Interview with Interfluidity’s Steve Waldman: “The government has chronically oversubsidized mortgage lending and homeownership”
Today we bring you an interview with Steve Waldman of Interfluidity. I decided to focus the interview around strategic default and the ever-expanding role of the government in the housing market.
Mortgage Calculator: I’d like to begin by asking you about your background. What made you decide to join the ranks of housing bloggers? How would you summarize your approach to the (current) housing market, and how has your background informed this approach? Finally, what is the story behind the name Interfluidity?
I’m much more of a finance blogger than a housing blogger, and the issues that drive me have more to do with questions of collective choice than particular markets or institutions. I actually began as a Java programmer interested in collaborative decision-making as a technical question. I imagined developing toolkits with which large, dispersed groups of people — everything from the membership of a nonprofit to corporate shareholders to the citizens of a nation — could design online processes that would result in “good” collective decisions. A good decision, in this context, has to meet two criteria: it has to effectively serve collective goals, and it has to be “legitimate”. There may be severe tensions between quality decisionmaking and legitimacy. Shouting masses rarely make good choices. You don’t want to put a million people in an online chatroom and then take a vote. But elevating a class of “experts” to positions of privilege and relying upon their wisdom also fails, both on grounds of legitimacy and quality. You want very dynamic processes in which hierarchies arise and shift, where there are elements of mass choice and applied expertise. You need to be very careful in how you allocate the scarce resource of human attention. All voices must be heard, both to capture dispersed information and to sustain legitimacy, but the cacophony must be filtered by some process that it both effective and fair. I began by imagining “online, stochastic parliamentary systems”, like a virtual US Congress where membership in committees was by degree and subject to constant revision, in which “floor time” was allocated by sending proposals to random samples of people, initially small but progressively larger based on feedback. But I couldn’t get around the problem of cheating. You can come up with very clever, fair schemes if you imagine people communicate only within your system. But when questions are high-stakes, real people will pick up the telephone, buy ads in the New York Times, do everything and anything to evade your careful procedures in order to get the results they want.
It occurred to me that financial markets seemed robust to this: markets are unstructured, everyone is “cheating”, seeking whatever edge they can get, and yet we use them to make some of our most consequential collective decisions: the large scale allocation of physical and human resources. And while financial markets are obviously imperfect, I thought that they seemed to work “pretty well”, in the sense that societies that used financial markets to guide economic decisions seemed to outperform other kinds of societies. I was entranced by the Hayekian story of how markets aggregate and communicate widely dispersed information. I also found it fascinating that markets achieve legitimacy by disguising human choices, sometimes good and sometimes bad, as facts of nature.
I began a serious study of financial markets, first just by reading textbooks, then by going through the CFA curriculum and now grad school. (I’m not a CFA charterholder, but I’ve passed all three exams. I hold no advanced degree.) I was struck by how much real financial markets differed from the kind of markets one would invent (and that people like Robin Hanson do invent) if you took the Hayekian story seriously. Real market institutions seem designed to hide information and shift consequences rather than reveal outcomes and allocate costs and rewards. I quickly shed a libertarian prejudice in favor of what is “emergent” or “natural”, and became a critic of a financial system ill-equipped to serve the purpose to which it is addressed. The housing bubble and obvious, persistent imbalances in the US economy during the mid 00’s helped to persuade me that my initial enthusiasm for financial markets was misplaced (although I remain hopeful that better conceived markets and market-like institutions could be powerful tools for collective choice).
Much of my education in economics came from blogs. I found conversations in comments sections to be exhilarating, they inspired me to learn in order to speak, like small seminars in a traditional university. I began interfluidity because I loved the conversation, and felt like I was outgrowing and perhaps abusing other peoples’ comments sections. I was also intellectually lonesome. I felt like I had things to say, so I gave myself a place to say them.
I don’t really know where the name “interfluidity” comes from. The word popped into my head, and captured my mood, what I was looking for, at the time that I started the blog.
I think that the moral thing for most borrowers to do, under present circumstances, is to default on loans when it is in their financial interest to do so.
Much of my thinking on economic and social issues comes back to T.S. Elliot’s proposition, “It is impossible to design a system so perfect that no one needs to be good.” Once upon a time, I chose to disagree. I thought it was the challenge of our day, and the grand project of modern economics, to build a system in which people pursuing their own self-interest would provide all social goods, in which the benevolent invisible hand would rule all and we’d have no need to rely upon ideas as shifty and manipulable as “virtue”. I have done a full 180 on this question. Economic self-interest and formal legal frameworks are simply insufficient to regulate a decent society. Elliot was right.
But it’s crucial to remember that “what is moral” is something we collectively decide, and not without constraints. A social order that routinely demands heroic sacrifice of people in the name of virtue will fail. Clever hypocrites will be rewarded while naive saints pay, and the overall tenor of society will not be virtuous. The most we can demand of fuzzy constructs like morality and social norms is what Arnold Kling calls “soft rule utilitarianism”, under which people accept modest personal costs on the theory that if everybody does so, we’ll all better off. But emphasis on the word “modest”, and expectations of reciprocity. Economic and legal scaffolding has to sit beneath informal social constraints so that in general it makes sense to be good. It is like the relationship between flesh and bone: You could not build anything as beautiful as a smile out of bone, but the smile will not survive if the jaw beneath is fractured and misshapen. We regulate the “bone structure” of our society explicitly via legal arrangements, and more subtly, via social and reputational incentives. There’s a kind of hygiene we have to attend to, in order to ensure that doing well and being good are not terribly inconsistent. Over the past few decades we’ve failed to attend to that hygiene, in large part I think because we let simplistic economic ideas persuade us that we didn’t have to, and that the pursuit of wealth yields virtue automatically and dirty is the new clean.
Whatever the reason, we find ourselves disillusioned. People in the financial industry earned huge sums making loans that shouldn’t have been made, offering “affordability products”, Orwellian slang for means of selling homes at unreasonable prices that buyers could not afford. They failed to perform the core social duty of creditors, which is to make prudent judgments about whether loans are likely to be in the mutual interest of borrower and lender over the full term of the debt. Once originators could resell loans, once the financial industry adopted practices of paying cash commissions and bonuses at the time of origination, once we had severed the nexus between the self-interest of the people making lending decisions and the long-term interest of borrowers, it was inevitable that bad loans would be made. So they were. Now that those bad loans are doing what bad loans do, lenders have suddenly found religion, and argue that the moral fabric of our society would be riven if homeowners behaved like, um, bankers. I think that under the circumstances, quite the opposite is true.
The financial industry has changed the economic and legal landscape surrounding consumer lending so that it simply bears no resemblance at all to interpersonal loans among people of good will in continuing relationships. But those are the norms they ask borrowers to adopt with respect to repayment. That act, demanding others act in accordance with standards from which one exempts oneself, is morally offensive. In a society which, despite economic difference, accepts no social class, ones moral obligation is to behave towards others as others must behave towards you. It is clear that, in general, banks and the special purpose entities that increasingly replace them treat their transactions with borrowers as hard-nosed business arrangements which they are willing to pursue on adversarial terms when doing so is in their interest. Borrowers should do the same. To do otherwise is to reward the cynical immorality of others, which serves no social good.
We might (or might not) wish to revise the norms surrounding bank loans to resemble those surrounding interpersonal lending. But that would be a forward-looking project, and would imply radically altering the behavior of future lenders, not simply exhorting borrowers to assume all responsibility and pay.
First, because the industry will block the sort of changes that would prevent future bubbles. Despite the housing bust and financial crisis, very many of the people whose poor choices generated the housing bubble would make the same choices over again if circumstances repeat. Many industry participants, even those whose firms eventually went bust, were very well remunerated for their poor practices and, whatever their regrets, they kept the money. No one wants to create a catastrophe. But financial professionals want to remain free to make money in the ways that they know, and those are not good ways.
Second, neither Congress nor the President want to make the changes that would prevent credit bubbles, because they have been led to believe that credit growth and economic growth are necessarily intertwined. Trying to rein in financial excess while exhorting banks to lend is like trying to regulate smoking while demanding tobacco companies increase their sales. In a sane financial system, credit would be extended far more conservatively than it has been. Credit contraction is consistent with growth, but only if it is offset by broad-based income expansion that would permit middle-class consumers to live well without borrowing, and potential homebuyers to generate equity for large down payments. Homeownership rates would fall substantially, as most people would be able to rent nicer homes than they could buy. Kicking our debt habit would require pretty big changes in our economic and political arrangements. To borrow from Churchill, we’ll get there, but only after we’ve exhausted every other alternative. I expect a bumpy ride.
I think the government should define vanilla mortgages, whose terms are standard and widely understood and vary in a single dimension. For example, “vanilla” 30 year fixed mortgages from different banks would be identical except for the interest rate. Consumers would not be compelled to stick to the vanilla contracts, and it might not be necessary to compel banks to offer them. But since the terms of the vanilla contracts would be widely understood, risk-averse customers could comparison shop loans without fear that lower apparent costs are offset by some tricky hidden “revenue enhancer”.
Vanilla contracts are a bigger deal for credit cards than mortgages, though. In the mortgage business, traditional prime mortgages define de facto almost-vanilla contracts. The availability of prime mortgages wasn’t enough to prevent many homebuyers from choosing more exotic contracts that served them poorly. Vanilla contracts are not a panacea. But many homebuyers did and do refexively opt for traditional prime loans, and that works out relatively well. Prime mortgages sometimes fail, but they’ve certainly done better than the menagerie of exotics, and they fail in predictable ways. Prime borrowers understand they will lose their homes if they don’t or can’t make their payments, but that’s really the only thing they need to understand. (When people layer borrowed downpayments, insurance, etc. on top of a prime mortgage, they are synthesizing a no longer “safe, vanilla” contract. Good vanilla contracts would be standalone. Note that strategic default would only be an issue in a few markets if 20% downpayment requirements had not been eliminated. If 20% unassisted downpayments had remained the norm, the bubble might well not have expanded to the point where strategic default would be attractive to borrowers in any market.)
All the government really has to do to make vanilla contracts work is to define and publicize them. They might need to create some incentive or requirement that banks offer them initially, but once consumers come to expect them, competition would force lenders to offer them at decent rates. There’s a danger that a vanilla contract could be poorly defined, or that industry lobbyists could slip “revenue-enhancing” language into the text. But there’s a political dynamic that corrects that. Since the government literally writes the contracts, consumer unhappiness with the terms of the contracts translates into local news melodramas and angry calls to representatives about mistreatment by a government agency. Congress finds excuses to tolerate predation by private banks, but would have a hard time doing nothing when it is the government perpetrating the abuse and constituents are angry about it.
I think the government has chronically oversubsidized mortgage lending and homeownership. We cannot know what would have been, but I think we’d have a different and better housing market if we didn’t tilt the scales of the buy/rent decision towards BUY BUY BUY. The business of shelter provision for middle class families is horribly inefficient, literally a cottage industry. Absent all the subsidies, middle-class housing might have become professionalized by now, which could lead to enormous savings in money and aggravation for people who now waste time fighting with plumbers and roofers on an ad hoc basis. It’s remarkable that homeownership rates have kept rising even as people’s tenure in jobs has fallen and mobility has grown more valuable. We’ve made homeownership a totem of middle class prosperity. In doing so, we may have, um, foreclosed consideration of a variety of superior arrangements.
I think government subsidy of homeownership is so deeply embedded into our political culture that these policies will expand and persist until some crisis renders them untenable. My perhaps paranoid suspicion is that, via Fannie and Freddie and the Fed, the government is currently shifting a lot of private sector losses onto public sector balance sheets. If politicians fail to hide the enormity of those losses, there might be sufficient scandal to force a rethink. But that’s a very big if, since with clever accounting, recognition of losses can be extended over a very long period of time and masked by offsetting revenues from new loans. And even if the public were outraged, policymakers and their lobbyists would have a hard time imagining a world without the mortgage income tax deduction, Fannie, Freddie, Ginnie, FHA, FHLB, etc., etc. We still have a lot of bad alternatives to explore before we do the right thing.
I’d consider buying a home with cash as an inflation hedge that is politically safe from forced liquidation. I view buying a home with a mortgage to be a leveraged speculation on future inflation, a bet that might pay off but is risky. If inflation does not materialize, or if deleveraging yields deflation, I think home prices stagnate or fall and mortgages become burdensome. The expiration of a tax subsidy or rising interest rates could trigger a price fall. But that in turn might trigger new interventions in support of housing or policies that lead to inflation. I’d as soon forecast a roulette wheel as give advice on housing as an investment right now. A house will always be worth the shelter it provides, but the dollar we use to measure that has become gelatinous, so it’s hard to say what will happen to prices. My personal bets are skewed towards inflation, but just because I lay my chips down on 35 doesn’t mean it’s sensible for anyone else to join me.
Usually when people are considering buying their first home, it is not primarily a financial investment. Though I may wish it were different, people with growing families in the US often want to become homeowners (and I may not be immune, when my time comes). I wouldn’t encourage or discourage buying now, just advise people that house prices are unusually uncertain and that they should be willing to live with a financial hit if that’s how things go. I’d also advise people to buy modestly and with as little leverage as they can manage, unless they wish to make a speculative bet on inflation.