Tuesday, July 15, 2008

The Mortgage Mess and Conflict of Interest

[Posted by Bill Henderson]

Looking for a primer on the Fannie Mae / Freddie Mac mortgage mess?  Over at Econbrower, UCSD economist James Hamilton has an excellent detailed post that lays out the problem.  In a nutshell, it comes down to market believing that Freddie and Fannie mortgage-backed securities were riskless because the government would never let them fail.  All that extra cash, available at artificially low rate for consumers, subsequently ran up the price of housing to unsustainable levels. Here is Hamilton's bottomline:

The overriding concern in dealing with the current mess is that the process of rapid and radical deleveraging would so impede the flow of new credit that the housing price declines, foreclosures, and bankruptcies significantly overshoot the values that we'd expect in a properly functioning credit market. In addition, I would worry about possible serious repercussions of a flight of foreign capital if there is a sudden perception that agency debt entails heavy risks.

The principle of "make those who caused the problem pay" has a lot of visceral appeal. But the principle of "don't impose severe and gratuitous extra costs on those who had no role in causing the problem"-- in other words, don't make the housing depression much more severe just to teach somebody a lesson-- has to be the basis for our policy decisions.

(HT: Tom Smith at the Right Coast.) The poor organizational incentives at Fannie Mae and Freddie Mac remind me a lot of Enron's go-go culture. Unfortunately, this debacle has potentially staggering macroeconomic consequences. 

To my mind, the legal analogue to the economist's "moral hazard" problem is conflict of interest; lawyers should be able to spot these issues. The peculiar aspect of the mortgage meltdown is that many Wall Street lawyers had clients that, at least in the short run, were benefiting from the conflict of interest.  From this unchecked growth, Fannie and Freddie executives got power, income, and patronage $$ to spend around to their politico friends, and investors got seemingly riskless securities.  But there was no vigilant regulator at the table assessing the risk implicitly being assumed by the government and taxpayers.   We operate in an adversarial system.  If the government lawyer never shows up, that is not the problem of the private sector lawyer. 

I would be interested to know, however, how many Wall Street lawyers perceived the mortgage-backed securities market as an eventual Ponzi scheme. Is it a pipe dream to teach lawyers to spot these types of issues?  And if they do spot the issue, what should they do with the information?


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Tracked on Aug 13, 2008 9:22:09 PM


With this kind of cowboy action from First Franklin it will be the end of the Mortgage Broker. The case that FF has against AMC doesn’t make sense all lenders (Mortgage Brokers, Bankers) will be in harms way of a contractual suite?
No lender will ever sign an agreement if any loss no matter what falls to the origination of the loan? I guess back to the stone age and lets wait on a list until the Bank can fund a loan for all of us that remember in the 70‘s. Somthing needs to be done with law suites that take up the courts time and we all pay for attorney's getting rich!

Posted by: intrested | Aug 21, 2008 6:53:31 AM

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