Countdown To Doom: Zero Hour

It's here! Lord have mercy, Part II of the famed Elizabeth Warren slam down has arrived at last!. After a wait of only, let's see, 898 days, give or take, Megan McArdle has delivered unto us her mighty tome, as related below on July 26, 2010:

As I’m going to write in the next few days, the thing I don’t like about Warren is that she’s sloppy with data, and also that her mistrust manifests itself in paternalism. It’s one thing to think consumers would be better off without certain kinds of credit; it’s another thing to be positively certain that you’ll be making them better off by making such credit unprofitable.

In The Four Most Important Things You Need to Know About the New Mortgage Rules, McArdle discusses the dread pirate Bureau of Consumer Financial Protection, an entity that Megan McArdle fought valiantly to vanquish. She declared that we didn't need financial transparency because we would never be able to understand financial documents anyway and that regulations can backfire; for instance, if you regulate payday loans, the poor might be forced to go to a loan shark instead.  As McArdle said in What Good Will The Consumer Financial Protection Bureau Do?:

The problem isn't that banks don't have the right disclosure form for high-annual fee credit cards; it's that people don't want them. Maybe they shouldn't want them. Maybe we should only get the things that Elizabeth Warren wants to give us. But now we're not talking about transparency. We're talking about the Consumer Financial Protection Bureau "protecting" you right out of financial products that the paternalistic technocrats don't think will be good for you. And that's problematic, both because it assumes that people are kind of like children, and because that protection often carries a high price. Usury Laws used to "protect" poor people from very expensive loans; they are often spoken of fondly by consumer advocates ruminating about payday lenders. The laws protected them so well that many of them couldn't get loans at all, and had to pawn their stuff, borrow from friends and family, or hit up a loan shark.

You thought I was kidding about the loan shark, didn't you?

Also paternalistic is regulating sub-prime mortgages.

[W]e frequently hear that there's too much information, now, and we need to simplify: better transparency, instead of just more. But long before the crisis we required simplified disclosures for both mortgages and credit cards; you got a sheet saying what your annual rate was, the minimum monthly payment, etc. Where the loan was adjustable, people had to be told that their rate could adjust. They didn't read it. Or they didn't understand it. Or they figured they'd pay of the car or refinance the house long before that happened.

The people who took out sub-prime mortgages were just stupid and lazy. There was no fraud; no no-doc loans or liar loans or robo-signing or corrupt rating agencies or criminal banks. Just a bunch of greedy homeowners who got what they deserved. Remember; the financial industry and its billionaires and CEOs, did nothing wrong. Why would they need more regulation?

There are two basic narratives of what happened. The first is that bankers had bad incentives: they took massive risks because the profits were so good in the up years that it was worth the risk of the bad, or because they could pass the risks onto some other sucker, or they thought Uncle Sugar would bail them out. The other narrative is that bankers had bad information: they didn't understand the risks they were taking.  

I've always preferred narrative B, because Narrative A doesn't make much sense. The CEOs of big banks lost vast sums of money, and their jobs, most of their social status, and so forth. They held onto the worst tranches of their securities, which implies they didn't know how badly they were going to blow up. Etc.  

I find it vastly more plausible, if not so comforting, to believe that systems can occasionally produce bad results even if the incentives basically point in the right direction. The FICO score revolution was valuable, but we took it too far. The money sloshing around US markets disguised the problems, because people who got into trouble tapped their home equity, or in a pinch, sold the house at a tidy profit. Everyone from borrowers to regulators was getting the same bad signal, that their behavior was much less risky than it actually was.

Having conclusively proven that the financial industry was just an innocent bystander in events that increased their wealth tremendously, McArdle concluded that a consumer financial protection agency would be useless.

It seems to me that the most likely outcome is a fairly useless agency that spends a lot of time playing with disclosure documents, and occasionally yells at banks about penalty fees, maybe requires banks to offer these plain vanilla loans of which Warren is so fond . . . but shies away from doing anything which will actually restrict credit availability. This agency won't do much harm, but of course, it's hard to see how it could do much good, either.

However, when McArdle wanted to warn us about the dangers of Elizabeth Warren, the consumer financial protection agency suddenly became much more dangerous.

.[..] I think it matters on two levels.  One, it matters how we evaluate [Warren's] work--and I've been disappointed at how uncritically some people I really respect have been willing to accept the 2001 and 2007 [medical bankruptcy] findings....  

It matters that we get this stuff right. I am among the majority who would like to see bankruptcies reduced in this country, and we're not going to be very effective at that if we run around thinking we can cure 2/3 of them by putting a national health care system in place, when in reality a third or less have any strong causal relationship with medical bills. Obviously, this was also held out as an argument for PPACA, making an implicit promise to the American people which I believe to be false.   

But it also matters because a large part of Warren's prominence comes from the fact that she's an academic. If she came from . . . well, the sort of think tank that publishes this sort of advocacy science . . . she would have considerably less glamor, and power.  

And perhaps it mattes most of all because this woman is now under consideration to head a powerful new agency. If this is how she evaluates data, then isn't that going to hamper her in making good policy? If we're going to have a consumer financial protection agency, I want one that has a keen eye to the empirical evidence on consumer welfare--not one that makes progressives most happy by reinforcing their prior beliefs.

And now that the Agency has issued the Ability to Repay rule, Megan McArdle helpfully explains how it will affect her readers. She does not explain much of the rule itself so let's go to the release from the Consumer Financial Protection Bureau:

Today, we’re issuing one of our most important rules to date, the Ability-to-Repay rule. It’s designed to assure the reliability of mortgages – making sure that lenders offer mortgages that consumers can actually afford to pay back. This is a simple, obvious principle that needs to be cemented in the housing market.  

In the run-up to the financial crisis, we had a housing market that was reckless about lending money. Lenders thought they could make money on a loan even if the consumer could not pay back that loan, either by banking on rising housing prices or by off-loading the mortgage into the secondary market. This encouraged broad indifference to the ability of many consumers to repay loans, which dramatically increased mortgage delinquencies and rates of foreclosures ...  

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act created broad-based changes to how creditors make loans including new ability-to-repay standards, which we are charged with implementing. Among the features of our new Ability-to-Repay rule:

• Potential borrowers have to supply financial information, and lenders must verify it;
• To qualify for a particular loan, a consumer has to have sufficient assets or income to pay back the loan; and
• Lenders will have to determine the consumer’s ability to repay both the principal and the interest over the long term − not just during an introductory period when the rate may be lower.

Since McArdle wants to blame homeowners, not the mortgage industry, for the housing bubble and crash, one would think that she would be happy to see an end to  no-doc and liar loans. But McArdle is also ideologically opposed to any regulation that might affect her own interests or those of her tribe. The Koches did not pay McArdle to be anti-regulation, they paid for internships and seminars and think tanks and magazines to find people who were already anti-regulation, people who would be happy to fight any attempt to protect consumers if it might harm the profit margin of corporations.

People who pride themselves on their support for a corrupt and deadly system because it personally enriches them and feeds their starving ego.

But let's get back to McArdle.

Last week, the Consumer Financial Protection Bureau released what it calls "one of our most important rules to date", the "Ability to Repay" criteria. Here's what you need to know:  

1.This will probably make it harder to get a mortgage, particularly if you are poorer  

Since that is the purpose of the rule, yes,  it will be harder to buy a house someone can't afford and will probably lose.

2. Nonetheless, it will not do that much to prevent default Arnold Kling, a former Freddie Mac economist who has long been my favorite source on housing finance, points out that debt-to-income ratios aren't a very good predictor of default risk.

As I point out in a new essay, mortgage defaults are driven largely by the borrower’s loss of equity. Thus, the most important risk factor at the time the loan is made is the size of the down payment. The rules ignore that. Instead, the focus in the borrower’s debt/income ratio, which is far and away the least predictive of the major factors used in predicting default (the down payment is most useful, followed by credit score and then by loan purpose, although the effects of these variables interact with one another so that it is not so easy to rank-order their importance).

Kling blames mortgages defaults on the government and feckless homeowners.

Defaults on appreciated homes almost never happen. Thus, in an environment of rising home prices, underwriting standards tend to become lax, and other risk-management measures tend to be loose. When house prices are rising, lenders are not punished for poor judgment, mistakes, or even for making loans based on fraudulent claims by borrowers regarding their income and financial situation. As long as house prices continue to rise, borrowers either keep up with their payments or sell their homes and use the proceeds to pay off their mortgages.

It is rising home prices that created lax standards, not lax standards that created a housing bubble to goose the economy. Kling:

Congress and regulators put pressure on financial institutions to broaden access to mortgage credit by lowering down-payment requirements. This allocated house price risk away from home buyers and toward financial institutions. Meanwhile, regulators approved maneuvers by financial institutions to minimize capital, notably through the creation of structured mortgage securities that earned high ratings from credit rating agencies. (See “Not What They Had in Mind: A History of Policies that Produced the Financial Crisis of 2008.”)   

Capital standards play a big role in determining the shape of the mortgage market. Financial institutions and mortgage financing mechanisms that are favored with low capital requirements are at a competitive advantage. Invariably, growth will take place where capital requirements are weakest.   

Mortgage capital requirements are very difficult to calibrate. If regulators make them too high, lenders will be driven out of the mortgage market and into other forms of lending, which may be even riskier. If regulators make capital requirements for mortgage lending too loose, they allow lenders to build up dangerous leverage, as happened in the years leading up to the financial crisis. It is my belief, based on what we saw take place in the recent decade, that it is impossible for regulators to allocate house price risk effectively to financial institutions. The only way to avoid a repeat of what we saw in 2008 is to make sure that home buyers take on some of this risk.

Don't regulate the financial industry, unload the risk on the homeowner. McArdle:

3.The government can continue writing mortgages under the old rules AEI's Ed Pinto notes that government entities like the Federal Housing Administration are grandfathered for up to seven years (or until they write their own final rules). So while it's probably going to get harder to obtain a new mortgage, it won't get much harder for quite some time. These days, federal government is effectively almost the whole market for mortgage originations. As long as they don't have to follow these new standards, borrowers with high debt-to-income ratios will still have options.

 

 The CFPB covers this as well.

In addition to the Ability-to-Repay rule, today we are also issuing a proposal for potential adjustments. There are two key parts to the proposal:

• First, a proposed exemption for designated non-profit creditors and homeownership stabilization programs, as well as certain Fannie Mae, Freddie Mac, and Federal agency refinancing programs. These programs generally appear to be already subject to their own specialized underwriting criteria, and they are designed to help consumers refinance into a more affordable home loan.
• Second, a proposed a new category for certain loans made and held in portfolio by small creditors, such as small community banks and credit unions, called “Qualified Mortgages.”

Qualified Mortgages are a category of loans where borrowers would be the most protected. They, among other things, cannot have certain risky features like negative-amortization, where the amount owed actually increases for some period because the borrower does not even pay the interest and the unpaid interest gets added to the amount borrowed.

 

While it is possible that McArdle did not read the release she linked to, it is more probable, given her history of misleading, misunderstanding and obfuscating regarding Warren, that McArdle is very carefully giving the wrong impression by withholding part of the truth. She does not say that Fannie and Freddie don't have to follow rules, she says they do not have to follow that rule, which is correct.They must follow other rules. She thereby creates the impression that the CFPB's rules are typical governmental bureaucratic waste of time. This is why she gets the big bucks; her skill in using elision and misdirection make her a valuable asset to propagandists.

4. The new rules tell you a lot about how the CFPB thinks

 

Actually, they tell you a lot about how Megan McArdle thinks.

The new rules are part of the CFPB's drive to create "qualified" mortgages: low-risk, easy to understand products that will prevent consumers from getting themselves into trouble. Their mandate is not to protect banks (and savers) from default; it's to protect borrowers from themselves. That's why their approach is focused on the household income statement. I go along with the CFPB in saying that even if you aren't likely to default, you should not have a debt to income ratio that approaches 50%. It's bad for your financial health. Too much of your income is tied up in long-term fixed obligations which cannot be shed without major financial repercussions. That leaves you extremely vulnerable to any sort of financial shock: a job loss, a family member who needs expensive care, an emergency. People whose debt-to-income ratios are so high are almost certainly skimping on necessary line items like savings.  

The difference between the CFPB and me is that I wouldn't mandate it; I don't like rules that make some people worse off, in order to protect still other people from themselves. But this sort of paternalism has strong support in a lot of the wonkosphere, most notably from Elizabeth Warren, the intellectual progenitor of this agency. They have clearly embraced financial paternalism as a core part of their mission. And this rule reflects that emphasis.

Here we see the other major category of McArdle's skill set, concern trolling. McArdle thinks accusing liberals of paternalism will give conservatives the opportunity to shout down liberals with accusations of hypocrisy, who will be immobilized by their white liberal guilt and unable to fight back.

So at long last, we have the Considering Elizabeth Warren, The Scholar Part II: The Paternalisming takedown! True, McArdle was so wary of stirring up another hornet's nest of embarrassment that she did not mention Warren by name until the last paragraph and the Warren part of the takedown is a few sentences, not the earthshaking event we were expecting, but beggars must not be choosers.

Although I'm kind of worried about her book. Going by the Warren example, the essence of it will fit inside a Twitter.