Setting Political Time Bombs

Politics is one field where an individual or group can take economically foolish actions for which they pay no price, indeed for which they can receive praise and reward, only to leave the aftermath to be blamed on someone else.

As one example.  A nationwide study of mortgage lending in 1990, reported by the Federal Reserve Board in 1991 and another study reported the following year, both showed that while the majority of applicants of black, white, Asian, and Hispanic applicants were approved.  The percentage denied ranged from 34% for blacks (1990 study) to 13% for Asian Americans (same study).  Note that the study was up front that it did not include data on net worth, employment history, credit history, etc. that go into estimating an applicant’s creditworthiness nor whether or how much those varied between the groups.  This did not stop people from immediately claiming these results as demonstrating racial discrimination by mortgage lenders.  Jesse Jackson claimed that it was “criminal activity” and that banks routinely and systematically discriminated against African Americans.

There are several problems with that, of course.  The first is that, as the study admitted, there are many factors that banks use to determine whether an applicant is a good credit risk or not and the study did not control for any of them.  Also, what about those Asian Americans?  They were approved more often even than whites.  If racial discrimination is to explain for the difference between blacks and Hispanics compared to whites, then why were Asians approved more frequently?  Do these presumably white racists they’re proposing as being the cause of the difference, actually favor Asians over other whites?

Also, consider what the result would be.  If the folk making the decisions were “grading” more harshly against blacks in rejecting more applications would that not mean that the remaining ones were actually more credit worthy on average than the white applicants?  If so, that means we would expect to see fewer defaults among mortgages issued to black borrowers (because those who remain are “really” more creditworthy thanks to more being rejected).  That’s not what we see.  Data from census data does not show a racial difference in default rates.

The Boston Federal Reserve Bank in its own study, which controlled for many of the factors used to determine creditworthiness found that blacks were rejected 17% of the time compared to 11% of the time for whites with the same criteria.  Approval rates of 83% for blacks, 89% for whites.  A six percentage point difference.  Moreover, this difference was entirely attributable to a single bank in the Boston area.  And that bank was owned by blacks.

Another factor.  Banks offering mortgages are not doing the borrowers a favor.  They are making a business transaction where the bank expects to make money.  Banks want to lend money.  The interest on those loans is how banks earn a profit.  The more loans they give to creditworthy applicants, the more money they make.  And even if they utterly despise the person they’re dealing with, once the loan is signed the only dealings they will have afterward is cashing the monthly check.  In my experience banks are far more concerned about green than they are about any possible color of skin.

But, despite the lack of evidence that the disparities in loan approval rates are a direct result of racial discrimination, politically it was popular to cite it as a reason.  Rather than address the possible causes of the differences in creditworthiness (which might stem from discrimination in other areas, or it might not, but even if it is focusing on the banks means that the actual discrimination is not being addressed) politicians and advocacy groups started putting pressure on banks to approve mortgages in a more racially balanced manner.  The banks could not conjure up more equally creditworthy applicants among blacks and hispanics–at all, let alone quickly enough to appease the mobs–they had to issue more loans to people with lesser creditworthiness.

This happened in the mid to late 90’s.   And people cheered the politicians pushing this for their “fairness”.  However, the politicians accolades did not make the higher risk of the loans being made go away.  In an attempt to mitigate those risks, particularly those of the higher risk “subprime mortgages”, banks went to the secondary market, bundling the mortgages together and selling them as bonds.

By the end of 2000 the effect of, on average, easier credit (giving credit to folk who would have been denied before) started having an effect on the housing market exacerbated by government policies encouraging home ownership among those less able to actually afford it than previously.  Supply and demand in all its splendor took off.  More people buying houses meant the demand went up, driving up prices.  And people who already owned homes started looking at this availability of credit and thinking to refinance, grab some of the extra equity (their house market value went up right along with the ones people were buying) to do all sorts of things–buy a car, go on a long dreamed vacation, make improvement, whatever.

Unfortunately this house of cards–built on a foundation of credit extended to those less able to keep up their payments–could not last.  The greater defaulting of those less credit worthy individuals started to come home to roost.  More homes were now on the market from said defaulters.  Starting in mid 2007 real estate prices started to fall.  People started finding themselves “underwater” (owing more on the house than its appraised value).  “Jingle Mail” (people mailing the keys to the mortgage company and walking away from their house) became a thing and the bubble burst.

But did this get blamed on the people who started the whole ball rolling, the ones who decided that skin color rather than creditworthiness as determined by the usual criteria should be the deciding factor in offering mortgages?  Of course not.   The “public face” of those voices was safely out of office.  It was his replacement who had to take the heat for events that he warned of in advance.  The person in office is blamed, even when the issues originated in the past under other people.

And so it is with most people’s short time horizon.  When policies are implemented politicians have little incentive to look ahead to what the longer range issues are likely to be.  It won’t be their problem.  And the people, bless their myopic little hearts, by and large have neither the inclination of the aptitude to look at the economic ramifications of their representatives policies and proposals.

And thus when the time bombs go off everybody scrambles to find someone to blame, rarely those actually responsible for the root problem, but someone ready to hand who might have some peripheral connection…maybe.

Now, take a look at current policy proposals and consider what ticking time bombs they are setting–or, hopefully, existing time bombs that are being defused.  The former is sadly much more popular than the latter since the latter involves hard choices and usually some degree of belt-tightening.  The former?  That’s usually some tasty bread and entertaining circuses.

6 thoughts on “Setting Political Time Bombs”

  1. Similar case in point: The current problems re: China and it’s increasing encroachment of the seas they claim as theirs. (Starting with the long term arguments regarding the Spratleys and similar atolls and reefs…) In this case, it’s not just one government to blame either, or any particular singular policy, but more of an attitude or set of attitudes regarding the situation, which leads to today’s problems regarding China.


  2. Also, consider what the result would be. If the folk making the decisions were “grading” more harshly against blacks in rejecting more applications would that not mean that the remaining ones were actually more credit worthy on average than the white applicants? If so, that means we would expect to see fewer defaults among mortgages issued to black borrowers (because those who remain are “really” more creditworthy thanks to more being rejected). That’s not what we see. Data from census data does not show a racial difference in default rates.

    So I guess banks that discriminate against Blacks must be rolling dice or something in order to avoid producing a statistically significant “file drawer effect”?


  3. With respect to the great bubble and resulting collapse of the housing market, while I agree the CRA and similar policies played a key role, there is substantially more to the story than that in my view. Bubbles can happen without government intervention, unfortunately. (To my surprise, it turns out that even the classic example of an economic bubble – the Tulip mania – is now being re-investigated in connection with certain legal changes made by the Dutch government around that time.)

    There were several additional culprits in the eventual crisis: (a) gain on sale accounting treatment for securitizations (and allowing the financial institutions to move the securitizations off book when the risk profile of the institution had either not changed or gotten worse), (b) complete failure by the rating agencies and certain entities issuing guarantees of certain tranches in the securitizations to identify and price the actual risks, (c) mark-to-market rules for many of the market participants and (d) the resulting inability to evaluate counter-party risk when the illiquid securitization markets seized up. Of these, the government is not to blame for the gain-on-sale accounting fiasco. Reporting immediate gains on securitization facilitated and motivated more subprime lending when, in reality, securitizations were long-term liquidity traps which released a tremendous amount of cash upfront but then were designed to later retain cash to protect the bondholders which invested in them. Quarterly or more frequent securitizations would then effective increase the reported earnings of the firm in question without really changing the risk profile of that firm. Without the gain on sale accounting treatment (and its’ arguable misuse), the financing for what was effectively a Ponzi scheme (or bubble if you prefer) in real estate would not have been as widely available. When the markets for the bonds and the securitization residuals froze, the result was a real liquidity crisis – much like some of the bank runs we’d seen historically play out from time to time. (Of course, part of the problem is it is HARD to tell what a bank or financial institution is worth because most of their assets relying on other people making payments in the future.
    Ironically, the subprime lending market had previously frozen up in a similar matter back in 1998-2000 or so after Long Term Capital Management failed and Russia defaulted – resulting in a string of the independent subprime issuers failing.) The markets can’t function to liquidate bad firms when you can no longer tell which firms are bad and which firms are good. (You also have a problem in the credit markets that bad judgment by a couple of players can essentially ruin the market for a period of time as they drive out the “good” or smarter folks which are less willing to lend and lose their money.)


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