The Swindled group does not include people who showed general irresponsibility (poor spending disciplines, broad financial naiveté, confused monetary priorities, etc.). Those people rightly deserve to be labeled as the Reckless. The Swindled refers to those cases where any reasonable person would see the borrower as a victim—where there was paper switching, direct lying, exploitation of language deficiencies, mental incapacity, and so forth. Let’s acknowledge that rare and despicable incidents such as these took place, but at nowhere near the level required to fuel a financial crisis.
Predatory Borrowing: The Reckless and The Gamblers
The sad reality is that predatory borrowing was a far more systemic problem than predatory lending. The fact is that 70 percent of defaulted loans had blatant misrepresentations on their mortgage applications.13 The FBI estimates that mortgage fraud (by borrowers) increased 1,000 percent from 2001 to 2007. In other words, borrowers frequently made false claims to get loans, yet why did that reality not become part of the postcrisis narrative? Why is “predatory lending” a commonly used term, whereas “predatory borrowing” is the odd contraption of a free market economist? (Tyler Cowen of George Mason University used the term early on in the financial crisis.) The reason is simple: the facts do not agree with the created narrative.
If we combined all predatory loans—cases where the lender perpetrated fraud against the borrower by deceiving him or her about the loan—and all cases of predatory borrowing—cases where the borrower perpetrated fraud against the lender—we still have only 25 percent of the total defaults in the financial crisis according to the Journal of Financial Economics.14 That means 75 percent of all defaults came from people who did legitimately qualify for a loan yet defaulted anyway—the Reckless and the Gamblers.
I suspect most readers know someone in one of these categories. I’m using a broad brush here because macroeconomics deals with macro circumstances, with broad economic trends, and with numbers that apply across certain classes and segments. No doubt I’ll step on some micro toes when discussing these macro events. Certain specific situations may very well have had exigent circumstances that paint a more sympathetic picture than my broad categories allow. I beg your pardon where those situations exist and ask for the benefit of the doubt as we examine some harsh realities.
The Gamblers are most likely to engender irritation and least likely to gain your sympathy. Some were extremely bad actors, confident they could speculate en masse, keeping 100 percent of any upside and passing along 100 percent of any downside to their lending institutions and, eventually, to the taxpayers. In other cases that I would still include with the Gamblers, the intent may not have been as sinister, the volume of transactions may have been lower, or financial objectives may not have been based on rank speculation—and yet the end result was the same.
An intelligent and financially capable borrower simply walked away from debt they could afford. This morally questionable activity was not rare. It was commonplace. And this activity did not have a minor financial impact. The Gamblers on Main Street were major actors in the financial crisis drama.
The national credit bureau Experian worked with the consulting outfit Oliver Wyman in late 2009 to conduct an analysis on these strategic defaults.15 The results were damning for the Gamblers. Using a sample of twenty-four million credit files, they found that borrowers with high credit scores were 50 percent more likely to strategically default, thus debunking the myth that it was less creditworthy and capable people struggling through the financial crisis. They also discovered these sorts of events—the abandonment of a mortgage obligation to pay when people were perfectly able to pay—represented fully 20 to 30 percent of the delinquencies that took place in 2007 and 2008 (a jaw-dropping one million incidents in these two years alone, with these incidents accelerating into 2009). After evaluating the other patterns and activities in the credit reports, the analysis indicated that the perpetrators were “clearly sophisticated.”
Another damning study from economists at the University of Chicago and Northwestern University16 found that those who personally knew someone else who had strategically defaulted made them 82 percent more likely to do so, demonstrating the lack of social stigma effect: if they did it, I can do it too. It pegged the percentage of strategic defaults as 26 percent of the national default levels. Wealthy communities were not remotely immune from the Gamblers’ misdeeds—in fact, they were the sweet spot for such activity. California saw strategic defaults multiply by a factor of 68 and Florida by a factor of 46! Meanwhile other states with lower median incomes saw their rates multiply only by a factor of 9.17 The delinquency rate for mortgages above $1 million reached 23 percent in the aftermath of the crisis, but it stayed at 10 percent for mortgages below $1 million. Perhaps wealthier people were more ruthless and reckless, but they also had more resources. Clearly it was not the poor and needy who led the rush off the cliff of strategic defaults.
When Monsters Wear Masks
The proof for the Gamblers’ existence on Main Street and their role in first creating and then exacerbating the financial crisis can be found in two empirical facts:
1.41 percent of all mortgage defaults took place in California and Florida, states that mandated nonrecourse financing (meaning, the borrowers could not be held personally liable for a failure to perform on their mortgage loans). In fact, the vast majority of all mortgage defaults came in nonrecourse lending states. Are we to believe that the exact conditions blamed for the financial crisis somehow magically plagued these few states, with no correlation to the fact that these states allowed borrowers to walk away scot-free?
2.To help borrowers who claimed challenges in making their monthly payment, loan modifications became a huge craze in the aftermath of the crisis (i.e., loan terms were restructured to make the monthly payment more favorable to the borrower, whether through a changed interest rate, an extension of term, or a forbearance on principal payment). However, something stunning happened:
a. 36 percent of those who received a modification to their loan defaulted again in just three months18
b. 58 percent defaulted again within eight months19
c. 67 percent defaulted again within eighteen months20
Why would a borrower who had gone through the trouble of getting a loan reworked to provide relief and an easier payment default anyway? Because at the end of the day, the value of the asset was worth less than the debt they were servicing on that asset. And so approximately one million borrowers walked away, despite having received favorable options to alleviate the anxiety around their monthly payment. An entirely new term for what we used to call failure to perform was created—the aforementioned “strategic default.” (Millions more “strategically defaulted,” but I am highlighting here those who received favorable relief on their loans in some capacity, and yet defaulted shortly thereafter anyway.)
The conclusion is impossible to ignore: the vast majority of strategic defaults came from people who had the resources to pay (and, in fact, had been given grace and financial assistance) yet still chose to walk away because they realized there would be virtually no financial repercussions to them personally. They saw an opportunity to get out from an investment that was upside down—and they took it.
The distinction between the Reckless and the Gamblers may evoke different moral responses. Whereas the Gamblers clearly had the financial capability to pay, the Reckless could no longer cover the debt obligations. And yet they had taken on the obligations with an understanding of the risks involved. So much of the confusion about the Reckless can be blamed on the vocabulary adopted to describe the financial crisis.
The mental imagery of a subprime borrower is one who has no job, no income, no assets, and no credit, yet received a mortgage anyway. The reality is that nearly all data describing the impact of subprime borrowing in the housing bubble includes data of what we might call “near-prime” borrowing, or “Alt-A” lendi
ng. While subprime borrowing proved to be harmful in the financial crisis, it was Alt-A lending21 that proved catastrophic.
Alt-A was the mortgage category that included nontraditional lending, but not necessarily to subprime, severely credit-impaired borrowers. The Federal Reserve’s own data on the subject shows roughly a 70 percent growth in subprime issuance from 2003 to 2005 (as the hot real estate market was becoming the bubble of all bubbles). But the same data also shows a stunning 360 percent growth in that same time period for Alt-A loans.
Much has been said about the roughly 20 percent default rate in subprime borrowing by the summer of 2008. Indeed, a 20 percent default rate is higher than the 10 percent default rate Alt-A loans were experiencing by that same summer. However, subprime delinquencies had been in the 5 to 6 percent range just a few years earlier when the housing market was doing well. So, the subprime default increased from 5 to 20 percent, i.e., by a factor of 4. However, before the bubble began to pop, Alt-A loans had a virtually 0 percent default rate (0.6 percent to be precise). By the summer of 2008, as the housing market melted down and the crisis began, the 10 percent default rate for Alt-As meant they had multiplied by a factor of 16! And from a pure dollars and cents standpoint, the Alt-A issuance throughout the key bubble-formative years of 2002–2006 was exponentially higher than classic subprime issuance. By the end of the bubble, Alt-A lending represented fully half (50 percent) of new loans issued in the mortgage market (over $1.4 trillion in 2006 alone), while subprime issuance had peaked at 16 percent of new loans issued.22
Significant data supports the fact that this middle ground of Alt-A lending created the most financial distress in the crisis. Yet why have those selling the narrative about the financial crisis gone to such great lengths to intentionally define it as primarily a subprime failure? Answer that question and you will understand why I believe this subject gets to the heart of the matter.
The term “subprime” effectively and even dramatically conjures up an image of a victim. They are sub-something. Those labeled as sub-anything have inferior capabilities. They are disadvantaged from the start. Only a greedy and heartless entity would go after something as helpless as the subprime, right? But by combining all data of “non-prime” (Alt-A and subprime) into one broad category of subprime, these storytellers have effectively poisoned the well in this discourse. If the narrative aligned with reality—a huge amount of totally intelligent and capable borrowers with adequate credit and debt service capabilities took out reckless, irresponsible, and nontraditional loans—there would be no room for a victimization movement.
This sleight of hand was not accidental. A massive amount of contaminated loans were at the heart of the capital losses that created the financial crisis. Those contaminated loans were taken out primarily by irresponsible borrowers who did have adequate credit and income to service them. It was the loan-to-value ratio—the fact that there was very little protective equity in these types of loans—that gave borrowers of adequate credit and income the economic green light to walk away when conditions changed.
When the source of their default was irresponsible borrowing and spending, a moral indictment is in order. What we do know is that consumer spending increased a stunning 6.9 percent in 2005 over 2004. We know that home equity extraction as a percentage of consumer spending tripled in the five years leading up to 2005.23 Total household debt exploded to 127 percent of household income by 2007. It was the Alt-A mortgage category that enabled this expanded borrowing—and borrow they did.
Fueled by access to more liquidity than they had ever seen, often with tax-deductible interest and always with lower interest rates than other options, reckless borrowers exploded in number in the years 2000–2007. The results were nothing less than utterly catastrophic. Wall Street, Fannie, Freddie, and government policy certainly deserve some blame for giving access to this credit, but for recklessly using this credit the real blame belongs to the envious among us, right here on Main Street.
Ten Percent Had No Conscience
The consensus view of the financial crisis is that the blame lies with those who made and sold the lending products. Such a view seeks to vindicate those who bought and used the product—an incomplete, inaccurate, and, indeed, morally flawed view of adult responsibility.
A perfect storm of government mandates, irresponsible policy fed down to government agencies, and the incompetent calculations of those in the credit and capital markets created the conditions necessary for this crisis. Indeed, Main Street could not have fed at the trough of easy borrowing, excessive spending, and living beyond one’s means without those accomplice actors. However, there has been a trend in our culture for decades to pardon the actual actor and participant in wrongdoing. The housing crisis is but one, albeit painful, example of this trend.
Recent years have seen a societal blame shifting from those drinking excessive amounts of soda to the soft drink companies, not the beverage consumer. We see fast food franchises demonized, and not those ordering and eating the food. Certainly there is a parallel with the tobacco companies, as well. My intent is not to fully vindicate all the corporate activity we observe. Corporate America shares a responsibility to be good corporate citizens, and in a free and virtuous society, our great companies should exercise that responsibility with appropriate focus on consumer options, consumer education, and integrity. However, the idea that all bad acting which takes place in society is the responsibility of those providing the raw material and not of those doing the acting is an idea that will undermine the entire strength and will of our culture over time. Such a view of moral agency overturns traditional values and makes victims of perpetrators.
Yet, this misguided view has governed the consensus narrative of the financial crisis and the Great Recession that followed. We’re asked to believe that the availability of bad loans is the problem, and the institutions making these bad loans available are the problem—but not the people taking them, and not the people failing to pay on them. A society with more moral intuition would never allow the prima facie response to be disgusted with those who lent the money instead of with those who refused to pay it back. And when the actor not making good on the debts so often had adequate, or even abundant, financial resources, this lack of moral clarity becomes even more appalling.
We are right to look upon the actions of Dick Fuld and his cohorts at Lehman Brothers negatively for excessively irresponsible acquisitions, purchases, and leveraging in the years that led up to the financial crisis. The economic ramifications were disastrous, and the moral pathology at play was beyond the pale. And yet, why should our response to an essentially identical moral pathology from Main Street be any different? Is what’s sauce for the goose also sauce for the gander, even if the gander doesn’t wear Armani suits or work on Park Avenue? Our communities in the culture and ethos of American life were filled with those living above their means, at varying degrees of self-awareness, as thrift very often became obsolete. There was a crisis of culture in the events that created the crisis, a covetous envy in the society-wide game of “keeping up with the Joneses.” And there was a crisis of culture that exacerbated the crisis, walking away from obligations without concern for personal integrity or collective economic impact.
Wall Street’s use of the synthetic CDO—an investment device used to bet that mortgage bonds would perform and that Americans would keep paying their house payments—proved to be a weapon of mass destruction for our financial system. But no exotic CDO bet caused any Americans to quit paying their bills. Wall Street’s error was not in causing Americans on Main Street to stop paying their bills, but in making the wrong bet as to whether or not they would.
In October of 2009, I sat in the thirty-fifth floor conference room in the Fifth Avenue offices of one of the premier credit hedge funds in the industry. As I talked to the portfolio manager about the crazy twelve months we had just experienced, he said one of the most chilling things I have ever heard.
“We had a financial crisis, David,” he said to me, “because 10 percent of the society had no conscience. The financial crisis only ended because it proved to be 10 percent and not 20 percent.”
The implication was clear. Ten percent of the population walking away from responsibility was enough to cause the crisis. We managed to barely emerge from the other side at 10 percent. Had the number been 20 percent, we would not have been so lucky. Yet have the moral scruples of society improved since the financial crisis or worsened? Wall Street has been forced to deleverage and now incurs a web of regulatory oversight that borders on the obnoxious. But what about the monster on Main Street, that green-eyed spirit of envy that drove so many of the people in neighborhoods with cul-de-sacs and picket fences to risk total economic collapse for just a little bit more? Has Main Street’s moral compass been deleveraged?
How we respond to that question as a society will determine whether 2008 was a painful memory in our economic history, or a foreshadowing of darker times to come.
5
THE ROBOTS ARE COMING
What Free Trade and Automation
Mean for the American Worker
It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbors, and to purchase with a part of its produce, or what is the same thing, with the price of a part of it, whatever else they have occasion for. What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom.
Crisis of Responsibility Page 7