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As I’ve looked into buying a home recently, I’ve come to discover that the US mortgage market seems to be completely detached from reality. Due to the Federal government regulations and a prevalence of standardized products, lending standards have become extremely mindless, with a heavy focus on wage income and gross debt. This is “mindless” because these two attributes are not necessarily the most important ones in accessing the ability to repay, or the overall risk of a loan.

A Better Way to Access Risk / Reward

If I were a lender and we were in a free market mortgage system, I’d analyze a real estate purchase in the exact same way I’d analyze any other business. Real estate is an investment, and it should be examined based on the potential profitability; the income-producing alternatives; the character, creditworthiness,and resources of the borrower; as well as the ability to repay.

The first thing I’d look at the potential income produced by the property. Could the borrower theoretically rent out the property at a significant higher rate than the mortgage payments? If so, the property itself may be lower-risk. If the situation is reversed and the mortgage payments were twice that of the potential rental value, I’d consider that high risk. It’s irrelevant whether the borrower wishes to actually rent out the property or not, because rental is merely an alternative action that helps access the true level of risk. If the borrower has a very good alternative action, they are very unlikely to default, since they would give up profit to do so. Even if they do, the bank is unlikely to lose as much money, since the property value likely increased in order to eliminate the arbitrage opportunity in the market.

The next thing I’d change is that instead of looking at “wage income” and “gross debt” for borrowers, I’d look more at a long-term income history, wage potential, and net debt (i.e. debt – assets). I’d also look at the borrowers’ assets and the potential of those assets to produce income offsetting the debt. This isn’t a radical notion; this is how any business in America would be examined. Why should individuals be treated differently?

Finally, I’d be much more likely to take a look at the borrower’s creditworthiness, character, and history. Lenders still examine credit scores, but I’d also want to know more about their rental history, and get to know them personally to understand what type of people they are. It’s not that difficult to assess one’s general demeanor from a 10-minute conversation. Part of the problem with the lending market is that we’ve taken the people side out of it, and have resorted to mindless standards.

Are some aspects of my vision unrealistic? Maybe. We live in a world where loans have been standardized so as to deal with a large number of applicants on very simple standards. But maybe the need for that is necessitated by the increasingly Federally-controlled system of lending. The greater the regulation, the subsidies, and the Federal intervention in general, the more of an advantage the larger banks have, and the more mindless the standards become.

Why Did Lenders Resort to Weak Standards During the Boom

The big counter to my argument is that without Federal standards, the banks will lend out recklessly. This to me is the biggest mistruth of all. The banks didn’t lend out recklessly during the boom years because they were naturally predisposed towards that result. Rather, they lent out recklessly because the Federal government offered them “free money” to do so.

The Federal Reserve Bank, under the leadership of Alan Greenspan, was the biggest culprit. It all started around 1997, when China decided to leave its currency peg unchanged (in spite of the fact that their currency was appreciating rapidly). This created a huge need by the Chinese government to buy US Dollar-denominated assets, with US Treasury securities being the only viable option given their size.

This market interference by the Chinese government led to artificially falling US interest rates. Except, if you look at what was happening in the US real estate market, it’s clear that Alan Greenspan should have responded by raising interest rates and tightening credit. Instead, after 2000, he went the exact opposite way.

With artificially low interest rates, the Federal Reserve was basically creating “free money” for the banks, so long as they lent that money out to someone. The easiest way to lend out was in the mortgage market. All of this was exacerbated after 2002, when President George W. Bush embarked upon a path of reckless fiscal policies that created even more “free money” (as budget deficits result in the creation of new money).

Meanwhile, Federal regulations on lending were already fairly tight and the Federal government played a major role in dictating the direction of the mortgage market. But it really didn’t matter, because once the Feds started giving away gobs of “free money” through flawed policies, the banks were going to find any way they could to take advantage. And they did.

Dodd-Frank and a Two-Tiered Market

The Federal government’s response to the financial crisis was not to get its own house in order. There were no reforms of the Federal Reserve, no reforms that contained Federal spending and budget deficits, no reforms that weakened the massive US intervention in the US housing market, and no reforms that eliminated the “To Big Too Fail” problem. Rather, the Federal government decided that the banks were the real problem, and the best way to punish them was with a massive host of regulations that tended to harm the small banks the most.

The entire premise behind Dodd-Frank is that consumer choice is bad. That banks should not provide consumers with options, because consumers are too stupid to understand them. Only the enlightened Federal government can protect the consumers.

Only problem is it’s all a bunch of rubbish. What Dodd-Frank has actually done is help create a two-tiered banking system, with the wealthy still having access to convenient financial products, while lower and middle income earners are increasingly shut out. Instead of making the mortgage market safer, we’ve merely made it smaller and less responsive. Indeed, in an ironic twist, while the risks in the mortgage market are now lower, they have merely been shifted out towards other assets.

As the Federal government artificially inhibits lending, we’re finding more and more Americans forced to move into the rental market, which appears to be creating a rental bubble of sorts. If personal mortgage lending can take no longer take on risk, then risk will now shift over to the commercial market. And while a commercial bubble may not become as out of control as the housing bubble, the end results won’t be any better.

The Solutions

If we want to prevent another financial crash like the one we saw in the housing boom, a better prescription would be:

(1) Begin limiting the power of the Federal Reserve to control interest rates. Use automated standards to regulate money supply, and only allow them to be overridden by 3/4 vote of all the Fed chairs. I’m not necessarily in the “End the Fed” camp (but we should certainly start examining that solution), and I’m definitely not in the “re-enact the gold standard camp” (which would be a disaster if there ever were one), but we definitely need to limit the power of the Federal Reserve, which was the primary culprit in creating the most recent financial crisis, and also a major culprit in creating the Great Depression, and the 1970’s Stagflation.

(2) A balanced budget amendment, which would prohibit Congress from creating new money via fiscal deficits. Our budget deficits are now 8% – 10% of GDP on a regular basis. That’s a lot of “free money” for the well-connected.

(3) Eliminate Fannie Mae, Freddie Mac, the interest mortgage deduction, and other Federal interventions into the housing market. Let’s stop convincing ourselves that home ownership is superior to renting or vice-verse. Both are good options depending on one’s own situation.

(4) Reform the FDIC, so that banks must purchase insurance from a private insurer, rather than FDIC. The private insurers are more likely to hold the banks more accountable for lending standards. This would also eliminate the “free lunch” from the FDIC for some of the larger banks.

If we do all of the above, the banks are going to be much more reluctant to make a bunch of risky mortgage loans. Moreover, this is more likely to result in the banks getting more aggressive when they should, and being more cautious when they should. As it is, with “free money” and Federal backstops, there’s no real incentive to innovate, nor is there an incentive for prudent lending.