Primed for a fix

Ezra Klein and Ryan Avent are having a throw-down over the subprime mortgage market. Did borrowers borrow more than they could afford, or were they rooked by unscrupulous mortgage brokers?

Neither Ryan nor I have any data on how these conversations actually went. But whether it was the loan officer pushing the borrower off the variable-rate cliff or the borrower begging for a bit more rope with which to hang herself or, most likely, a bit of both, doesn't much matter. It is perfectly well understood that borrowers, by and large, know nothing of loans. It's a market that operates with a huge asymmetry of information. And though we know that loan officers are, in fact, loan salesmen, they are not presented that way -- instead, they're offered up as helpful experts waiting to guide you to a safe and secure financial solution. They're presented, in other words, like loan doctors.

What's supposed to govern their behavior isn't merely basic morals and business ethics, but a sense of concern for their company. If too many individuals enter into loans they can't afford, defaults will rise and the bank will suffer. Which is exactly what's happened. The loan officers, and above them, the banks, and above them, the regulators, were the ones with the knowledge, power, and authority to head off this mess. This market works, it exists, because we trust them to run it in such a way that does not massively exploit the ignorance of individuals, and does not put the entire economy at risk. They failed. But, unlike with the individual borrowers, they failed when their whole mission in life was to not fail, when they were paid to have the tools and information to not fail, and now, in reconstructing this market, we need to figure out what regulations will keep them from failing again.

To which Ryan responds:

Somewhere between the idea that consumers are wholly responsible for their own actions and the idea that the state must be an attentive and omnipresent nanny, there has to be some middle ground. I thought, and I thought that others generally thought, that businesses were generally out there to turn a profit, and while this might often encourage them to engage in helpful, service-oriented behavior, I should not assume that any business has my well-being as its first and highest concern. That’s my job. I cannot fathom the notion that customers ought to be able to walk into a lender’s office with no idea what they can afford and expect that they’ll get a product that’s best for them. I can’t imagine excusing customers who “know nothing of loans” and yet borrow five times what they earn in a year.

There is absolutely a limit on the due-diligence that we can expect consumers to undertake. Having to outthink devious loan sharks is one thing. Understanding that it might not be a good idea to borrow massive amounts of money under terms one doesn’t entirely understand is quite another. If we approach the economy from the point of view that consumers are essentially idiots who can be easily played by anyone, anytime, then the entire economy falls apart. Democracy falls apart. We have to begin from the point of view that people will try to look out for themselves, and when they don’t, there should be consequences.

Technically, Ezra's analysis strikes me as simply incorrect: whatever asymmetries of information exist run towards the borrowers, not the lenders. The terms of the mortgage you sign may be disguised in fine print, but the lender has to put them in print in order to get you to sign them. The lender, on the other hand, has only limited means at his disposal to determine your likelihood of paying.

That does not excuse mortgage brokers who deceived confused borrowers about the terms. But realistically, lenders did not lend to massive number of people who couldn't repay them because they wanted to be mean, and damn well didn't care what it cost them as long as they could thrust massive numbers of people into bankruptcy. We've just participated in a national folie-a-deux, where overoptimistic lenders gave too much money to slap-happy borrowers counting on a miracle to bail them out of a mortgage they couldn't really afford.

But I'm not sure that it really matters who's at fault, because whoever started it, everyone's hurting about equally. Ezra's argument, naturally, is that this means the government should step in to prevent this sort of thing. But the government is a very blunt instrument. As of this writing, the vast majority of subprime borrowers are making their payments on time. Defaults are expected to rise sharply, but even if the number doubles, or more, that would still mean that a majority of subprime borrowers are able to make their payments. Should the government have "protected" them from owning their home?

The government used to protect poor people, and young people, and people with bad credit histories, from getting loans, by making it illegal to charge the high interest rates that would make those loans profitable. Were they better off? They didn't have credit card debt, to be sure, or huge mortgages. Instead they had pawnshops, or time payments, or convictions for kiting checks, all of which used to be popular ways of handling things like emergency car repairs.

Which is to say, maybe there aren't regulations that can keep them from failing again, at least not at acceptable cost. I think it's safe to say that the fallout from this credit crunch is that subprime borrowers, including people with fine credit but low incomes, will be finding it harder to get any sort of loan; to that extent, Ezra's wish has already come true. Pushing to further restrict their credit access might well hurt more people than you help.