When Markets Fail

I just finished reading Broke, USA: From Pawnshops to Poverty, Inc. How the Working Poor Became Big Business by Gary Rivlin. It is a disturbing read about what Rivlin calls the "poverty industry" in the United States. Poverty is in fact a lucrative business opportunity for the many entrepreneurs that Rivlin profiles. This is a discovery not lost on major banks that now have large investments in companies that provide sub-prime loans of all types. I knew from doing research on my own book--The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy--the counterintuitive result that collectively the working poor represent an enormous source of wealth for those who know how to tap into it. Rivlin's reporting explains how the systematic stripping of resources from communities on the financial edge is accomplished.

In my book, I liken some of these payday loans, sub-prime mortgages and credit card products to old-fashioned "company stores." But, as I read Broke, USA, I was reminded of another analogy raised in the book by Stacy Mitchell-- Big-Box Swindle: The True Cost of Mega-Retailers and the Fight for America's Independent Businesses--colonialism. Mitchell reports on the systematic destruction of local economies and businesses by mega-retailers such as Wal-Mart, Home Depot, and Target. The rationale for allowing mega-retailers entrance into a community is the market demand for their products. But, often after the destruction of local businesses and jobs, there is no longer enough wealth left in the community to support these large retailers. The corporations move on, abandon their stores, and leave a shuttered main street as well. To Mitchell, this is not the free market at work. Rather, it is exploitation akin to colonialism, in which a large power imbalance allows a distant corporation to appropriate wealth for its own enrichment at the expense of a local community.

But, the question I kept wondering about was: Why doesn't the market for loans work for poor people? Much of Rivlin's reporting was about political battles fought in state legislatures, not about businesses trying to out-compete other businesses with a better product. One of Rivlin's protagonists, Martin Eakes is founder of the Center for Responsible Lending (CRL), a company that specializes in providing reasonably priced mortgages to high-risk, low-income homebuyers. Eakes argues that CRL shows that it is possible to lend at reasonable rates to "sub-prime" borrowers and make money. He contends that the usurious, triple-digit annual interest rates, routinely charged by sub-prime lenders are not necessary, and should be banned.

However, in Rivlin's narrative, Eakes spends more time joined with community activists lobbying for bills to protect consumers against predatory lending, than expanding the CRL business model to compete nationwide against the sub-prime lenders by offering a lower-priced product. It is this paradox that gnawed at me while I read the book. It was only by the end that I realized the reason the market fails for sub-prime borrowers, and why government intervention is necessary.

The argument from the sub-prime lending industry is that interest rate caps take away consumer choice. No one forces people to take-out payday loans, pawn possessions, or sign documents for sub-prime home equity loans. Because these choices are freely made, the borrowers must see some value in the loan product. If the demand for sub-prime loans didn't exist, neither would the sub-prime lenders.

I tend to have a bias in favor of these kinds of arguments. I believe that consenting adults should be free to make decisions with their money for or against products. I have also observed that in any event, markets are extremely resilient and difficult to stamp out. One only needs to look at the markets for vices--such as drugs, gambling, and prostitution--to see the futility of trying to eliminate the supply of a product or service when there clearly exists a demand.

As a result, I tend to believe that the best way to effect change is through the market. Educating consumers on how to act in their best interests is my preferred approach. My writing, in books like the Two Headed Quarter, is intended to teach consumers how to make the best choices, not to proscribe choices. Admittedly, my bias is influenced by my own societal role as an educator.

However, I also know that markets cannot solve all problems. We would not have roads, airports, the Internet, universal phone and electrical service, without the intervention of the government acting for the common good. I also know that markets can and do fail. I was never naive like Alan Greenspan, who seems to have believed that the self-correcting tendencies of markets would eventually right all wrongs. (This belief came from a man whose job was to artificially manipulate the mortgage market by raising and lowering interest rates.) As we have recently seen, market failures can be spectacular and so threatening to the financial order, that the most committed "free market" advocates will abandon their principles and grovel before Congress when their luxury lifestyles are at stake.

But, I realized by the end of the book that the problem is deeper than lack of education. For a market to work the participants must trust each other. They must act in good faith. It would be impossible to conduct business of any kind if no trust existed between the buyers and sellers. The simplest economic interactions-grocery shopping, car repair, hair styling, eating in a restaurant-could not happen. Think about the implied contract when you order food off a menu, drop your car off for an oil change, or get your hair cut. You trust in an honest delivery of the service, and the provider trusts that you will pay.

During the financial crisis of 2008, banks could not trust other banks to repay loans, and the entire system for extending credit on a daily basis to cover short-term obligations froze. Without government assurances the banking system might have collapsed, not because of a shortage of money, but because of a shortage of trust.

Many of the lending practices profiled in Broke, USA violate trust. The lenders are not acting in good faith when they sell loans to people who cannot possibly repay the money, sell unnecessary and overpriced mortgage insurance, provide less favorable loan terms when the borrower qualifies for better terms, and then sell the toxic products to investors representing them as a safe securities. It is disingenuous for the lenders to rationalize these actions by saying that they were only acting in their best financial interests, and that the borrowers and investors should have taken more care to act in their best interests because that is how free markets work.

No, free markets will not work if greed is the only motive driving them. There is a famous quote from Adam Smith that is frequently invoked to justify greed. He wrote:

"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest."

--Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations

But, self-interest in the community setting that Smith describes is more than just maximizing income. It's also about sustaining the relationships necessary for a community to exist in the first place. The butcher, the brewer, and the baker, will not be in business for very long if greed is their only motive. They must trust in and look out for each other, or else none of them will have their needs met. Their self-interest is not just money; it includes a need for each other.

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

The Deceptive Math of Financial Leverage

In physics a lever is a tool for obtaining a large torque (rotational motion) with a relatively small force. Anytime you use a screwdriver, a lug wrench, a jack, a crowbar, or a doorknob, you are using a lever. In each of these circumstances the rotations achieved would be nearly impossible without the lever.

By analogy, the leverage principle in finance is intended to magnify rates of return on invested money so that relatively small amounts of money can grow much faster than the actual rate of return on the investment. But in finance the tool used to obtain leverage is debt. Borrowing against an asset to fund an investment is financial leverage.

For example, a homebuyer who takes out a mortgage is leveraging the asset—the home—to increase the rate of return on the money used for the down payment. Suppose a buyer puts $10,000 down on a $100,000 house and finances the remaining $90,000 using the house as collateral. If the value of the house rises 50% to $150,000, the homebuyer now has $60,000 of equity in the house. The $10,000 investment has multiplied 6-fold even though the asset only increased 50% in value. Had the buyer paid $100,000 cash for the house a 50% return on investment is all that would have been achieved.

Investors in the stock market can also use leverage. An investor with a normal brokerage account is allowed to borrow up to 50% of the value of stocks owned to purchase more stocks. That means $10,000 can be used to purchase up to $20,000 worth of stocks. This is called buying on margin. If the stocks double in value to $40,000 the investor now has $30,000 in equity—a tripling of the initial $10,000 investment.

Leverage seems like a kind of financial magic. For many investment banks and hedge funds it was magic because these institutions were not bound by the normal rules that limit ordinary investors and homeowners. Stockowners cannot borrow more than 50% of the value of their stocks; homeowners cannot borrow more than the value of their homes. But, in the unregulated dream world of investment banking and hedge funds, there was no limit on the amount the managers could borrow against their assets. For example, by the time Lehman Brothers went bankrupt it was leveraged more than 30 to 1. It owed $30 for $1 in assets it held. Imagine a homeowner borrowing $3 million against a $100,000 home. That might sound crazy, but that’s effectively what Lehman Brothers did.

The motivation for investment banks and hedge funds to leverage their assets to such absurd levels is that it allows them to report fantastic rates of return for modest investment gains. Suppose a $3 million cash investment returns just 5% in a year so that the value is $3.15 million. That does not sound all that impressive. But, suppose the fund managers had only $100,000 in equity in that $3 million investment. The total equity after the 5% gain is now $250,000. The fund managers can now report a “return on equity” of 150%. That is an eye-catching number to report to investors, prospective customers and stockholders. The managers can reward themselves with bonuses for the their remarkable results. At the same time the appreciation of the actual investment was nothing out of the ordinary. It is a beautiful example of a two-headed quarter—using numbers to have it both ways.

But leverage has a dark side. Not only does it magnify gains it also magnifies losses. In the example above, if the $3 million investment loses just 3.3% of its value, the $100,000 of equity is completely wiped out. In markets with normal volatility, a 3.3% downward move is not unusual for a solid investment. The problem is that many of the investments were in mortgages, which are also a leveraged investment. Many of the subprime mortgages being called assets, were for homeowners who had no equity in their houses. Leverage was piled upon leverage. No wonder the banks have no idea what the mortgage securities they hold are worth. Homeowners with no equity have every incentive to walk away when prices fall. After all, when a homeowner invests nothing, there is nothing to lose.

In the same manner, the executives and fund managers had nothing to lose by taking on such absurd levels of debt. They pocketed huge salaries and bonuses for their financial “genius.” And it was an ingenious scheme—taking home the profits and billing the taxpayers and stockholders for the losses.


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

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