How much should the government pay for the bad mortgage-backed securities that the banks no longer want? I find a profound irony in that question. A problem in the current financial crisis is that no one knows what many of these securities are worth. Settling on a price that will solve the problem is tricky. If the government pays too little the bailout could fail and the banks will go under anyway. If the government pays too much banks will reap enormous profits at the expense of taxpayers and have little incentive to change the lending practices that resulted in this mess.
The reason no one knows a fair price to pay is that the securities in question are too complicated for anyone to understand. The irony is that the complexity was intentional. The securities were designed to make it difficult if not impossible for anyone to know their underlying value.
Much as been written during this current financial crisis on the question of whether free market capitalism is dead. But the mortgage industry during the past few years was anything but a free market. The idea behind a market is that fair and accurate prices will result from negotiations between buyers and sellers acting in their own best interests. But, for consumers to act in their own best interest, they need to understand the agreements they enter.
Corporations have put enormous effort into making contracts so complex the normal rules of the market do not apply. The premise behind my book, The Two Headed Quarter, is that financial companies can mislead consumers without lying by presenting numbers in such complex ways that rational decision-making becomes impossible. Bob Sullivan’s book Gotcha Capitalism exposes how companies use complex contracts to cheat consumers out of money with hidden fees and surcharges. The idea throughout corporate America is to find deceptive yet still legal methods for taking as much money as possible from consumers without them noticing.
Now there is no money left in the consumer’s pocket for the corporations to take. But, it turns out that a constant flow of money from the consumers is needed or the system falls apart. This was never a “market” in the ordinary sense of the word; it was a Ponzi scheme.
In a healthy marketplace, buyers and sellers need each other. Sellers need satisfied customers willing to come back and give referrals. A small community-based business will not survive without repeat customers. Buyers need merchants that they can trust to provide reliable goods and contribute to quality of life in their communities. A business with contempt for its customers, that exists only to acquire as much money as possible, will eventually fail.
Failure is of course what has happened. But, what I find deeply ironic is that these corporations are now victims of their own deceptions. These corporations attribute their failures to customers who did not understand agreements designed not to be understood. Now these same corporations are shocked to discover that no one understands the agreements. The executives who created the complex securities don’t understand them, Treasury Secretary Paulson doesn’t understand them, Fed Chief Bernake doesn’t understand them, would be buyers don’t understand them. A security that cannot be understood cannot be fairly priced.
A mortgage is actually a simple idea. Over the long run it benefits no one to turn package mortgages into complex, incomprehensible, financial instruments. As the government moves forward to craft better regulations to prevent a future financial catastrophe’s it should consider going back to basics. A free market will work but only if the participants understand the agreements.