Mark, See if you can work with this version. I left your comments since I don't know if you've read my responses yet. -- DanKarmel - 10 Jun 2010

Link fixed. -- MatthewZorn - 24 Jun 2010

Altercasting The Homeowner

-- By DanKarmel - 11 Apr 2010

The Collapse

When we discussed the collapse of the mortgage industry in class, Eben solicited suggestions for what had gone wrong. One person stated that the problem was the widespread societal assumption that home prices would never stop appreciating. At some level, this was correct. With few exceptions, home prices had grown steadily for generations. Borrowers were willing to accept adjustable-rate mortgage loans because they were confident that by the time the rates on their mortgages were due to adjust, they would have almost certainly generated wealth in their homes simply by living in them, and they could then refinance their mortgages before the more onerous rates kicked in.

However, as Eben pointed out, this was only part of the story, since lenders and investors made similarly poor decisions. The issue isn’t why most laypeople thought real estate values would never depreciate, but rather why so many supposed economic and financial experts thought so. First of all, not all of them did. Yet some of the legitimately most qualified minds in finance actually bought into the hype. Personally, I recall a friend who received a Finance degree from Wharton telling me how her professor used to sing the praises of the subprime securitization invention – it had made the dream of home ownership possible for millions of people, and all the while at very little risk.

Hot Potato

The critical element uniting all the players, whether they believed that real estate was never going to die, or whether they were prepared to make billions pushing it over, was that no one bore the risks for their bad investments. Mortgage lenders originated the loans and would generally sell them in huge pools to investors within weeks, sometimes days. The loans were then passed along and cut up through various entities, all the way up to the government-sponsored Fannie Mae and Freddie Mac. At both the front and the back, the ones usually left holding the bag were the original borrowers and the government-sponsored corporations.

I'm no housing-bubble-2008-collapse-expert, but this seems to be a trivial and probably incorrect recollection of what exactly went on and why everyone was tied together. First, this paragraph seems to suggest something contrary to your statement “no one bore the risks.” Indeed, if the catalyst for the crisis was the vaccuum in the demand for housing created by changing population demographics (as I believe), then the reason for the catastrophe was that the housing industry connected itself to everything. To borrow Matt Taibbi's metaphor, the housing market seemed to have its tentacles on everything. Indeed, the problem is not that “nobody bore the risks” but rather that everyone bore the risks, thanks to junk mortgages tied to junk CDOs tied to insurance policies tied to just about everything. Therein lies the problem—too many people bore opaque risks they didn't understand and the only people who did understand them shrugged them off onto other people.

Even the major credit rating agencies, like Moody’s and Standard and Poor’s, the entities most in need of a proper perspective on risk, were paid by the banks issuing the securities they were rating, and similarly created risks for which they were in no way accountable. It would be as if “Hollywood studios paid movie critics to review their would-be blockbusters." So to answer the question of why some of the best minds in finance didn't figure out that they were building a house of cards - they had no incentive to.

This is one way of looking at it. The other equally plausible way of seeing it is sheer ignorance. Or smart people do stupid things. Or maybe they knew exactly what was going on and just thought they could get out in time and missed the last boat. I think what you mention is certainly a problem—but it does not answer the question--at least not sufficiently here.

After The Sale

Why aren't individual borrowers allowed to play the game too? Instead, they are the ones being called upon to make good on moral obligations somehow being read into the contracts. The altercasting mechanism identified by Leff in Swindling & Selling may help explain the way that borrowers act after the sale, especially when their mortgages are underwater.

For one, we call the borrower a “homeowner.” Of course, there’s a difference between that and owning your home free and clear. Yet the mortgage industry wants you to be a homeowner right away, regardless of what sticks you get in that bundle - because why would a homeowner walk away from the home he owns? Additionally, the deal itself is being burdened with all sorts of extraneous notions. In The Path of the Law, Holmes wrote that “[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it and nothing else.” When you take a mortgage, you borrow money in exchange for a promise to either pay it back or forfeit the security. Although borrowers are aware that they were making an exchange, as opposed to getting a gift, they are mistaken as to the exact nature of that exchange. If they understand that the mortgage crisis is a result of a misalignment of incentives and risk, then perhaps they can look at their own contracts, which are allocations of risk, and more accurately understand what part of that risk they bargained for, if any.

I'm sort of confused about the conclusion here. Maybe the solution is just to tell people walk away. I think there is a valuable insight here—if we recast the situation to the “homeowner” as one of a failed bet, we might be able to convince people to walk away from failed mortgages. Obviously this cannot happen for a number of political and psychological reasons. But the problem isn't a misalignment of incentives and risk, it is a problem of information asymmetry. In the transaction chain that you have identified, mainly, homeowner → lender → bank A → big bank B → AIG → other banks, there seems to be one or two groups that are able to peek at the cards of all the other groups. If all of the groups had access to the same information, many of these transactions never occur and homeowners, when their bets fail, simply walk away. (This information assymetry is not really unique to the mortgage crisis but occurs in the stock market too. )

One thing I have thought about recently is that if the problem is information assymetry then a possible solution is not less opaqueness but more opaqueness. We seem to think that the SEC, FTC, etc. are doing their jobs. We seem to think that the stock market is regulated. We seem to think that there is no insider trading. But I think that we might be wrong, especially on the insider trading. And, again, the problem isn't the insider trading itself, but that there is a select group of people who can get away with it at higher frequencies than other groups. Thus, the problem is the whole incestuous regulatory system itself. If we just did away with all of it, allowed insider trading and opaqueness, maybe people would do their due diligence before taking on risk. Sure, mortgage rates are higher and loans become more expensive in order to insulate against unknown risk. But, the “open information” that accompanies things like mandatory financial statements and whatnot seems to do more harm than good. We ignore the risks of shoddy accounting because we thing regulation is competent.

Hi Dan, I'm just going to read back a bare-bone outline of your essay. I'm not even sure what it's about, so maybe if I give you a simple reiteration of my understanding, you can see if you expressed yourself clearly.

So my take on what you said is that I don't know really what you're saying. Your essay is scattered and doesn't really finish its thoughts. I don't understand what you are trying to say. My suggestion is that you pick a thread of thought in your essay and develop it more thoroughly. Your essay needs a big-time rewrite though. Rewrite it when you get the time, and I'll do a more substantial edit. I think at this point your thoughts are too incomplete for me to really add anything of value.

*Why exactly did home prices depreciate? I realize this is not the point or focus of your essay and maybe I would not waste too much time with this. But, I personally think it might have something to do with this. Also see an article titled "The baby boom, the baby bust, and the housing market" (written in 1989)! In other words, the evidence and research was done and available. In fact, I'd suggest using population demographics to analyze supply/demand is rather elementary. I think there must be some significant cognitive defects in the minds of everyone involved to ignore such an obvious red flag. I hope some other people can swoop in and help edit--no need to stick to the formal rules of the assignment. -- MatthewZorn - 23 Jun 2010

Matt, thanks a lot for the feedback. Do you have another link though? The one above is taking me to an error page. -- DanKarmel - 23 Jun 2010

You are entitled to restrict access to your paper if you want to. But we all derive immense benefit from reading one another's work, and I hope you won't feel the need unless the subject matter is personal and its disclosure would be harmful or undesirable.

To restrict access to your paper simply delete the "#" on the next line:

# * Set ALLOWTOPICVIEW = TWikiAdminGroup, DanKarmel

Note: TWiki has strict formatting rules. Make sure you preserve the three spaces, asterisk, and extra space at the beginning of that line. If you wish to give access to any other users simply add them to the comma separated list