by Ted FrankChristopher Peterson disagrees with my assessment of subprime mortgages:
In [Ted Frank's] view the market is currently adjusting to the problems in mortgage origination. Everything will work out if we just leave the markets alone because "lenders have every incentive to lend only to those who can repay." I disagree. The current legal system creates the incentive for loan brokers and originators to (1)take large commissions and closing costs, (2) pass off bad loans to the secondary market, (3) distribute the revenue from lots of closings to management and employees, (4) wait for the bankruptcy code's preference window to close, then (5) declare bankruptcy when the secondary market tries to exert its recourse options.
Except what Peterson is describing is intentional securities fraud, for which there already exists plenty of civil and criminal deterrent. Management doesn't escape scot-free: in the First Alliance Mortgage case, its chairman and CEO, Brian Chisick, was on the hook for $20 million in an FTC action over that bankrupt company's mortgage practices, even aside from the losses he incurred from the drop in value in his equity interest in the company.
Moreover, in such a scenario, the secondary market investors lose their money in their investments—surely deterrent enough to engage in appropriate due diligence to not invest in a fly-by-night operation that is issuing bogus loans. Why victimize them twice? The only thing that accomplishes is to punish the honest by creating an infeasible risk premium.
The multiply-illegal scam Peterson posits (involving mortgage fraud, securities fraud, and possibly bankruptcy fraud and breaches of fiduciary duty) just is not a viable business model for any reasonable length of time: can we identify anyone who is living high off the hog through these means?
Is it possible for a lender to have such poor oversight over its brokers that the brokers rip off both borrowers and lenders to acquire commissions to which they would not obtain if they acted honestly? Absolutely, but the case of the potentially unethical mortgage broker is no different than any other agent who represents the principal to third parties, from nursing home aides to car salespeople to law firm associates to Wal-Mart's top advertising executive. Management's desire to exercise appropriate controls over its agents so that the latter does not realize improper rents through fraud is self-regulating. The incentives to create the appropriate incentive structure already exist, and those organizations that fail to do so will be driven from the market. But to impose liability on peripheral investors who have no control over the actions of those agents defies every principle of fairness and justice. It's an underhanded way to achieve an under-the-radar ban of a legitimate practice through litigation risk that would not fly politically if the same activists were to propose it in a straightforward fashion.
(And why stop with financing? Surely fraudulent mortgage lenders would not be able to achieve their ends without office supplies or grocers or telephones. Those vendors of goods and services are at least as much a but-for cause as the secondary investors. What's the principle that holds liable the pension fund that purchases mortgage securities as a means of diversifying its portfolio, but not a Dunder-Mifflin for selling the paper that a First Alliance used to print out its forms?)
Those pension funds and hedge funds and investment banks and insurance companies that invest in mortgage securitization do not do so out of charity or because they have an idiosyncratic fondness for the ideal of homeownership; they do so because they are looking for a place to put capital to invest within a diversified portfolio. Mortgage securities compete with any number of other investment options: equity, debt, commodity, derivative, real estate, ad infinitum. If Frank-Bachus passes, there are countless other options for capital placement that will not involve incalculable liability for matters completely outside the investors' control. Consumers will not suddenly have increased recourse if upstream investors in mortgage securitizations are liable for low-level broker fraud. Instead, the mortgage securitizations just will not happen because that money will instead be elsewhere in the marketplace.
Mortgage fraud will decrease, but so will legitimate mortgages—and indiscriminately. Families that wish to use their home equity to finance medical or college or home improvement expenses will be deprived of a consumer choice that they responsibly believe will make them better off. Mortgage interest rates will be higher, and consumers will be unambiguously worse off—even aside from the repercussions throughout the rest of the economy from the shock of credit contraction. This is bad law that contradicts fundamental notions of fairness, and bad public policy that helps noone.