Is it Moral to Knowingly Send Borrowers into Default?

I have a question. Suppose you are a mortgage loan officer, and you have been assigned to the subprime loan division.

You look through the statistics and find that, using your firm's criteria, if you loan to people who are subprime 15% are going to have serious troubles and default, but 85% will not. Fortunately, even with a 15% default rate, with the interest rate you are charging on these loans, the loans are still profitable to the firm (but wouldn't be if the default rate went up, but we'll hold the default rate constant for this exercise). If you could sort people into those who will default and those who won't you would, but a priori, given the information at your disposal, there's no way to do that.

So here's the situation. If you make the loans - which is profitable for both you and the firm since you are on commission - you will be sending 15% of your customers into a troubled situation, but 85% will do just fine.

If we take an asymmetrical information approach, as is common, i.e. that borrowers know more about their ability to repay then lenders, then some of these loans that go into default are due to borrowers knowingly getting in over their heads. But that won't be true in every case, perhaps not even in most cases, so there are quite a few loan customers who will find themselves, unexpectedly, in serious trouble.

Should you feel guilty about making these loans? Is it ethical to make them at all, i.e. to knowingly send 15% of your customers into foreclosure (even though you don't know for sure who it will be)? It's hard to imagine the government allowing any other product to be sold that would, upon bringing it home, cause serious difficulty in the lives of 15% of the customers, so why is this different? If you think it's okay to make these loans, would your answer change if, say, the chances of repaying/defaulting were 50-50 or worse? Is it okay no matter the default rate so long as it's profitable? I have a feeling that different answers to this question explain a lot about who we think ought to be held accountable for the subprime mess.

I would make the loans even though 15% of them would cause people trouble. So long as the loans remains profitable, and they are not sold fraudulently so that people enter willingly and with full knowledge of the probability of default, I would accept an even higher default rate. Does that make me a bad person? I get the feeling some people think loan officers should only make loans when there is a very high probability of repayment - near 100% - but I can't agree with that as it would prevent an awful lot of people from purchasing a home. But it does seem like as the default rate increases, there comes a point when the default rate is sufficiently high so as to make one wonder about the morality of making the loans even if they remain profitable.  If two-thirds of my customers would be completely ruined from purchasing my product, I might wonder about that. So why is 15% okay? Is it because the 85% of the customers who benefit more than compensate for the 15% who do not? That's my answer.

What do you think? [Update: Mostly, so far, you think I missed the boat, in particular that the real question is the morality of steering people into loans that are more profitable for the firm, but are not as good for the borrower, something that relies on asymmetric information, but here it's the lender who has superior information about loan products, loan risks, and eligibility (is this like steering a customer to purchase a sports car that is more profitable for the firm even though another, safer, lower monthly payment model fits the customer better, or is it fundamentally different?).]

Comments

[Bill]

I'm going to have to agree. It's like many things in life where we tolerate losses because the gain to society is greater than the losses. Why should the 85 percent of the people who repay not be able to obtain financing because 15 percent of the people are not able to repay? It's not like the bank can single out those who will eventually not be able to repay. If they could, they probably wouldn't make the loans. Since the banks cannot separate good borrowers from the bad borrowers and since the gains are rather large relative the the losers, I'd say that the banks should continue to make the loans. It isn't unethical at all in my opinion. It "feels" unethical to me but like many things in economics I've found, the feeling doesn't stand up to logic.

[Dormilon]

"It's hard to imagine the government allowing any other product to be sold that would, upon bringing it home, cause serious difficulty in the lives of 15% of the customers..."

Really? Your imagination must have strict limitations. Have you considered images of alcoholic beverages (what percent of those "bringing it home" have abuse problems?), tabacco, motor vehicles (knowing that, at worst, more than 40,000 customers will perish from operating the product YOU sold them), credit cards or snowboards (indeed, no skills test requires their purchase, how many will injure themselves later on?).

In short, your concern has everything to do with the ability of underwriting to protect a financial or mortgage-lending institutions from the risk of foreclosure. Ideally these folks are better regulated and motivated to reduce this risk in a way that balances Type I and Type II errors. Obviously, underwriting standards were allowed some (excessive) leeway as home price appreciation protected many homebuyers from getting in over their heads. Those days are over.

Now those same home buyers should be forced to swallow the same jagged pill as those who saw underwriting requirements as a mere nuisance toward home ownership and a direct shortcut to the American dream.

[Alex Tolley]

"If two-thirds of my customers would be completely ruined from purchasing my product, I might wonder about that"

Clearly we have to weigh the benefits to borrowers as well as the defaults. If the net effect is bad, then this is clearly unethical.

However, the creditworthiness of a borrower is not a binary state. Some borrowers could quite possibly be categorized as high risk, i.e. high probability of default. In that case, the loan agent is making a decision to lend even though the probable outcome for the individual is bad. That would be unethical (applying a "first do no harm" ethic).

Ideally the profit on the loan should be tied to the risk of default, thus acting as a brake on bad lending. It was the separation of this connection that led to over-lending and what is likely to be cases of unethical behavior.

[anne]

http://delong.typepad.com/sdj/2007/12/riverside-count.html

December 5, 2007

Riverside County, California on $1.70 a Day
By Brad DeLong

" 'The risk is that you could be modifying loans for people who don’t need it,' said Sharon Greenberg, director of mortgage strategy at Barclay’s. 'There’s only so much you can do without talking to the borrower. You’re spending $60 a month on cable TV; can you get by with less? You’re spending $200 a month on food for two people, but food costs in your area show that you should be able to get by with $100 a month. These are the kinds of conversations that loan-servicing companies have to have with borrowers.' "

Food costs in your area show that when there are no crawdads, you should be able to eat sand. No refinancing for you, Mr. Moneypants McRichington!!

[anne]

There is a problem that is being continually overlooked, but has been studied and written about repeatedly; much of subprime lending was discriminatory. Much of the lending wnet to African Americans and Latinos who would otherwise have been able to gain regular rate loans. Why are we failing to understand this disciminatory nature of subprime lending that the New Yrok Times was writing about from 1999?

When I pitch a high cost mortgage to an African American woman who could otherwise qualify for a low cost mortgage, I am not thinking there is an 85% she will be able to pay the mortgage. I am taking advantage of an African American woman.

[Winston]

Access to credit is a wonderful thing, especially if you are temporarily poor (either because you haven't had time to build up assets or you've had them destroyed through accident or illness). For the 85%, being able to borrow money makes their lives significantly better. It may even be a better option for the 15% who eventually default. They are at least able to use credit to postpone the pain of whatever is causing their non-payment. I would even say that if the case is that 2/3 of the borrowers would default, it might be better to allow them that choice because they might not be worse off with the loan than they were without it.

An example of the good and bad of lending to marginal borrowers is payday lending, which on the downside can trap people in an endless cycle of debt, but on the upside can allow people the ability to eat or not be evicted, both of which are also valuable.

[jck]

Mark:
The default rate is irrelevant.
Expected loss matters most and the question is: considering the "class:subprime borrowers" are the non-defaulters going to pay the losses of the defaulters so the loan business remain profitable, that is can you charge a risk premium sufficient to cover the expected loss you will have to deal with the class.If the answer is yes then that's as moral as selling life insurance, some people thinks it's ok and some don't.
The issue about subprime is whether the borrowers were paying enough in relation to the risks they represent.I don't think so.

[Mark Thoma]

Yes, thought about the alcohol example after posting - and remembered all the attempts to restrict, make illegal, etc. in the past - and the fact that addiction is an issue, and decided not to do an update to mention that. Seems like gov has worried about the harm, quite a bit.

All products have risks, yes, but selling cars where 15% fail randomly and there is a serious accident seems to raise issues. Again, hard to imagine gov wouldn't step in to try to reduce it (speed limits, seat belts, crash tests, etc. - though not sure I want that much regulation of mortgage markets).

[Doug]

This question -- which is directionally a reasonable one to ask -- needs some clarification in order to be useful in the current context. Perhaps, one version of the question would clarify whether the 85% are possible to achieve without the 15%. More to the point, though, the question either should take an explicit stand to include or explicitly exclude reference to the following widespread patterns we know were happening over the past several years:

1. People being guided into subprime when they could have afforded loans with better terms
2. Explosion of exotic loan types with terms that are very complex to understand
3. Liar's loans
4. Incentive systems that rewarded the sales of loans with all or some of the patterns in #s1 through 3

There are probably other core patterns worth mentioning as well. The point, though, is that the question about ethics posed here does not reflect the 'real world' in which the loan officers acted. Evidently, many more loan officers were comfortable living with their own ethics doing all the above things than those who were not.

[ST]

Another issue that would very much change the answer to the question posed is this: Are we talking about loans made to new buyers to put them in homes or about home equity or refinance loans?

In the first case, 15% is probably an acceptable risk, but in the second case, where the 15% are actually losing the equity they have in their homes (and may not understand how a subprime loan increases this likelihood) we will get a very different answer.

From the Seattle Times:

"Nationally, less than 1 percent of Ameriquest's [a subprime mortgage lender's] loans that year [2004] helped people buy homes. The next year, less than 3 percent of Ameriquest loans nationally were for home purchases."

[calmo]

For the sensitive, conscience-bearing but somewhat innumerate: (binary state 1):Should you feel guilty about making these loans? (And shouldn't this question budge you unfeeling brutes to feel ...something?) and for the somewhat numerate, conscience-lite and so sensible: (binary state 2): Is it ethical to make them at all, i.e. to knowingly send 15% of your customers into foreclosure (even though you don't know for sure who it will be) [Shall we apply the Laffer Curve Analysis and entertain other numbers?...~certainly not ethical for 95%, certainly ethical for 1%, but what of 1 in 5 if you are comfortable with 1 in 6?...what about 1 of 2...binary states being something of a fixation at the moment, yes? no?]Now flip to St Peter --so much depends on this, you atheists... ok buddhists, too (why B exclusive at a time like this?)... with his graphing calculator, as he decides the case:
binary state 1: hell.
Dang! Is there a round 2? I just need more practice, you?

[Worker]

Not wrong unless you are creating the loan with intent to foreclose. While it is true that mass market lenders lose from foreclosure, it is not always true with smaller private lenders who target loan offers to specific properties and neighborhoods.

In the rapidly appreciating (and gentrifying) urban neighborhood I lived in, that happened fairly often I think, especially prior to 2004-2006 bubble peak. It was a way for developers to get properties.

There was a poor crackhead around the block who inherited a house with good market potential. I could not loan money knowing he would default, even knowing that someone else would do so and reap the profits.

[William Smith]

Prof Thoma,
I think I would make the loans too, but I would make sure that the applicants understood that 15% of these loans go bad, either due to a priori problems or subsequent negative issues (lost job, etc). I would also make sure they understand that this is (?) higher than the rate for normal loans and that the applicants can't qualify for them. Only then are you completely absolved. Anything less and you are talking shades of gray.

[calmo]

"talkin shades of gray"...like just try sellin off-white bed sheets to St Peter.
But "a priori problems" sinks me and I'd say your chances look damn good skippin by that gate keeper.
Ok, could've been a stumble but that is a huge boulder you have turned up William: a priori problems. Uncommon philosophical ingenuity...maybe more.

[Brooks]

There are a number of elements of ethics involved here.

Key considerations that come to mind:
- The magnitude of potential harm to a buyer (of any product or service).
- The probablity of harm.
- The degree to which buyers (or particular types of buyers) have reasonable difficulty assessing the risk appropriately (access to information, knowing enough to know what information is needed, ability to analyze).
- The degree to which the the probability or magnitude of harm cannot be mitigated by the buyer post-purchase.
- The degree to which harms to buyers affect others in society (e.g., foreclosures harming the economy; harming others' ability to get home loans, etc.).

Generally speaking, the higher any of the above conditions, the greater the ethical obligation of the seller to disclose and explain all risk-related information, and the greater the responsibility of government to mandate such disclosure and require indications that such matters are understood by the buyer. In extreme cases, banning is appropriate.

As for the specific example, my answer would depend on the extent to which disclosure/explanation could change some of the conditions listed above. Obviously there are many transactions in which the risk of loss is great, including many investment transactions (growth stocks, junk bonds, venture capital, etc.), but which we don't ban and which are not unethical for the seller.

[James Killus]

I'm not sure about the ethics of making such loans, but I think that the "bad result" that follows needs proper weighting. But how to weigh such things? Perhaps if we were to look at the psychology of those who participate in the system, some insight might be obtained.

[billy]

This is simply glossing over the issue. Subprime is such a vague word. What does that mean? Are you drinking the kool-aid that this is all borrowers with poor credit? Is Thoma claiming here that borrowers with poor credit was the problem?

Is it ethical to be the middleman and lend other peoples money, without checking the ability of borrowers to repay? And take the commissions and run, leaving the borrower and lender to fight it out? eg: stated income, NINA loans

It was a classic bubble. Which kind to all kinds of fraud being _allowed_ to occur. Rising asset prices ensured that all kind of dodgy loans would get refinanced.

That was the golden rule - dont't worry about the ability to pay, because rising asset prices would lead to refinancing.

So what Thoma ignore here is the fact that NOT 15%, BUT FAR MORE CLOSE TO 100% loans were made with the assumption that they would get refinanced. Not refinanced because the borrowers ability to pay or the borrowers credit improved, but because of rising asset prices. Not just rising asset prices, but 10-20% price rises annually.

As I have stated here previously, it won't be the poor subprime, credit-less people who scream for bail-outs. It will be the vast middle class who thinks that owning a house entitles them to free money in the form of 10-20% appreciation. And who pretends that weath as real, even though during a period of 2-3% economic growth.

The subprime meme is a cover - wait till the Alt-A and Option ARMs made to the doctor/laywer/professional crowd starts defaulting.

So ask the right question - is it ethical to lend money to people who will default ~100%, if not for 10-20% annual increase in house prices?

[Bruce Wilder]

"you will be sending 15% of your customers into a troubled situation, but 85% will do just fine."

So many facts not in evidence, I just want to scream.

Maybe the 15%, who go into default, are the lucky ones. Why are they in trouble? They're not paying. Maybe, your loans are leading to immiseration for 50%, who are (just barely) able to keep up with the payments.

And, what are the alternatives? I look at the interest rates on credit cards (and the rules that govern what those rates are), and the interest rates on such "conveniences" as payday loans and -- how shall I say this? -- competitive pricing does not leap to my mind as a plausible description of the institutional environment.

A reasonable intervention is the usury ceiling. If a government agency intervenes and forbids an interest over, say, 15%, how many of the loans would the loan officer still make? How many more people could make the payments, not default, and not skrimp at the supermarket to keep up the payments?

I think we ought to consider the possibility that, left to their own devices, lending institutions might have an unfortunate tendency to favor loan sharking. The higher the interest rate, the higher the default rate -- the equilibrium may be somewhere society does not want to be.

[robertdfeinman]

The only reason such loans are offered is because banks can charge usurious interest rates. The same is true of credit card debt. When there were limits on interest rates credit cards were not issued to those who couldn't pay, or they were issued with very small credit limits.

So if there is a limit to how much you can charge, the willingness to accept risk will decline. And yes, in the old days banks expected most mortgages to be paid off. This was especially true when they held the loans themselves. That's why the collapse in the 1930's was so devastating, there was no real concept of adequate reserves or credit insurance and the bad loans snowballed.

The counter argument:
It allows people who couldn't afford to buy a home under the old rules to do so. This may mean that the old rules were too strict. It may also mean that many who thought they were buying a home were actually only leasing it in effect. It also means that the borrowers who are credit worthy are overpaying.

So perhaps the hypothetical question is poorly set. There are some factors which will cause some to default and other not to. Aside from the random effects (like a sudden illness) it is possible that many of these can be determined. It is just more profitable for banks not to do so. It is even more profitable for all the middlemen not to do so. The real estate brokers, loan originators, building inspectors, title companies, closing lawyers, etc. all get their cut regardless of what happens next. Imagine how cautious they would become if they only got paid after a few years of successful mortgage payments by the buyer.

Whenever those taking the risks and those making the money are different groups, the risk goes up.

Casting the question as a morality play obscures the factors at work. Firms are in it for the money. Some would say they are required to be in it only for the money. If this is wrong that the proper solution is to rewrite the laws dealing with incorporation to include other factors beside profit. This exists in the EU where there are considerations about workers and the environment as part of the corporate framework. The US has just chosen to adopt a greed is good philosophy.

[Bruce Wilder]

MT: "not sure I want that much regulation of mortgage markets"

I think this remark makes you appear sadly self-deceived about how much regulation of the mortgage market exists. In light of familiar facts concerning the thoroughgoing regulation of real estate sales and home mortgages, credit and bankruptcy, it seems a bizarre view to quibble over "how much". Not that there might not be plenty to say about the technical efficiency or about who benefits from hiring lobbyists to write blatantly unfair rules.

Remind me again why Angelo R. Mozilo isn't in jail?

[btgraff]

This kind of risk /benefit analysis is not uncommon - like Ford deciding to save a few bucks on the bumpers of Ford Pintos.

No doubt people who lose their homes or go bankrupt suffer, but it is quite different from being killed or deformed due to a bad product. Selling subprime mortages is far more ethical than, say, selling cigarettes - which offers no real benefit to someone who is not already a smoker, but will not doubt lead to a high percentage of those who start to get cancer or lung or heart disease.

We have speed limits, knowing full well that at 70mph accidents there will be more deaths per mile driven than at 55 mph.

What is beingmissed in this analysis is that the cost of those who default effectively increases the premium of everyone's interest rate - a 15% default rate might add 1% to the interest rate all 100% pay, a 50% default rate might add a 3% premium - but the higher premiuum itself means that more borrowers will fall into arrears - so if a company is profitable by overcharging borrowers (a 3% premium on loans where 15% would default if the premium were only 1%), it is actually creating some of the defaults.

[hank]

> is this like steering a customer to purchase a
> sports car that is more profitable

Yes, it's like that, when the customer is 85, has cataracts and hearing trouble, won't come up for a driver's license review for another four years, and needs to drive for doctor visits and groceries and church.

[Arne (not anne)]

Wha if the 85 percent who do not default are those that successfully flip a house during the rising bubble?

Selling to someone who does not know that they need to plan on flipping the house is immoral.

What if everyone plans to flip the house, but the 15 percent who default are the ones who got hit by the collapse in prices?

Loaning to someone without the reserves to play this game (when you know that is the game) is immoral.

What if there is no bubble and the 15 percent who default were people who were willing to stretch their finanaces, but who had unexpected expenses or lost there job (or lied on the application)?

Then you should make the loan.

Then

[Bernard Yomtov]

Bruce Wilder raises an important point: Who says the non-defaulting 85% end up happy with their situation? Maybe they are able to make the payments some way or other - working extra jobs, dipping into retirement savings, etc., but would have been better off not getting a mortgage. So the moral weighting can't just be 85% fine and 15% disastrous.

[save_the_rustbelt]

Any business setting credit policy has this problem:

1) set the policy too tight, deprive customers of goods/services and deprive us of profits

2) set the policy too loose, and we give credit to customers who will not pay the debts, causing grief for both of us

Having said that, 15% is really high for most businesses, so we would likely tyake steps to pare that down.

Mortgage officers on commission may well be one of the worst ideas on the planet, the last time that practice was wide spread we had the 80s S&L bubble and crash.

I guess we never learn.

[NoeValleyJim]

I think that a 15% fail rate on a loan cohort is not really that bad, since the cost of falling behind in payments and being evicted is not really that severe, especially for former renters, who would not have had the chance to buy a home any other way.

There is also the "free will" issue here. If someone wants to take out a loan and someone else wants to lend to them, do we want to prohibit it? This obviously does not excuse cases of fraud, but in general I think people should be free to arrange their affairs as they see fit. Why would this be an exception? Is there obvious coercion going on? I just don't see it.

[Patricia Shannon]

During the depression of 1990-1992, my home equity line of credit allowed me to make my house payments. So that was good.
After I had to relocate, all my extra money went to paying off my home equity loan. I eventually lost it to foreclosure anyway. So I would have been better off financially losing it earlier, because I would have been saving the money that went to the mortgage and equity loans on a house I was not living in.

[calmo]

Always go with the typo Gods, people, and get a whiff of aRne's Wha if the 85 percent who do not default are those that successfully flip a house during the rising bubble? An application of the Laffer Curve, yes? Suppose the flip was a modest, respectable Republican clothgain and indexed to HF manager's 2/20 fees 30yr tbills?
Suppose you gave all your flippery to the Church knowing St Peter was on your case to the State knowing that funds were needed to bolster regulations everwhere to starving children in 3rd world countries because with this example you could seed a real heist of the 85% 60% 50% remaining guilty consciences who are somewhat off the road to Ethical behavior?

[lonesome moderate]

When I pitch a high cost mortgage to an African American woman who could otherwise qualify for a low cost mortgage, I am not thinking there is an 85% she will be able to pay the mortgage. I am taking advantage of an African American woman.

Anne - do we know for a fact that most of the people affected would in fact have qualified for the low cost mortgage? I had thought that this was primarily a continuation of the redlining issue, where people were denied loans because of factors that were widely considered to be proxies for race (e.g. zip codes), and most of the borrowers would not have qualified for any loans at all ten years ago.

[Icarus]

We have learned...

Mortgage companies are out of business. Banks and the CDO's they invested in are losing value by the week. And, people who signed up not only for ridiculous loans they couldn't afford, but, also overpaid for those homes, are going into default at high rates.

This is the system learning.

I think we all knew when housing prices skyrocketed that sustaining it wasn't feasable, and, that the prices reflected a distorted reality.

Unfortunately, there will always be those information/financial brokers who made money on this distortion. The corollary is that they will eventually lose their job.

The system learns.

[Don]

I don't see the issue w/ morality, so long as there is disclosure, disclosure, disclosure, i.e., the borrower knows what they are getting into and aren't lied to about it.

When I first got started in the real estate closing business, one of my customers was Ameriquest Mortgage (you may have heard of them). Their loans were beyond sub-prime. As a closing attorney, it is not my job to pontificate on the merits of one of my client's loans (the client is always the mortgage company), but Ameriquest's loan officers would come to the closings and I would constantly be correcting them as they said things that were not in the black and white paperwork of the deal. (Always remember--if you are dealing w/ real estate and it's not in writing, it is not legally enforceable). I know it was the borrower's job to understand the deal and decide for themselves, but I also knew they would rarely read any of the paperwork, even though federal law provided them three days (if a refinance--and Ameriquest's loans were almost always refinances) to look everything over and back out of the deal if they wished.

After several months of representing Ameriquest at these closings, I had had more than I could stomach of loan officers trying to tell borrower's something that wasn't true--usually that the borrower could refinance out of the usurious-rate loan in a year if they made their payments on time--and severed my relationship w/ them. It was one of the best things I ever did. That was in 1999. I'm still here, Ameriquest isn't.

Was it a moral decision? In some respects it was. But I could see the handwriting on the wall--these loans were ripe for failure, and I would be dragged down w/ the lender when the lawsuits began, so as much as it felt good morally to do them no more, it was even better financially. Like I said, I'm still here and doing real estate closings.

Through the years I have dealt w/ many, many sub-prime lenders that are now out of business--Ameriquest, New Century, Option One (almost gone), et al. Each time I closed a loan for one of them, I wanted to go home and take a shower, knowing full well that each loan was a disaster waiting to happen, and all it would take is one bad loan to get tangled up w/ and I would have been gone. So around 2003, I quit taking any more sub-prime business, which mostly meant cutting off my mortgage broker clients. I turned my practice to one of Countrywide's retail "A" branches, and it made all the difference.

Which brings up a question for Bruce (or anyone)--why do you think Angelo Mozilo should be in jail? My experience may be limited to just the local area in which I operate, but it has been that Countrywide is one of the best, most forthright lenders in the business. I don't know Mozilo personally, so I'm really just curious.

I know Gretchen Morgenson of the New York Times has made a living lately in pointing out Countrywide's deficiencies, but as bad as they might seem, it's my experience that they are the best out there. It seems to me that because Countrywide is now the biggest, it makes them an easy target for all that ails the residential mortgage market.

[lonesome moderate]

If I were a loan officer and this was the most troubling situation I ever had to deal with, then I would sleep just fine at night.

Unfortunately, there have been far worse abuses than this. Something like one of the scenarios in "Why Subprime Auto Loans Default" would certainly bother me more.

[Bruce Wilder]

Don: "My experience may be limited to just the local area in which I operate, but it has been that Countrywide is one of the best, most forthright lenders in the business."

You are misinformed.

[anne]

What we know is that regardless of neighborhood, regardless of income, regardless of credit rating, African Americans and Latinos in selected studied cities have been given subprime (high cost) mortgages in disproportionate numbers. Why this should be is not clear however. Possibly the reason may be less long-term family experience in asset accumulation or financial matters.

A Seattle real estate attorney-professor, a former student, has been telling me the problem was not ethnicity or race, but who could be sold the highest cost products. The effect is discriminatory, but the reason was to sell the highest cost products.

[Arne (not anne)]

Calmo,

I do not get it. My typos were minor enough that the point should still come through.

I can reread my post and it still makes sense.

I cannot reread your post and make any sense of it.

[anne]

Low-cost mortgages can wonderfully open the housing market, as the GI 3%, 30 year, no or minimal down-payment mortgages did after the World War, but sub-prime mortgages are not these.

[hank]

Hey Don, as an attorney -- do you have any obligation to report behavior like you describe by your client to anyone, or to do anything about it? Was resigning from representing them an option, or something you had to do under the ethics rules? I guess this varies state by state, but I'm not sure.

[anne]

Trusting the several years of complaints from the University of Washington real estate specialist, subprime sellers of mortgages have been ethically abusive while the abuses have been well known and generally ignored.

[mark]

jck says...
Mark:
The default rate is irrelevant.
Expected loss matters most and the question is: considering the "class:subprime borrowers" are the non-defaulters going to pay the losses of the defaulters so the loan business remain profitable, that is can you charge a risk premium sufficient to cover the expected loss you will have to deal with the class.If the answer is yes then that's as moral as selling life insurance, some people thinks it's ok and some don't.
The issue about subprime is whether the borrowers were paying enough in relation to the risks they represent.I don't think so.

Posted by: jck | December 05, 2007 at 10:26 AM

End of discussion.

[ed in texas]

If the 15% bother you, you shouldn't be making loans.
At all.
There is no pure upside to anything in this world.

[Alex Tolley]

To follow up on BW's point about whetherthe 85% are happy, what about the effect extra loans made on driving up house prices? It was the excess capital that helped create the bubble. This made it more expensive to buy a home, even if one could afford it, transferring wealth to the sellers and "impoverishing" buyers. Whilst the individual loan officer might not be guilty of causing this, one has to ask whether the industry as a whole might be regarded as being unethical in this regard?

[Don]

Hank,

That's a good law school ethics question. I would say that I would have had a duty to report something I knew to be illegal--to the appropriate criminal and civil authorities--and then resign. So far as I know, there was nothing blatantly illegal about what they were doing.

Unfortunately, unethical does not equal illegal. Looking back, I may ought to have done more, but I never allowed a borrower to walk away from a closinig table who clearly misunderstood the black and white of the documents, which often meant correcting loan officers when they told them something that was not in accordance w/ the documents. It caused an unbearable tension in the attorney-client relationship, the best remedy for which I knew was to refuse any further representation, but I don't think the bar would have required it of me.

Of course, borrowers had every opportunity to review the closing documents (or have their own attorney or mortgage person do so) for three business days after the closing (if a refinance) and decide not to go through with the transaction. I'm not sure what it says for the borrowers that very few ever canceled their loans.

Bruce,

With all due respect, I believe it would be impossible for me to be misinformed about my own experience w/ Countrywide. What I'm asking about Mozilo is why the acrimony? He may be a dog--I don't know him. But I don't know any reason he should be in jail. It's not a question meant to raise your hackles--I just want to learn what the basis for your opinion is. About Mozilo, as I have no personal experience, I may well be misinformed.

[wjd123]

I would make the loans even though 15% of them would cause people trouble. So long as the loans remains profitable, and they are not sold fraudulently so that people enter willingly and with full knowledge of the probability of default, I would accept an even higher default rate.--Mark Thoma

How did Mark go from what percent of defaults would be acceptable to this qualification about "full knowledge." How does one expect borrowers to have "full knowledge" when the loan officer who is working on commission has an incentive to sell people the loan, not talk them out of it? Are banks to forgo their fees when they know that they can repackage these loans and sell them to the greater fool, those who accept the evaluation of risk assesors paid by an interested party? And how high is the bar to escape acting fraudulently? Would signing a paper saying you understand the loan and your risks be sufficient?

Isn't this more of a problem of acting ethically than staying within the law? Is the loan officer absolved from acting unethically if he or she just mentions the percentage of defaults or does the loan officer have to make an individual evaluation: "Of the 15% of people who will default there is a 50% chance that you will be one of them." Isn't that what loan officers are suppose to be good at, evaluating risk. If what Mark meant by "full knowledge" is just mentioning the percentage of people who default on sub-prime loans, that hardly seems relevant to me.

And I would also expect that people who apply for sub-prime loans aren't all that sophisticated when it comes to financial matters. Shouldn't financially sophisticated people be making the decisions and not relying on the unsophisticated to have "full knowledge" of what they are doing? Wouldn't sub-prime borrowers be the very people unable to afford an outside consultant even if prudence over rode their desire to get that home.

Is Mark's qualification just a way of overlooking the obvious? After all unethical activity comes from how people act and not playing the percentages.

Furthermore, I'm not so sure that buyer assurances, "You were given the odds," aren't really lender protections in disguise. People who take out financial loans have a three day grace period to reconsider the loan before the contract goes into effect. My guess is that there are more lenders saying that "You had three days." then there are unsophisticated people stopping loans during their grace period.

I don't know what Mark meant by "full knowledge," however, just being quoted the percentages of the default rate on sub-prime loans hardly seems to fit. Isn't Mark's qualification just insisting on form over substance?

[gordon]

Prof. Thoma: "It's hard to imagine the government allowing any other product to be sold that would, upon bringing it home, cause serious difficulty in the lives of 15% of the customers, so why is this different?"

It's not different - the US H. of R. has just (15/11/07) passed The Mortgage Reform and Anti-Predatory Lending Act of 2007. Under this Act, according to the linked press release:

"Mortgage originators will be required to provide full disclosures and present consumers with appropriate mortgages. This means that the originator will have to ensure that a consumer who receives a mortgage loan: 1) has a reasonable ability to repay the loan; and 2) will receive a net tangible benefit from the loan in the case of a refinancing...[the Act] will prohibit the undisclosed and unfair compensation schemes that disadvantage borrowers, and require regulations to prevent steering for subprime loans. Mortgage originators who engage in predatory practices and loan steering will be subject to strict penalties".

OK, I know this is the third time I've tried to get some response from either Prof. Thoma or commenters on this piece of legislation, so I'll promise not to talk about it again unless somebody else raises it first. Fair enough?

[Ab]

I don't understand why the government is stepping in and creating bills like the Mortgage Reform and Anti-Predatory Lending Act of 2007. The open economy should illiminate these lenders that are making bad loans and their company should go out of business. Unfortunatley the Fed has started bailing these lenders out by cutting the Interest Rate. Where has the Open Market Gone??

[Farrar Richardson]

You've missed Calmo's point, Arne n.a.

"I cannot reread your post and make any sense of it."

85% (fateful percentage) of Calmo's posts are not supposed to make sense, but are delightful nonsense. If we can determine which are among the remaining 15% (obvious losers), we have a moral obligation to tell him

Stop Making Sense, Calmo

[bill mccullam]

well, we sell a product that is not essential to life, so our view is distorted. We do not accept credit cards since we feel that people should not be indebted for something they don't need. This is not the same as selling a home, which people do need. However, I think the question should be rephrased, thus: "Would you still make subprime loans if you knew (a) that 15% of borrowers would be in trouble, and (b) that median home prices would decline 2-8% per year for the next 8 years??

[wally]

It is ethical to do so. The 15% that you pose is arbitrary; even highly-rated prime borrowers have some default rate. You know that, too, so then your question becomes: is 15% unethical and under 1% ethical... but ethics must answer based on the situation, not the numbers.

[Don]

Gordon,

All this law would do is require more paperwork. It changes nothing. I can assure you, every sub-prime loan I ever did had a mountain of disclosures along w/ them, but the borrowers never paid them any mind.

So far as only lending money to folks that can pay it back? --The inquiry would change to make the evaluation for the ability to repay be based on the adjusted rate--but that's often two or three or even seven years down the road. How in the world can anyone know what a) the ability of the borrower to repay would be in 2-7 years; and b) what interest rate to use in figuring out the adjustable rate payment. These loans are typically tied to the one year Libor--any idea where that will be next week? No, and we certainly don't know what it will be in two years from now.

Receiving a "net tangible benefit" just looks like meat for the lawyers--what exactly does "net tangible benefit" mean? I can tell you how the lawyers will protect their clients--by making the borrower sign a statement saying that indeed, they did receive a "net tangible benefit" from all the trouble they just went to. It's almost Orwellian.

Regulation can't fix this mess. Only a more prudent fed can, because that's how we got here to start with. If they'd stop printing so much money, then the money wouldn't run out of good places to hide.

[calmo]

Arne, you denyin the Gods made a vizit? ...that you planted the typo to attract the innocent?...ok, half-crazed?
Lemmesee anyhow, ("anyhow", you defenders of the AAA prime readers, is tryin to skip over the reliability of the report that I might be less than prime, you know?)[Come back William and chat us up..."a priori problems", more please]
anyhow, Arne (not anne) [Just cave in to "Barne" for the hard of seein...and hard of typin, you know?]
has a valid (Don't arouse our suspicions!): point (calmo scurries back up thread...finding this gem:)Selling to someone who does not know that they need to plan on flipping the house is immoral.And this is such a concise decision procedure for moral lending it is a mystery why it has not been implemented. Lender: "You know you'll have to flip this property before it resets?"
Homeflipperowner: "Absolutely."
I dunno about "valid", but tricky for sure. The trick is that the next homeflipperowner to whom the house is flipped has to not know (willful ignorance people...William can splain this, William?...the help you get these days...) that his predecessor is not flipping him.
Muchado about Blacks and Hispanics being over-represented as anne points out, but basically the "underprivileged", (not the fools as previously reported by smart money), are soon parted from their money, yes?

[save_the_rustbelt]

An Ohio judge through out 14 foreclosure cases because the alleged owner (Duetschbank) could not prove ownership.

What is markedly different here is that the mortgages were packaged and resold mutiple times topsy-turvy through any number of investors, in what can best be called a frenzy.

the current owner is so far removed from the orignal transaction that I don;t know how this can be worked out.

[wogie]

I wonder if a distinction should be made between mortgage loans for home buyers as opposed to homeowner refinancing of existing mortgages when rescue attempts are considered.

A huge amount of refinancing -- extracting equity -- has occurred to support expanded consumption (rather than saving) and a great many of these loans were subprime with teaser rates that have now put the borrowers homes in jeapordy. In a sense, these borrowers have had their cake and now want to eat it too -- perhaps at the expense of taxpayers. Why should these borrowers be rescued -- aside from any questionable need to prevent a downturn in the economy?

[mrrunangun]

Hey guys, the whole mortgage mess is a consequence of deliberate policy decisions taken by our government. In the sixties and seventies we embarked on policies that led to inflation and high interest rates while at the same time had an industry chartered by the same government to loan money for 30 years at 5% and take in demand deposits at 4 1/2%. When the interest rates went way up, depositors demanded their cash to invest at the higher rates, but the cash was in those cheap 30 year mortgages. The S&L industry went predictably bust.

In the current environment, ordinary people have been encouraged to behave with what used to be considered reckless folly. Over the past 10 years farmland for miles in any direction from here has been replaced by expensive subdivisions. I have marveled at where they have found so many people with so much money to buy these lovely homes. Turns out, they didn't necessarily have the money, they just had to bet that the government would bail them out as it has every other form of speculator over the past 15 years. That bet is looking good right now. I should have tried to get Deustche Bank to lend me $4million to buy a waterfront manse in a tony suburb. Maybe I could get a judge who would let me keep it. That seems to be what the really smart guys did.

[Patricia Shannon]

mrrunangun, the individuals weren't betting on the government to bail them out. They were assuming that house prices would continue to go up and that their paycheck would continue to increase as they gained experience at work. That might be considered "betting", but they didn't see it that way. They were acting on their own experience. They thought like normal human beings. People usually assume things will be better in the future. Otherwise, life would be miserable.

[Michael Cain]

Will you share your information with potential borrowers? Ie, will you tell them that you expect 15%, or 1%, or 30% of households taking out this type of mortgage to default, and that your firm is charging rates high enough that they will make money at that default rate? How much information asymmetry is needed to make it unethical?

[calmo]

I wonder if I can bridge a couple of disparate (not desperate) lines from Patricia that hit-me-right-between-the-eyes-didn't-have-a-chance-to-move. From way up thread (December 05, 2007 at 12:46 PM)So that was good.What was good? Don't nit-pick at a delicate moment like this! Something needed to be affirmed and was. Ok, twas preceded by this:During the depression of 1990-1992, my home equity line of credit allowed me to make my house payments. That was good. It could just as easily have been the discovery of blue cheese on Mars...such was the impact of So that was good. (You figure I need counseling? You figure I am in counseling?) [You know it! This is The Group, isn't it? Hello?] How rare izit to hear "So that was good."? (outside of identifying some rare moments in generally sociopathic behavior...not mine, people). Sorta heart-warming to feel the positive direction in that field festooned with BAD signs (ie That is Immoral! Unethical! Reprehensible.), yes? YES?
And that one from the post just above:
Otherwise, life would be miserable.The lie, life is good and prosperous, the economy is growing (unlike your share in it) --conceals the truth: wages alone won't put a roof over your head. Won't you leave your misery behind, get comfortable and join us in this little masquerade?
So, 'that was good' needs to be enhanced cultivated...nutured as if you were child-minding without a whip and the truth, house affordability, subsistence wages disparity of wealth/power recognized and addressed. Castigating the subprime lenders and mortgage holders does not address the wealthy's complicit role. Paulson's move to freeze rates for some deals only serves to limit the lender's costs and shift our moral indignation away from the rich and powerful.

[Bruce Wilder]

Don: "With all due respect, I believe it would be impossible for me to be misinformed about my own experience w/ Countrywide."

I regret my earlier tone, though, honestly, it is not that hard to find some pretty harshly critical reporting on Countrywide, its home mortgage loan practices and its chairman in particular. Mozilo accelerated some planned stock sales, in advance of Countrywide's stock market plunge, which looks suspiciously like insider trading, earning well over a $140 million for his disastrous stewardship of the company. Countrywide's loan promotion practices, which included cynical techniques to mislead borrowers, have been widely reported.

[Betsy L. Angert]

Dearest Mark . . .

You may have heard this story on Marketplace Morning Report. For me, this saga speaks to the fact that even those in the mortgage business, those that are educated, and people who were not poor, just hopeful, are victim to what we as a country have created. In our infinite desire for immediate gratification, we forget the tale of the hare and the tortoise. When possibilities seem wondrous . . .

I am reminded of the many times I read or heard economists state that we do not teach personal finances in school.

I share this tearful tale. You may wish to follow the link and listen to the entire anecdote. When you hear Ramon speak and listen to the narrator, describe the setting, it is all soooo sad. This is one chronicle of many.
The subprime effect on new Americans
Wednesday, December 5, 2007

Subprime mortgages may be hurting the market now, but at some point these loans helped someone buy their first home. Dan Grech has the story of one immigrant family's housing success, then struggle.

DOUG KRIZNER: Subprime mortgages have become a curse. With all the economic damage they've done, it's easy to forget they made it possible for many to buy their first homes. Especially immigrants who had yet to build up good credit. So how are these new homeowners faring now? From the Americas Desk at WLRN, Dan Grech has one story.

DAN GRECH: Catalina Brayan is from the Dominican Republic. When she arrived in the U.S., she found work in the only business she knew: Sewing. From 6 a.m. to midnight, for 40 years.

Catalina raised her son Ramon in eight different homes, always on the move in search of a safer neighborhood. Ramon says there was one constant: the click of the sewing machine.

RAMON BRAYAN: There's a lot of mothers out there that wouldn't make the type of sacrifice my mom made for me. So I feel indebted to her for life.

Ramon was the first person in his family to graduate high school, to finish college, to get an MBA. He began repaying his debt to his mom in Thanksgiving of 2001, when he bought her a brand new house.

BRAYAN: It was a surreal feeling, like just being in the living room of our new home. Like, all the furniture was still in boxes, and we're like, eating turkey on the floor. And I'm just looking around and just like wow, you know, I did it.

Ramon started his career in ad sales, but a cousin lured him into real-estate finance. He started working for Resmae, a subprime mortgage lender. He made $30,000 in a single month.

BRAYAN: Then your mind starts wandering. You see it as, OK, I made 30 this month, it's going to stay like that. You know, me being a business person as well, I'm like, let me buy some more property and hold onto it.

Subprime lending, much maligned now, did offer many Hispanics like Ramon Brayan the opportunity to own a home. The number of Hispanic homeowners nationwide jumped by nearly 50 percent in just seven years.

Ramon sold that American Dream. And he bought it, too. He purchased the home for his mom, another for himself, his childhood condo and an investment property. All four have adjustable-rate mortgages. All four are subprime loans.
Betsy L. Angert
BeThink.org

[sk]

I look at it in a different way - is it moral and ethical for a flight school to take on pupils even when they know that 50% of them never complete the course and actually get a private pilot's license ? or is it ethical for a school to take on students even when they know that will drop out ?

So long as the stats are presented ( as the hang gliding instructor told our class of 20 in the pub at the end of the first day - I think maybe 2 of you will actually stick with it and become pilots !) then its quite moral.

Because along the way, they have some fun and get value for money. Same with subprime borrowers.

-K

[Ace]

I think it is deplorable to take advantage of the ignorance of others or to reassure them that they can refinace out of the loan in 2 years when this may not be true.

Beyond that, no bail out until they show some commitment to find their own path to honoring what they agreed to.

If they had not been offered a loan that was beyond them, they would not have owned a home to begin with. So, if they lose the home, they are about back where they started.

What a lot of these people need to do is tighten their belts, take in boarders or two families team up and share one home, so they have 4 wage earners to carry the load.

They could agree to an equity sharing program that might make it possible for them to sell out in the future and buy two modest homes so they can each own their own.

Meanwhile, why should the rest of us tighten our belts to bail them out and allow them to live better than us?

[calmo]

A young voice people, hear that? "Hang gliding" doesn't describe your attempts to get into your long underwear...and "flight school" does mean aircraft it appears and not strategies to consider in hand-to-hand combat.
Ok, sk (from CR's no?) whatizit like to still have all your very own teeth? [We not only see it "in a different way", we look it.]I look at it in a different way - is it moral and ethical for a flight school to take on pupils even when they know that 50% of them never complete the course and actually get a private pilot's license ?Tis not a moral issue, ergo quit looking at the neighbor's wife.
Because along the way, they have some fun and get value for money. Same with subprime borrowers.Do you figure this picture of fun was the one Fannie was running with? Or was it a tad heavier on the responsible young family, well-dressed and hopeful --pleased about their progress so far?

But the stats IIRC do show that GenX is a huge chunk of that foreclosure picture and although I might sound sassy (I shall try hang-gliding as the weather improves...), I am so glad you joined us for this poke.

[calmo]

Greetings Betsy...dearest (the Devil made me do it!)...we have missed you (Hope it's reciprocal...) "BeThink", izat a European condensation of Descartes? Is there a reason why you have removed the Thinking part from the Being part? Does it work as a compound verb for you? (I bethink itiz not a verb.)
Allow me to nibble, not weep, on this:For me, this saga speaks to the fact that even those in the mortgage business, those that are educated, and people who were not poor, just hopeful, are victim to what we as a country have created. I don't know that all of us countrymen and countrywomen have perpetrated this saga, you know? I know some want to hook Greenspan, others the Fed, others (like Ace above), the spineless subprimers who just don't know how to get tough when the going gets tough.
I do think our complacency has contributed and I do think our complacency has been cultivated and I do hope that the new leadership inspires us to be more vigilant. I do think that the investment community mob group coalitionalliance needs to reappraise its position and the country's well being at this point. I am not too confident about their capacities at the moment.

[Don]

Bruce,

I'm aware of the accusations about Mozilo's insider trading, but that's a somewhat different matter than the performance of the company he founded and runs. As you say, there's reporting aplenty about the evils of Countrywide. I'm just saying that it's not been my experience--that in fact my experience has been just the opposite of what is usually reported--at least when I compare my experience w/ Countrywide to other players in the industry. Of course, I am fully aware that one person's experience do not a scientific study make.

So far as insider-trading goes, I personally just roll my eyes when I see another executive accused of touting his firm's prospects while also selling the company stock. All CEO's have to be a bit optimistic and somewhat good salesmen--walking the thin line between puffery and outright lie--about their company's prospects. In any event, virtually all of an insider's transactions in company stock are required to be made public for the very reason that insider's have information generally unavailable to the public at large. If a prospective investor hears a company executive tout the company's prospects while at the same time he's selling the stock, then the investor ought to be wary of what he's hearing, and do some further investigating. If, as Mozilo claims, his stock sales were part of a long-term program of diversification, perhaps there is nothing to worry about. But that assertion turns on trust, and really, trust is all an investor has. If an investor doesn't believe Mozilo, or any CEO to be trustworthy, he certainly shouldn't give the company he runs any of his money to manage.

[Patricia Shannon]

In the Atlanta area, zoning laws make it difficult to even build modest priced housing. When affordable housing is planned, well-off people who live nearby come to the zonding board meetings to protest, because they don't lesser beings living near them.

[richard]

I'm not sure that this example can be taken in isolation - as was pointed out earlier, other types of transactions pose similar ethical conflicts.

But I'll suggest one that seems salient to me: the gambling industry. Given the fixed nature of gambling probabilities, it is not difficult to calculate revenues per seat per hour, nor is it difficult to make a profit. The social consquences are non-trivial: it is likely that a small number of gamblers accounts for the bulk of revenues, and not all of these high-volume gamblers are affluent. Like the purchaser of a mortgage, they are potentially outwitted by a corporate concern who knows the odds better than they do.

[BJ Feng]

No, in this case, they outwitted the corporate concern. I still don't see how someone who put zero down, and in some cases took out equity after purchase, can be considered the loser here.

As for subprime loans, there are plenty of legitimate reasons for people to get one. I am such a case. Because I am self-employed, I needed a no-doc loan, probably considered Alt-A because my income wouldn't have been high enough to qualify. I choose a 15-year fixed mortgage at 5.25% and have had no problems paying. No one knows my financial position better than myself. If some loan grunt had to make sure I could afford the loan based on my income for that year, I could never have gotten a mortgage period. That's because I was starting up a company and paid myself next to nothing in salary even though I knew I would be able to make enough to cover the mortgage in the future.

My credit scores were high enough to qualify me for a better loan if not for my no-doc requirement, but I was not forced into taking a subprime loan (Alt-A) loan when I qualified in theory for a prime loan. I choose the Alt-A loan because it was the best option for me and I bet most people were not deceived either. The only difference is that I was responsible and didn't choose to go zero down, interest only with an equity cashout on top. It amazes me that those people are getting sympathy, and now get to keep their low teaser rates while I have to continue to pay my regular fixed rate.

[Zuil Serip]

Analogous situation: Is it moral to market and sell a very fast sport car even if you know that such cars have a 1% fatality rate for irresponsible drivers who chose to drive too fast?

I'd say that if the car is not badly built, inherently flawed, or misleadingly marketed - and that the loan does not hide information or seek to mislead, then it is indeed moral to sell either product to well informed adults.

I suggest that to refrain from doing so because of a statistical knowledge that some will abuse the product is both condescending and not particularly helpful - these people are likely to find other ways to go broke or kill themselves.

[Patricia Shannon]

what if you seek out drivers who have previous speeding tickets and market agressively to them?

[Icarus]

Patricia...

What is the alternative? Excluding issues of false documentation...shouldn't people be free to obtain the loans they can? Do we want 'big brother' telling people what risks they can take?

[Real Person from the Real World]

I have to agree, for once, with Anne:

"When I pitch a high cost mortgage to an African American woman who could otherwise qualify for a low cost mortgage, I am not thinking there is an 85% she will be able to pay the mortgage. I am taking advantage of an African American woman."

Also, form what I read, sorry no citation, was that these loans had additional fees that were added on, that just made the situation worse. These people were purposely steered towards loans that were not the best for them. This is not providing loans to people to help, this is discriminatory greed. People with more than enough income for a load get perks and benefits that save them money. Those with a precarious financial situation are milked for as much as possible.

Wherever you have fees and commission based sales, there are always those who will take advantage of the "sucker" at the other end.