Bell Curve The Law Talking Guy Raised by Republicans U.S. West
Well, he's kind of had it in for me ever since I accidentally ran over his dog. Actually, replace "accidentally" with "repeatedly," and replace "dog" with "son."

Friday, April 24, 2009

Transparency and Paternalism

A penchant for transparency, some are calling it a "radical transparency" is becoming a theme of this administration. The effect of the Chicago School is making itself known this way. Transparency in this context means that the solution to many problems posed by the legislative process or the market is more information. So rather than forbid certain mortgage practices, the goal is to require more up-front disclosure of true risks. Rather than forbid earmarks, require that their authors be disclosed up front (query whether credit for earmarks is always bad). Rather than forbid abusive credit card practices, require up-front disclosure in "plain language." (Similarly, the approach to torture at first glance was to disclose information, not punish). The idea is that the marketplace - whether the marketplace of ideas or the market for any good or service - will move away from bad practices if there is more information. Consumers and voters can, in other words, be trusted. The position that one should ban - rather than just order disclosure of - exploitative or abusive economic practices is often called paternalism.

There's an interesting divergence between political and economic transparency. Those who favor term limits are justly accused of being paternalistic. Their message is: stop me before I vote for an incumbent again. Voters, in their view, must be forced to discard incumbents. Transparency (publicizing that they are incumbents) does not prevent their re-election. Yet those same (conservative) people often resist economic paternalism. Liberals, like me, often favor protective economic legislation but resist cramping political choices. (The justification for my position is that the power dynamics in economic relationships are largely absent in the voting booth).

Does transparency work? In one almost definitional sense, we know it does not. By placing the onus on the consumer to navigate the shoals, you guarantee that some will fail. Some will miss the disclosures, fail to understand their import, or undervalue the risks. For reasons of poverty and liquidity, some will make choices they otherwise would not. Advocates of transparency say this is the price of freedom. Maybe so. The other serious concern is that the power relationships in the economic sphere may render disclosure moot. What does disclosure matter about credit cards if the few remaining banks issue credit cards with the same terms? What if the terms you want are simply not offered? What if - as is normally the case - everything is presented on a take-it-or-leave-it basis. Ever tried to negotiate with AT&T or your health insurer? Can't be done. Take it or leave it. Transparency is not working if all it does is tell you exactly how you are being screwed.

I think the Obama administration should be less afraid of the charge of "paternalism" and a bit more skeptical about the ability of the market to drive out bad practices through better information. Their hearts are in the right place, believing correctly that if transparency can work, it is a better choice than paternalism. But we should be realistic, too.

Think of this example as typical. When you drive into a car parking lot, you get handed a ticket that spells out the terms of liability (basically, they won't take any responsibility for your car not being stolen in their unprotected lot). Negotiating with the teenager or immigrant manning the booth - if there is even a person at all - is not possible. You either park there or not. All the lots will have the same pre-printed tickets. There is no option except to park on the street. Where street parking is limited, as in big cities, you basically find yourself with little or no choice but to accept those terms offered. This (sometimes called a "contract of adhesion") is a failure of transparency. Even if the parking lot were ordered to place its theft statistics in big numbers on a banner on the front, that might deter some, and might encourage some improvement, but not much overall would change. You still could not negotiate and still have too little choice. This is where government needs to step in to make a decision, possibly, to require that parking lots acccept liability for theft (or not).


Raised By Republicans said...

I'm not unsympathetic with LTG's criticisms of transparency as a solution to the financial mess. But he's misunderstood some important things that might bring us back to thinking transparency has an important role to play in the future.

First, when the economists advocate for transparency, they aren't trying to solve the information deficit for the actual mortgage borrower. From the perspective of economists these people should have much of the information they need - they know how much they make, they know what the monthly payments will be. What these people don't know is the probability of and size of increases or decreases in value for their homes/interest rates on the loan. And really increasing transparency won't address either deficiency. So in that sense, LTG is correct to complain that transparency isn't a direct solution to that particular problem. However, it was never intended as such so blaming the Chicago School advocates for not fixing this aspect of the problem is a bit unfair.

What the transparency approach is designed to fix is the problem of mortgages with no income reporting at all. Many of the subprime mortgages were issued without any verified disclosure of the monthly income of the intended borrower. That is, it was possible - and indeed alarmingly common - for borrowers to lie about their income or even be encouraged to lie about their income or even leave their income off the form entirely to be filled in later by the loan officer. Of course, if each mortgage agreement had to include a pay stub or something in the file (my bank asked for one), it would give more information to the lenders about the risk that the borrower will default.

And it would also help the next step (which is related). This is where some local S&L sells the high risk mortgage to a middle man who combines it with thousands of other high risk loans and sells it again, and again and again. Often dividing up individual mortgages into pieces until it is almost impossible to trace back any package of these high risk loans to their original and individual borrowers. This game of mortgage hot potato disconnects the risk from the person who originally offered the loan. Why ask for a pay stub if you won't be holding the mortgage by the end of business tomorrow? This practice also makes it nearly impossible to assign anything other than a purely speculative price to these bundles of high risk loans. So increasing transparency (things like requiring full reporting of the sources of the loans even as the loans change hands over and over again, preventing misleading practices like subdividing loans and combining them with parts of others loans) here would help.

Another area that transparency would help is when the big financial giants in New York, London etc get over leveraged buying these bundles of loans, that they report their debt to asset ratio more completely and more accurately. Had they been doing that from the start, they would not have been allowed to get so exposed to the housing bubble.

Transparency is designed to help banks and banks' stockholders. But it would also have positive effects for borrowers. By making it less attractive for the less honorable lenders to play mortgage hot potato with high risk loans, the transparency approach would make high risk loans less appealing to the lenders. This would, in turn, reduce the aggressive tactics these lenders were using to get borrowers to over leverage themselves to sign onto a loan.

I suspect the differences of opinion I may share (if I understood LTG correctly) with LTG is that I see the problem as being mitigated or fixed if fewer high risk/bad loans are issued and/or the effects of those loans defaulting in large numbers is contained to those financial institutions willing and able to assume those risks. LTG sees the problem being mitigated or fixed only if the people who took out these high risk mortgages are allowed to keep buying homes given their current income levels (thus the comparisons to negotiating with the phone company or health care insurance provider).

The Law Talking Guy said...

I don't think I misunderstood anything, RBR, but I think he has. (FYI: it is obnoxious to say that someone else "misunderstood" something, since it's calling another person stupid. It is more respectful and accurate to say a person has misrepresented or "seems" to misunderstand something. You can avoid alot of bad feelings on a blog by eschewing inflammatory language.").

The transparency being advocated by the Obama administration is *not* to spare banks from the risks of "liar loans" (mortgages with no income reporting). When the Obama administration speaks of transparency in the mortgage industry, it speaks almost exclusively about borrowers understanding the real risks of exotic mortgages.

The focus on mortgage fraud and exotic loans is all about protecting the borrower from his lack of information about what exotic mortgages really mean. RBR's analysis that the borrower has all the information he needs is what is being rejected. The borrowers took out exotic loans not just because they believed appreciation was inevitable, but because they did not understand the risks of ARMs resetting. The transparency advocates want to see things like showing what the payment (not just the %) will be if the loan re-sets to 5%, 10% or higher. When it comes to those who did no more than bet on the market always going up - speculators - the Obama administration is not interested in helping out.

RBR may be correct that the "liar loan" problem is substantial, but it is not the focus of any transparency initiatives by the Obama administration. Lenders were not misled about the borrowers' financial condition, they didn't care. The problem is to make them care. Everybody knows that lenders can require any information they want. Transparency in the borrower's financial condition is not a problem for lenders - the desire to look for information is the problem. It is a problem created by and easily solved by banks and investors. If nobody will buy "liar loans," nobody will make them.

So why did investors buy liar loans securitized into bundles?
When it comes to the problem of bundled/securitized mortgages, the concern of the Obama administration is also not really transparency (revealing hidden information) but accurate reporting (precluding false information). They want to change the rules so that B grade instruments canot be sliced in a way to magically and improperly create A grade investment-quality paper out of hash. This is how they intend to defeat the "liar loans" - by making paper based on them undesirable.

I am inclined more to exercise paternalism to protect individuals than institutions from individuals

Pombat said...

Hmmm. "It is obnoxious..."; "It is more respectful & accurate to [etc]... You can avoid a lot of bad feelings on a blog by eschewing inflammatory language."

I agree with the second quote.

On topic, I find myself agreeing with a mix of both views. I think it would be good if the lenders knew that they'd be stuck with any bad loans they made, because they'd take less risks, I also think it would be good if borrowers weren't stupid, and happily took responsibility for themselves rather than trying to blame the lenders for giving them the loans (I saw a credit card debt documentary in the UK, a guy earning GBP15k had wound up with GBP115k of credit card debt. When asked why he kept accepting cards etc, he said that he figured that the bank thought he could afford it, so he was going to trust their judgement, and anyway, there was all this stuff he wanted to buy). Which if I take it to an extreme means I think that mortgage calculations should turn up in school sometime. But how many kids - out of the group that will grow up to be subprime borrowers - pay attention in maths classes?

(I didn't see the formulae until uni, but they're not complicated if all you want to do is plug in numbers and see what comes out. We now have a nice little spreadsheet for doing just that. Comparing the life interest of a loan against the principal was scary though.)

All boils down to basic human greed - the lender can make money from offering the loan, the borrower can get something they want. Maybe making it compulsory to give the borrower the monthly payment amount at several different interest rates in writing could help a little? A standard piece of paper with a disclaimer across the top along the lines of "no-one knows what will happen with interest rates, don't take this mortgage if you can't afford any of these monthly payments", and then a simple table with several different lines of "if interest rate is x%, monthly payment will be $y. Can you afford this?".

Raised By Republicans said...

LTG, I didn't mean to imply that you were stupid by saying you misunderstood the purpose of the transparency advocates broadly defined (and you did open your comments to a fairly broad range of applications by bringing the loosely defined group of "Chicago School" economists). Geez! If everyone who ever misunderstood anything was stupid there'd be no smart people. And from a rhetorical point of view, if the standard for respect is that we all assume each other to be omniscient, I guess I don't respect a lot of people - including myself.

"RBR may be correct that the "liar loan" problem is substantial, but it is not the focus of any transparency initiatives by the Obama administration. Lenders were not misled about the borrowers' financial condition, they didn't care. The problem is to make them care. Everybody knows that lenders can require any information they want. Transparency in the borrower's financial condition is not a problem for lenders - the desire to look for information is the problem. It is a problem created by and easily solved by banks and investors. If nobody will buy "liar loans," nobody will make them."

The quotation above is an example of where LTG, who I honestly (and with no sarcasm intended) think is really nice and intelligent and good in so many ways, has misunderstood a point of my argument. Here is where I think some more explanation would be helpful to the debate (and in no way intending to imply that LTG is stupid).... There is more at work here than a simple one-time transaction between a single borrower and a single lender. The place where the transparency falls apart in the system that led us to this was when the mortgage starts being passed around from bank to bank to bank without any further input from the borrower.

In short, I agree with LTG that the problem is making that initial lender care about the borrower's inability to pay. That's where all the transparency stuff about reporting the details of the loans, honestly filling out the applications, and accurately reporting debt-asset ratios for the big banks comes in.

The big banks bought the bundles of liar loans for a variety of reasons: a) They couldn't determine what percentage of the bundle was liar loans and what percentage was perfectly manageable subprime loans (many subprime mortgages are just fine). b) They were planning on selling the bundle to the next sucker in the chain themselves. c) They were lying about the value of the loans to inflate their own "assets" on the balance sheets. There are other reasons but these are the ones that I think fit with the aspect of transparency I was arguing about.

So, if I understand LTG correctly, there really isn't THAT big a disagreement here.

The Law Talking Guy said...

I guess my take, Pombat, is that I agree that borrowers are definitely taking out loans they cannot afford, but we don't exactly know why they do it or how to control it. We have discovered that if borrowers are allowed to do this sort of thing en masse, it hurts the whole economy, so the libertarian solution (do nothing, let the market sort it out) is not a very good one. We need to figure something out.

When it comes to figuring out how to control irresponsible lending, do we rely on transparency or paternalistic regulation? Who - the borrower or the lender - is most likely to be able to make the best-informed decisions?

As a practical matter, I think the best-informed person is clearly the lender, not the borrower. It may sound counter-intuitive, becasue surely the borrower knows his own finances better than anyone. But the borrower is not familiar with the market for loans. The lender makes thousands of loans and knows, or should know, what sort of default rate to expect given the borrower's economic status. In other words, the lender can actually assess the borrower's creditworthiness better than the borrower. And lending worked a lot better when they actually attempted it, rather than allow borrower to take out almost any loan the borrower claiemd to be able to afford. Why the disparity? Not just lack of math training. The residential borrower has likely never taken out a loan anywhere near this size in his or her life, and may be expected to err. We are learning about "mental accounting" and other observations from behavioral economics that help explain how long-term financial decisions get poorly made by individuals with so much emotionally invested in the outcome (e.g., where my family can live). Hence my comment about paternalism: we shouldn't really trust ourselves so much in making these decisions.

Those errors, we are finding out, hurt not just the borrowers, but the rest of us too.

The Law Talking Guy said...

I think the disagreement, RBR, is over what the Obama administration is doing. I think you have it wrong. When the Obama administration talks about transparency, they are talking about protecting borrowers from irresponsible lenders by disclosing loan terms. They are not talking about what you are talking about. In other words, you are addressing another topic, albeit a related one.

I talked about the Chicago School first because Obama is related to it, and second because I think that helps explain an administrative bias towards transparency (more of a free market solution) rather than paternalism.

We are unlikely to talk about paternalism with regards to protecting banks or institutional investors, because paternalism is premised on the somewhat naive or childlike status of the small citizen (hence needing the state to act as parent or pater).

Raised By Republicans said...

LTG, I'm sorry if I was a bit off topic. But it was very difficult for me to know exactly what you were talking about with regard to Obama administration transparency policy because in your original post you never mentioned a specific policy. Rather your original post was a general critic of the concept of transparency with regard to the current financial crisis without much specific connection to any one transparency policy advocated by or implemented by Obama's administration.

In that context, I responded to your general critic with some general remarks about how transparency does have a place in all of this.

If you would rather talk about a specific policy or policies being considered or implemented by the Obama administration I'd be glad to narrow the focus. I might even agree with you.

The Law Talking Guy said...

RBR, you wrote that I misunderstood what was going on because, "First, when the economists advocate for transparency, they aren't trying to solve the information deficit for the actual mortgage borrower." So you knew what policies I was talking about, but you thought I didn't understand what "economists" meant by transparency here. So I don't think you can say that my critique was so general you couldn't tell if it was about specific policies. I was observing that solving information problems for consumers, just as it is for citizens in government - disclosure of bad practices so that you can avoid them, rather than prohibiting bad practices.

I didn't misunderstand transparency at all, nor did I misunderstand what "economists" mean by it. You suggested, however, that other policies might be more helpful in this crisis, namely disclosure to investors of the contents of mortgage-backed securities. I can agree with that. But I actually think that those policies are somewhat misrepresented if we just call them transparency (solving an information deficit). They require regulation, e.g., prohibiting an AA rating for bonds made of junk.

Raised By Republicans said...

I still think that your original post was a general criticism of a the concept of transparency - rather broadly defined actually. And in the context of that general critique you were drawing some conclusions about how transparency cannot be appropriately applied to this crisis. In that context, I do think you missed something important about what economists were talking about when they advocate transparency in financial regulations.

It is not the case that the economists are talking about transparency for the borrower - for the most part. You implied that you thought that was the case but did not mention any specific policy. So I was left to respond to a general criticism of transparency as a concept in which you said it could not be productively applied to the current situation.

The Law Talking Guy said...

RBR, I was not just making a "general criticism of transparency" but discussing its limits for protecting individual consumers. Not every post is a jeer or a cheer, you know.

I also think you are incorrect about what "economists" are talking about. There's so much discussion about whether there was really mortgage fraud or just ignorant consumers, and whether the proper response is more disclosure or prescriptive regulation. Economists are also talking about requiring additional disclosures for sale of mortgage-backed securities, but that is a smaller discussion, I think you will find. It also tends to be more favorable to prescriptive regulation (i.e., banning certain practices) rather than just requiring more disclosures.

Raised By Republicans said...

LTG, I don't see how your original post could be described as anything other than general. And I don't see how it could be described as anything other than critical of the reliance on a transparency approach to policy responses to the current financial crisis.

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