Can We Stop Ourselves?

We know how to prevent it, but we don’t seem to want to pay the price.

It’s like our dependency on fossil fuel. We talk about it and make gestures to cut back on emissions, but essentially we are immobilized. Our financial system is set up to give immense power to moneyed special interests, the banks and investment firms that have recruited squads of lobbyists and spent billions on political campaigns to protect their way of doing business. As a result we can’t protect ourselves from the long-range dangers posed by their insistence on issuing loans backed by inadequate assets.

Banks are still too big to fail. Limits on speculation are inadequate. The revolving door between regulators, legislators and traders is spinning. A key issue now is the size of down-payments required for those buying homes. As Peter J. Wallison of The American Enterprise Institute explained: “If the required down payment for a mortgage is 10 percent, a potential home buyer with $10,000 can purchase a $100,000 home. But if the down payment is dropped to 5 percent, the same buyer can purchase a $200,000 home. The buyer is taking more risk by borrowing more, but can afford to bid more.” Can afford it, that is, so long as the buyer earns enough to make the payments.

“In other words,” Wallison continues, “low underwriting standards — especially low down payments — drive housing prices up, making them less affordable for low- and moderate-income buyers, while also inducing would-be homeowners to take more risk.”

So who is in favor of this risky practice? Almost everyone it turns out. Banks and mortgage companies like it because it means more business for them. Real estate developers like it because they can sell more units. And prospective home owners like it because there are fewer obstacles in the way of realizing their dreams, even if they are being unrealistic about affording them.

But they can easily end up being the losers in this scheme: “The losers, as we saw in the financial crisis, are borrowers of modest means who are lured into financing arrangements they can’t afford. When the result is foreclosure and eviction, one of the central goals of homeownership — building equity — is undone.”

And if this happens often enough, we have a situation like the credit bubble – and eventual crash – of 2008.

It is unlikely that we will repeat that specific debacle. Everyone now is aware of the sloppily put together securitized mortgages that brought down Lehman Brother and almost destroyed AIG. This time it will be something else, some danger less well advertised.

When bankers are caught up in the frenzy of making money, their eyes are on the opportunities in front of them and the competition they face from other bankers. They easily neglect the danger signs. They also tend to over-estimate their intelligence and skills as there is often a competitive advantage in being brash and self-confident. No one is telling them “watch out.”

But the deregulated, politically powerful, over-extended, hyper competitive financial world is much less safe than it can appear, and holds the potential for multiple losers.