Subprime Solutions
by Christopher D. Carroll
Professor of Economics
Johns Hopkins University
February 1, 2008

I recently posted a comment on Martin Wolf’s excellent January 30 column in the Financial Times on the Fed’s rate cuts. Though some skeptics have warned of inflationary risks, my view was that that the sharp drop in rates is a prudent response to the unfolding housing market/subprime mess.

One unsatisfying aspect of that whole discussion was that monetary and fiscal policy are blunt instruments for dealing with the kinds of credit market problems that are one of the most troublesome aspects of the current situation. Here, I try to provide a more integrated picture.1

1 A Two Part Diagnosis

1.1 The Housing Wealth Effect

Some of the present economic anxiety reflects an expectation that, whether or not they have mortgages, worried consumers will tighten their belts in response to the decline in their home values.

The bitter truth is that average home values are not likely to return to their bubble-era peaks anytime soon (though the time to recovery will vary widely by location). If exuberant consumer spending over the past few years was based on unrealistic home valuations, there is no way of avoiding an eventual return to earth. (This is just the flip side of the oft-repeated point that the national saving rate in the U.S. is unsustainably low.)

If the downward adjustment in spending turns out to be as gradual and diffuse as the boom, there is probably little that economic policy either can or should do to impede the process; the new reality must eventually seep into consumers’ spending choices.

But this ‘gradual adjustment’ scenario is not really what financial markets and policymakers seem to worry about when the housing wealth effect is discussed. The worry is that there will be a sharp dropoff in consumer spending and business investment; if this happens too rapidly, the economy’s normal adjustment mechanisms will not have time to operate and we could suffer an unnecessary and painful recession.

While ex post it is clear that the Fed (along with most financial market analysts) underestimated the size of the looming housing market adjustment, traditional cyclical tools (including both Fed rate cuts and the economic stimulus package now under consideration in Congress) seem reasonably well suited to the task of preventing a calamitous decline in spending; see my FT comment for a more nuanced case (or the recent piece by Larry Summers).

But the wild gyrations of the stock market over the past 6 months, along with remarkable increases in bond risk spreads, seem to be signaling fears of a substantially deeper problem.

1.2 The Mortgage Mess

The root of the spreading credit markets problems is that, to borrow a phrase from the movie industry, “nobody knows anything.”

In Hollywood this phrase is shorthand for the fact that even industry veterans find it impossible to predict the fortunes of a project before the box office speaks. Credit markets are supposed to be different: Loans are made in the expectation that, for borrowers with any given credit score, a predictable percentage of them will go bad, and the rest will be faithfully repaid. Any individual mortgage default is a tragedy, but the proportion of defaults is a statistic. So similar mortgages can be bundled together into a security, turning mortgage brokers and loan officers into ciphers between semi-anonymous financial markets and semi-anonymous borrowers, with each side benefiting from the increased efficiencies.

Or at least, that was the idea. And over the broad sweep of time, it’s an idea that has worked remarkably well. Thanks to the miracle of securitization, local risks can be shared nationally (and globally); credit is now available to many people who would never have gotten to know the Jimmy Stewart of “A Wonderful Life” (especially members of minority groups and people with imperfect credit records); and a much wider variety of borrowing options make a far better match to many consumers’ needs than the venerable one-size-fits-all 30 year fixed rate mortgage.

But in the reorganization of the mortgage industry, it seems that a crucial link has been broken. Nobody in the new system is really accountable for making the kind of common-sense judgments that were the bread and butter of loan officers back in the bad old days when Jimmy Stewart ran the local savings and loan.

If a borrower tells a broker that her income is $100,000 when it’s really $75,000, who has the incentive to ferret out the truth? If an appraiser swears that a home is worth $500,000 when its cookie-cutter neighbors have recently sold for $400,000, how could the Australian city council that funded that mortgage possibly know any better? And if a broker tells a borrower that a complex new mortgage is a “great deal,” how can someone without a degree in accounting and another in law be reasonably expected to wade through the 2-inch-thick stack of legalese that obscures most mortgages today and conclude differently?

As in many other spheres of life, the options have gotten so complex that even experts can have trouble figuring them out.2 This is a situation that is ripe for abuse, and it is clear that such abuse has been widespread (though exactly how widespread is unclear; it is to be hoped that the recently announced FBI probes will help answer that question).

What “nobody knows,” for many of the loans made in the last two years, is what the mix is of rotten and sound loans – a problem made much worse by the fact that with declining housing prices, some loans that would otherwise have been sound will inevitably go bad.

2 What Not To Do

Whatever the breakdown may be between honest errors, dishonest errors, sleazy marketing, and fraud, it is clear that a lot of loans have been made that will never be repaid. Despite the FBI’s belated probes (where were they 2 years ago?), the problem is far too massive, the responsibility far too diffuse, and the situation far too ambiguous for criminal prosecution to clear up more than a tiny proportion of the problem.

Unfortunately, policymakers’ first instinct seems to be to try to force the markets to freeze in place before everything gets worse. The Bush Administration announced a “voluntary” plan under which issuers of adjustable rate mortgages would agree to freeze those rates for a time (although shareholders of the financial institutions named in the agreement immediately threatened to sue their boards if they complied, and one presumes that if a “voluntary” plan reflected the best interests of the financial firms they would do it anyway).

This was a terrible start to the discussion, because the easy way for Presidential candidates and members of Congress to up the ante and make Bush look bad was to make his “voluntary freeze” mandatory and increase the time period for the freeze – which several of them promptly proposed doing.

Freezing the disaster in place is just about the worst option imaginable. The only real way this problem will be resolved reasonably quickly, and at the lowest cost, is if the bad loans are renegotiated, the good loans are sold off, and markets regain confidence in the their ability to judge the risks associated with any given package of loans. A government-mandated one-size-fits all solution will prevent exactly the kind of information flow that is vital to repairing the situation.

As my FT piece argues, this is not just theory – Japan’s disastrous policies of the 1990s reflected precisely the same instinct to try to avoid the consequences of a bubble gone bad by pressuring lenders not to ask their problem bubble-era corporate borrowers to repay. Motivated by a misplaced concern to help the CEO’s of the doomed borrowers save face, this failure to bite the bullet probably cost Japan hundreds of billions of dollars, compared to the outcome that could have been achieved if policymakers had not put tremendous pressure on lenders to excercise such forbearance.

3 What to Do

It is easier to diagnose the problem than to prescribe how to fix it. Any eventual fix will need to include a much more aggressive system for detecting and punishing outright fraud and “predatory lending,” which surely occurred and will surely crop up again. But a system in which major players have the wrong incentives cannot be shored up indefinitely by the threat of prosecution. Eventually the system must be redesigned so that all the players have the right incentives.

An obvious starting point would be to try to impose more accountability on mortgage brokers and loan officers who orginate the loans that go bad. A well designed system would keep public track of the individual history of mortgages approved by each loan officer or broker, and that information would be a part of the public record of the mortgage. A broker or loan officer whose loans regularly went bad would rapidly become unemployable, because the any pool of mortgages that contained more than a few of his loans would be tainted and securities markets would not touch it with a ten foot pole.

But a better long-term solution might be to encourage the development of a new kind of player in the mortgage market: a “third party verifier” whose job would simply be to make sure the the borrower had a basic grasp of the nature of the loan she was agreeing to.3 Because this idea is easily misunderstood, let me make clear that the purpose is essentially the same as the one that that 2-inch stack of legal documents was originally supposed to accomplish: Clarity for both sides about what the fundamental deal is. (The legal documents have become extensive and impenetrable because they no longer exist to protect the borrower but to protect the lender.)

The simplest example of how a 3PV could fulfill his role would be simply to produce an audio recording in which the buyer makes a statement, in his or her own words, of what payments the loan would require them to make, and when. This would be easier for a fixed rate mortgage than for an adjustable one, and for some borrowers than for others, but industry-standard practices would rapidly emerge. And if the borrower cannot articulate what they are committing themselves to, it seems clear that they do not understand it.

To be clear, the 3PV’s would not be government employees – they would be a private service provider, like the title company or the borrower’s lawyer. The chief requirement would be financial independence from the lender, enforceable by law and by delisting from the profession. Entry should be open to anyone: The role could be played by personal finance experts, lawyers, former mortgage brokers, or anyone else who can gain the confidence of a borrower and a lender in this role. Every mortgage verified by a 3PV would record that 3PV’s unique ID, and (as with the example of brokers above) a 3PV would have a strong incentive to make sure that borrowers knew what they were getting into, because a 3PV whose verified loans regularly went bad (something that should, ideally, be Googleable) would not find many takers for his services on either side of the bargain.

How to encourage the development of this profession is a difficult issue. Mortgage rules vary widely from state to state, and Congress is not competent to design the rules. Perhaps the best route would be to make any future expansions of Freddie Mae, Fannie Mac, and the other GSE’s contingent on their developing and implementing a 3PV program.

Ultimately, the resolution of the subprime lending mess will require some mechanism for increasing the transparency and accountability of the lending process, and in particular some mechanism that binds together the long-term interests of the supplier of funds, the broker of funds, and the borrower of funds better than the system we have now. I would guess that whatever emerges will have some of the characteristics of the 3PV mechanism proposed above, whether or not the details are the same.