Friday, January 16, 2009

Banker's Cognitive Dissonance

Photo by darkpatator.

Jamie Dimon just doesn't get it. I suppose it's his job as CEO of JPMorganChase not to get the point about the need for reasonable mortgage modification to avoid unnecessarily wasteful foreclosures that are deepening (causing?) the current economic mess we're in. The Financial Times reported yesterday that Dimon strongly opposes--surprise, suprise--current bills in Congress that would allow bankruptcy judges to value claims secured by principal residences at the realistic, current value of the home, rather than the fanciful, contrived value on which the mortgage was based. This isn't the place for a drawn-out explanation of "mortgage strip-down," but suffice it to say that the current bills bring the treatment of principal residence mortgages into line with the treatment of other secured claims (it's actually more involved than this, but this is the takeaway point for non-specialists).

As a policy matter, thess bills essentially punish banks (and MBS securitization trustees and servicers) for unreasonably refusing requests for modifications of distressed mortgages (that in most cases help the banks/investors to avoid major losses in foreclosure). If the lending industry had responded to Congress and supported reasonable modifications before, these bills wouldn't be in the hopper. But these banker folks are now infamous for their unreasonableness (recall, these are the same rocket scientists who valued my home at a discount to actual recent sales prices for identical homes in my townhome association because the other places had been on the market too long!). Now, Dimon will have to lie in the bed that he and his like have made. One of these bills very likely will pass, probably the Durbin bill, behind which even Citigroup and other lenders have thrown their support.

Dimon invites us to feel sorry for the banks, whom this bill would put "at the mercy of the vagaries of the courts." This is ridiculous, as the bill does no such thing--the market value of the property defines the value of the bank's claim. There's no judge discretion or beating up on mortgagees going on here; it's simple market economics. And by the way, Dimon clearly has no problem with borrowers being at the mercy of the vagaries of the market . . . What goes around, comes around.

Dimon's main argument against this bill is the same old, tried-and-true argument that every economist/banker/fill-in-the-conservative-blank levels against any kind of consumer protection or market regulating legislation: it will make banks less willing to lend for fear that loans will be modified or destroyed in bankruptcy. For Heaven's sake, when will bankers stop making this utterly ludicrous argument. First, perhaps a bit less lending is exactly what the doctor ordered, at least less lending to the droves of people who should never have received loans on the terms that these banks and brokers foisted on them in the past several years (leading to our current predicament). Second, no amount of consumer protection has ever inhibited banks from lending, either here or in other countries, even after banks have made their "sky is falling" arguments before passage of legislation (see, e.g., the broad-ranging adoption of consumer bankruptcy in Europe over the past 20 years--lending certainly hasn't ground to a halt there!). Finally, the Durbin bill (as amended in the deal to secure Citigroup's support) applies only to mortgages already existing--not to prospective mortgages. This tired argument about "we will be hesitant to lend if you pass this law" is totally off the mark with respect to the Durbin bill.

My favorite comment: Dimon warns that passage of the bill will "lead to an increase in personal bankruptcies." Well, no @#$%, Sherlock! That's the whole point. We wouldn't need more bankruptcies if the bankers would act reasonably in dealing with the foreclosure crisis, but since they've amply demonstrated that they're incapable of dealing with it responsibly, Congress is stepping in. This is like criticizing the release of a new cancer drug for fear that it will lead to more doctor visits by sick people. Indeed!


Alex said...

My problem with this is that it ONCE AGAIN rewards irresponsible behavior. The cirlce has been completed.

Irresponsible consumers take on too much debt to buy property valued at idiotic levels because of the market competition with other irresponsible consumers.

When these irresponsible homebuyers realize the they can't pay their mortgage, the banks lose money. Banks go crying to Congress who bails them out. The same banks that opposed the cramdown provisions of first mortgages in bankruptcy are now bought off and throw their support behind the program.

Irresponsible howbuyers get to keep their house, not pay any tax on the discharge of the mortgage indebtedness AND the only ones who pay for it are the responsible homeowners who didn't buy too big of a house to start with.

Net result. Banks recapitalized, their executives keep their bonuses earned through years of irresponsible lending. Irresponsible homeowners get to keep their houses (many of them which are very nice). The only ones who are worse off are the 90% of responsible homeowners who didn't overborrow but must now pay for the bailout. That's just unfair. When you reward irresponsible behavior you'll get more of it.

What needs to happen is that fail business, failed consumers must be allowed to fail. Capitalism doesn't work when the downside of the risk is restricted when the upside potential is unlimited.

Jason Kilborn said...

Bankruptcy has been a fundamental part of U.S. capitalism since the 1800s. It may seem unfair to allow individuals to be relieved of their fairly contracted debts, but bankruptcy is about the systemic problems above this kind of individualistic perspective. Bankruptcy is a collective response designed to avoid larger systemic negative externalities that would otherwise flow from allowing businesses and individuals to fail, as you propose. I am sympathetic to much of what you say, Alex, but your comments miss some pretty serious meta-problems that the mortgage modification process (and bankruptcy generally) are designed to address. These are the pressure valves that allow capitalism to function without leading to riots and revolts every few years . . .

Alex said...

Jason, I understand and appreciate your point about the role bankruptcy in society. However, by changing the rules retroactively to allow cram downs of existing mortgage obligations WHILE simultaneously allowing the discharge of indebtedness income to be tax-free, you've now made the bankrupt debtor far better off than corresponding financially responsible debtor.

Let's not forget the magnitude of benefit that's being extended here. Take many properties in California for example. A very average house in California can be upwards of $1M. If property values have fallen 30%+ in certain areas as has been widely reported and you allow the bankruptcy court to reduce the first mortgage indebtedness to the FMV of the property, you're giving the bankrupt debtor a $300,000 windfall. That makes last year’s $1,200 stimulus checks look like play money. I doubt anyone would argue that this should be the result of bankruptcy.

In no way to I support the notion of debtor's prisons or any of the other archaic methods used in the past (to very little success) in making people accountable for their debts. However, the last thing we should do as a society is incentivize irresponsible behavior, be that at the corporate or personal level.

There is nothing wrong with people losing their house if they purchased a house they cannot afford. Economic is often defined as the rational allocation of limited resources. When you disassociate consequences from choices, you end up with irrational and therefore inefficient allocation of those resources.

Finally, I believe that pro-cram down arguments ignore the societal impact of these behaviors on the financially responsible. From everything I've seen no more than 10% of mortgages, nationwide, are underwater. We're therefore advocating a significant redistribution of income from the 90% of responsible debtors to the 10% of the irresponsible ones.

The problem is exacerbated because of the government involvement. The government is using tax dollars to bail out the banks which in turn use that money to offset the losses on the cram downs. The more you allow this, the higher the tax burden will have to be on those who are financially responsible. Do you not believe that this could itself lead to the riots and revolts you seek to avoid?

Jason Kilborn said...

No, people don't riot because others are receiving benefits--history suggests that people riot because they've been squeezed out of their homes and can't make a living and feed their children. Riots are caused not by envy and greed, but by destitution and despair.

The cram-down rules (and bankruptcy generally) are designed to prevent one or a few creditors from upending a reasonable collective compromise and externalizing unnecessary pain onto other creditors, the debtor, and society (I hope you admit that the irresponsibility here was nearly universal, not focused on borrowers or even lenders and brokers, but extending to government and a law-and-economics-driven blind faith in markets and a consequent craze for deregulation).

The responsible folks will not suffer NEARLY as much as a consequence of forgiveness to those victimized by mortgage brokers and bankers, as debtors and society would suffer if we took the classical (and deeply flawed) law-and-economics approach of incentives and punishments. Once again, your arguments return to the mantra of individualized unfairness, and while I remain sympathetic to some of these arguments (particularly with respect to the largely unsupervised bank bailouts), bankruptcy and mortgage modification are about macro/collective loss-cutting. This situation is like chemotherapy: The cure really sucks, but it's far better than allowing the disease to run rampant.

Alex said...

Jason, I’m not sure I agree with the premise that riots are not caused by greed and envy. If we speak of wide spread riots which lead to revolution on a national scale, I believe history refutes that position – particularly if we look at the American experience. Certainly the American Revolutionary War wasn’t caused by destitution or despair but by economic objections to the wealth transfer mechanisms of the British monarch. Similarly, the American Civil War, notwithstanding the revisionist moral justification we now attribute to it, was caused more by economic issues than by destitution and despair. Do you really think that South would have ceded from the Union if the North was more accommodating to the economic concerns of the South?

Secondly, I believe that it is incorrect to characterize everyone who took a loan out that is now underwater as a victim. While I do believe there are plenty of cases of irresponsibility by multiple participants in the mortgage market (builder, borrower, realtor, mortgage broker, lender, investor, investment firm and regulator), I also believe there were plenty of cases where the borrower alone bears the sole responsibility. Entrepreneurial risk taking is the cornerstone of our economy – and the market functions best when it is encouraged. Is the divide 50/50? I don’t know, but all I’ve read and what I’ve experienced first hand leads me to conclude that the actual figure probably isn’t that far off.

Again less than 10% of mortgages nationwide are in default. Enacting retroactive cram down favors a very small minority at great expense to large majority and does so in a manner that rewards bad behavior and has been shown to be ineffective. All the evidence I’ve seen is that well over 50% of restructure loans (either principal, interest or both enter into a new default within 12-months). See Therefore, your chemotherapy analogy seems to fail because the medicine you advocate doesn’t to improve the situation.

Finally, my argument not based on an individualized unfairness, but instead out of the macro-economic reality that cram downs (1) do not work (2) they create a huge moral hazard by rewarding failure and (3) they undercut the free market economy that built the US. The problem with our economy isn’t that the free-market has failed, but instead that we haven’t allowed it to kill off the failed ventures. If I continue your medical analogy we’ve got cell mutation that doesn’t sustain life but instead of allowing it to die off, we’re trying to protect it at the expense of the entire organism.

From top to bottom (ultra-rich CEO to lowly ignorant homebuyer) we’ve disassociated the consequence of bad choices. The Chairman of Lehman (Mr. Fuld) earned over $700 million dollars in the last 7 years leading up to its collapse, but has to return none of it. His bonuses were based on inflated fictitious earnings (which he signed off on). Yet he suffers no consequence for the decisions he made (and/or allowed to be made) which led to the collapse of the firm. The remedy for this dysfunctional economy is not to further disassociate risk and return or choices and consequence but instead to re-establish the relationship between the two.

Anonymous said...

I am reminded of a quotation from a member of the Astor family who, when asked whether he felt bad about foreclosing on a debtor, replied, "No, because in our view it is not the debtors money we are taking, it is our own."

Now I certainly understand and agree with your point that BK is a social safety valve which insulates us from the social cost of insolvency and lowers overall transactions costs.

However, Dimon has a point: lenders will be reluctant to make new loans if the courts have the power to upset the bargained-for balance of risk vs. pricing set crystallized in the mortgage. Why is that bad, considering that excessive lending got us into this mess? Well, as a student of financial history you probably recall that the money supply contracted for FOUR YEARS following the '29 crash-- what we need is for the TARP equity infusions to begin flowing as soon as possible, which is only going to happen if banks are as confident as they can be about their risk profile in the future.

Finally, I read with interest your comments on your own tanked refi transaction, which was evidently caused by a lowball appraisal despite the existence of some pretty solid comparables. What's to prevent the same situation from prevailing in a hypothetical debtor's BK proceeding, only to have her be in a positive equity situation once the market normalizes? Where is the lender's "schmuck insurance?"

Your writing is excellent and full of useful facts and citations, which I enjoy immensely.

Jason Kilborn said...

Anonymous, thanks so much for your insightful comments and your very kind words. Our only divergence of view seems to be empirical (or to put it another way, how much we trust the banks). Based on years of research on lending by banks and other institutions to people on the economic margins, I no longer believe for a SECOND that any risk will make banks less likely to lend to the consumer market. Banks' practices have become so completely irrational in recent months--I can't explain why banks are not lending to businesses with proven track records despite the infusion of TARP funds, so I can't begin to believe that standard economic theory will accurately predict a constriction in the lending market due to possible strip-down of mortgages. Indeed, the bankers constantly ignore the fact that bankruptcy courts have had the power to strip down the value of cars securing loans for years, and the car financing market hasn't even contracted, let alone dried up. I would like to believe and support Dimon and the other bankers, but they have proven themselves to be such miserable mismanagers of risk, I just don't believe that they either (1) understand what they're saying or (2) are telling the truth on what they do understand. Sad state of affairs. If banks become the victims of shoddy appraisals and aggressive strip-down, I'll have a tough time feeling much pity. What goes around comes around. H.R. 200 is on its way, it seems.