Who cheated whom?

Nobel-prizewinning economist Gary Becker writes this week about the subprime bubble. He ably punctures the notion that the bankers were all a bunch of evil cheaters:

Many economists and members of Congress have claimed that the housing crisis was greatly magnified because unqualified home buyers with limited incomes and assets were not fully aware of the terms of their mortgage loans, such as that the low initial (teaser) interest rates were only temporary. This belief in the beneficial effects of greater knowledge about mortgage terms is inconsistent with the evidence that the most sophisticated banks and investment companies, including Merrill Lynch, Citibank, and Morgan Stanley, have written down their housing investments by billions of dollars. No one can reasonably claim that these banks lacked the skills and knowledge to evaluate all the terms of, or the likelihood of repayment, on the subprime and other mortgages that they originated or held as assets. The losses to investors have been so large, and have so eroded their capital base, that some of the major investment companies have needed large infusions of capital from Middle Eastern and Asian Sovereign Funds (see our discussion of these funds on December 10th).

Although there was some fraud by mortgage lenders and by borrowers, fraud was not the main reason why so many subprime mortgages were issued. Otherwise savvy investors greatly undervalued the risks associated with many of the mortgage-backed securities that they held. They and borrowers alike did not fully appreciate that interest rates were likely to increase from their unusually low levels, and that many borrowers lacked the financial means to meet their mortgage repayment obligations at higher rates, and sometimes even at the low initial rates they had received.

Given the low interest rate lending atmosphere of the past few years, it is highly unlikely that borrowers would have turned down the mortgages they received if they had much better information about terms, or that lenders would have been more reluctant to originate or hold these mortgage assets if they had better information about the credit and other circumstances of borrowers. This is why I doubt that the rules proposed this week by the Federal Reserve to require lenders to get more information about borrowers, and to provide more information to borrowers about the terms of mortgage loans, would have been effective in warding off this crisis, or will be effective in preventing future crises.

He goes on to point out that the same people criticizing banks for issuing loans to people in marginal neighborhoods with inadequate credit were, several years ago, some of the loudest voices raised against "redlining"--that is to say, the practice of refusing to issue loans to people living in marginal neighborhoods with inadequate credit1. But I want to focus on this point.

The housing bubble was a great national folie-a-deux. Buyers and lenders alike were deluded by long years of easy credit into thinking that risks were lower than they actually were. It is not plausible to argue that the banks knew the loans would go bad . . . and nonetheless jammed billions of them into their portfolios.

To many people, of course, this cries out for regulations to keep the bankers from being stupid: force them to up their loan quality. This is likely to just replace one kind of error with another. Most people who got subprime loans are not in default, and I will be very, very surprised if the number of defaulters even gets near the 50% mark. Why would we want to cut off credit to the sensible majority who can meet their payments, in order to protect those who take out loans they can't afford? There is no way to tell Class A from Class B--or believe me, the banks would already have weeded the latter group out.

It is characteristic of major economic problems that whatever problem you're having now seems like the only problem worth solving, no matter what the cost. But the cost of denying credit to millions of people is very high--and tellingly, it will not be borne by any of the people who are advocating it.

1 But why does the quality of the neighborhood matter, I hear you cry? Because when housing booms end, the marginal neighborhoods experience the fastest and deepest declines in home values. That means that a lot more people in those neighborhoods end up "upside down" on their mortgages: the value of the loan exceeds the value of the home. That means that they can't get out of a tight spot by refinancing, or selling; even if they sell, they owe the bank money, meaning they have to declare bankruptcy.