April 19, 2009

The Subprime Fiasco: "Predatory Lending" or "Predatory Securitizing?"

For years, mainstream economists pooh-poohed the very existence of the concept of "predatory lending." When two willing parties agree to a transaction, how can one be "predator" and one "prey"?

Of course, this totally ignores differences in, say, math ability between lenders and bottom-of-the-barrel borrowers.

Yet, while I think the concept of "predatory lending" has some merit, especially in areas such as credit card lending, it's mostly throws us off the scent in figuring out the subprime mortgage disaster.

After all, the point of making predatory loans is to extract a stream of high monthly payments from the borrower. But the point of originating worthless mortgages was not to get paid back a lot of money over the next thirty years (many borrowers wouldn't last past the two year teaser rate period, and by 2005-2006, a fair number of borrowers never made more than one payment -- what economists Haughwout, Peach, and Tracy of the New York Fed jocularly refer to as "juvenile delinquent mortgages"). No, the point was to extract a high payment now from credulous saps to whom you sold the dubious mortgages.

What hundreds of anecdotal accounts show is a process often involving collusion between the borrower and the originator of subprime mortgages to defraud institutions farther up the financial food chain by selling them garbage.

We had a ridiculous system in which big investors let themselves get duped by small grifters. The borrower 100% knew he wasn't making the $132,000 per year he put down on his mortgage application. The mortgage broker was 95% sure the stated income figure was a lie. The storefront mortgage broker's boss was 90% sure. The loan officer at Countrywide who bought the loan from the storefront mortage sales firm was 75% sure. The Countrywide salesman who securitized it into mortgage-backed security and sold it to Fannie Mae was 50% sure, while the Fannie Mae buyer was 25% sure, while his boss was 10% sure. The Fannie Mae CEO just assumed that the Law of Large Numbers was magically going to make his risk disappear through diversifying. Just diversify the diversity and it's all good!

Of course, many financial firms then played a game of Hot Potato with each other, repackaging the garbage loans and selling them on to rich but but even more clueless folks, or insuring themselves with AIG against losses.

Thus, the term "predatory securitizing" may be more useful for describing much of what happened during the Housing Bubble than "predatory lending."

A Google search shows that nobody has used the term "predatory securitizing" before, and only a handful have used "predatory securitazation." I would prefer the former version -- "predatory securitizing" -- since it's in the same format as "predatory lending."


Jim O said...

Well then copyright it!

agnostic said...

They securitized me a mickey.

Anonymous said...

Steve, what do you say to the libertarian argument that state-sanctioned predatory lending is ultimately more humanistic than forced poverty or borrowing from the local ethnic Tony Soprano?

Anonymous said...

"what do you say to the libertarian argument that state-sanctioned predatory lending is ultimately more humanistic than forced poverty .."

Get out of here! Is that really a libertarian argument? They're getting weirder by the day if so.

I keep getting the feeling that libertarians listened carefully to the lefts caricature of the evil capitalists and said to themselves, "Hey, that's what we should be!". It's lucky for them that the left never accused capitalists of eating their own young, or they'd feel obligated to do that as well.

Anonymous said...

The reason this occurred is not (not that I suggest you are saying this) that all investors are complete buffoons, including institutional investors. The reason is that rating agencies stamped many of these things with AAA ratings. You have previously identified the real culprit here, and that is that nobody was willing to say "hey, housing is a bubble. Stop investing in it and securities related to it." The whole housing prices haven't dropped since the GD was a compelling argument to people drunk on the notion of bags of money.

Keep in mind that these players are the most sophisticated out there. Thus, another important aspect of the situation is that compensation incentives encouraged employees to engage in creating and selling these securities, even in if they--being on the ground--knew they were probably over-rated by the rating agencies. As you state, top managers never got the picture that lower level managers had because the lower level people had no reason to pass the information up.

Anonymous said...

I thought this was obvious! It's a very strange scam that starts out with me taking a big wad of cash out of my pocket and handing it to you, in the hope that I will be able to get back something more valuable from you in the future. Scams don't work that way. Scams work by you giving a big wad of cash to me, right now, and me giving you something worthless in return.

So the idea of predatory lending in a traditional sense really doesn't make much sense. Banks that hold loans aren't going to give their money to people they expect to lose it. It would be cheaper to just buy the damn houses outright! But if you can use a single wad of cash repeatedly to generate an unlimited stream of worthless mortgage securities to sell to suckers, well, now you've got a criminal enterprise worthy of respect!

clem said...

Well then copyright it!In the U.S., anything you write is automatically copyrighted at its moment of creation.

You also can't copyright titles; but maybe if Steve wrote and published a book with only those two words in it, and anyone else tried to use them, he could try to claim copyright infringement (of the entire text).

I'm just sayin'....

(I don't think you could trademark the phrase either, unless you started using it in a business/product context. Then again, I'm not a lawyer....)

Pat Shuff said...

Okay, Maybe The Community Reinvestment Act Is A Problem (BAC)

The effect that the Community Reinvestment Act (CRA) on the housing is one of the touchier questions in the financial crisis debate. The act was designed to encourage more minority lending, and though it doesn't require banks to lend out to shaky borrowers, banks make certain CRA commitments in order to get regulatory approval for acquisitions.

A possible effect of this is that banks wishing to grow via acquisition end up with an outsize volume of these commitments.

So what's the effect at national banking giant Bank of America (BAC).

On the company's conference call, CFO Joe Price said the CRA book accounts for 7% of the total in residential mortgages, but 24% of the losses.

That alone doesn't put all the problem on the CRA' shoulders, but obviously the losses in this portfolio are way out of proportion.


Jim O said...

You're right on both counts, Clem. BTW, I wasn't being, you know, serious.

John Seiler said...

And, ultimately, everyone just assumed that if the loans went South, they would be covered by the Federal Government -- which is all-knowing and all-wise in its regulations of lending and use of taxpayer money. And it never would inflate the dollar to cover its spending. Never. Really.

Anthony said...

Anonymous says:
"if you can use a single wad of cash repeatedly to generate an unlimited stream of worthless mortgage securities to sell to suckers, well, now you've got a criminal enterprise worthy of respect!"

Fractional-reserve banking uses a single wad of cash to generate a much larger wad of cash, but that fractional reserve places a limit on how big the larger wad is.

Until some genius figures out a way around the rules, by using securitizing to get around the reserve limits, and turn a limited money-generating process into an unlimited one.