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Risk


In the spring of 2003, my wife and I were wrestling with whether to move to a larger house. My wife has a large family, and our small house wasn't really up to hosting the epic family holiday events that usually feature 20-30 people at a minimum. At the same time, we were considering Catholic school for the kids--more for religious reasons than academic ones--and we weren't sure we could afford both a new home and Catholic school tuition.We knew a neighborhood where we might be interested in living. We had several friends from the parish that lived there. With California home prices rising so fast, though, it seemed out of reach for us. We talked to the realtor who helped us buy our first home, who encouraged us to meet with a banker. The four of us sat down at the realtor's office and talked options.The banker was very optimistic that we could obtain a loan that would allow us to move into the neighborhood we wanted. "We have all kinds of new products," he told us and proceeded to explain various types of adjustable rate mortgages, "interest only" loans, and other options that I could only vaguely understand. By the end of the meeting, my head was swimming, but I began to feel optimistic that maybe we could afford the "home of our dreams" as the saying goes.In the end, though, we decided that we simply couldn't afford a higher mortgage and Catholic school tuition. A faith-based education for our children was more important to us than a larger home. Six years later, we're still in the same house.In light of recent events, I've taken to wondering what would have happened if Catholic school tuition had not been a consideration. Would we have been tempted to take out a larger loan than we could handle? It could have happened very easily. Looking back over two decades, almost nothing seemed to have stopped the inexorable rise of California real estate values. Betting on rising values seemed like a reasonable risk back then. After all, if the banker lending you the money thinks you can handle it, you should trust him, right? He's the one bearing the risk, right? Back in those days, I had little understanding that most home loans were quickly packaged into securities and sold.I tell this story because I'm getting a bit tired of hearing that the root of the current financial crisis is irresponsible families who borrowed more than they could afford. The truth is that it became very difficult in the early part of this decade to figure out exactly what the "responsible" decision was with respect to a home loan. My wife and I are reasonably well educated and we still had a difficult time running the numbers. What of those families who-rightly or wrongly-placed their faith in what the lender and the realtor were telling them? Expert advice is, after all, why one hires professionals in the first place.I'm not suggesting that there weren't buyers in the market who were driven by speculative greed. There certainly were. I suspect that most of us, though, shared very common American dreams: a first home or a home "just a bit bigger" than the one we had. There may be some sin in that, but I'm not inclined to be lectured about it by newspaper columnists living in Greenwich and Chevy Chase.If there is anything good to come out of this current crisis, I wonder if it might be a re-assessment of the extent to which families are now expected to be experts in financial risk management. From our retirement portfolios to our college savings accounts to our mortgages, families are now expected to perform very sophisticated calculations regarding the likelihood and cost of future events. I suspect I don't speak only for myself when I say that I'm finding the burden of doing this increasingly overwhelming.

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You are right to feel overwhelmed. The current system of financial services has a number of flaws that all can be traced back to an almost religious belief that markets can solve all problems and that government regulation only undermines the efficiency of markets. The proponents of this view have consistently favored deregulation. Classical economics' assumptions regarding the efficiency of markets do not hold in many circumstances. When these assumptions do not hold, markets are not efficient. Economists label these circumstances "market failures" and will support government intervention in the form of regulation to correct such market failures. One of the assumptions of classical economics is that all market participants have perfect information. This assumption is frequently not the case, particularly when sophisticated and complex financial products are involved. Proponents of deregulation have tried to find alternatives to government regulation. In the case of information asymmetries, they have argued that the problem can be corrected purely by requiring full disclosure and educating consumers on financial matters.Lauren Willis has an article entitled "Against Financial Literacy Education" which debunks the ability of financial literacy education to correct the problems of information asymmetries. Here is the abstract for the paper:"The dominant model of regulation in the United States for consumer credit, insurance, and investment products is disclosure and unfettered choice. As these products have become increasingly complex, consumers' inability to understand them has become increasingly apparent, and the consequences of this inability more dire. In response, policymakers have embraced financial literacy education as a necessary corollary to the disclosure model of regulation. This education is widely believed to turn consumers into "responsible" and "empowered" market players, motivated and competent to make financial decisions that increase their own welfare. The vision is of educated consumers handling their own credit, insurance, and retirement planning matters by confidently navigating the bountiful unrestricted marketplace. Although the vision is seductive, promising both a free market and increased consumer welfare, the predicate belief in the effectiveness of financial literacy education lacks empirical support. Moreover, the belief is implausible, given the velocity of change in the financial marketplace, the gulf between current consumer skills and those needed to understand today's complex non-standardized financial products, the persistence of biases in financial decisionmaking, and the disparity between educators and financial services firms in resources with which to reach consumers. Harboring this belief may be innocent, but it is not harmless; the pursuit of financial literacy poses costs that almost certainly swamp any benefits. For some consumers, financial education appears to increase confidence without improving ability, leading to worse decisions. When consumers find themselves in dire financial straits, the regulation through education model blames them for their plight, shaming them and deflecting calls for effective market regulation. Consumers generally do not serve as their own doctors and lawyers and for reasons of efficient division of labor alone, generally should not serve as their own financial experts. The search for effective financial literacy education should be replaced by a search for policies more conducive to good consumer financial outcomes."The paper can be accessed at: http://ssrn.com/abstract=1105384

I might add that the general belief in certain circles that this kind of financial information is readily available to consumers allows people to say that if someone makes a bad or ill informed decision it can only be their own fault.

Been there; done that. Excellent post, Mr. Nixon. Thanks for sharing your story and yes, it is the same story for many of us. I use a trusted friend who is a financial advisor with Edward Jones but have to say that the performance this year is pathetic and it is difficult to take a wait and see attitude.In terms of house decisions and private Catholic education, relied upon my father who is an excellent retired engineer who plays the market. His advice has been simple, clear, and almost always right. My sister decided to move to a suburb with first rate public schools when they needed a bigger house (5 kids). But after years of catholic education, etc. it was a difficult decision.

1. The mortgage/banking industry was bailed out in the 80s.2. Chrysler was bailed out many years ago.3. This time it is unequaled since the depression.4. Bankers and Wall Street knew that risks were extremely inordinate. Greed again. 5. It was not rocket science that there was no equity in the homes. The projection was that the 100% increases would continue, thereby creating equity. Like the 80's. 6. So yes homeowners knew the risk but were avalanched by the greed and boom mortgage, banking and investment industry.Perhaps the most important point is that as long as those regulated keep bankrolling political campaigns, true fiscal prudence will never happen. It is not the rules that are the problem. It is the enforcement. The appraisal industry which was reformed as a result of the 80's boondoggle, just rationalized the increases. The principle was that five or six people were willing to pay a million for a $600,000 dollar house then the house was worth a million. Very easy deception which made refinancing go crazy also. Forget the fact that there was no food on the table. The next increase would solve everything.

Peter,Not to disturb you. But the Spring of 2003 was probably a good time to buy. That is when everything began to escalate. 2005 and later were the disastrous buys.

Peter,It is pretty clear that you are not the only one overwhelmed intimidated by "very sophisticated calculations regarding the likelihood and cost of future events." The CEOs of investment banks obviously were, even though they were the ones designing and selling mortgages, derivatives, etc. George Bailey probably gave the best explanation when he kept his S&L afloat; and his uncle Billy gave the best caution when he carelessly hid his money in a newspaper and then handed it to Old Man Potter. The money is in my house, and yours, and can be catastrophically lost in the blink of an eye if those reponsible make mistakes, get greedy, or just get overwhelmed to the point where they do something 'irrational'. We need to keep an eye out for another, which I suppose is another word for regulation.

But hasn't the "American Dream" changed as a result of our unfettered consumer culture? Just look at the meteoric rise in average square feet of homes over the last several decades or the use of credit card debt to finance the purchase of consumer goods or our insatiable appetite for pills. I am hoping that the good that comes out of this crisis includes an increase in our national savings rate.

Are the critiques (in some ways more like condemnations) of capitalism made by John Paul II and Benedict XVI relevant here?

MAT, I agree with you generally, but how in heaven's name do you expect Americans to increase their savings when the country's in debt, and there's a war and $1.5 trillion in completed or proposed bailouts to pay for?And what's going to be safe to invest IN? What's going to make matters worse is a growing elderly population that either didn't save or had their savings gutted, and will have to rely on SSI, at a time when legislators will be more tempted than ever to borrow against the fund and further chip away at (if not gut) Medicare.You could write a dystopian novel about a world in the not-too-distant future in which the aging boomers are all issued non-removable bracelets that read, "Do not resuscitate; over 50."It'll be mercy killing for the aged. Without the mercy.

I think it best to leave such financial decisions to women. They have a good sense of money and are generally sceptical of over-spending.

Jean Raber: I agree with you - we are in a pickle right now and have some hard choices coming down the road which everyone wants to ignore and pretend don't exist. I was just trying to be optimistic: Spe salvi facti sumus.

Great post, Peter. The decision tree you and your family faced is one that I can definitely relate to.Regarding understanding financial services: I suppose we can educate consumers (and I struggle with the consumer financial products as well), but education is only half the battle. Wisdom and prudence have to come into play. Peter, I thought you showed great wisdom in choosing Catholic education over a larger home. I'm sure there are many Catholic families who make the opposite choice, and I'm not saying they're wrong in all cases (although I'm sure the financial state of Catholic education would be far healthier if they'd settle for more modest dwellings). I believe a lot of economists would say that if more consumers settled for smaller dwellings and deeper savings accounts, we would experience a recession in the short term, but in the long run the economy would be far healthier for it. But savings are another bit of wisdom that seems to have fallen away.

There is an ethical dimension to this. It is not right to gamble with someone else's money when they have no idea that this is what is happening. I quite agree with the views in the first comment by Elizabeth Brown. The Free Market model assumes that all participants have full information. But in real life even with the best intentions this is hardly possible. And when you add to that by creating quite complicated derivatives which effectively masks the nature and quantum of the risk, I think that is unethical behaviour. But by the rules of the financial market it is quite proper. So one wonders, is there a place for ethics in any of this?World financial crisis is a consequence of idolatry of money, Peruvian cardinal says( http://www.catholicnewsagency.com/new.php?n=13875 ).........In this sense, he pointed out that the financial crisis in the Unites States is not because of bad loans but because of corruption by those who were supposed to oversee mortgages, those who were supposed to handle lending, those who were supposed to be in charge of financial oversight and who were part of a great network of corruption.

I am going to be a bit of a wet blanket. One of the things that makes the mortgage crisis so confounding is that there is enough ethical fault and greed to go around and then go around again. Peter made a prudent decision that speaks well to his character. But surely, there are two pieces of information that were available to any reasonably educated buyer including Peter and his wife, and that is: a "comparable" that shows the cost of the mortgage at the best fixed rate the buyer could obtain, and a chart showing that, as of 2003, long-term insterest rates were close to a historical low point, and any "adjustable" mortgage was much more likely to become more expensive over time even without teaser and other nasty provisions. In other words, if you couldn't afford the house at a fixed rate, the vagaries of chance were not in your favor that an adjustable rate would make it more affordable in the long run.This isn't to say that homeowners deserve no relief, it's to say that we really need to examine why we have become so spellbound over the idea of a bigger and nicer house that we would become blinded about what it could mean for our ability to pursue other goals (travel, education, etc.).

Speaking of homeowners and relief: I understand that in the ongoing negotiations for the rescue package, (I'm following the prez's lead in eschewing the word "bailout" :-)), Rep. Frank is pushing the idea that bankruptcy judges be empowered to unilaterally adjust mortgage T's & C's to keep families who can't afford their payments in their home rather than evicting them. The social justice side of me *loves* this concept. I would like to know, Barbara and other dotcom legal eagles, if there is anything legally problematic about this. e.g., not that I know anything about law, but are bankruptcy judges even Federal judges? Can the Federal government give county judges this kind of authority, without the state's approval?

Barbara:With respect, I disagree. Let me try to explain why.First of all, comparing fixed rate and ARM mortgages isn't quite that simple--at least it wasn't simple for me. Interest rates will fluctuate over the life of a 30 year fixed rate loan. If interest rates are, on average, lower than what you locked in as your fixed rate, you will pay more in interest than you could have. Part of the value of an ARM was that you weren't leaving as much money on the table. Once we made the decision not to move, my wife and I did a refi with a "good" ARM (rate is tied to Prime + 1, with a max 1% increase per year) and we've held onto it. I'm not sure it's always irrational to prefer an ARM to a 30 year fixed even if interest rates are low, particularly if you are not sure you will hold the house for a long time. Families are much more mobile than they used to be. Lower interest rates means you accumulate equity in the house more quickly. This is a legitimate consideration.What makes this more complicated is making this decision in the face of rapidly rising real estate prices. It's very easy to say what goes up must come down, but looking historically, this had rarely happened in Northern California. Prices might flatten for awhile, but they didn't decline a lot. If you are convinced that buying a home is a good long term investment, but your income is not rising as fast as home prices, you face a real fear of being "frozen out," i.e. the longer you wait the more unaffordable buying a home becomes. So the pressure was to get into something now before you are frozen out.If you are a young family--as we were--it's safe to assume that your income is going to rise over time. A home that is slightly a stretch for you now will ultimately become more affordable. So it's not crazy to take a risk on an ARM at a low teaser to get you into the house with the assumption that you can refi in a few years before the balloon hits when your income is higher. The fact that everyone in the process--realtor, bankers, friends--is telling you this is the way to go makes it harder to get outside the bubble and think more critically about it.A lot of this comes down to whether it was irrational to bet that home prices would keep rising. I'll admit that by 2005-06 it was pretty clear that real estate was overvalued, but this wasn't so clear before then. Northern California is a very desirable place to live with a limited amount of land for development. There is a structural supply-demand imbalance that has afflicted the place for years.I'm sure you can argue with these points. But if you were a real estate consumer in California in the early/mid part of the decade, you were overwhelmed with information related to all the points I've raised. It absolutely was not an easy call to figure this all out.God bless,Peter

Peter, I think your long answer affirmed my point: Adjustable rate mortgages are affordable based on optimistic assumptions that put a great deal of risk in the lap of a buyer who could not qualify for a fixed mortgage on the same asset. The fact that those risks haven't materialized in previous cycles doesn't really change that. I also found this statement "If you are a young familyas we wereits safe to assume that your income is going to rise over time" to be astounding. Incomes, on average, have not risen for people outside of the top 5 or 1% of earners for going on 8 years, and yet, you make this assumption -- based on what?But I want to focus on another aspect of this crisis that I think is usually unremarked on. Sellers almost always view a real estate transaction in terms of the sales price. Buyers, however, have gotten into the habit of looking at affordability based solely on the amount of their monthly payment. BUT. The amount of the mortgage is based on the seller's view of the transaction -- and if the buyer must sell, it's the amount of the mortgage, not the monthly payment, that determines whether he will win or lose in the deal. In other words, the real estate market has become an exercise in overemphasizing financing at the expense of underlying value. This focus on financing is what has allowed values to balloon so precipitously. In the long run, values were unsustainable because the increase in the price of housing was significantly outstripping increases in income. If, indeed, everyone had to at least qualify for a fixed mortgage in order to consider an adjustable vehicle, your dilemma might not have been nearly as acute because values would not have risen so high, so quickly. In 2003, it might not have been a big risk but it was completely unpredictable when the top would arrive.