Balkinization  

Thursday, September 24, 2009

More on Posner's Shift in Views

Brian Tamanaha

A post last December asked whether Judge Richard Posner’s pronounced shift in economic views would also lead to in a change in his approach to law and economics. As the preeminent contemporary figure in law and economics, a comprehensive rethinking of the field by Posner would be significant.

His very public evolution in economic views continues in a recent piece in The New Republic: “How I Became A Keynesian: Second Thoughts in The Middle of A Crisis.” His topic is macroeconomics, not law, but this passage bears on law and economics:
The dominant conception of economics today, and one that has guided my own academic work in the economics of law, is that economics is the study of rational choice. People are assumed to make rational decisions across the entire range of human choice, including but not limited to market transactions, by employing a form (usually truncated and informal) of cost-benefit analysis. The older view was that economics is the study of the economy, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Keynes wanted to be realistic about decision-making rather than explore how far an economist could get by assuming that people really do base decisions on some approximation to cost-benefit analysis.

I will take the liberty of changing a few words in the last two sentences of this passage to draw out what might be the implications for law and economics:
“An alternative view is that legal scholarship is the study of law, employing whatever assumptions seem realistic and whatever analytical methods come to hand. Legal scholars want to be realistic about decision-making rather than explore how far economic analysis can get by assuming that people really do base decisions on some approximation to cost-benefit analysis.”

Is this a plausible extrapolation? (Posner's jurisprudence writings have gestured in this direction for some time, although when he wears his law and economics hat he usually does the same old stuff.) For decades, critics of law and economics have objected to its narrowness and thoroughly unrealistic assumptions (only partially ameliorated by the greater realism of behavioral law and economics). As a mode of analysis--as a thought experiment--it is undoubtedly useful. But anything more than that...What say you now, Judge Posner?


Comments:

Brian Leiter has his October 8, 2004, post at his "Leiter Reports: A Philosophy Blog" with the title:

"Is Economics a 'Science'?" at:

http://leiterreports.typepad.com/blog/2004/10/is_economics_a_.html

that is quite relevant, especially following Paul Krugman's NYTimes Magazine article (9/6/09) titled "How Did Economists Get It So Wrong?" and the many follow up responses by some of these economiststs. Economics is a social science, not a natural or physical science. And clearly the law is not a natural or physical science. What happens when you combine law and economics? If economics is not rational choice, how does it help us understand law, especially constitutional law? How does economics aid originalism in its many variations, especially when originalism may not be rational in the present day and age? Or is it that economics does not come into play with regard to constitutional interpretation? Economics is important with respect to commerce and perhaps should influence the commerce clause in the present day and age, in a rational way.

By the Bybee (no, I still have not forgotten), if a constitutional convention were held, what might be the role of economics?
 

Oh, anyone familiar with what the scientific analysis of behavior has discovered over the last fifty years knows that the models of behavior implicit and sometimes explicit in law and economics vary from prescientific to silly. That's not how behavior works.

A common example: deterrence. Low likelihood one-time events have little effect on behavior, even when outcome cost is high. Pushing up outcome cost doesn't help; increasing likelihood of the event does. Law is made and enforced with almost zero recognition of this fact of behavior.

Economics seems to have learned a little about behavior lately, but the vast majority of the field wouldn't know a schedule effect if it came up and bit them in the grant proposal.

Here's one way to engineer a non-rational choice. Train a response on CRF (one reinforcer delivered for each qualifying response). Move to FR (fixed ratio: one reinforcer delivered for each N qualifying responses) and gradually increase the ratio. At some point the cost of doing the work to get the reinforcer is higher than the rational benefit of the reinforcer. The organism will continue to emit a high steady rate of behavior past that point. Irrational? Of course. It's a schedule effect. A very simple example.
 

Well, it seems to me to be a jump from the fact that people do not act as rational economic actors and do not do cost-benefit analyses (which is one reason why government intervention in the market is sometimes required) to the conclusion that wealth-maximization / utility maximization concerns do not or should not factor in legal decisionmaking.

And I say this as someone who is in no way a law and economics disciple. But a lot of Posner's best work really did conceptualize important approaches to the law-- the economic interpretation of the Hand formula is far from the end-all and be-all of negligence law as Posner would have had it, but on the other hand, it stands for the proposition that one purpose of negligence law is to create incentives for someone to treat the interests of others, and the costs that one might impose on others, as equally important to one's own interests.

It seems to me that one can endorse Keynesian skepticism about whether people are actually rational while still saying that the law should create incentives for rationality.
 

Of course it's not a science. Was anyone confused about that?

But to be fair, it is a body of scholarship, and some of it is quite good. There were scholars of economics who correctly predicted that the market would not self-correct to prevent the present mess. They noted that some risks taken over the last decade were not rational. Some of them even noted that "rational" is meaningless if you say human choices are by definition rational. Apparently few were listening, and no one who was in a position to prevent anything, but there were voices drawing from a body of scholarship who spoke these inconvenient truths at the time.
 

one purpose of negligence law is to create incentives for someone to treat the interests of others, and the costs that one might impose on others, as equally important to one's own interests.

Which I think has delivered some good results.

I believe the economics model is to put the externalities back into the system.

The most successful consumer product ever sold creates externalities of a hundred billion dollars a year or so in the U.S. I see some potential there.
 

" Of course it's not a science. Was anyone confused about that?"

Consider the "predictive" goals of economics with its elaborate mathematical models to provide solutions. How many of us are prepared to challenge such models? Perhaps when the results are announced, they should be accompanied with a prominent WARNING concerning accuracy comparable to cigarette warnings and to TV prescription drug warnings/side effects.
 

Interesting proposal. Would it apply to pundits?
 

jpk:A common example: deterrence. Low likelihood one-time events have little effect on behavior, even when outcome cost is high. Pushing up outcome cost doesn't help; increasing likelihood of the event does. Law is made and enforced with almost zero recognition of this fact of behavior.OTOH, it works the other way sometimes. Consider state megabucks lotteries.

Here's one way to engineer a non-rational choice. Train a response on CRF (one reinforcer delivered for each qualifying response). Move to FR (fixed ratio: one reinforcer delivered for each N qualifying responses) and gradually increase the ratio. At some point the cost of doing the work to get the reinforcer is higher than the rational benefit of the reinforcer. The organism will continue to emit a high steady rate of behavior past that point. Irrational? Of course. It's a schedule effect. A very simple example.Gambling behaviour is illustrative here as well.

Cheers,
 

This comment has been removed by the author.
 

Our housing bubble was based on basically rational behaviors - except for one assumption.

Our housing bubble was started when the Boston Fed artificially boosted housing demand by instructing the banks to lower their underwriting standards, “Closing the Gap: A Guide to Equal Opportunity Lending,” Boston Federal Reserve (1993), followed by HUD instructing Freddie and Fannie to create a secondary market for these mortgages in the late 90s. Steven A. Holmes, “Fannie Mae Eases Credit To Aid Mortgage Lending,” New York Times (September 30, 1999). To the extent that all you are concerned with is broadening home ownership, this is a rational way of doing it. However, the underlying assumption that the non-creditworthy would actually pay back these loans was irrational.

When the increased demand caused the prices of housing to increase for years on end, it was perfectly rational for investors to buy real estate to make a profit on the bull market in the sector. That is how you make money in any market.

It was also rational to leverage your investment with less expensive variable interest rate loans because there was a low transaction cost to switch to a 30 year fixed mortgage when interest rates went up.

Thus, the bubble was not irrational based upon what people knew at the time. The failure was the lack of transparency in the government's lowering of the underwriting standards causing investors to remain ignorant of the fact that the bubble was started by mortgages that could go bad in the future, as they started to fail in 2005.

It would be disappointing if Judge Posner completely abandoned his sensible cost benefit legal analysis simply because he was caught up in an entirely irrational intellectual investment in Keynes' stock. Keynes' complete blinkered focus on demand and his advocacy of government stimulus to goose demand is nonsense that has been repeatedly proven to be wrong from the New Deal, to the Japanese Lost Decade and now to Obama's Porkulus bill.
 

Bart:

I look forward to your peer-reviewed, scholarly analysis of the housing bubble, which takes into account all the relevant economic data in reaching your conclusion.

Or, as it was put long ago, there are more things on heaven and earth than are dreamt of in your philosophy.
 

"Thus, the bubble was not irrational based upon what people knew at the time."

Has the backpack been replaced with a "rational bubble machine" that will continue to blow bubbles on this Blog?

I should note that assuming the housing bubble was not irrational, perhaps people were. Just like guns don't kill people, bubbles don't cause recessions, people do by pumping it up. In any event, it's all the fault of the New Deal perhaps augmented by the Bush/Cheney Fast Shuffle.
 

Dilan:

You will have to settle for my annotated post. Reasoned discourse of the facts is hardly limited to academic peer reviewed papers.
 

Shag:

If you disagree with my contentions, you are welcome to offer a rebuttal rather than your usual snarks.
 

Bart:

Economics is very complicated. It's the study of the collective effects of the individual behavior of hundreds of millions of actors. People invest years of time developing complex mathematical and behavioral models to establish tenuous cause-and-effect relationships.

Yes, it is true, you don't have to be a peer-reviewed academic to discuss the basics of economic theory. But that discussion is going to be blunderbuss, imprecise, and general. It's certainly not the type of discussion that can isolate the "cause" of a housing crisis.

The economy cannot be described with your limited set of conservative talking points. (Nor, by the way, can it be described with a very vulgar Keynesianism that comes out of the keyboards of many on the left.)

You really have a problem understanding your limits. Judge Posner is, in addition to being a judge, a man who is very studied in economics and who has published economic analyses of law, sex, and a number of other aspects of life. He might know a bit more about this topic than you or me.

More importantly, though, in the end, it will take years of academic study to isolate the various variables that contributed to the housing crisis. I am sure that loosening of lending criteria was part of it (though you are a fool if you think that was all driven by government officials trying to increase lending to minorities). I am sure that lack of regulation is part of it. I am sure that bank mergers and allowing enterprises to get too big to fail is a part of it.

And there will be big arguments about the interaction of these elements, just as there are still big arguments as to what caused the Great Depression. But the idea that some lawyer from Colorado with minimal economics training can preempt them all and figure it all out-- and mighty conveniently, blame the whole thing on one particular policy that his ideological compatriots have criticized-- is preposterous.

Until you gain some understanding of what you DON'T know, Bart, nobody should bother taking you seriously.
 

Dilan:

I deal with expert witnesses all the time in my practice and I have learned never to defer to "expert" opinions simply because the witnesses are credentialed. Rather, I research their opinions and see if they withstand scrutiny.

I have spent a good deal of time researching the causes of the housing bubble because it is the subject of a chapter in my book. This includes email exchanges with academics who are also researching the subject where I asked them to expound on their published findings and where I bounced my opinions off of them.

The sequence of events is pretty convincing:

After the Fed pressed the lenders to lower their home mortgage underwriting standards and HUD enacted regs compelling Freddie and Fannie to make the lower standard mortgages 50% of their portfolio, home prices started their rapid and ahistorical rise.

I could not find any historical trends at work here. Once inflation is accounted for, home prices had not previously risen appreciably through the economic booms and busts between 1979 and the late 90s.

In the summer of 2006, foreclosures started spiking. Foreclosures usually do not occur until some months after mortgages go delinquent. Thus, the delinquencies had to have started in 2005.

The economy was booming in 2005, so there was no economic reason like job loss to explain these delinquencies.

Housing prices were still soaring in 2005, so folks were not going delinquent because their mortgages went upside down, although that would be a major cause for the continued collapse after the bubble burst. In fact, walking away from a mortgage when the value of your home is appreciating is economically irrational.

That leaves the non-creditworthy borrowers who do not conduct themselves in an economically rational matter. These deadbeats simply reneged on their mortgages the same way they do their other bills.

These are not "conservative talking points." Most conservative talking head "analysis" simply blames Jimmy Carter's CRA for causing the problem and the Clintons for making it worse. In fact, the original CRA required the banks to maintain sound underwriting practices and was a largely harmless. Things did not change until the Fed undermined underwriting standards to achieve what it thought were CRA goals. Go google the Boston Fed manual I annotated above and read the .pdf. The suggested underwriting "reforms" would be considered irresponsible if made by a housing advocate like ACORN, but are absolutely appalling coming from the Nation's leading bank.
 

I deal with expert witnesses all the time in my practice and I have learned never to defer to "expert" opinions simply because the witnesses are credentialed.

Bart, it's one thing to be skeptical of expert opinion-- especially in court cases where people are hired guns. It's another thing to dismiss the value of expertise altogether and assume that any ordinary person can evaluate the economic factors that cause a recession.

As I said, the economics profession is still debating the causes of the Great Depression, one of the most studied panics in history. And you are going to tell me that a lawyer in Colorado working part time can isolate a single event that caused the housing crash?

In any event, bearing in mind that I am no expert here, I can certainly see holes in your argument even as presented.

After the Fed pressed the lenders to lower their home mortgage underwriting standards and HUD enacted regs compelling Freddie and Fannie to make the lower standard mortgages 50% of their portfolio, home prices started their rapid and ahistorical rise. I could not find any historical trends at work here. Once inflation is accounted for, home prices had not previously risen appreciably through the economic booms and busts between 1979 and the late 90s.

Well, housing increased immensely faster than inflation prior to 1979. Indeed, houses in California that cost $25,000 in 1969 went for $125,000 in 1979. You might have heard of the California tax revolt and Proposition 13. Well, the REASON this happened is because of the real estate boom-- people's property values were going up so fast that they couldn't afford their property taxes (which were based on the reassessed value).

The economy was booming in 2005, so there was no economic reason like job loss to explain these delinquencies.

This is the fallacy of composition. Indeed, it is just about a textbook example of it.

Just because "the economy was booming" doesn't mean ALL SEGMENTS OF THE ECONOMY were booming or that there were not portions of the economy that were not functioning as they should have.

Indeed, imagine if someone said the following about the Clinton boom: "the economy was booming, so there was no economic reason to explain a sudden crash in the value of technology companies".

In this case, there were all sorts of reasons to explain delinquencies. Yes, banks were selling lots of subprime loans. Guess what? THIS WASN'T CAUSED BY THE GOVERNMENT. Surely government didn't help matters any, but the big reason why subprime loans were booming is because banks could make money by securitizing these loans, and as long as there was market for securitized mortgages (and you can point to Fannie Mae's implict government guarantee here), and the ratings agencies would give these securities top ratings, the banks could loan money with no risk.

Now note, that was going to happen whatever the Boston Fed did or didn't do.

Further, note we were in an era of extremely loose credit. It wasn't just subprime mortgages-- banks were issuing credit cards, which aren't even nominally secured, to bad credit risks. The government didn't tell them to do that.
 

And the real estate industry was encouraging people to buy more home than they needed and to flip houses-- irresponsible behavior that, again, was not mandated by the government.

Note, Bart, I am not saying that you are wrong about the Boston Fed. But notice how complicated this all gets. And it gets complicated because macroeconomics is the product of the sum of many inputs, and no single input has a controlling force.

Housing prices were still soaring in 2005, so folks were not going delinquent because their mortgages went upside down, although that would be a major cause for the continued collapse after the bubble burst.

This is a strange statement. Just because housing prices are going up doesn't mean you can't have delinquencies. First of all, since the market of good risks was relatively thin, more and more mortgages were going to subprime borrowers. Further, new products were being introduced-- Alt-A loans, liar's loans-- which increased risk even more. And lots of mortgages were being issued with zero down and teaser payments and interest only terms-- which means you had more and more houses where even the increase in housing prices was not enough to put the borrower in positive equity.

Again, your reasoning seems to be "it can't be X so it must be Y". But economics isn't a field where you have clean, dichotomous choices. There are a ton of variables, and if it isn't X, it might be A, B, C, D, or some combination of those, as well as Y.

That leaves the non-creditworthy borrowers who do not conduct themselves in an economically rational matter. These deadbeats simply reneged on their mortgages the same way they do their other bills.

This is a very one-sided way of putting this. These transactions, every one of them, had at least a lender, a borrower, and a broker. That's 3 parties. The borrower certainly got in over his or her head and shouldn't have. But the lender isn't supposed to be lending to people who are likely to get in over their heads. And the broker isn't supposed to be brokering transactions that are likely to place the buyer in over his or her head and the lender in danger of not getting paid.

And you know what? The borrower was the least informed of the 3 of them. Yes, the borrower should have known the risks. But the brokers and lenders, eager to sell more homes and more mortgages that could be securitized and fobbed off to some other party, knew the risks far better than the borrower did. Every loan officer and real estate broker in America knows about the risk of loan transactions with teaser rates, interest only payments, zero down, and negative equity. And yet they weren't warning people of the risks, let alone avoiding structuring such risky transactions.

Look, the borrowers deserve their share of the blame. But they are a small piece of a huge puzzle. It's going to take a generation to sort this all out. Certainly, a part-timer with little economics training popping off in Colorado isn't going to be the person who finds a magic bullet.
 

"I have spent a good deal of time researching the causes of the housing bubble because it is the subject of a chapter in my book."

A work of fiction, no doubt.
 

Bart:

I deal with expert witnesses all the time in my practice and I have learned never to defer to "expert" opinions simply because the witnesses are credentialed. Rather, I research their opinions and see if they withstand scrutiny.

This from a person that can't even read the holding in a Supreme Court case when it's explicitly pointed out to him, and who doesn't understand what the FRCP say, this in the field that he's supposedly credentialled in.

For Bart, facts, whether presented by credentialled authorities or not, are something to be disposed of when it gets in the way of his Troot.

Bart and facts need to make an acquaintance some time, before people should bother listening to him.

Cheers,
 

OTOH, it works the other way sometimes. Consider state megabucks lotteries

Interestingly enough, that's not the other way. Here's how.

Low likelihood high cost bad outcomes have little effect on behavior.

But low likelihood high benefit good outcomes do have some effect on behavior.

Why?

Because it's not the other way. The first fails to reduce incidence of behavior. The second creates new behavior.

This is analysis of behavior.

Here's a little deeper analysis: I wasn't kidding about "some effect" of lotteries. What the folks who run the lottery know: you'd never get strong behavior change on the big jackpot alone. So they also pay out on a whole bunch of smaller wins. Keeps that RR (random ratio) schedule real. Otherwise, for the vast majority of humans participating, there's no schedule at all; it hasn't paid off even once.

Here's some more deeper analysis: in seeking to deter, there are other contingencies that increase behavior. The crime has its own payoff. And a number of smaller crimes that preceded it had their own smaller payoffs. If you could cut the contingency for them, you could extinguish a number of related behaviors in the individual. Interestingly, there is some recognition of this in some circles: you do want to catch the small crimes, you do want to deliver more than "slap on the wrist" outcomes; the behavior analysis tells you why, but there are folks who have grasped the basics without the analysis.

Are you bored yet?

I found EAB (experimental analysis of behavior) hecka interesting. It does tell you some useful stuff.
 

Gambling behaviour is illustrative here as well.

You bet. Here the schedule is RR (random ratio) not FR. RR schedules create high rates of responding that are highly resistant to extinction (behavior goes back to baseline when you break the contingency). It has been my privilege to watch rats on RR schedules and slot machine customers in Las Vegas and Atlantic City. Damn if the analysis isn't strikingly illustrated.
 

Gambling behaviour is illustrative here as well.

You bet.

ARRGGH!
 

Sarah Palin's Hong Kong speech may have been a source of our intrepid backpacker's knowledge on the housing bubble. This brings to mind the burlesque (Old Howard in Boston) routine with a male crooner singing "I'm forever blowing bubbles ... " when a chorus* girl prances, scantily dressed, on the stage, waves to the audience and says, "Hi, I'm Bubbles."

*The Old Howard advertised a chorus of 60, which led to the comic's response "Well, some are 55."
 

Dilan said...

And the real estate industry was encouraging people to buy more home than they needed and to flip houses-- irresponsible behavior that, again, was not mandated by the government.

Actually, the banks primary regulator, the Fed, made it quite clear that the banks needed to lower underwriting standards as instructed by the Fed or the bank would be subject to large civil suits by groups like ACORN.

Even so, the mortgage lenders delayed compliance until the second Clinton Administration when the Clinton HUD enacted regulations to compel Freddie and Fannie to create a secondary market to buy up these CRA junk mortgages and Raines and Gorelick were appointed to head Fannie to implement these dictates. Bush's HUD continued these policies enthusiastically.

Once Freddie and Fannie created a secondary market to buy these junk mortgages, the mortgage lenders had no incentive to drag their feet any longer because they could pawn off the risk on other banks buying bundled mortgage instruments. Indeed, lenders like countrywide enthusiastically go with the program to extensive government praise.

BD: Housing prices were still soaring in 2005, so folks were not going delinquent because their mortgages went upside down, although that would be a major cause for the continued collapse after the bubble burst.

This is a strange statement. Just because housing prices are going up doesn't mean you can't have delinquencies. First of all, since the market of good risks was relatively thin, more and more mortgages were going to subprime borrowers. Further, new products were being introduced-- Alt-A loans, liar's loans-- which increased risk even more. And lots of mortgages were being issued with zero down and teaser payments and interest only terms-- which means you had more and more houses where even the increase in housing prices was not enough to put the borrower in positive equity.


Agreed. The defaults are the non-creditworthy folks to which I referred. However, I have come across no research indicating that exotic mortgages were defaulting at this time. It was simply too easy to refinance and escape the exotic mortgage using equity created by the boom.

BD: That leaves the non-creditworthy borrowers who do not conduct themselves in an economically rational matter. These deadbeats simply reneged on their mortgages the same way they do their other bills.

This is a very one-sided way of putting this. These transactions, every one of them, had at least a lender, a borrower, and a broker. That's 3 parties. The borrower certainly got in over his or her head and shouldn't have. But the lender isn't supposed to be lending to people who are likely to get in over their heads.


I could not agree more. That is what is so appalling about the Fed's detailed guidance on how to undermine underwriting standards.

The borrower was the least informed of the 3 of them. Yes, the borrower should have known the risks.

Actually, most of the non-creditworthy buyers had no idea what they were getting into. They simply do not know how to manage credit, which is why they could not get home mortgages prior to the adoption of the Fed's guidance.

BTW, as a side note, the President of the Boston Fed who issued the guidance to the mortgage lenders later became President of Freddie Mac and ignored his own FSO's warnings that he was destroying Freddie by buying up all the CRA junk mortgages. The President blew the CFO off and pocketed tens of millions buying up this toxic waste. This thing was corrupt from top to bottom.

Finally, I do not claim to be able to explain everything that went on. That research will go on for years. However, the causes are becoming pretty clear.
 

There's no reason to pay attention to someone who repeatedly spouts unsubstantiated crap, and then refuses to correct himself when he's shown to be outright wrong. Particularly when that person is a partisan ideologue. There's no shortage of opinions, some good, some not-so-good, some just ignerrent tripe, out there. Best to ignore those blogiators that are repeatedly proven unreliable and biased.

Cheers,
 

Bart, lets suppose the Boston Fed had never taken that action.

Now, what would have happened? Well, there was still rising home prices. And there was still a limit on the number of creditworthy borrowers. And there was still a mortgage securitization market. And there were still ratings agencies who catered to their best clients.

Under those circumstances, BANKS WOULD HAVE DONE EXACTLY WHAT THEY DID DO. With or without the Boston Fed. Why? Because there was money to be made. You issue the subprime loan, rig the terms so that the thing will have to be refinanced in a few years when the home rises in value, and then sell the mortgage to someone else who takes the loss if the market falls.

The transaction is a moneymaker in a rising market with or without the Boston Fed. Indeed, it is COMPLETELY analogous to the margin buying that went on in the stock market before 1929. As long as the market is shooting up, buying on margin (even beyond one's means) makes a ton of sense and is an easy way to make money, and offering huge margins is a moneymaker as well as the commissions/interest can be paid from the increase in the stock's value.

What is weird is why you think that if the Boston Fed hadn't acted, this wouldn't have gone on.
 

Dilan:

Without the green light from government regulators to lower underwriting standards and a government created and subsidized secondary market to buy up the resulting CRA junk mortgages, the demand that created the bubble would have never occurred. Until the government intervened, the housing market has been cruising along for decades under basically the same rules without any problem.

The securitization of mortgages, credit card and lines of credit predated the housing bubble and did not cause the bubble to burst. There is nothing wrong with such asset based instruments.

The Fed claimed that the underwriting rules it pushed created mortgage debt that was just as reliable as standard mortgages. Read the manual they issued. The banks being pressured to make these junk mortgage loans were not about to argue with the Fed when they resold this garbage just like standard mortgages at a AAA rating.

Thus, the CRA junk mortgages were mixed in with standard mortgages to form standard asset based instruments rated AAA. The rating was the problem, not the securitization itself. The problem is easily solvable. Restore standard underwriting rules so that all mortgages are actually AAA rated again.

However, bad ideas never seem to die in Washington. Having blamed the evil mortgage lenders and Wall Street rather than themselves, Congress is back at it again with new House bills to again extend credit to the non-creditworthy.
 

Without the green light from government regulators to lower underwriting standards and a government created and subsidized secondary market to buy up the resulting CRA junk mortgages, the demand that created the bubble would have never occurred.

The second half of this is correct, and the first is utter BS.

Yes, you needed a secondary market. And yes, Fannie Mae, Ginnie Mae, etc., were all implicitly government backed. (I suspect that even without these enterprises, somebody would have figured out that there were short term profits in securitizing mortgages, but I can't prove that, so I will concede your point.)

But "green light from government regulators"?!????? Bart, teaser mortgages have NEVER been illegal. Nor have subprimes. The difference is, when mortgages were not securitized, they were too risky.

And you are ignoring that it isn't like mortgages were the only subprime credit being offered. Ever hear of payday loans? The proliferation of credit cards? If it all depended on government regulators' blessing, how come all these other expansions of credit to noncreditworthy borrowers occurred at the same time.

May I humbly suggest, Bart, that it was your beloved free market that did this, not the government?

The securitization of mortgages, credit card and lines of credit predated the housing bubble and did not cause the bubble to burst. There is nothing wrong with such asset based instruments.

Well, what do you mean by "wrong"? I don't think such instruments are immoral, but there is plenty that can GO wrong with such instruments, because they separate the risk-taker from the party to the underlying transaction, and because they consolidate and homogenize risk while concealing its nature to the holder of the security. And they also create an incentive for ratings agencies to curry favor to their clients by pretending the risks don't exist.

Now, of course, I can think of possible regulations that could address both of these problems. But if you just let the free market go wild, one of the risks of securitization of loans is going to be the writing of more risky loans.

The Fed claimed that the underwriting rules it pushed created mortgage debt that was just as reliable as standard mortgages.

Bart, you are assuming that bankers are idiots. You really think that one banker in the country didn't understand why it was that there was short term profit in issuing junk mortgages that assumed future increases in home value and then securitizing them?

There's no possible way that they relied on assurances from the federal government here. They LOVED this. It was like printing money. All that the federal government did is cover their behinds in a way that was convenient for them.

Thus, the CRA junk mortgages were mixed in with standard mortgages to form standard asset based instruments rated AAA. The rating was the problem, not the securitization itself.

This is somewhat true (though there are other problems with securitization). But you don't unpack WHY this is. Has it occurred to you that ratings agencies get repeat business by not rocking the boat and issuing low ratings?
 

The difference is, when mortgages were not securitized, they were too risky.

Yep. Likewise when credit default swaps were not available.

Posner's recent discovery of problems in the model he held dear has met with some skepticism. He seems to be saying, how is it the market didn't avoid the problem in the usual way, excessive risk would be recognized as such by rational actors who would act to cut off further investment? His critics appear to be answering, oh, but it was entirely rational to make unprecedented profits in the short term when the long term downside would be someone else's problem.

My guess is these analyses are ultimately facile. They miss the point that there were three levels of understanding at work.

A very small number of financial analysts understood the mind-bendingly complex new financial instruments. They planned to get out before the crash.

Thousands of bankers and underwriters understood they were making money like crazy and the brain boys assured them it was OK. Most investors were at about that same level.

Millions of buyers had no idea that their mortgages would be sliced and diced, or that they were signing up for a loan they couldn't afford. Why would the bank loan me the money if they thought there was no way I could pay it back?

Were they all rational actors? They had widely different comprehensions of what was happening, and it could be argued that each acted rationally according to his understanding. But that seems to me to miss the point. Rational is moot when the instruments are too complex for the folks in the biz to understand. Warren Buffet's famous characterization of “financial weapons of mass destruction” does leave him a certain "I told you so" at this point.
 

Dear Bart de Palma proffers his opinion and then states:-

"I have spent a good deal of time researching the causes of the housing bubble because it is the subject of a chapter in my book. This includes email exchanges with academics who are also researching the subject where I asked them to expound on their published findings and where I bounced my opinions off of them."

That is the teeniest bit reminiscent of a non-expert trying to convince a Judge that his opinion evidence ought to be received and reminds me of the the classic if cynical definition an English Judge once gave, only half in jest: "an "expert witness" is someone who cannot make a living at his chosen profession and is therefore forced to hire himself out as a professional perjurer".

Bart has been known from time to time to post on this blog accounts of how well his various investments are doing, but I am not entirely convinced that his DUI practice in Colorado, however worthy and profitable, affords the sort of experience in areas such as investment and commercial banking, securitisation, credit default swaps, regulation of banking and financial services markets, or multi-jurisdictional cross-border corporate insolvency, that might qualify him as an expert on such matters.

I do not know whether the BBC i-Player works in North America but, should it do so, then those with an interest in the latest débacle and some viewing hours to spare may find the first three 60 minute programmes in this BBC2 series of passing interest: The Love of Money.

I recollect that my first encounter with corporate scams concerned the fallout from a little outfit called Investors Overseas Services Limited. Since then, a corporate scandal has come along every two or three years affording much gainful employment to teams of insolvency practitioners, litigators and other vultures like me - only too happy to rack up the billable hours feeding off the carrion of the collapse.

What I can offer from my 40 years of relevant experience is the view that with minor variations the underlying causes of most scandals in banking and financial services are the same: absence of a proper regulatory framework or sloppy regulation, excessive commissions earned by the mis-selling to the gullible of a proposition that sounds too good to be true (which in due course turns out to be just that), inadequate risk analysis, excessive rewards for risk-taking, sloppy internal and external audit and a corporate culture of "greed is good".
 

Dilan:

1) As I pointed out before, there is no evidence the foreclosures in 2006 that burst the bubble by the end of the year were from exotic mortgages. As you acknowledged earlier, the mortgages that did fail were too risky because the borrowers were non-creditworty.

2) Bundling mortgages into securities does not encourage borrowers to reneg or lenders to make mortgages to borrowers who will reneg any more than bundling corporate bonds into mutual funds encourages corporations to reneg or the banks issuing the debt to lend to corporations likely to reneg. As you just acknowledged, the government created secondary market bought up this junk.

3) I have no problems with the government correcting their mistake and reestablishing traditional underwriting standards for mortgages in order for them to receive AAA ratings in these instruments, for that is the problem no matter how you want to spin it.

4) I am a little reluctant to have the government decide what forms of loans I can have access to as a borrower. The government needs to tread very carefully here. It is necessary to have markets for even junk loans. Ask California currently and the United States after a decade of the current projected annual Trillion + dollar deficits.

5) The government gutted the home mortgage underwriting standards. I have shown you the proof in writing. There is no similar proof of some Wall Street conspiracy to gut home mortgage underwriting standards. None. You may humbly suggest that the free market is to blame, but your suggestions do not carry much weight without evidence.

6) As with most socialism meant to compel the free market become more egalitarian, the effort to broaden the home mortgage market to include the non-creditworthy ended very badly with the usual unintended consequences that you get from centralized planning.
 

Mourad:

It would be fascinating to examine whether the Brits were simply following our Fed's lead in gutting underwriting standards or whether your government was involved in the same mischief.
 

Bart:

There is no one thing that is "the" problem. As long as you claim that there is, you have no credibility, because it is clearly your partisan ideology talking, not the facts.

I pointed out how securitization makes the problem worse. I pointed out how bankers knew what they were doing and made money. I pointed out how loose credit was not limited to the mortgage sector. You don't care, because you will never accept a data point that will lead to a non-right wing answer.
 

Our intrepid backpacker seems to be making a challenge or considering adding another chapter to his work of friction [sick!] with this:

"Mourad:

It would be fascinating to examine whether the Brits were simply following our Fed's lead in gutting underwriting standards or whether your government was involved in the same mischief."

And perhaps our intrepid backpacker will find a connection between the Boston Fed and the Brits. Sounds like a conspiracy across the pond.

But with our intrepid backpacker pumping the Boston Fed as the cause of the housing bubble, his work of friction [sick!] like a bubble may soon pop. Possibly he will follow in the footsteps of Beck and Malkin; now that's scary. Most likely, though, he will be charged with BBUI.*

*Blowing Bubbles Under the Influence
 

Dilan:

Additional evidence securitization had little or nothing to do with the gutting of underwriting standards:

1) Lehman failed with billions of their own CRA junk mortgages on their books. Lehman did not make these loan merely to securitize them.

2) All these securitization options remain today, yet mortgage lenders have all returned to standard underwriting standards.
 

Bart wonders:-

"It would be fascinating to examine whether the Brits were simply following our Fed's lead in gutting underwriting standards or whether your government was involved in the same mischief.

Indeed it might be. I would encourage Bart to do so.

He might do worse than to start with the Financial Services Authority's consumer website Money Made Clear - Home Mortgages which will provide him with an idea of the types of mortgage available over here.

The FSA as regulator takes action about unfair terms in consumer contracts - including mortgages. Some examples where they have acted to require regulated entities to change the terms of their contracts are given here.

The FSA also regulates the manner in which mortgages are sold - whether directly by a provider or through advisers and brokers (who are also regulated) - see the regulation of smaller such firms here

There are no significant guarantees of mortgage lending by the government, there is no securitisation, there is an enforced code of practice relating to how mortgagees who fall into arrears should be handled including the need to refer people for advice on various forms of assistance, mortgage possession actions (in our system we do not use forclosure) are fairly carefully scrutinised by the Courts.

Insofar as there has been a crisis here - and there has been a big one - it was because here was insufficient appreciation by bank executives and their regulators of the systemic risks inherent in allowing our institutions to become over-exposed to US institutions operating in the US mortgage backed securities and derivatives market. When Lehman Brothers and AIG went down, interbank lending in London effectively froze until the extent of each insitution's exposure in the US was ascertained. This led to problems with banks then thought to have insufficient reserves or capital. A number were put into forced marriages - the others were bailed out in one manner or another by the Treasury. No institution has closed its doors, interbank lending is at last showing some signs of life, Barclays Bank picked some useful parts of Lehman Brothers rather cheaply in the post insolvency fire sale.

I suppose it could have been worse.
 

Bart:

You are the one trying to isolate single causes, not me. Securitization HELPED it happen, because it separates the parties who make the transaction from the parties who bear the risk. It isn't the ONLY cause, though.

The funny thing is, the exact same argument you REJECT on this issue you probably ACCEPT on health care. On health care, conservatives are constantly saying how insurance, by separating the cost-bearer from the service-consumer, encourages increased costs and warps the market. Securitization does the same thing in the mortgage industry, and yet you are telling me it doesn't have the same effect.
 

The EconoSpeak Blog has a 9/16/09 post titled "When Did The US Housing Bubble Begin?" available by scrolling down at:

http://econospeak.blogspot.com/

There are a number of comments, including a couple by me (perhaps of a snarky nature?). The post includes several links of interest.
 

I agree with Dilan and others that the most nefarious consequence of securitisation is the disconnect of the lender from the risk. Another is the disconnect of the lender from the work-out.

Securitisation passes the administration of the mortgage to an entity which has no discretion and this prevents an effective operation to work out temporary problems which borrowers may experience thus increasing repossessions and homelessness.

In the USA, it seems to me that a further major issue was the fragmentation and in some cases total absence of regulation. See this article in the WaPo As Subprime Lending Crisis Unfolded, Watchdog Fed Didn't Bother Barking.

fousnorp
 

In both the USA and the UK political dogma, mainly from the free-market advocates, has meant that families who in Europe would be expected to rent their homes, have been hoodwinked into home ownership usually by making the provision of social housing more difficult. This has vastly increased the risk inherent in mortgage lending.

As an example, take my home. It was built by a "speculative builder" in the 1930's in a North London suburb, His target market were workers in the City of London financial district. Not the "masters of the universe" but the "worker bees" in the hives of the head offices. The house was first sold in 1937 for £495. At that time the average annual salary of a bank clerk was around £520 a year. Today, the equivalent numbers are that the house is worth £250,000 but the average salary of a worker bee in the City (assuming he has not yet been replaced by a computer) is only around £40,000. So in 1937 the lender was contemplating a transaction where the capital asset represented 0.95% of the borrower's annual earnings, while today the lender is contemplating a transaction where the value of the capital asset will be 6.25 times the prospective borrower's annual earnings. So this house is now way beyond the reach of a bank clerk.

In the 1930's and right through to the 1960's, a lender would only advance 75% of its own valuation of the property which would be below the selling price. It would expect the borrower to have saved the 25% needed to make up the difference. It would expect the borrower to be able to demonstrate that he could meet the repayments and typically cap the advance at 1.5 times annual earnings.

Enter Margaret Thatcher - a Reaganomics devotee: non-profit municipal housing for rent for the working classes must go - so tenants were given the right to by their municipally owned homes at a gross undervaluation of the market value and municipalities were prohibited from borrowing to build new social housing. The gospel according to Thatcher was that everyone must become a homeowner or at worst a tenant of a property which the free market must provide. Thatcher's policies were very populist and popular at the time. But insane.

Now we know the irreversible consequences: huge house price inflation and immense pressure on the institutions to provide ever more risky finance. At the worst period mortgages went to up to 100% of valuation and the cap on advances went to up to 3 times the borrower's annual earings plus 1.5 times those of a spouse. Repayment periods went from 15 years to 20 years to 25 years or even longer. Many UK borrowers are now on mortgages where repayments will still be due after retirement. Those who cannot afford to buy have little hope of social housing - which is increasingly a ghetto for the indigent. Many are now in private sector rented accommodation with no security of tenure and with the rents in many cases being met by welfare. The waiting list for social housing in some London boroughs is 18 years. Only the unintentionally homeless with children can jump the queue.

So far as mortgage lending is concerned, the risks today mean that lending decisions require close internal supervision and intensive external regulation - which the UK has at least implemented and which has mitigated the consequences of the decisions taken decades ago.

In the USA less regulation and less consumer protection has given you a return to Hoovervilles.

And dear Bart wants to defend the policy of "greed is good", "leave everything to the market"?
 

Dilan:

As often is the case, we are talking past one another.

Securitization can only separate a lender from the risk of its loan if the risk is not disclosed to the security's buyer. The problem with asset based instruments including CRA junk mortgages was not the instrument, but rather the misrepresentation of the risk as AAA rather than something between junk bond and moderate risk status. If there was proper disclosure of the risk, the instruments would have sold at a discounted rate to take in account the higher risk of failure.

Of course, proper disclosure of the risk would have eliminated the secondary market for CRA junk mortgages beyond the government subsidy through Freddie and Fannie. This is why the Boston Fed was arguing that underwriting standards were too high and loans made under the Fed's suggested liberalized underwriting standards were just as reliable as standard mortgages.

As I noted above, I have no problem with government regulation requiring a more accurate and transparent disclosure of risk in the debt bundled in mortgage based securities. What I question is going beyond the need for transparency to a more ham handed prohibition of various loan forms some bureaucrat thinks is too risky simply because it was used to lend money to the non-creditworthy in the past.
 

Gretchen Morgenson's NYT Business Section (first page) article today (9/27/09) titled "The Mortgage Machine Backfires" illustrates a currently serious problem that securitization has brought about, especially with respect to subprime mortgage foreclosures resulting from the Mortgage Electronic Registration System created in 1997 to accommodate securitization for recordings in registries of deeds.

Back in the early 1990s, I was engaged on a limited basis to review documents in connection with the sale of mortgages of 1-4 family residences to an investment firm for purposes of securitization. These mortgages were not what became to be known as subprime mortgages, as there were minimal down payments of 5% or slightly less. The forms of the mortgages were not of the Freddie Mac variety and thus not "standard" forms as most mortgages sold for securitization. In this instance, the home owners had long histories in the community serviced by the lender. I was curious about how the risks were addressed by the purchaser of these mortgages where the owners had low equities and where the mortgage documents were not in "standard" form. I was told that the investors looked upon this as low risk because these home owners would do just about anything not to lose their homes. Perhaps investors purchasing subprime mortgages for securitization had similar thoughts, even though there were less, if any, equities and the home owners did not have such long histories in their neighborhoods.
 

Today's (9/27/09) Washington Post has an interesting report by staff writer Binyamin Appelbaum titled "As Subprime Lending Crisis Unfolded, Watchdog Fed Didn't Bother Barking."

By the Bybee (no, I haven't forgotten), the Boston Fed is not mentioned.
 

When the increased demand caused the prices of housing to increase for years on end, it was perfectly rational for investors to buy real estate to make a profit on the bull market in the sector. That is how you make money in any market.

It was also rational to leverage your investment with less expensive variable interest rate loans because there was a low transaction cost to switch to a 30 year fixed mortgage when interest rates went up.


In Bart World it is rational to embrace the exuberance and ride the bubble for all it's worth. When the bubble pops you look around for the weakest members of society, or any government policy designed to assist the weakest members and point the finger at them.
 

Securitization can only separate a lender from the risk of its loan if the risk is not disclosed to the security's buyer. The problem with asset based instruments including CRA junk mortgages was not the instrument, but rather the misrepresentation of the risk as AAA rather than something between junk bond and moderate risk status.

1. I would argue that this is an inherent risk of securitization when the ratings agencies have an incentive to please the people paying for the ratings.

2. Even in a properly functioning market, bear in mind there won't be perfect information flows. It's much easier for the banker to know how risky the mortgages are than even the ratings agency.

Think of it this way, Bart. Imagine we had banned securitization (and therefore there had been no Fannie Mae either). Do you have any doubt that it would have been more difficult for the subprime scandal to happen?
 

Securitization of financial products that have "standard" formats, e.g. Fannie Mae forms of residential mortgages that are bundled, are difficult enough to properly value and assess risk. I recall back in the 1980s a bright investment banker coming up with the securitization of commercial mortgages that are bundled, even though such mortgages take varied forms. This investment banker made a lot of money since investors were always on the lookout for some new financial product in a rising market, getting into the game earlier. But eventually, as they say in the Middle East, the fit hits the sham. It's an aspect of the Ponzi scheme, especially when the financial product is not well understood. Securitization has extended into the bundling of even more exotic financial products. Like a Ponzi scheme, eventually the "success" stories reach the retail level of less sophisticated investors, who end up holding the short straws. For the investment banker, the slicing and dicing involved with these financial products generate lucrative fees, so they are heavily marketed, first to sophisticated and eventually to unsophisticated investors anxious to get into the action as markets rise. With the benefit of hindsight, perhaps there could have been more extensive disclosure of the risks involved. But investors probably still would have bought into these exotic securitization products rather than risk being left behind during rising markets. Tulips offered by Madoff could probably have sold as well.

As for this bright young investment banker, he tried bundling commercial leases. Alas, the risks were a little more obvious to investors since such leases differ significantly. But these bright young investment bankers continue to reach for the brass ring that is becoming more elusive - at least until the next rising market. Yes, there is a sucker born every minute. Understanding and recognizing value and risk is for the Warren Buffetts; and even he can sometimes be taken in.
 

I was reminded of the "Prudent Investor Doctrine" (formerly known as the "Prudent Man Rule when I took Trusts in the early 1950s) by Stewart Sterk's "Rethinking Trust Law Reform: How Prudent is Modern Prudent Investor Doctrine?" available via SSRN:

http://ssrn.com/abstract=1476970

This is my next read. Perhaps it will address securitization bundling more prudently than some do. I haven't met too many prudent men - or women - recently.
 

Dilan:

Think of it this way, Bart. Imagine we had banned securitization (and therefore there had been no Fannie Mae either). Do you have any doubt that it would have been more difficult for the subprime scandal to happen?

Securitization is a means of raising capital to, in this case, raise money to make mortgage loans. Bundling hundreds of mortgages into one instrument drastically reduces the transaction costs of selling mortgages one at a time and thus makes mortgages more attractive as an investment for a wider array of banks and insurers looking for places to park their required capital reserves.

Eliminating securitization would have substantially reduced the size of the entire home mortgage market, not just or disproportionately CRA junk mortgages. I suppose eliminating securitization could have ameliorated the CRA junk mortgage problem in a throwing the baby out with the bathwater sort of way. However, one can the save the baby and still throw out the bathwater by simply addressing the root problems - underwriting standards and transparency in risk disclosure.
 

Kevin Drum (9/26/09)@

http://www.motherjones.com/kevin-drum

provides "The Meltdown List" that includes Item 2 (of 18):

"Mortgage securitization mania."
 

Eliminating securitization would have substantially reduced the size of the entire home mortgage market, not just or disproportionately CRA junk mortgages.

I actually-- as I think I said in my first comment-- don't totally disagree with you about securitization; it has good points and bad points. But you should think about your background assumption that a huge home mortgage market is such a great thing. There's a good argument that we give way too much governmental aid to homeowners at the expense of renters (see, e.g., home mortgage interest deduction) and that this policy went way beyond the issues relating to loosening loan standards, which were simply part and parcel of an attitude that anything that increases home ownership is automatically good.

In other words, depressing the housing market may not be the worst thing in the world, if one thinks that the housing market had been artificially inflated.
 

Securitization can only separate a lender from the risk

What a perfectly lovely hypothetical!

It only happened a few million times.
One might guess that's sufficient fact to establish that yes, lenders got separated from risk. Gosh how did that happen.

Yes, I think loans got made that wouldn't have been made otherwise. I think that was the plan.
 

depressing the housing market may not be the worst thing in the world, if one thinks that the housing market had been artificially inflated.

Yes -- but I think there's a more accurate way of putting it. More accurate but not more comforting, I'm afraid.

There was no way the price run-up was sustainable. But the further it went before the bubble burst, the worse the damage. And it went a long way.

So it's not a question of a correction being a good thing or what one thinks of it: prices had to come down. They could not be pushed artificially high indefinitely. Not possible.

The question instead is why the artificial run-up went so long.
 

Bart De Palma wrote:-

"Securitization is a means of raising capital to, in this case, raise money to make mortgage loans. Bundling hundreds of mortgages into one instrument drastically reduces the transaction costs of selling mortgages one at a time and thus makes mortgages more attractive as an investment for a wider array of banks and insurers looking for places to park their required capital reserves."

A mortgage lender who wishes to raise money on its portfolio may either borrow in the wholesale money market based on its balance sheet and reputation, or it may borrow on the security of its loan portfolio in which case the prospective lender can come in and do due diligence.

Securitisation of mortgages was a means of enabling the fly boys in an unregulated market to sell derivatives allegedly backed by a portfolio of assets to a much wider range of marks than Bart apparently appreciates.

Those marks, for example, municipal treasurers or pension plan trustees had absolutely no means of doing any due diligence on the underlying assets to assess their true quality. So to provide the illusion of security the bonds would also be backed with a credit default instrument.

So the sales pitch from the likes of Lehman Brothers would have gone along these lines:

"You should put some money into property its a booming market and these derivatives are ideal - you get a much higher rate of return than on a T-bill because the borrowers have to pay much higher interest rates than the US Government does and if they don't pay their homes will be repossessed. You do not need to know anything about the quality of the bundle of mortgages underlying your bonds because you can take out this super duper credit default swap (a kind of guarantee, bubba) issued by, for example, AIG - they're the biggest insurance company in the USA - too big to fail. And because of that, the bonds are rated AAA by the guys we paid to rate them. These bonds are as safe as houses."

As safe as houses built upon sand which as Bart's quick and agile brain will recall are not known for their stability - see Matthew 7:27: "and the rain fell, and the floods came, and the winds blew and beat against that house, and it fell; and great was the fall of it.".

And behind the sales pitch was the knowledge that the sales team earned a whole load of commission both on the bonds and the credit default swap.
 

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