretty smug. I had an "I told you so!" situation. I was right. No, you just can't loan 125% of the value of a home and expect to come out okay in the long run. Ditech and a bunch of other companies were wrong. Such companies would lose their shirt.
I don't know what happened to Ditech. Somebody told me that they went under at some point. That is quite understandable. However it soon became apparent that there was more to it than that. I think the problem was much, much bigger than a few companies making bad decisions and losing money. Common opinion seems to be that they didn't lose money, at least not all of them. They got rich. How can that be?
Apparently our whole economy was brought down by bad home loans on a massive scale. Many people believe that rich Wall Street people made those bad loans purposely, that making bad loans is a way to get rich. They got rich, according to popular opinion, but the country suffered. Those rich Wall Street people were greedy, but jerks. That explanation seems to satisfy the general public. But it doesn't satisfy me for more than about ten seconds. Yes, I know people are greedy. I'm greedy. Everyone is greedy. It's part of human nature. What about it? Being greedy is not enough to make a person rich.
One mystery was solved. How can you loan over 100% of a home's value and expect it to work out? Simple. You can't. Events seemed to prove that beyond any doubt. But now a new mystery emerges. How can you make money by making bad loans? It never worked for me, and I've made a bad loan or two in my life time. If I make a bad loan I lose money. I can cite a few examples. But somehow a rich Wall Street banker makes bad loans and gets richer. Just how does that work? Can I do it? I'm greedy. I don't have the wherewithal to do it with home loans, but maybe I could do it on a smaller scale, maybe with used cars. How about if I make bad loans on used cars? Will that make me rich? How?
I once made a bad loan on a used car. I picked up a very nice 72 Oldsmobile once in my younger days. I don't remember just why I bought it, but it was a beautiful car. One of my friends also thought it was beautiful and wanted to buy it. I sold it to him for a little more than I had paid for it, and let him make payments directly to me. I didn't think of it in terms of a bad loan at that time. As much as anything I was just helping out a friend. I can't remember the details, but after all was said and done of course I lost a little money. So how is it that one can get rich by making bad loans?
Making a loan can be thought of in terms of buying and selling. When I get a loan on either a car or a home the bank is giving me money and return gets a promise. The bank is a buyer. I am the seller. I am selling a promise. The bank is buying my promise, and paying good money for it. My promise is a valuable commodity. In my life time I have sold promises to buy houses and cars a number of times. When making a loan the bank pays real money, and in return they get a promise. One can say it's a lot more complicated than that, and of course it is. One can say that the bank gets the money back with interest, and that's a lot more than a promise. And one can argue that that promise is backed by the legal right to possess the property if the promise goes bad. That's true enough, in the long run. But in the short run they are buying a promise. No bank, I presume, wants to foreclose and get stuck with property. I don't know if banks always lose money when they foreclose, but I suspect they usually do. If the promise is not valuable in its own right, banks normally don't want to lend. Any lender purchases a promise. Any borrower sells a promise.
So with this perspective shouldn't we ask how one plans to get rich by buying trash? The trash I'm talking about, of course, is a bad loan, or many, many bad loans. I've bought lots of trash in my life, but none of it has ever made me rich. So how can a rich Wall Street banker get richer still by buying a lot of trash? Every bad loan is a bad promise. How do you get rich by buying trash?
I think the answer is pretty simple. Unfortunately I don't have many details, but I have heard enough from various sources to convince me of the truth of the basic idea. You can get rich buying trash if there is an aftermarket for that trash. If I go out, for example, and buy a bunch of used cars at prices considerably more than their value, if I buy a bunch of trash, in other words, I wouldn't normally expect to get rich. However if I can turn around and sell that trash to someone else for slightly more than I paid, then I can get rich, or at least richer. This is the "bigger fool" idea. I may be a fool to pay that much, but there's a bigger fool who will pay me even more. I buy trash, but sell it at a profit.
So who is the bigger fool eager to buy a trillion dollars worth of bad loans?
Financial institutions buy and sell assets all the time, though I know very little about all that. A good loan is an asset. It has a market value. It’s understandable that home loans are just another commodity traded by financial institutions. Indeed more than once my wife and I were informed that starting the next month we were to send our mortgage payment to a different place? Why? They sold our loan. Why did they sell it? I suppose there could be many reasons. A loan is a commodity. They are traded, just like any other commodity. I doubt if our home loan was ever sold individually by a lender. I think home loans are packaged up hundreds or thousands in a bundle. But they are traded. One financial institution, for one reason or another, wants to turn their outstanding loans into cash. Another financial institution, for one reason or another, wants to turn their cash into an income producing investment. So they trade. But they trade only because the buyer, the financial institution with cash to get rid of, believes in the value of the package of home loans that they are buying. But why would a bad loan have any market value? Why would a bundle of bad loans attract a buyer?
And who is that buyer, the bigger fool?
Perhaps the simple answer is just Fannie May and Freddy Mac. Perhaps it's a lot more complicated. I don't know. But surely the driving force of that aftermarket in home mortgages is the federal government. Who else would be the bigger fool? Who else has the motivation to buy a trillion dollars worth of trash? And what is that motivation?
The motivation, of course, is to do good. People like to do good. When they can do good with somebody else’s money, the appeal is even greater.
As I understand it the center of all this is the CRA, the Community Reinvestment Act. I don‘t know much about it, but I think the basic story is that it was enacted into federal law in the seventies and has been tweaked every few years since then. I think it was intended to do good. It gives lending institutions both a stick and a carrot to do certain things. I think the CRA includes a lot of binding regulations requiring lending institutions to make loans to groups that have trouble getting loans. That's the stick. The carrot, I think, is some mechanism by which those loans are taken off the hands of the lending institutions that made them. I wouldn't want to make a bad loan myself, but I can imagine if I were required to do so by law, and given the means to make a little profit to boot, I suppose I would do so. Perhaps also part of the carrot is that warm fuzzy feeling that you are doing good by giving loans to people who really shouldn’t get them. When I agreed to take payments from the buyer of the 72 Oldsmobile I mentioned, I did indeed feel good. I was helping a friend. I was doing good.
It's hard to do good. I think that is an idea that needs a lot more thinking about.
My analysis is woefully short on details. I don’t know much about these things. But what is a better explanation? There seems general agreement that bad loans were made on a massive scale, a trillion dollar scale. Are we to believe that bankers suddenly took leave of their senses and threw out hundreds and hundreds of years of banking experience and accumulated wisdom, and somehow thought they could make money by making bad loans? I am painfully aware that people make foolish mistakes, and I'm sure that includes bankers now and then. But I am also aware that governments make mistakes. And government uses other peoples’ money. I’ll keep an open mind about these things. But I’ll also remain skeptical of explanations that don’t seem right, that seem to have big holes in them. The big holes in the “bankers got rich by intentionally making bad loans” theory are first, the mechanism, and second, the motivation of buyers in the aftermarket for these bad loans.
The saddest thing about this to me is we are not learning the right lessons. Again and again I hear, even from very intelligent people, that our present economic problems are caused by inadequate regulation of financial institutions. My view, based on all that I have talked about, is that our problems come not from a lack of regulation, but from bad regulation. Those carrots and sticks, I presume, are real regulations with real teeth. That is bad regulation. The cure is not more bad regulation. As a libertarian I tend to think the cure is a whole lot less regulation. But I don't know much about such things. Maybe the cure is good regulation to replace the bad regulation. The important thing, it seems to me, is that no cure is possible if we don't understand the cause.