Thesis: Borrowers should think about their mortgages as contracts allocating risk, and realize that they expressly pay higher interest rates in exchange for the possibility that they may default on their mortgages.

• Mortgages are contracts
  • Banks agree to lend money to borrowers.
  • Borrowers agree to pay back loans plus interest.
  • Damages - if a borrower breaches the contract, the bank is allowed to take possession of the security.
• Allocations of risk
  • Lender’s risk:
    • If the borrower breaches the contract, the bank risks losing money. Whether the bank loses money depends on the remaining borrower obligations under the mortgage, the costs of foreclosure, the costs of resale, and the amount received upon resale.
  • Borrower’s risk:
    • If the borrower cannot or does not pay the mortgage and the bank is able to foreclose on the property, the borrower loses equity built in the home, if any.
• Banks assess risk differently for different borrowers, loans, and securities.
  • Different rates are charged to different borrowers - lenders realize that some borrowers are more likely to default.
    • FICO, credit history, occupation, DTI
  • Different rates are charged for different loans - lenders realize that borrowers are more likely to default on loans with certain characteristics.
    • LTV, 2nd Mortgages, ARM Schedule, loan size, Interest Only, loans for Non-owner occupied homes.
  • Different rates are charged for different homes - lenders realize that some homes are more or less likely to appreciate or depreciate in value, and that borrowers are therefore more or less likely to default.
    • Geographic location, type of home (SFR/Condo/3-4 Unit/Rural/etc.), accuracy of appraisal
  • Banks have the option of lending without risk, e.g. T-bonds, but they would get lower rates in exchange.
• Conclusion
  • Banks expressly consider how a given borrower, loan, and security affect the possibility of default; that affects the benefit required in exchange (i.e. the rate).
  • Borrowers pay more or less and banks receive more or less based on the bank’s assessment of these risks.
  • Where a borrower has an absolute obligation to pay, the bank is insulated from risk; the mortgage is a pre-defined security and income stream. That would mean borrowers pay additional rates and the banks receive additional rates without a corresponding exchange in the benefit/risk.
  • A borrower who chooses to default is exercising a right that was reserved in exchange for benefits given to the lender.

-- DanKarmel - 11 Jul 2010

Here are my edits. This webpage is beginning to look ugly though. I'll leave it to your discretion if you want to edit it to just show the most recent edition. -- MarkBierdz - 7 July 2010

Altercasting The Homeowner

-- By DanKarmel - 11 Apr 2010

The Collapse

When we discussed the collapse of the mortgage industry in class, Eben solicited suggestions for what had gone wrong. One person stated that the problem was the widespread societal assumption that home prices would never stop appreciating. At some level, this was correct. With few exceptions, home prices had grown steadily for generations. Borrowers were willing to accept adjustable-rate mortgage loans because they were confident that by the time the rates on their mortgages were due to adjust, they would have almost certainly generated wealth in their homes simply by living in them, and they could then refinance their mortgages before the more onerous rates kicked in.

However, as Eben pointed out, this was only part of the story, since lenders and investors made similarly poor decisions. The issue isn’t why most laypeople thought real estate values would never depreciate, but rather why so many supposed economic and financial experts thought so. First of all, not all of them did. Yet some of the legitimately most qualified minds in finance actually bought into the hype. Personally, I recall a friend who received a Finance degree from Wharton telling me how her professor used to sing the praises of the subprime securitization invention – it had made the dream of home ownership possible for millions of people, and all the while at very little risk.

This section is labeled the collapse and it appears to be an attempt to briefly explain the collapse. You say “at some level, this was correct” in the first paragraph combined with the line “the issue isn't isn't why X but rather why so many supposed economic and financial experts thought so” (emphasis added). I want to say two things about this. Is this the issue of your paper? If it's not not, which I believe is the case, then this line is really confusing. The other thing I want to say, is that this seems like your attempt at explaining in part the causality of the collapse. Home-owners had to buy into the myth that prices would always go up, but financial experts apparently also had to be making some mistakes on their end. That's logically sound for now but see my comments at the end.

Hot Potato

The critical element uniting all the players, whether they believed that real estate was never going to die, or whether they were prepared to make billions pushing it over, was that no one bore the risks for their bad investments (can this really be the critical element if it's not actually true? Your last line in this paragraph contradicts your first statement). Mortgage lenders originated the loans and would generally sell them in huge pools to investors within weeks, sometimes days. The loans were then passed along and cut up through various entities, all the way up to the government-sponsored Fannie Mae and Freddie Mac. At both the front and the back, the ones usually left holding the bag were the original borrowers and the government-sponsored corporations.

Even the major credit rating agencies, like Moody’s and Standard and Poor’s, the entities most in need of a proper perspective on risk, were paid by the banks issuing the securities they were rating, and similarly created risks for which they were in no way accountable. It would be as if “Hollywood studios paid movie critics to review their would-be blockbusters." So to answer the question of why some of the best minds in finance didn't figure out that they were building a house of cards - they had no incentive to.

See Zorn's comment for this paragraph. I have nothing more to add to it for now.

After The Sale

Why aren't individual borrowers allowed to play the game too?(What's the game these not clearly identified others have been playing?) Instead, they are the ones being called upon to make good on moral obligations somehow being read into the contracts. The altercasting mechanism identified by Leff in Swindling & Selling may help explain the way that borrowers act after the sale, especially when their mortgages are underwater. (It is only at the end of your piece that you bring up the altercasting mechanim. If this piece was really going to be about altercasting, you should've have tried to put it in the beginning. It's apparence here is awkward; your previous two sections could've transitioned to many different places and it is not clear why it has transitioned here.)

For one, we call the borrower a “homeowner.” Of course, there’s a difference between that and owning your home free and clear. Yet the mortgage industry wants you to be a homeowner right away, regardless of what sticks you get in that bundle - because why would a homeowner walk away from the home he owns?(This simplifies the various reasons a person may not walk away from an underwater home. You also make the naming of “homeowner” sound like a conscious choice of the mortgage industry. Maybe it is, but you haven't established this.) Additionally, the deal itself is being burdened with all sorts of extraneous notions. In The Path of the Law, Holmes wrote that “[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it and nothing else.” (I feel like the Holmes quote here is just fluff to please Moglen. It has its purpose, but it's more pretentious than useful.) When you take a mortgage, you borrow money in exchange for a promise to either pay it back or forfeit the security. Although borrowers are aware that they were making an exchange, as opposed to getting a gift, they are mistaken as to the exact nature of that exchange. If they understand that the mortgage crisis is a result of a misalignment of incentives and risk, then perhaps they can look at their own contracts, which are allocations of risk, and more accurately understand what part of that risk they bargained for, if any.

I think Zorn has some interesting comments here but I'm not going to respond to them yet as I think it's too distracting for the moment. I want to get this essay on track, so that you can walk away with a decent rewrite. If you later incorporate some of his comments in your paper, then we can go down that road.

Here are my comments: One section doesn't lead into another. They connect, as in, it's not the case that one moment you are talking about the diet of giraffes and the next moment the valuable speculation that is occurring in the moon real estate market. But their connection is superficial, and one section doesn't lead into another. I think (and correct me if I'm wrong) the real goal of this piece is to get people to think about their mortgages differently, as allocations of risk in a situation where allocations of risk were fucked up. You should lead with that point and use the rest of your 1000 words to support that. I understand that this style of writing I'm recommending is very standard, but I think it fits best for what you're trying to do. Otherwise, it's not clear the path this paper is walking and it reaches its conclusion haphazardly and almost randomly.

You are over-simplifying. It appears that you are trying to explain the financial crises as mainly a misallocation of risk-based incentives. In no where does your paper justify that that is mainly what happened. I use the word mainly here because it appears that 2/3s of the paper are about explaining that situation so that you can move to your third point. I think summing up the that various casual factors of the financial collapse in less than a 1000 words is silly. There are a myriad of casual factors for why anything happens, let alone something as complex as the mortgage collapse. Certainly, you can frame the misallocation of risk-based incentives as a significant casual factor – a casual factor that warrants a change in behavior or a serious looking-at. But you need to watch your language so that you are not trying to simplify the whole story.

Your conclusion, if taken seriously, basically nullifies the importance of the previous two sections. Who cares why my mortgage went underwater if I can be better off in walking away from it? I would not ask any moral questions. I wouldn't feel more or less justified in walking away if I knew the people making these loans and their whole industry was a bunch of inbred fuck-bags. I would just walk away.

Suggestions: I think this piece needs a big rewrite. I don't want to tell you about what to write, but this topic sort of dead-ends itself. Zorn has a lot of interesting comments; maybe you can take-up some of what he has said and elaborate more on it. You might even be somehow able to tie it in with what you've talked about.

If you want to bring in Leff, you could try comparing the mortgage crises to a ponzai scheme. Then you may have something interesting to say about gray boxes and black boxes intersecting with Zorn's idea of a regulatory hands-off policy and your idea of consumers perceiving risk-imbalances and acting accordingly. That's just a suggestion. My main suggestion is that this paper needs to say something else.

It's harsh; I know, but that's my honest feedback. If you want to continue with your thesis, let me know, and I can try to help you elaborate and polish it. Otherwise, I think the best advice I can give is go in a different direction.

I know this is a lot to ask, but does anyone out there feel like doing a rewrite on this paper so I can do my rewrite? -- DanKarmel - 22 Jun 2010

Mark, See if you can work with this version. I left your comments since I don't know if you've read my responses yet. -- DanKarmel - 10 Jun 2010

Link fixed. -- MatthewZorn - 24 Jun 2010

Altercasting The Homeowner

-- By DanKarmel - 11 Apr 2010

The Collapse

When we discussed the collapse of the mortgage industry in class, Eben solicited suggestions for what had gone wrong. One person stated that the problem was the widespread societal assumption that home prices would never stop appreciating. At some level, this was correct. With few exceptions, home prices had grown steadily for generations. Borrowers were willing to accept adjustable-rate mortgage loans because they were confident that by the time the rates on their mortgages were due to adjust, they would have almost certainly generated wealth in their homes simply by living in them, and they could then refinance their mortgages before the more onerous rates kicked in.

However, as Eben pointed out, this was only part of the story, since lenders and investors made similarly poor decisions. The issue isn’t why most laypeople thought real estate values would never depreciate, but rather why so many supposed economic and financial experts thought so. First of all, not all of them did. Yet some of the legitimately most qualified minds in finance actually bought into the hype. Personally, I recall a friend who received a Finance degree from Wharton telling me how her professor used to sing the praises of the subprime securitization invention – it had made the dream of home ownership possible for millions of people, and all the while at very little risk.

Hot Potato

The critical element uniting all the players, whether they believed that real estate was never going to die, or whether they were prepared to make billions pushing it over, was that no one bore the risks for their bad investments. Mortgage lenders originated the loans and would generally sell them in huge pools to investors within weeks, sometimes days. The loans were then passed along and cut up through various entities, all the way up to the government-sponsored Fannie Mae and Freddie Mac. At both the front and the back, the ones usually left holding the bag were the original borrowers and the government-sponsored corporations.

I'm no housing-bubble-2008-collapse-expert, but this seems to be a trivial and probably incorrect recollection of what exactly went on and why everyone was tied together. First, this paragraph seems to suggest something contrary to your statement “no one bore the risks.” Indeed, if the catalyst for the crisis was the vaccuum in the demand for housing created by changing population demographics (as I believe), then the reason for the catastrophe was that the housing industry connected itself to everything. To borrow Matt Taibbi's metaphor, the housing market seemed to have its tentacles on everything. Indeed, the problem is not that “nobody bore the risks” but rather that everyone bore the risks, thanks to junk mortgages tied to junk CDOs tied to insurance policies tied to just about everything. Therein lies the problem—too many people bore opaque risks they didn't understand and the only people who did understand them shrugged them off onto other people.

Even the major credit rating agencies, like Moody’s and Standard and Poor’s, the entities most in need of a proper perspective on risk, were paid by the banks issuing the securities they were rating, and similarly created risks for which they were in no way accountable. It would be as if “Hollywood studios paid movie critics to review their would-be blockbusters." So to answer the question of why some of the best minds in finance didn't figure out that they were building a house of cards - they had no incentive to.

This is one way of looking at it. The other equally plausible way of seeing it is sheer ignorance. Or smart people do stupid things. Or maybe they knew exactly what was going on and just thought they could get out in time and missed the last boat. I think what you mention is certainly a problem—but it does not answer the question--at least not sufficiently here.

After The Sale

Why aren't individual borrowers allowed to play the game too? Instead, they are the ones being called upon to make good on moral obligations somehow being read into the contracts. The altercasting mechanism identified by Leff in Swindling & Selling may help explain the way that borrowers act after the sale, especially when their mortgages are underwater.

For one, we call the borrower a “homeowner.” Of course, there’s a difference between that and owning your home free and clear. Yet the mortgage industry wants you to be a homeowner right away, regardless of what sticks you get in that bundle - because why would a homeowner walk away from the home he owns? Additionally, the deal itself is being burdened with all sorts of extraneous notions. In The Path of the Law, Holmes wrote that “[t]he duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it and nothing else.” When you take a mortgage, you borrow money in exchange for a promise to either pay it back or forfeit the security. Although borrowers are aware that they were making an exchange, as opposed to getting a gift, they are mistaken as to the exact nature of that exchange. If they understand that the mortgage crisis is a result of a misalignment of incentives and risk, then perhaps they can look at their own contracts, which are allocations of risk, and more accurately understand what part of that risk they bargained for, if any.

I'm sort of confused about the conclusion here. Maybe the solution is just to tell people walk away. I think there is a valuable insight here—if we recast the situation to the “homeowner” as one of a failed bet, we might be able to convince people to walk away from failed mortgages. Obviously this cannot happen for a number of political and psychological reasons. But the problem isn't a misalignment of incentives and risk, it is a problem of information asymmetry. In the transaction chain that you have identified, mainly, homeowner → lender → bank A → big bank B → AIG → other banks, there seems to be one or two groups that are able to peek at the cards of all the other groups. If all of the groups had access to the same information, many of these transactions never occur and homeowners, when their bets fail, simply walk away. (This information assymetry is not really unique to the mortgage crisis but occurs in the stock market too. )

One thing I have thought about recently is that if the problem is information assymetry then a possible solution is not less opaqueness but more opaqueness. We seem to think that the SEC, FTC, etc. are doing their jobs. We seem to think that the stock market is regulated. We seem to think that there is no insider trading. But I think that we might be wrong, especially on the insider trading. And, again, the problem isn't the insider trading itself, but that there is a select group of people who can get away with it at higher frequencies than other groups. Thus, the problem is the whole incestuous regulatory system itself. If we just did away with all of it, allowed insider trading and opaqueness, maybe people would do their due diligence before taking on risk. Sure, mortgage rates are higher and loans become more expensive in order to insulate against unknown risk. But, the “open information” that accompanies things like mandatory financial statements and whatnot seems to do more harm than good. We ignore the risks of shoddy accounting because we thing regulation is competent.

Hi Dan, I'm just going to read back a bare-bone outline of your essay. I'm not even sure what it's about, so maybe if I give you a simple reiteration of my understanding, you can see if you expressed yourself clearly.

So my take on what you said is that I don't know really what you're saying. Your essay is scattered and doesn't really finish its thoughts. I don't understand what you are trying to say. My suggestion is that you pick a thread of thought in your essay and develop it more thoroughly. Your essay needs a big-time rewrite though. Rewrite it when you get the time, and I'll do a more substantial edit. I think at this point your thoughts are too incomplete for me to really add anything of value.

*Why exactly did home prices depreciate? I realize this is not the point or focus of your essay and maybe I would not waste too much time with this. But, I personally think it might have something to do with this. Also see an article titled "The baby boom, the baby bust, and the housing market" (written in 1989)! In other words, the evidence and research was done and available. In fact, I'd suggest using population demographics to analyze supply/demand is rather elementary. I think there must be some significant cognitive defects in the minds of everyone involved to ignore such an obvious red flag. I hope some other people can swoop in and help edit--no need to stick to the formal rules of the assignment. -- MatthewZorn - 23 Jun 2010

Matt, thanks a lot for the feedback. Do you have another link though? The one above is taking me to an error page. -- DanKarmel - 23 Jun 2010

You are entitled to restrict access to your paper if you want to. But we all derive immense benefit from reading one another's work, and I hope you won't feel the need unless the subject matter is personal and its disclosure would be harmful or undesirable.

To restrict access to your paper simply delete the "#" on the next line:

# * Set ALLOWTOPICVIEW = TWikiAdminGroup, DanKarmel

Note: TWiki has strict formatting rules. Make sure you preserve the three spaces, asterisk, and extra space at the beginning of that line. If you wish to give access to any other users simply add them to the comma separated list