The market seems (more or less) competitive on the supply side. So the greater the opportunity for fraud (by lenders), the more lenders will enter the market. This will bid down prices (interest rates on loans). The loan contract will move toward lower price, lower quality. Of course prices are lower on average but for those who end up ripped off the real price, ex post, is much higher.
On average who loses from such a shift? Well, to some extent there is a pooling of heterogeneous tastes into a single market segment. The ones who don’t like the lower price, lower quality equilibrium will be the higher valuation buyers for the contract, that is the wealthier people in the relevant loan class, not the poorer people. The poorer buyers in the market segment might well be better off.
This result does not require buyers to be wary about fraud. It is even possible to get a superior outcome if buyers are totally unaware of prospects for fraud. To the extent buyers are suspicious, they will invest resources in monitoring the behavior of suppliers. Often such monitoring is simply keeping/capturing pecuniary externalities, and thus it is oversupplied relative to a first best. If buyers are fully unaware there will be no socially wasteful monitoring and the lower prices still will arrive.
You might say "Ah, but we cannot dismiss pecuniary externalities when insurance markets are incomplete." I might say "Ah, but aren’t buyers generally risk-loving in terms of prices"?
The bottom line is this: whenever you see fraud, apply tax incidence analysis to understand the final results.
“Risk loving in terms of price”? I see no evidence of this. People get very upset
when the price of their house goes down. It may look like they love risk in an
environment where prices are mostly moving sharply upwards. Certainly people are
willing to bear some greater risk to buy a house whose expected rate of appreciation
is 20% per year than 2% per year. But that is not the same as being risk loving.
Fraud by lenders who don’t disclose terms…
Buyers are not “risk loving in terms of prices” in the sense relevent here. Yes, mortgage buyers like volatility in disclosed interest rates, so they can seek refinance opportunities. But Tyler hasn’t presented an argument that fraud increases that. What fraud clearly increases is undisclosed interest rate volatility, i.e. the chance you will get an interest rate much higher than you thought you were getting. There is no corresponding upside risk, i.e. no chance you will get an interest rate much lower than you thought you were getting. Buyers do not love that kind of risk. Indeed, given the well-documented fact of strong loss-aversion, there is every reason to believe a known interest rate would be preferable to a 90% chance of a lower interest rate and a 10% chance of a much higher interest rate constructed in such a way that the average is the same as the known rate.
Tyler – your analysis is not far off but you have the market participants backward. The
consumer/homebuyer/borrower got a fat package of disclosure documents stating what payments were
required and any resets imposed by the loan. Admit they didn’t spreadsheet this out but the borrowers
generally were given the idea from the broker that the rate would change down the road and they should expect to refi (=more business to the broker).
Now remember the offer that homebuyer/borrowers were being given. They need shelter. If you rent
an apartment you must put up a security deposit, first/last month rent and if you dont pay by the
10th you will be on the sidewalk by the 15th. They were given the opportunity to buy a house with
no money down and the closing costs rolled into the loan. They were given a FREE OPTION on the
upside in home prices. No surprise that the strike got over fair value there. Plus look at their
downside vs. rent. If you NEVER make a payment on the mortgage it will take around a year before
you get tossed (yes the time varies by state). Again, they had NO investment in the home.
So buying a home with 2006 subprime terms was better than rent both to the upside and downside.
And these are subprime credits. Which means that by and large they are people who have in the
past stiffed their creditors — and were rewarded for this with these terms on buying a house.
So yes there was massive fraud going on. But it was the loan buyers (i.e. investors) who were
defrauded not the borrowers. Typically the first mortgage was done at 80% purchase price and a
second mortgage for the remaining 20% — and the second was not disclosed to the investors in the
first mortgage. They just saw an 80% LTV purchase money first mortgage. Later, the existence of
the seconds were disclosed but only on an aggregate basis. The SEC generally prevented disclosure
of loan level info — in the interest of protecting investors!
The interest of the lenders/investors in credit here was generally ceded to the rating agencies, who have
in fact resorted to the “we wuz fooled” defense as to why they now expect AAA securities to default
as a result of this.
Tyler,
Is there a lot of evidence of lenders who did not disclose terms? I think the problem is that borrowers never bothered to read the terms since to them it felt like they were getting free money.
There is definately evidence of fraud in inflated appraisals (but don’t have a source handy).
In my opinion market really need harder regulation for morgage companies to prevent that these will sold any more loans to people who are not qualified. I have read that now the bad loans are threating the entire economy. I don’t want to create a mountain out of a molehill, but the situation seems to be really bad. According to some real estate experts the number of foreclosure auctions will doubble in 2008. So there are not many reasons for being optimistic.
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