Even In Tough Times, Choose Market Over Regulators

The meltdown in the subprime mortgage market has resulted in a substantial number of people losing their homes, tough times for many lenders, and significant challenges for the investment industry. But should government have foreseen the danger signals and moved to more aggressively regulate the subprime sector? And, what, if any, is the correct course of action for government now given the continuing troubles plaguing real estate?

Despite the political hue and cry for some government action, the best course would be no action at all, according to faculty panelists who discussed “Consumer Protection Legislation: Subprime Mortgages & Beyond” at the 56th Annual Management Conference at Gleacher Center May 16.

Moderated by Kevin Murphy, George J. Stigler Distinguished Service Professor of Economics, the panel included Nobel laureate Gary Becker, University Professor of Economics and of Sociology; and Richard Posner, senior lecturer at the University of Chicago Law School and Judge of the United States Seventh Circuit Court of Appeals.

Posner said much of the subprime problem developed because consumers were offered attractive, initially low mortgage rates that often covered 100 percent of a home’s value. Much of this took place in an environment of rising housing prices, which “exploited the naiveté of people who have no business experience,” he said.

When interest rates rose under terms of the mortgage agreements and housing prices began falling, many of those in the subprime category found themselves with loans that exceeded the value of their homes, and payment schedules they could not meet.

“What could be done?” Posner asked. “Instruct people in the basic pitfalls of the market? Take a regulatory approach? We already have the Truth-in-Lending Act. Warnings often have the opposite effect” of what they intend, he said.

Posner also suggested “there is evidence that some normal people have cognitive quirks” that contribute to bad decision making. They “tend to be bad at evaluating probabilities,” he said. “When approached by an aggressive broker, are they able to evaluate the risks?”

Becker disagreed with the idea of cognitive quirks and noted that the bursting of the so-called real estate bubble and the ripple effect it has had on financial markets affected “some of the most clever people around.”

“Retrospectively it’s easy to be brilliant,” Becker said. “Everyone thought the housing boom was gong to continue. But what else could we have done? Not much.”

Commercial banking is already among the most highly regulated industries, Becker pointed out. “I guarantee you there will be bubbles in the future and maybe that’s one of the prices we have to pay for a vibrant and free economy,” he said.

Murphy suggested that buying into a rising real estate market is “not a bad bet. It’s not clear it was a bad idea to get in, but it was a bad idea to get in at the last minute.”

“Most people typically do things they don’t understand very well,” he said.

– Franklin R. Shuftan