PrefBlog

I have great respect for Alan Blinder, a former Vice Chairman of the Board of Governors of the Federal Reserve System, but his recent op-ed in the New York Times is not the type of thing of which reputations are made.

As enumerated by James Hamilton of Econbrowser, Blinder finds six sources of fault leading to the current liquidity crunch:

(1) home buyers who took on mortgages they couldn’t repay; (2) mortgage originators, for issuing same; (3) bank regulators, who didn’t have the inclination or authority to monitor this closely enough; (4) the investors who ultimately provided the funds for the mortgages, and (5) securitization, which led to assets that are “too complex for anyone’s good”. Running out of fingers on one hand, Blinder brings out the dreaded economist’s other hand for (6) ratings agencies which underestimated the risk.

JDH made my day by suggesting – as he suggested at the Jackson Hole conference,  reported here on September 4  – that the key to understanding is point (4) and:

As for (6), the ratings agencies are only offering investment advice– I see the person who puts up the money as the one who unambiguously must take responsibility for the decision. And how exactly are regulators in a better position to tell an investor that he or she is making a stupid investment, if that is indeed the core problem?

Hurrah!

But, back to Blinder:

Here, something can be done. For openers, we need to think about devising a “suitability standard” for everyone who sells mortgage products. Under current law, a stockbroker who persuades Granny to use her last $5,000 to buy a speculative stock on margin is in legal peril because the investment is “unsuitable” for her (though perfectly suitable for Warren Buffett). Knowing that, the broker usually doesn’t do it.

But who will create and enforce such a standard for mortgages? Roughly half of recent subprime mortgages originated in mortgage companies that were not part of any bank, and thus stood outside the federal regulatory system. That was trouble waiting for a time and a place to happen. We should place all mortgage lenders under federal regulation.

There definitely needs to be more argument here before this idea is worthy even of consideration. What Blinder is suggesting is that mortgage lenders be deemed to have some kind of fiduciary duty to mortgage borrowers. I don’t see how such a thing could possibly work.

When I go to a bank and mortgage my house, I’m dealing with them as principal. It is accepted as a given that they are going to try and skin me … it’s my job to avoid being skinned. I can bluster, I can swear, I can threaten to walk, I can offer more business … it’s all part of the negotiation game. They can do the same thing.

If the mortgage lender has a fiduciary relationship with me, who exactly is doing the negotiating? Is it the teller who has fiduciary responsibility and is negotiating with the credit department on my behalf? Or does the credit department have that responsibility? What if I don’t want somebody negotiating for me – and charging a fee for their efforts? Will I be allowed to take responsibility for my own actions, and do the equivalent of stock-trading through a discount broker, in which the discount brokers fiduciary duty is strictly limited to order transmission and takes no responsibility for advice?

Predatory lending has been discussed before and I don’t have any big problems with some regulations that say “Thou shalt not … “. I have much bigger problems with the concept of mandatory fiduciary relationships – which is essentially what Blinder is suggesting. Encourage the mortgage brokerage business by all means; let clients hire somebody to negotiate for them and get the lowest rate – or advice against the entire idea of mortgaging – if that’s what they want. But his idea consists, essentially, of making it mandatory to give a mortgage broker a slice of the transaction – a costly and patronizing stance.

The other vague suggestion I take exception to is:

Under the current system, the rating agencies are hired and paid by the issuers of the very securities they rate — which creates an obvious potential conflict of interest. If I proposed that students pay me directly for grading their work, my dean would be outraged. Yet that’s exactly how securities are rated. This needs to change, but precisely how is not clear.

Well … this has been discussed at length, notably by S&P in their Senate testimony. We’ve tried ‘Subscriber Pays’ … it doesn’t work very well. Since – as noted by Econbrowser – the Credit Rating Agencies are giving advice only, and have no fiduciary responsibility to the lender, the problem is, as stated in Professor Coffee’s Senate Testimony is that credit ratings have achieved regulatory status and thus amount to a license for portfolio managers to buy such-and-such a security.

To which I have to say: don’t make such a license so important; not unless the licensor wants to pay for it themselves, anyway, which amounts to nationalization of the Credit Rating Agencies, a solution with a brand new set of problems. Simply enforce the Prudent Man Rule for those who have a fiduciary responsibility for the investments.

It’s a messy solution … but life’s messy.

Note: In my comments on Econbrowser, I mentioned bank perps and other Great New Ideas that have come to grief through having a class of target investors that was far too homogeneous. I have discussed this concept before, in Sub-Prime! An Idea for a Master’s Thesis.