Revisiting the Crime Scene

Mike Konczal has a post featuring the Grayson/Clay/Miller amendment to the current Consumer Financial Protection Agency proposal. The basic idea is that the agency would be required to do a periodic, statistical analysis to identify those financial products that were most implicated in causing bankruptcies and foreclosures in each state. The CFPA would then have to announce what these products are and who sold them, and could then take corrective action to restrict those products.

This reminds me of something that Andrew Lo said in his Congressional testimony back in November, of which I’ve discussed other aspects in the past. Lo recommended creating a Capital Markets Safety Board modeled on the National Transportation Safety Board:

“[T]he financial industry can take a lesson from other technology-based professions. In the medical, chemical engineering, and semiconductor industries, for example, failures are routinely documented, catalogued, analyzed, internalized, and used to develop new and improved processes and controls. Each failure is viewed as a valuable lesson, to be studied and reviewed until all the wisdom has been gleaned from it, which is understandable given the typical cost of each lesson.

“One successful model for conducting such reviews is the National Transportation Safety Board (NTSB), an independent government agency whose primary mission is to investigate accidents, provide careful and conclusive forensic analysis, and make recommendations for avoiding such accidents in the future. In the event of an airplane crash, the NTSB assembles a team of engineers and flight-safety experts who are immediately dispatched to the crash site to conduct a thorough investigation, including interviewing witnesses, poring over historical flight logs and maintenance records, and sifting through the wreckage to recover the flight recorder or ‘black box’ and, if necessary, reassembling the aircraft from its parts so as to determine the ultimate cause of the crash. Once its work is completed, the NTSB publishes a report summarizing the team’s investigation, concluding with specific recommendations for avoiding future occurrences of this type of accident. The report is entered into a searchable database that is available to the general public (see http://www.ntsb.gov/ntsb/query.asp) and this has been one of the major factors underlying the remarkable safety record of commercial air travel.”

Lo was talking more about financial crises than about individual bankruptcies, but the analogy still holds. If a regulator notices that a lot of people are dying in a particular kind of accident in a particular kind of car, it will investigate to find out what is going on.

Now, the statistics could actually be a bit tricky. It’s entirely possible that the most toxic products on the market will not be the ones that are involved in the most bankruptcies and foreclosures. Most bankruptcies are (I believe) caused by illness, job loss, or divorce, which strike people independently of whatever mortgage they happen to have. If we just count up the mortgages of people who go bankrupt, we might find that more had 30-year fixed mortgages than had option ARMs, simply because more people in general have 30-year fixed mortgages than option ARMs. But for now I will make a bold assertion that these statistical problems could be addressed — it doesn’t seem like the world’s most complicated model to estimate.

The Grayson/Clay/Miller amendment attempts to sidestep the banking industry’s main contention, which is that the CFPA will have a “chilling” effect on financial innovation. It also plays a kind of “sweeper” position (“free safety” is the American football metaphor) in that it can catch products that do not on their face seem all that bad, but turn out to be homewreckers later. The common-sense argument for it is that no one could reasonably oppose a provision that simply asks the CFPA to investigate existing problems and clean up after them. Still, the industry will no doubt come up with arguments against it. That, at least, is what Felix Salmon assumes, reading the overall trends.

By James Kwak

26 responses to “Revisiting the Crime Scene

  1. I wonder about the practical issues here.

    If an entity goes bankrupt because it bought a AAA-rated MBS backed by sub-prime mortgages, is that an argument against MBS in general? Or just against those backed by sub-prime mortgages? Or neither, because the real problem was the unconscionable conflict of interest for the ratings agencies?

    Airplanes have a lot of moving parts, but any particular crash is caused by just one. (Or by one design flaw.) The financial system crashed because of the combination of many of bad ideas, mostly involving giving everyone an incentive to lie.

    In short, I am not sure I buy the NTSB analogy at all.

  2. 1. It’s dead in the water.
    2. As Nemo points out it’s not practical and would never work. We ALREADY know ARMS mortgages are horse manure and we ALREADY know credit default swaps are horse manure. What was the ensuing action????
    3. The financial institutions will find another scapegoat when necessary. The banks and Republicans are still trying to use the Community Reinvestment Act as a scapegoat for their casino gambling with taxpayer backstops.
    4. Nobody currently attending Yale (including post-graduates) should EVER be allowed to use American football metaphors in conversation and/or writing.

  3. It’s been a long time since I’ve seen an NTSB report identify a single contributing factor. Usually there are a dozen or more major contributing factors in a fairly complex series of interactions.

    The difficulty will be picking the proper methods of accumulating the statistics so that good analysis can be performed. It sounds like a good idea. It might be even better to concentrate on gathering and presenting the best statistical database of failures, much like the other economics statistical databases. Non-governmental groups could then do analyses instead of a group vulnerable to political pressures to avoid criticizing sacred cows.

  4. Supplementary note to #4 above, this also includes those currently attending Notre Dame.

  5. It’s retrospective, not prospective, but it’s a good addition. Given the amount of time before a significant number of negative outcomes emerge and the typical review cycle (time from allegation to review to hearings/open comments to final rule), there remains ample opportunity for abuse – particularly in an upward trending market when foreclosure can be avoided through property resale.

    There’s also the problem of separating selection bias from effect (are subprimes defaulting at a higher rate because of the loan, or because it’s just a higher risk category… which then prompts the question – are subprime borrowers better off with or without access to this ‘product’?). But you are correct that some decent modeling should be able to address most of this.

    The panel will also confront the anti-paternalistic libertarian response: “Who are _you_ to say those inner city poor folks aren’t better off with these teaser-rate loans, when _they_ are surely better judges of their own welfare.”

    Finally, the enforcement mechanism doesn’t measure one of the primary (non-paternalistic) arguments against bad products – systemic issues arising from their widespread use. If subprimes remained limited, then those who lost jobs could sell and perhaps avoid bankruptcy. But the masses of subprimes bid up housing prices (which had sharp negative effects even on those who acquired standard loans) AND jointly set themselves up for disaster (because they all defaulted at once). In that sense, subprimes had sharp negative externalities… and that’s a non-paternalistic justification for banning them outright.

  6. Plebeianswillrevolt

    “because the real problem was the unconscionable conflict of interest for the ratings agencies”…

    Whew,… aren’t you overlooking that the agencies were just bought and paid-for whores. Come on Nemo. You are drinking kool-aid.

  7. While I think that the amendment is generally a good idea, it also seems to me to be overlegislation. Why not simply give the agency a mandate, without specifying how to do it? It is not like legislators have any particular expertise in this area. No wonder there are so many stupid regulations!

  8. CBS from the West

    I think this approach might or might not be workable. But to be workable, the agency would have to have access to a wide array of many types of data. To adjust for confounding variables will require information on the “epidemiology” of who takes out different kinds of loans, their financial state beforehand, and the health of their bodies and marriages.

    Also, my friends in Aerospace Medicine tell me that investigation of crashes is only the tip of the iceberg of safety investigations. A large part of the information comes from “near miss” incidents, which are mandated to be reported and are also investigated from an epidemiologic perspective. It’s not clear to me how one would define a “near miss” in finance.

  9. 4 Stars!

    Another good watch is “Incredible Journey the Story of West Hampton Dunes”. It is NOT about sand and beaches. It is about crisis and what got us there and what will lead us out.

  10. “Sweeper? James, are you a football fan?

    BTW, unless I am much mistaken, Sweepers are also supposed to play a key role in the attack, at least bringing the ball from the defense and initiating the counter. So the metaphor isn’t quite perfect.

  11. I would have said you are describing the role of the libero here rather than the true sweeper, although I acknowledge there’s a lot of overlap these days. When I played as a SWEEPER (middle of or just behind the back line) I might make the first pass to a midfielder and go up for set pieces, but that was about all. When I played as a LIBERO (just in front of and helping out the back line) I had more of the role you describe.

    To pick Chelsea as an example (not that I support them; just that I happen to know the names there), John Terry would be a sweeper and Michael Essien a libero.

  12. Re #2:
    Are we 100% sure or only 99.99% sure? If only 99.99% we must do a 10 year study costing 500 million dollars to get that extra .01% of certainty.
    While we are investigating, I would like to see investigations of these questions?
    *Do credit card interest rates above 30% cause more credit card defaults?
    *Are astronomical hospital bills ever a factor in bankruptcy? (There are studies, but again are they 100% sure?)
    *What role do sunspots play in mortgage defaults?
    *Are banks completely innocent of all foul-play?
    *Can we blame everything on another country and invade it?

  13. 1. Even if regulation could work in theory, this still seems too weak. Rather than figuring out what caused the crash after it has happened (that is, shutting the barn door after the horse is gone), it would be better to try to prevent it.

    We should be applying the precautionary principle here. The right analogy isn’t the NTSB investigating a crash after the fact but the FDA requiring drug trials to prove safety before a product is approved.*

    This should be the standard for alleged financial innovations.

    2. But are these innovations at all, or “innovations”? It’s clear that nothing the finance sector has done in decades has served any social or value-adding purpose at all. The only purpose has been antisocial profit, rent-seeking and con jobs.

    3. So we should reject in principle the proposition that we need to tolerate the existence of the finance racket at all.

    Having established that, the only order of business would be developing the attack plan to destroy it.

    4. As the current example demonstrates, “regulation” cannot in fact work. You cannot set an anodyne goal and then successfully restrain a powerful, entrenched racket. The evidence is dispositive.

    A. The existing political cadre is too captured and corrupted to overcome the fierce resistance the rackets put up against even meager reforms like the CFPA.

    B. Even if you could get something enacted which could in theory do the job, and even if you started out with regulators who were principled and willful, regulation automatically faces a permanent war of attrition vs. lobbying, bribes, extortion, and seduction.

    The rackets will forever seek to undermine, evade, and gut all regulation. This is their very nature. So if you believe in regulation, you have to believe in the permanency of incorruptible, strong-willed, public-principled regulatory personnel.

    I think the evidence has long since proven that you cannot trust the accident of having good personnel where the structure militates against it.

    5. So the only solution is to change the structure. That means, for starters, breaking up the TBTF rackets once and for all.

    [*Of course under Bush the FDA largely abdicated as well. So here too we see: regulation cannot indefinitely work where a corporatist structure systematically works against it.]

  14. Come on Russ, you’re not playing the game. We are the arm-chair quarterbacks here trying to come up with the best way to ineffectively regulate people who can’t be regulated. You could at least play along with our high-minded but totally useless aspirations.

  15. Have you checked out his blog? This fellow’s a thinker and he’s thinking good thoughts.

    Now, back to my regularly scheduled bile.

  16. Is there a big difference between “unconscionable conflicts of interest” and “being bought and paid for”?

  17. ARMS mortgages were developed back in the 70′s to protect the Banking industry as a result of the pre-Volker Fed’s irresponsible monetary policies that led to rampant inflation. ARMS worked well for over 20 years until the abuses of the CRA began.

    The CRA was perhaps the largest welfare scheme in American history. It pushed imprudent, risky lending practices for the less fortunate on a massive scale as a prerequisite for banks to stay within the Fed’s good graces. A set of practices that encourages lending in the trillions of dollars to a special preferable class of poor people with low FICO scores, little capital, and inability to repay the loans, will only to financial ruin, which it unfortunately did.

    The Credit Default Swap scam needed the government guarantee to interest the market. If there was no allusion of a guarantee, many of the MBS scams wouldn’t haven’t taken hold as they did. Preferential government intervention into the marketplace, if not tightly controlled and fully transparent, will almost always turn into a scammer’s paradise.

  18. This is me, doing my “someone’s been brainwashed by the media” thing again.

    A few points: there are plenty of (a) agency ARM mortgages; there are also plenty of (b) subprime fixed mortgages. The default rates on (a) are considerably lower than on (b).

    If I am a large industrial company and I’m worried that my health care provider is going to go under, doesn’t it make sense to buy some CDS on them? (this kind of scenario isn’t that uncommon).

    The media has sensationalized a bunch of financial buzzwords– the “toxic lexicon”– and everyone just blatantly repeats it. This makes me sad. I’m all for regulation, consumer protection, etc., but just calling any financial product that was in any way involved in the crisis “horse manure” is just silly.

  19. It’s the Zombie CRA comment, killed 1000x over but continuing to haunt us.

  20. The CFPA would have authority to determine which products consumers can choose from. In short, the bill would create a regulatory overlay of the entire business community, extending far beyond traditional financial services. We need to take control of consumer choice. How does CFPA affect you? http://www.friendsoftheuschamber.com/issues/index.cfm?ID=469

  21. My comment was more a commentary on this post rather than Russ’s comment (I am a great admirer of Russ’s blog).

  22. Excuse me Audrey, I know this is off-topic, but I was wondering if you’ve seen the Boogy Man lately. I’ve been looking for him everywhere, under the bed, in the closet…

  23. Audrey: “We need to take control of consumer choice.”

    Absolutely. And to do that we need to give the consumer more power. And to do that we need a Consumer Protection Agency.

  24. Plebeianswillrevolt

    yes there is a, difference…. but especially bothersome is the scapegoat implication that Moodys were the bad guy and all these honest banks were innocent dupes.

  25. Paul,
    It’s interesting that in your little dream world (and the REAL world for that matter) the CRA didn’t have so much effect in fixed-rate mortgages as they did ARMS (adjustable rate mortgages). Could it be because ARMS were only created to put banks at the advantage??? Could it be because ARMS were a pile of manure from the very beginning??? I don’t suppose you or the Mortgage Bankers Association would like to talk about that.

  26. This is why who we pick for congress is important. This whole Gay thing is something else:

    http://americaspeaksink.com/2009/10/charlie-crist-and-the-film-outrage/