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Paul Kiesel
Paul Kiesel
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The New Republic: Economic Innovation and Mortgage Fraud

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Transparency. This word gets thrown around a lot when describing how banks and mortgage brokers were able to sell the some of the dubious mortgages (mortgages that were filled with TILA violations) that have crushed parts of the U.S. economy and that have depressed the housing market. It was a lack of transparency that allowed for this to occur.

Had banks and lenders been more transparent in their fee structure, terms, etc., we wouldn’t be in the credit/mortgage/housing crisis we’re currently stuck in.

Below is the last half of an article that will be published in next week’s issue of The New Republic. It is further evidence to a thesis that is consistent with most of my blogs: A major lack of transparency led to the types of economic innovation amongst banks and lenders (option ARM loans; continuous refinancing by banks), thus, allowing for banks to get richer in the short term (year after year, until housing prices began to drop), but in the long term it would be its innovation that would lead to its demise (housing bubble popping; Bear Stearns; IndyMac failure; etc.).

[. . .] The task of unraveling all that went wrong in our financial system is a difficult one, but in essence the financial system’s latest innovation was to devise fee structures that were often far from transparent and that allowed it to generate enormous profits–private rewards that were not commensurate with social benefits. The imperfections of information (resulting from the non-transparency) led to imperfections in competition, helping to explain why the usual maxim that competition drives profits to zero seemed not to hold. One should have suspected that something was wrong when bank after bank made so much money year after year. One should have suspected that something was wrong with the economic system when millions of Americans owed billions to credit card companies and banks in “late fees,” “penalties,” and a variety of other charges, transforming a high annual interest rate of 20 percent into a truly usurious effective interest rate of 100 percent or more for those who fell behind in their payments.

Perhaps the worst problems–like those in the subprime mortgage market–occurred when non-transparent fee structures interacted with incentives for excessive risk-taking in which financial managers got to keep high returns made one year, even if those returns were more than offset by losses the next. Behind the subprime crisis were mortgages designed to encourage repeated refinancing of homes–a pyramid scheme that generated billions of dollars in fees for the mortgage company as long as home prices continued to soar. It was inevitable that the bubble would break. But, by then, the profits that had been pocketed would make these financial wizards secure for life–or, at least, that was their hope.

To put it another way, had those in the financial sector allocated capital and risk in a way that fueled the economy, they would have had handsome profits. But they wanted more, and so established incentive structures that encouraged gambling. If they gambled and won, they could walk away with a share of the profits. If they gambled and lost, the investors would bear the consequences. It was almost as if the entire financial system was converted into a giant casino in which the system was rigged to guarantee those running the games huge returns, at the expense of the players. But in Las Vegas and Atlantic City, the games are near zero-sum: The gains of the casino owners approximately equal the losses of the players. The financial-system-as-casino, on the other hand, is a negative-sum game. Those on Wall Street may have walked off with billions, but those billions are dwarfed by the costs to be paid by the rest of us. Some have lost their homes and life savings–to say nothing of their dreams for their own futures and those of their children. Others are innocent bystanders who resisted the false promises of the mortgage brokers and the credit card companies, but now find themselves out of jobs as the economy weakens. And the poor are hurt as state revenues plummet, forcing cutbacks in public services.

The current woes in America’s financial system are not an isolated accident–a rare, once-in-a-century event. Indeed, there have been more than one hundred financial crises worldwide in the last 30 years or so. Here in the United States alone, we have had the S&L crisis in 1989, the dot-com/WorldCom/Enron problems of the early years of this decade, and now the subprime-morphing-into-the-beyond-subprime collapse. In addition to these national problems, there were regional troubles–real-estate crises fed by excessive lending in Texas and the Southwest in the mid-’80s, and in California and New England in the early ’90s. In each of these instances, financial markets failed to do what they were supposed to do in allocating capital and managing risk. In the late ’90s, for instance, so much capital was allocated to fiber optics that, by the time of the crash, it was estimated that 97 percent of fiber optics had seen no light.

In short, the problem with the U.S. economy is not that we have allocated too many resources to the “soft” areas and too few to the “hard.” It is not necessarily that we have allocated too many resources to the financial sector and rewarded it too generously–though a strong argument could be put forward to that effect. It is that too little effort was devoted to managing real risks that are important–enabling ordinary Americans to stay in their homes in the face of economic vicissitudes–and that too much effort went into creating financial products that enhanced risk. Too much energy has been spent trying to make an easy buck; too much effort has been devoted to increasing profits and not enough to increasing real wealth, whether that wealth comes from manufacturing or new ideas. We have learned a painful lesson, both in the 1930s and today: The invisible hand often seems invisible because it’s not there. At best, it’s more than a little palsied. At worst, the pursuit of self-interest–corporate greed–can lead to the kind of predicament confronting the country today.

Joseph Stiglitz is University Professor at Columbia University, winner of the 2001 Nobel Memorial Prize in Economics, and co-author of The Three Trillion Dollar War.