Monday, September 04, 2006

Should government protect people from their own stupidity?

"They may wonder about the proper course. But I am convinced that here, as in all other areas of public policy, the just and efficacious solution is liberty." - Rep. Ron Paul (R-Tx), MD.

This BusinessWeek Online article talks about the alleged danger of the increasingly popular Adjustable Rate Mortgage. It cites several anecdotes of people who didn't realize what they were getting into and, frankly, should have known better: always read the fine print.

"Those who took the bait" -- as if we were dealing with instinct-driven fish, instead of living, breathing capable of intelligent thought. There's the old caveat that "if something seems too good to be true, it probably is," but that doesn't apply here. The lenders aren't scamming anyone, and people should realize almost instinctively that if their mortgage payments are reduced, there will likely be a catch sometime in the future. Didn't Gordon, the Sacramento police officer, stop to question what was happening when his monthly payment went from $2443 (assuming a $500K house, 10% down, 30-year fixed-rate mortage at 5.1%) to $1697? What about Harold, who refinanced his home and seems to be quite aware of the future payments he can't afford? What was he doing?

"But others, caught up in real estate mania, ignored or failed to appreciate the risk [of ARMs]." Why must the rest of us be condemned when we were smart enough to pay attention to the Federal Reserve's actions, and to seek clarification from anyone possible so we would know exactly what we were getting into?

"There was plenty more going on behind the scenes they didn't know about, either: that their broker was paid more to sell option ARMs than other mortgages; that their lender is allowed to claim the full monthly payment as revenue on its books even when borrowers choose to pay much less; that the loan's interest rates and up-front fees might not have been set by their bank but rather by a hedge fund; and that they'll soon be confronted with the choice of coughing up higher payments or coughing up their home." However, these are irrelevant, as are the allegations of deceptive accounting practices, to the real issue: the borrowers were never forced into the deal, nor were they denied opportunities to understand every ramification. Do you buy a car from a dealership based on how much the salesman will make in commission, or based on how good a deal it is for you? Do you worry about the particulars of the relationship between the dealership and its loan financing company, or do you only care about the interest rate?

The article tries to imply that the financial sector's usage of ARMs is shady or improper, but it's no different than someone selling a bond for ready cash to a buyer who's willing to assume the risk that the borrower may not repay the full balance. Mortgages, primarily fixed-rate ones, are often used as assets in mortgage-backed securities for certain investors to buy. Such transference of risk has happened for a long time, and the investors, like mortgage borrowers should be, are well aware of the risk. Similarly, certain hedge funds may be snapping up ARMs, but buying heavy-risk investments is what they do. They'll pay banks a certain percentage of the loan's total value, counting on enough borrowers to pay back the loans successfully so the hedge funds will make an overall profit. What they're not counting on is people defaulting: they're not in the real estate business, so mortgage holders will auction a seized house as quickly as possible for whatever they'll get. Rarely will they break even, let alone exceed the balance still owed, and some states also don't permit banks (or whoever the mortgage is payable to) from making a profit on foreclosures.

Some people feel that government should regulate ARMs more strictly, although not what financial firms do with them afterward. These people, as the article describes, want government to regulate ARMs' availability to the borrowers. I ask, are people unable to read through a legal document and understand it thoroughly? Are they too cheap or lazy to pay an accountant a few hundred dollars to give them an amortization table and explain every implication? Shouldn't they be intelligent enough to realize that this isn't something they can just return to the store when they find it doesn't work for them?

Some, like Paul Krugman, believe that government must insulate people from life's risks. Libertarians and true conservatives oppose that primarily from a moral, freedom-based perspective, but we also note that such protection doesn't make economic sense. Government has no true ability to protect people: it can only force people to protect themselves, at higher costs to themselves, though some people perfectly accept the risks and don't want to assume those costs. Sometimes a higher cost is not getting the product or service you wanted, not because of availability in a free market, but because government policies have made it so expensive that they priced it out of your reach. Perfect examples are live-saving medicines and medical procedures that are illegal in the U.S. without the FDA's say-so: FDA approval involves delays, which kill people who could have used the medical breakthroughs, and higher prices because of all the jumping through bureaucrats' hoops, which kills people who can't afford the increase to the drugs' prices.

"[The lenders] know they're selling crap, and they're doing it in a way that's very deceiving," said the Sacramento policeman. Well, one of my friends and his wife have an ARM, and it's been great for them. They were smart enough to make much higher payments when interest rates were low, so when interest rates rose, they already had paid off a lot of principal and weren't hit as hard. But how would they be affected if government decided to start "protecting" people from ARMs? Let's consider some scenarios.

1. Mandatory disclosure of all details before closing, so that people know what they're getting into. But that already happens, and in black and white too: borrowers aren't prohibited from reading the contract, which lays out every detail.

2. A mandatory sit-down with a bank official, who will explain the risks involved. Most people, however, would go through this like they're back in school: with glazed eyes and short attention spans.

3. Mandatory consultation with an accountant. But my friends clearly didn't need this, so it would only make them waste money. Even if the law required banks to pay the fee, who's stupid enough to think the bank wouldn't somehow pass it on to the borrower? Perhaps there could be an option to waive this, but then what's the point of a law requiring it? Moreover, people would sign a waiver indicating they understand all the risks, yadda yadda, only to claim later that they weren't fully informed.

4. Legislation restricting the number of ARMs (perhaps as a percentage of all mortgages issued), or restricting them to to people who meet a certain debt-income ratio. But what of people who don't happen to win the inevitable "lottery" for ARMs, or who can't meet the arbitrary requirements, notwithstanding that they know what they're doing?

It's a nice thought that government policies can reduce the risks of life, but protecting a few people denies the rest their freedom to assume risk, and it's economically inefficient anyway. Without exception, government's "protection" makes it more expensive for everyone: the stupidity of some becomes unnecessarily higher costs for everyone else. Think about this the next time your car passes a safety and emissions inspection with flying colors, the next time you buy agricultural products that had to be inspected before you could buy them, or the next time you're stopped at a "sobriety checkpoint." Each of these, and countless other examples where government interferes in our lives, involves a pound of prevention to get an ounce of cure.



Anonymous Anonymous said...

Proofread your title Perry boy.

Monday, September 04, 2006 9:07:00 AM  
Blogger Perry Eidelbus said...

Well Bobby, there's a difference between my changing the title later and forgetting to change one verb's conjugation, and your innate lack of command of the English language.

Monday, September 04, 2006 10:15:00 AM  
Blogger Jeff Hess said...

Shalom Perry,

That's true, you're absolutely right. It is not the role of government to protect people from their own greed or ignorance.

My classic example is gambling. If people who are completely ignorant of the laws of probability wish to make casino owners richer, well that's their choice. But I do take time in my math classes to teach 6th graders how craps and roulette work and why, in the long run, the house always wins. (I don't however think government ought to be engaged in promoting gambling in the form of lotteries, etc., as an alternative to taxation.)

Government may have a limited roll in ensuring that it possible to make an informed decision about any action -- full disclosure laws, etc. -- but beyond that, people need to figure out that if a deal looks to good to be true, it most likely isn't.

Micro managing scams or high-risk business deals is a game of whack-a-mole. As soon as you plug one hole, the grifters or deal makers pop out of another. Government has too many more important tasks to deal with.


Jeff Hess

Monday, September 04, 2006 9:04:00 PM  
Blogger Perry Eidelbus said...

OK, you agree that "It is not the role of government to protect people from their own greed or ignorance," but government does precisely that by attempting to increase people's awareness of their circumstances. If a government cannot legislate morality, how can it also legislate intelligence or at least greater cognizance?

Laws mandating full disclosure are superfluous. If you don't already trust the organization fully, then why are you doing business with it? And if the organization deceived you when you entered into a contract in good faith, there are already laws against fraud.

Saturday, September 09, 2006 5:51:00 PM  

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