Posts Tagged ‘James Surowiecki’

Define “innovation”

With Congress now reckoning with the proposed Consumer Financial Protection Agency*, Robert Shiller is the latest of a passel of commentators to point to subprime lending and the many risky (for the borrower) features that make it profitable – and which the new agency would have the power to ban – as an example of imperfect but positive example of financial innovation, in that subprime made property ownership possible for people who otherwise couldn’t have achieved it. I was surprised to see similar thoughts from The New Yorker’s James Surowiecki, less so to pick up on the same meme from John Carney and too many others to keep track of at this point.

Felix Salmon has one sharp take on why Shiller is wrong. I’ll offer another. The majority of subprime mortgages were refinances of existing mortgages – often of prime loans for people whose credit had deteriorated due to financial distress, or who really could have qualified for prime. In the 1990s, many subprime lenders were doing 90 percent refis of existing mortgages (just check out their Home Mortgage Disclosure Act data).

In the 2000s, with the advent of no/low doc mortgages and piggyback lending, where borrowers would take out two mortgages covering most or all of the purchase price, more borrowers used subprime loans to buy homes, but refis and home equity loans still represented about half of subprime lending – meaning that as fast as new borrowers were coming into the pool, they were taking out new mortgages to get cash back. Just look at New Century’s 2006 HMDA report: 76,442 purchase mortgages and 101,848 refis. (New Century did another 40,000 or so second mortgages for buyers who couldn’t muster down payments – as much as guaranteeing that they now owe more than the homes are worth.) In a report that year, the Center for Responsible Lending noted that at least 60 percent of subprime borrowers get another subprime loan when they refinance, severely increasing the likelihood they’ll go into foreclosure.

For too long, “financial innovation” has been code for exploitation of the vast gap in financial knowledge between lenders and borrowers, and for taking advantage of consumers’ short-term needs for cash in situations of economic distress. True innovation will involve figuring out ways to close that gap – to keep credit a profitable business without stealing home equity as a matter of course.

The proposed Consumer Financial Protection Agency is charged with striking exactly such a balance between protecting borrowers and supporting innovation and the availability of credit – and when there’s a tie, innovation is supposed to win. To ban a product or feature, the agency has to have (this is from the bill now in Congress):

reasonable basis to conclude that the act or practice causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers and such substantial injury is not outweighed by countervailing benefits to consumers or to competition.

That’s an awfully high bar. CFPA tilts in favor of financial innovation, for better and for worse.

* “Now” now turns out to mean in September – too many Dems balked.

Wednesday, July 22nd, 2009 | Tags: , , ,
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