“According to a recent Nightline program, none of the Wall Street executives who engineered the sub-prime debacle have been convicted on criminal charges. Why do you think that is?” 

I think that the most obvious answer is the correct one: the authorities were not able to find sufficient evidence of criminal behavior in any of the cases they investigated, and they investigated many, because there weren’t any to be found. Imprudent violations of firms’ own internal policies abounded, but such violations are not criminal.

 Lenders Are Always Profit-Hungry

Underlying your question, and implicit in the Nightline approach, is an assumption that the sub-prime debacle was engineered by a profit-hungry group of lenders and investment bankers who, for some unknown reason, decided to run amuck. Given that assumption, the failure to convict anyone must mean either that law enforcement has been co-opted, or that all the suspected criminals who were investigated were clever enough to destroy all evidence of their misdeeds.  

But both the assumption and its implications are wrong. True, lenders and investment bankers are profit-hungry, but they are always profit-hungry, so this does not explain anything. Profit-hungry lenders in the 90s made mortgage loans only to borrowers who met rigorous standards applicable to their capacity and willingness to repay. During the period 2000-2006, in contrast,  profit-hungry lenders made loans to many borrowers who did not meet these same standards. Profit-hungry lenders did not change their character between these periods, what changed were the circumstances under which their decisions were made.

 Behavior In a Housing Bubble Is Different

In the later period, they operated in a housing bubble. A housing bubble is a market environment in which rising house prices generate an expectation that price increases will continue indefinitely. The central feature of a bubble is self-reinforcement, where price increases lead to actions that further stimulate price increases. The expectation of rising prices is the air in the bubble.  

Economists don’t completely understand what causes bubbles, but they appear intermittently throughout history, beginning with the Dutch tulip mania in the 17^th century. A central feature of all bubbles is that very few of those participating in them realize that they are in a bubble. A few mavericks and  misfits not part of the social fabric of the industry affected may perceive what is going on – in our recent housing bubble, a few of them made  fortunes betting against the market – but the great majority reinforce each other in the belief that the price increases will continue. The absurdity of this belief does not emerge until the bubble bursts, when it becomes painfully evident. 

In a housing bubble, it is extremely difficult to make a bad mortgage loan. If the borrower’s income is inadequate, several devices are available to reduce the payment during the first few years. At the end of that period the loan can be refinanced with the reduced payment extended, with confidence that the increase in house value during the initial period will cover the higher loan balance and settlement costs on a new loan. If the borrower can’t make the payments, there will be sufficient equity to allow him to sell the house and pay off the loan balance. In the worst case where the lender is forced to foreclose, the equity generated by rising prices will be sufficient to repay the balance and cover the foreclosure expenses.  

Continuing price increases make underwriting requirements, which are designed for a static environment, largely irrelevant. By ignoring them, lenders do good deeds, making homeowners out of people who never thought they had a crack at homeownership, and in the process make money for themselves. In a bubble, everybody wins.

 Hindsight Clarifies a Great Deal

Until they lose. With the perspective provided by hindsight, it may be difficult to believe that so many intelligent people, including CEOs of major public companies, believed (or acted as if they believed) that house prices would rise forever. But it really wasn’t that implausible. For one thing, they didn’t have to believe that prices would rise forever, only that the price inflation would last through their tenure – when it ended, the resulting problems would then be someone else’s.  Until the crisis, furthermore, there had not been a nation-wide decline in house prices since the 1930s, only local ones that were invariably mild and short. Other countries had experienced sharp price drops, but that was easily disregarded as irrelevant.

 Contagion

The optimism generated by bubbles is also contagious. To appreciate its force, consider that the bank regulators were caught up in it almost to the same degree as the industry players. The regulators did finally realize what was going on, but only a few months before the bubble burst -- far too late to do anything constructive about it. And the regulators were not subject to any of the internal pressures that blinded the corporations operating within the bubble.

 Power Shifts

A bubble generates a subtle shift in power within corporations, a shift largely unrelated to the table of organization that shows who reports to who. Power shifts to those who direct operations within the bubble, who are responsible for engineering substantial “profits” for the firm. Even CEOs with strong personal doubts could not bring themselves to explain to their boards why they had curtailed operations that were generating such great results. And both top management and boards feared incurring the wrath of major shareholders if they fell behind competitors who were earning enormous “profits” by operating within the bubble.

 Profit Illusion

In the previous paragraph, I put the word “profit” in quotes because after the bubble burst we realized that they weren’t profits at all, they just looked like profits at the time. One of the major features of the housing bubble was what might be termed “profit illusion”, and dealing with it is the key to any successful policy designed to prevent another bubble in the future.

  Public Policy Reaction to the Financial Crisis

When the housing bubble in the US collapsed, the resulting financial crisis generated enormous costs – costs that could have been many times higher if not for timely and massive interventions by the Federal Government. The consensus of the post-mortems was that the bubble and subsequent crisis never should have happened, and that new laws were needed to prevent it from ever happening again. The result was Dodd-Frank (DF), a massive piece of legislation directed almost entirely to that end.  

DF is typical of legislation passed in the immediate aftermath of disasters. With the disaster fresh in mind, political barriers were easy to overcome, which is the case for acting promptly. The downside is that the results in many cases are knee-jerk and not well thought out.  

Since the major abuse within the bubble was the violation of underwriting standards, a major thrust of DF was to create barriers to that ever happening again. The barrier was to expose lenders to legal liability if they made loans that were not “qualified mortgages” as that term was to be defined by the new Consumer Financial Protection Bureau (CFPB) established by DF.

 Consumers Are the Big Losers

The CFPB recently declared that qualified loans cannot have any of a long list of provisions that are viewed as risky, including negative amortization, an interest-only period, a balloon payment, waiver of all documentation requirements, or a term exceeding 30 years. Under these rules, which become effective January 1, 2014, a lender making an unqualified loan that goes into default is vulnerable to legal action by the borrower. For all practical purposes, therefore, the market will consist of qualified mortgages. 

This approach will probably prevent another housing bubble, but it is the most anti-consumer measure that could have been adopted -- and under the guise of “consumer protection.” Consumers lose a raft of potentially useful options that render mortgages unqualified, no matter how useful they may be in a particular case – not to mention the innovations of the future that will not materialize. Innovation would require application to CFPB to accept a new option as “qualified.” The home mortgage market will be thoroughly bureaucratized.  

 A Better Alternative: Eliminating the Profit Illusion

It didn’t have to be done this way. The many options that existed during the bubble period could have been preserved by eliminating the profit illusion associated with the riskier ones. The profit illusion was an essential part of the bubble -- without it, the bubble could not have been maintained or even begun.  

You eliminate the profit illusion by eliminating the profit associated with violating underwriting guidelines. Existing accounting systems allow lenders to record as income all the upfront fees collected in originating loans, and all the interest received from borrowers beginning in month one. During the bubble, the same accounting system was used for the best prime loans and the riskiest of sub-prime loans. When large numbers of the riskier loans went into default, it became clear that a major part of the “income”  collected in prior years was not income at all but should have been set aside as a reserve for future losses.  

Eliminating the profit illusion requires that reserves be set aside on each loan based on its risk. This is “transaction-based reserving”, or TBR. It is common practice in the insurance industry, including mortgage insurance, where it works very well.  

As applied to home mortgages, a portion of the risk increment paid by the borrower, say 50%, would constitute a required allocation to a contingency reserve. For example, if a prime mortgage was priced at 4% and zero points, the reserve allocation for a 6% 2 point mortgage might be 1% plus 1 point. Allocations to contingency reserves don’t become income for an extended period, and are not taxable until released. 

The designers of DF operated in an environment hostile to lenders, who were blamed for the crisis, and solicitous of consumers who were viewed as victims of it. Yet their “remedy” has been welcomed by lenders, who appreciate knowing exactly what the rules are, while it deprives consumers of options that they would otherwise have, and ought to have. This is what comes of legislating in the immediate aftermath of a crisis.