As the financial crisis has unfolded over the past few weeks, many high profile leaders have had their faith in a market driven economy shaken. Even Alan Greenspan had to admit in testimony before Congress that the assumptions behind his economic policies were wrong. He now says he made a mistake in believing that banks “operating in their own self-interest, would do what was necessary to protect their shareholders and institutions.”
Actually, I think markets work well when the conditions for them are allowed to exist. But we are seeing the unmasking of one of the greatest economic deceptions of all time—the claim that in the United States a market determined home prices. The “invisible hand” that Adam Smith envisioned setting prices in a marketplace is suppose to be just that—invisible. Smith’s economic model rested on the assumption that many buyers and sellers acting in their own self-interest and without government interference would negotiate fair prices for scare commodities.
But lets count the ways the so-called “housing market” has failed to meet these conditions.
Government subsidies for homeowners – For decades the federal government has taxed homeowners at a lower rate than renters. It accomplishes this by allowing payments for home mortgage interest to be deducted from income. Homeowners can borrow up to the entire equity in their house and spend the money on whatever they want—cars, vacations, college tuitions—and the interest paid on the loan is tax deductible. Renters are not allowed to deduct interest paid on loans. The effect of this policy is that homeowners are taxed less as long as they remain in debt. That makes owning a home intrinsically more valuable than just having a place to live.
Government-backed loans eliminate lenders’ risks-The point of Freddie Mac and Fannie Mae was to encourage banks to loan private money to purchase homes by promising public money if the loan went bad. This policy effectively privatized gains and socialized losses. The result is a moral hazard that subverts the functioning of the market. Banks can loan money under the most outlandish of circumstances because they have everything to gain and nothing to lose.
A single person sets interest rates – The Federal Reserve Chief dictates interest rates. It’s no accident that Alan Greenspan had the nickname “Maestro” when he ran the Federal Reserve. Rather than allow market processes to determine interest rates he orchestrated market movements by dictating the rates himself. Allowing the judgment of one person to determine something as fundamental as the cost of money on such a grand scale is the antithesis of a free market.
Of course the government had good reasons for these policies. Congress decided that communities benefited from widespread home ownership. In other words a social good resulted if more people owned homes rather than rented. But government manipulation of markets to achieve a social goal is the definition of socialism.
That is where the great fraud arises—the creation of a socialist system for home ownership but labeling it a “free market.” The claim that no regulation is needed for mortgages because the market will operate is absurd. Socialist systems need regulation; otherwise the moral hazards are too great. The government appears to have no plans for ending the mortgage interest deduction, ending bailouts of failed lenders, or ending Federal Reserve control of interest rates. If it continues to use these policies to manipulate home prices its needs to be intellectually honest. The government should admit that fact that the housing market has been socialist for decades and adopt appropriate regulations to protect the public.
Showing posts with label mortgages. Show all posts
Showing posts with label mortgages. Show all posts
Thursday, October 30, 2008
Tuesday, August 19, 2008
Motivations Behind Bad Loans
I’ve written columns for the Baltimore Sun on the mortgage crisis and the emails I received from readers included these comments:
“It is hard to feel sorry for folks who got in over there heads, knew it and now what us to bail them out.”
“You are omitting the fact that the majority of subprime borrowers are in their current situation due to fiscal irresponsibility or carelessness.”
My response to these comments is that the goal of my writing is to educate consumers so that they are able to make better decisions. Markets do not work as intended if the consumers do not understand the contracts they sign.
But, for the people who write these comments, their underlying assumption is that homebuyers do know or at least should know what they are doing when they sign a loan agreement. The mortgage crisis is the result of character defects—greed, irresponsibility, over consumption, and so on. Pick one or several character flaws from a list and that explains the problem.
Of course, attributing misfortune and/or good fortune, on one’s character is as old as the Bible. Outcomes do depend on character, although not always. More personal failures and successes result from chance than most people would like to believe.
But the issue of character is an interesting one and I’ve been pondering it after recently reading two profiles of homebuyers facing foreclosure. In both cases the numbers involved in the loan agreements were so outrageous, it’s hard to believe any reasonable person would be party to such a contract.
A July 30, 2008 article in the Baltimore Sun profiled Veronica Peterson, a single mother of four who operates a home daycare in Columbia, Maryland. She is loosing her $545,000 home to foreclosure after the rate adjusted from 8.25% to 11.25%. The article provides few other details on her income and mortgage payments. However, if I work with the numbers provided and assume a 30-year loan, such an increase would mean monthly payments changing from $4094 to $5293 per month, an increase of $1199 per month. This does not include taxes and insurance that must add an additional $500 to each monthly payment.
I cannot image how a home daycare operator could generate the kind of income needed to support monthly payments that high; especially since the State of Maryland limits the number of children home daycare providers can care for to no more than eight. The average cost of daycare in Columbia, Maryland is about $1000 per month. That means by law she cannot gross more than $8000 per month and she must still pay income taxes. Living in a half-million dollar home while paying no taxes is sure to raise questions from the IRS. She said her mortgage broker inflated her income. I wonder what number was stated for her income on the loan application and how it compared to her tax return.
Another profile I read was in Jay Hancock’s August 8 column on Kimberly Thomas who showed up at a closing to find the interest rate on her mortgage from Wells Fargo Bank changed from 7.13% to 10.65%. The change resulted in the monthly payment going from $3000 to $4667. Her monthly take-home pay is $5000. The title company agent conducting the settlement told her to sign the documents anyway. It was 6 PM and no one else was present or available to contact. He assured her the bank would correct the “mistake” the next day.
But the next day Wells Fargo insisted that there was no mistake and that she was bound by the terms of the agreement. Because she couldn’t afford the terms, she ended up not taking possession of the house or making a single payment. The mortgage went into foreclosure immediately. She sold the house for which she paid $505,000 for a $95,000 loss and spent tens of thousands on legal fees. Eventually a jury agreed that Wells Fargo had acted fraudulently and awarded her $1.25 million in damages. Wells Fargo maintains they did nothing wrong and are appealing the verdict.
So what is it about the character of these people that results in situations where the numbers in the agreements are so ridiculous as to be unbelievable? My own take is that it is a combination of optimism bordering on wishful thinking, wanting to please others, and willingness to trust people presenting themselves as “professionals.” Homebuyers want to believe what the agents and brokers are telling them. And, the agents and brokers are very good at telling people what they want to believe. The fake friendships that develop allow the brokers and agents to take advantage of people who want to please others. Homebuyers do not want to anger people by scuttling deals at the last minute and willingly believe that everyone is acting their best interest.
Brian Paul, the lawyer for Kimberly Thomas, said: "She honestly believed there was a mistake in the terms that could be fixed after the fact."
I remember my own experiences with home buying. The real estate agent told me: “It’s impossible to overpay for a house because it has to be appraised. The bank will not allow you to pay more than the appraised price.” I’m sure all the homebuyers he works with get that same line and many believe it.
I remember a refinance of my house where the day of closing, a settlement sheet was faxed to me with a completely different set of numbers than previously agreed to. I took a hard line telling the broker the deal would not happen unless the numbers were changed back. Within an hour a new settlement sheet appeared with the original numbers. But many people are reluctant to “cause problems” at the last minute. It is also easier to walk away from a refinance than a home sale.
So, is believing the best about ourselves and others a character flaw? It can be when it allows us to be taken advantage of and enter into agreements not in our best interest. As I warn in my book The Two Headed Quarter, the lender and realtor profit from immediate sales, not the long-term financial health of the borrower. If the government, or some other investor backs the loan the lender is at no risk. That means homebuyers must look out for their own interests. Don’t believe the agent when he or she tells you that a bank would never loan you money if you couldn’t repay it.
In fact the real crux of the mortgage problem is the ability for agents, brokers, and executives to profit by gambling with money that is not their own. That is the point I made in my previous post. Wells Fargo and its agents don’t care if a loan is paid back because they will collect commissions and fees while selling the loan to other investors. The loan would become somebody else’s problem, not theirs. The homebuyers might have character flaws but the behavior of the lenders in these cases is criminal.
Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy
“It is hard to feel sorry for folks who got in over there heads, knew it and now what us to bail them out.”
“You are omitting the fact that the majority of subprime borrowers are in their current situation due to fiscal irresponsibility or carelessness.”
My response to these comments is that the goal of my writing is to educate consumers so that they are able to make better decisions. Markets do not work as intended if the consumers do not understand the contracts they sign.
But, for the people who write these comments, their underlying assumption is that homebuyers do know or at least should know what they are doing when they sign a loan agreement. The mortgage crisis is the result of character defects—greed, irresponsibility, over consumption, and so on. Pick one or several character flaws from a list and that explains the problem.
Of course, attributing misfortune and/or good fortune, on one’s character is as old as the Bible. Outcomes do depend on character, although not always. More personal failures and successes result from chance than most people would like to believe.
But the issue of character is an interesting one and I’ve been pondering it after recently reading two profiles of homebuyers facing foreclosure. In both cases the numbers involved in the loan agreements were so outrageous, it’s hard to believe any reasonable person would be party to such a contract.
A July 30, 2008 article in the Baltimore Sun profiled Veronica Peterson, a single mother of four who operates a home daycare in Columbia, Maryland. She is loosing her $545,000 home to foreclosure after the rate adjusted from 8.25% to 11.25%. The article provides few other details on her income and mortgage payments. However, if I work with the numbers provided and assume a 30-year loan, such an increase would mean monthly payments changing from $4094 to $5293 per month, an increase of $1199 per month. This does not include taxes and insurance that must add an additional $500 to each monthly payment.
I cannot image how a home daycare operator could generate the kind of income needed to support monthly payments that high; especially since the State of Maryland limits the number of children home daycare providers can care for to no more than eight. The average cost of daycare in Columbia, Maryland is about $1000 per month. That means by law she cannot gross more than $8000 per month and she must still pay income taxes. Living in a half-million dollar home while paying no taxes is sure to raise questions from the IRS. She said her mortgage broker inflated her income. I wonder what number was stated for her income on the loan application and how it compared to her tax return.
Another profile I read was in Jay Hancock’s August 8 column on Kimberly Thomas who showed up at a closing to find the interest rate on her mortgage from Wells Fargo Bank changed from 7.13% to 10.65%. The change resulted in the monthly payment going from $3000 to $4667. Her monthly take-home pay is $5000. The title company agent conducting the settlement told her to sign the documents anyway. It was 6 PM and no one else was present or available to contact. He assured her the bank would correct the “mistake” the next day.
But the next day Wells Fargo insisted that there was no mistake and that she was bound by the terms of the agreement. Because she couldn’t afford the terms, she ended up not taking possession of the house or making a single payment. The mortgage went into foreclosure immediately. She sold the house for which she paid $505,000 for a $95,000 loss and spent tens of thousands on legal fees. Eventually a jury agreed that Wells Fargo had acted fraudulently and awarded her $1.25 million in damages. Wells Fargo maintains they did nothing wrong and are appealing the verdict.
So what is it about the character of these people that results in situations where the numbers in the agreements are so ridiculous as to be unbelievable? My own take is that it is a combination of optimism bordering on wishful thinking, wanting to please others, and willingness to trust people presenting themselves as “professionals.” Homebuyers want to believe what the agents and brokers are telling them. And, the agents and brokers are very good at telling people what they want to believe. The fake friendships that develop allow the brokers and agents to take advantage of people who want to please others. Homebuyers do not want to anger people by scuttling deals at the last minute and willingly believe that everyone is acting their best interest.
Brian Paul, the lawyer for Kimberly Thomas, said: "She honestly believed there was a mistake in the terms that could be fixed after the fact."
I remember my own experiences with home buying. The real estate agent told me: “It’s impossible to overpay for a house because it has to be appraised. The bank will not allow you to pay more than the appraised price.” I’m sure all the homebuyers he works with get that same line and many believe it.
I remember a refinance of my house where the day of closing, a settlement sheet was faxed to me with a completely different set of numbers than previously agreed to. I took a hard line telling the broker the deal would not happen unless the numbers were changed back. Within an hour a new settlement sheet appeared with the original numbers. But many people are reluctant to “cause problems” at the last minute. It is also easier to walk away from a refinance than a home sale.
So, is believing the best about ourselves and others a character flaw? It can be when it allows us to be taken advantage of and enter into agreements not in our best interest. As I warn in my book The Two Headed Quarter, the lender and realtor profit from immediate sales, not the long-term financial health of the borrower. If the government, or some other investor backs the loan the lender is at no risk. That means homebuyers must look out for their own interests. Don’t believe the agent when he or she tells you that a bank would never loan you money if you couldn’t repay it.
In fact the real crux of the mortgage problem is the ability for agents, brokers, and executives to profit by gambling with money that is not their own. That is the point I made in my previous post. Wells Fargo and its agents don’t care if a loan is paid back because they will collect commissions and fees while selling the loan to other investors. The loan would become somebody else’s problem, not theirs. The homebuyers might have character flaws but the behavior of the lenders in these cases is criminal.
Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy
Tuesday, August 12, 2008
The Dream World of Mortgages
I dreamt the other night of being at a casino. I sat at a $5 per hand blackjack table and began playing. As the dealer flipped the cards across the felt strange events started to happen. Each time I lost a hand the other casino patrons would take up a collection to cover my loss. Then someone would rush over to add more chips to my stack. But each time I won I got to keep the money. I simply put the chips I won in my pocket. Wow, I thought; I should try this at a more expensive table.
I moved to a $10 per hand table and the same thing happened. Next I tried $50 per hand and then $100. No matter how large a bet I placed or how long a particular losing streak lasted, the lost chips would magically reappear. But, any win was mine to keep and no one seemed to care. An attractive waitress came to offer a drink. I asked for some Grand Marnier and tipped her with a $100 chip. She rushed back with the drink, a seductive smile and a food menu. I kicked back and doubled-down on a hand blackjack players call a hard-16. (Yes, I know that is a stupid play, but I might win and it doesn’t cost me when I lose.) I think I’ll just stay here. No need to go back home and return to that activity called work.
Then I awoke and regained my senses. Real life isn’t like that; or so I thought. I made some coffee and as I sipped and savored the aroma my eyes focused on the morning newspaper. I read about the government bailing out near bankrupt companies with names ending in Mae and Mac. Wait, I must still be dreaming. Is the caffeine working this morning?
Indymac, Freddie Mac and Fannie Mae were run as private companies with stockholders and highly compensated executives. The executives made a series of large questionable bets on real estate that for several years paid off handsomely. But now fortunes have changed and the bets are losing big time. Like many problem gamblers, these executives did not know how to control risk, stay within a budget, or quit before going completely broke. But it didn’t matter to them because while they got to keep their winnings for the bets that paid off, ordinary citizens are being forced to take up a collection to cover the bets that lost.
Government talk and action on the financial crisis caused by bad loans is completely disingenuous. Political leaders extol the virtues of free, unregulated, private enterprise motivated by profit seeking executives and corporations. But when these private businesses fail, our leaders tell us that taxpayers must step in to prevent the entire financial system from collapse. It turns out that the Maes and Macs performed a necessary public service, much like a utility. But Marylanders already know what happens when utilities are deregulated and run for profit. We pay extra on our electric bills every month for that improvement.
IndyMac grew rapidly during the real estate boom by specializing in so-called “Alt-A” loans. These loans did not require homebuyers to actually document the income or assets they claimed. After its failure the FBI launched an investigation of the company for possible fraud. I’m just shocked, shocked to think that without documentation, bank officials might have just made up the numbers on loan documents.
Private enterprise works well with private money. But, in the mortgage business we have a system that allows private gain to accrue from risking unlimited amounts of taxpayer money. The result is that since March authorities have indicted more than 400 people who worked in the real estate industry. We the taxpayers are now footing the bill for massive amounts of collusion and outright fraud.
In Maryland, I know of no legal blackjack games. Neither the state nor federal governments trusts its citizens to play the game responsibly. But, while casino blackjack is stacked against the player, at least it’s regulated in states where it is allowed. Many tax-paying citizens were financially ruined in the poorly regulated real estate market. But, the government says that they should have made more responsible choices. Do they think this is a dream world?
Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy
I moved to a $10 per hand table and the same thing happened. Next I tried $50 per hand and then $100. No matter how large a bet I placed or how long a particular losing streak lasted, the lost chips would magically reappear. But, any win was mine to keep and no one seemed to care. An attractive waitress came to offer a drink. I asked for some Grand Marnier and tipped her with a $100 chip. She rushed back with the drink, a seductive smile and a food menu. I kicked back and doubled-down on a hand blackjack players call a hard-16. (Yes, I know that is a stupid play, but I might win and it doesn’t cost me when I lose.) I think I’ll just stay here. No need to go back home and return to that activity called work.
Then I awoke and regained my senses. Real life isn’t like that; or so I thought. I made some coffee and as I sipped and savored the aroma my eyes focused on the morning newspaper. I read about the government bailing out near bankrupt companies with names ending in Mae and Mac. Wait, I must still be dreaming. Is the caffeine working this morning?
Indymac, Freddie Mac and Fannie Mae were run as private companies with stockholders and highly compensated executives. The executives made a series of large questionable bets on real estate that for several years paid off handsomely. But now fortunes have changed and the bets are losing big time. Like many problem gamblers, these executives did not know how to control risk, stay within a budget, or quit before going completely broke. But it didn’t matter to them because while they got to keep their winnings for the bets that paid off, ordinary citizens are being forced to take up a collection to cover the bets that lost.
Government talk and action on the financial crisis caused by bad loans is completely disingenuous. Political leaders extol the virtues of free, unregulated, private enterprise motivated by profit seeking executives and corporations. But when these private businesses fail, our leaders tell us that taxpayers must step in to prevent the entire financial system from collapse. It turns out that the Maes and Macs performed a necessary public service, much like a utility. But Marylanders already know what happens when utilities are deregulated and run for profit. We pay extra on our electric bills every month for that improvement.
IndyMac grew rapidly during the real estate boom by specializing in so-called “Alt-A” loans. These loans did not require homebuyers to actually document the income or assets they claimed. After its failure the FBI launched an investigation of the company for possible fraud. I’m just shocked, shocked to think that without documentation, bank officials might have just made up the numbers on loan documents.
Private enterprise works well with private money. But, in the mortgage business we have a system that allows private gain to accrue from risking unlimited amounts of taxpayer money. The result is that since March authorities have indicted more than 400 people who worked in the real estate industry. We the taxpayers are now footing the bill for massive amounts of collusion and outright fraud.
In Maryland, I know of no legal blackjack games. Neither the state nor federal governments trusts its citizens to play the game responsibly. But, while casino blackjack is stacked against the player, at least it’s regulated in states where it is allowed. Many tax-paying citizens were financially ruined in the poorly regulated real estate market. But, the government says that they should have made more responsible choices. Do they think this is a dream world?
Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy
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