13. The Mortgage Meltdown in Cleveland


Prof: What I’d like to
do this morning is spend eight or ten minutes with a few slides
that are framing and background to the case.
And then I’m going to ask Nancy
Hite to impersonate Sharon Oster,
with the flying chalk on the board,
and I’m going to come around and talk to all of you about the
case. And we’ll work it through B
school style. When you look at the
institutions involved in the mortgage system,
don’t assume that they were designed brilliantly,
or that they were thought out from beginning to end.
The concept of
“kluge,” is that in your vocabulary?
Tim, is that,
“kluge,” is that a– hands up if
“kluge” is familiar.
I’m not going to get anywhere
with that idea. “Kluge”
means things that are complex and badly designed.
And there’s a wonderful book by
Gary Marcus called Kluge, which is about badly
designed stuff, from economic institutions;
to human memory; to the human spine,
which is a highly error-prone structure,
and is as it is not because evolution said,
“What’s the very best support column I can make for a
bipedal creature?” but, “What’s the best I
can do by evolving from a four-legged to a two-legged
creature?” And the spine shows all kinds
of design imperfections that are attributable to the fact that it
evolved in a horizontal plain and then was readapted in a
vertical plain. And the institutions at play
in, what Posner calls the Depression of ’08,
and what most of us call the Recession of 08/’09,
though it is, perhaps, the mother of all
recessions, it has not actually obtained
the depth of unemployment and under-utilization of plant and
equipment that would match up with the one in the 1930s.
Of course, we could still get
there. It is possible that it is now
1931 and another dip is out there.
I don’t think that but there
are those, including Will Goetzmann, who we saw a few days
ago, who speculate that it might be so.
This is a cast of characters
for subprime lending; left to right:
the homebuyer, the broker,
the appraiser, the mortgage lender,
the investment banker and the investors in the bonds created
by the investment banks. And in the row I’m touching are
the principal incentives that make the whole system go.
And the critical thing is that
three, and arguably four,
of the main steps in the process are fee-driven,
so that the alignment between the decision maker and the
investor, or between the decision maker
and the potential home buyer, may be muted by the decision
maker thinking “fees.” If I’m thinking–let’s suppose
I were a college admissions officer and I was paid by the
live students delivered to the school,
I might become very generous in my view;
I might find creativity in unexpected places;
I might imagine analytic firepower where none existed.
And so, in all these steps,
the bias toward “yes,”
the bias toward completing a transaction,
is a very powerful piece of the story.
The risks are chartered here.
What we’re going to do,
when we do the case, among other things,
is to fill in the bottom row. What are the ways in which we
would expect people in each of these roles to be tempted to get
out of line? Out of line ethically;
and quite possibly out of line legally.
As in the case,
there is a broker, right, who gets way beyond both
ethical and legal bounds. Home ownership in the United
States, 1900 to 2000, looks like this.
And notice it’s a truncated
scale, the bottom of the scale is forty percent.
The big story is a huge
normative emphasis on home ownership.
The belief, going back to
Jefferson really, that when people own property
they become “bought-in citizens”,
citizens who identify with the Commonwealth and who can be
counted on to act in public-spirited ways.
And there’s a great run-up in
home ownership between World War II and the 1980s,
and it is fuelled by very profitable mass development of
suburban housing; it is financed by FHA and
related government entities; and it is rewarded by the
Internal Revenue Service tax code, which gives a strong
incentive for people to take out mortgages on a principal
residence. Now, home ownership,
I assume–do any of you own a home?
Oh, I should say that Jaan
Elias, who wrote the case, is with us.
Welcome Jaan.
Jaan Elias: Hello.
Prof: Do you own a house?
Jan Elias: No.
Prof: Sometimes I envy
that. Home ownership has all kinds of
hazards. I just learned that my slate
roof, a hundred year old slate roof, is at the end of its
lifetime. And that’s comparable to buying
a–it’s about the same price as the highest-end BMW,
to replace a slate roof; that’s a hazard.
Suppose that you get laid-off;
your mortgage payments continue. Suppose that there is a
catastrophic illness; the mortgage payments continue,
the local property taxes continue, the unanticipated
maintenance issues continue. And there is quite a lot to be
said for relative caution about undertaking a debt amounting to
several years’ income in purchasing a house.
Now, there’s also a political
dimension to this, which is that the old fashioned
local banking method of writing mortgages was extremely cautious
and was, first explicitly and then,
later, implicitly racist and “genderist.”
It was all about well-employed
white men. And there is an ideological
strand, that is not Jeffersonian but is
more recent, and has to do with equality of
opportunity to own houses, which has pushed policy towards
are more permissive attitude. Finally, there is,
of course, the pro-market view, which became dominant in this
country in the Ronald Reagan era,
which says “Let people cut the deals they want to cut.
Get the government out of the
transaction. Deregulate.”
And in many cases deregulation
was a spectacular success, for example,
the airline industry, the trucking industry,
but deregulation of finance is a slipperier undertaking.
A history of home values here.
It’s an index chart that has
1890 indexed to 100 and the gist of the argument in this
chart–did I take this from the case, or not?
Jan Elias: No.
Prof: The gist of the argument in this chart is that:
by the time we are done with the current meltdown,
home values, adjusted for inflation,
will be back about where they were in 1890.

This is a map of Philadelphia,
and it’s a historically interesting map.
I couldn’t find a comparable
one for Cleveland, though I’m sure one exists.
In 1937 mortgages were
collapsing all over the country. And the Roosevelt
Administration pushed through Congress a piece of legislation
called The Home Owners Loan Corporation,
HOLC, Home Owners Loan Corporation.
And the Home Owners Loan
Corporation was charged with finding out how to know in
advance if a mortgage would likely fail.
And the technique was not to
look at credit scores but to look at housing locations;
and to look at the condition of housing in a neighborhood;
and at the demographics of who lived there.
And it was crudely racist and
biased in many, many ways.
It was explicitly racist about
blacks; it was explicitly racist about
Jews; it was explicitly racist about
Italians, most of all Southern Italians.
And it was a four-point scale,
the worst category – level D – was red,
and the term “redlining”
comes from this, and the idea was to tell the
banking world not to lend money in those zones.
Yellow was a little better,
then blue, then green and the idea was to
put mortgage money into the safest,
wealthiest neighborhoods with the most homogeneous
populations. And from the point of view of
managing the mortgage crisis, it was not a terrible policy.
From the point of view of
managing cities and communities, it was catastrophic because
what it did was to accelerate the creation of slums in areas
where mortgage money was unavailable for the sale or
purchase of housing, or, for that matter,
for the large-scale repair of housing.
They did it to two
hundred–they did the process to two hundred American cities in a
single year, including New Haven.
Across Chapel Street is class D.
This is the Case-Schiller home
prices story and let’s lay it out here from the year 2000 to
2007. And this is,
when Goetzmann talked about Case-Schiller being a reassuring
data series, if you look at it between here
and here, if you look at a five-year
period or even a six-year period,
it looks like a process of continued appreciation in home
prices. And there was nothing in the
data, that would have, given conventional econometric
models, would have triggered the suspicion that the end was nigh.
The chart is also interesting
because Cleveland is this line. So that, Cleveland is a less
extreme story in price appreciation than the cases
everybody talks about, which were Miami and Las Vegas
and Los Angeles. This is the same story shown in
year-on-year percentage change and it actually doesn’t add much
to our knowledge, I’m going to skip it.
This is Cleveland price
appreciation from 2000 into 2007,
compared with the country at large,
and the gist is that Cleveland was not a hot–
not a hot city. And it was–it is in that
respect, I hope I’ve got–I’ve missed a chart here.
There’s a huge story about
Northeastern industrial cities, by which I mean virtually all
the cities from St. Louis on the left side to
Boston on the right side. They all had their take-off in
the middle of the nineteenth century.
They were all going almost
vertical in the years 1850 to 1900,1910.
By 1920 their growth rates
slowed down almost to zero, and were– fluctuated wildly
during the Depression years, recovered briefly in World War
II, and then went sharply south from 1950 on.
New Haven’s case,
the strength of the inner city economy forms an almost perfect
arch, with the starting point in
1840, the peak in 1950, and the bottom in about 1990.
And there’s actually been a
little bit of recovery since. But Cleveland is a classic
industrial city. It is the place where Standard
Oil set up its first large refining plants.
It was an advantage-point in
transportation because it was an intersection between very high
quality east-west freight rail and Great Lakes shipping.
And when rail became
subordinated to trucking and when suburban development became
dominant over the reuse of industrial urban neighborhoods,
Cleveland suffered mightily. This income map of Cleveland,
where medium incomes, under $22,700,
are shown in the darkest rust tone, is where the case takes
place; the green dot is approximately
the location of Slavic Village. I wouldn’t swear to it or argue
with Jaan if he said move it three or four degrees of the
compass north or east or south or west,
but it’s right about there. And it is on the edge of a
large post-industrial working class neighborhood,
or mega-neighborhood, in a declining industrial city.
So, there’s the great arch.
And the concentration of
subprime lending in Cleveland, shown in the darkest tones
here, includes the neighborhood we’re talking about.
And then there’s Posner.
On page 284,
I hope all of you have memorized page 284,
where he’s apportioning blame: “But although the
financiers bear the primary responsibility for the
depression,” that’s his name for the
recession, “I do not think they can
be blamed for it, implying moral censure,
any more than one can blame a lion for eating a zebra.
Capitalism is Darwinism.”
Pretty dark interpretation.
>
Prof: Is it Jennifer?
Student: Yes.
Prof.
Douglas W. Rae:
That’s the trouble with letting me learn your name;
you get cold called. There’s a story in this where a
local broker ends up being sentenced to prison.
Do you remember that part of it
or not? Student: Mark.
Prof: Okay, Mark.
Can you give us a little recap
on Mark? Student:
Mark Kellogg submitted fraudulent data for about
seventy homes, and–or somehow ended up,
I’m not sure of the process of flipping a house exactly,
but he did it to seventy homes and they all ended up defaulting
on the loans, the people that he sold it to.
Prof: Okay,
so Mark’s sin would be what? Let’s try somebody else.
What’s Mark–if Mark were a
relative of yours and you had to have Thanksgiving dinner with
him while he was on furlough from Ohio State Penitentiary,
what topic would you want it to reflect on;
ethical topic? You want to take a shot at this?
Student:
Perhaps, as you just mentioned with the topic of preying on
zebras, perhaps something like that,
and that– using a position to benefit
from people at a much>
than you, and to their
detriment and to your gain. Prof: Okay.
So the buyers,
on your telling, are zebras.
Okay, that’s a plausible
position. If the buyers are zebras,
are the zebras in any way blamable in this story?
What do you think?
Student:
It’s possible that they’re blamable,
if they were given good information,
but in this situation they were given completely wrongful
information and led to believe that it was true.
Prof: Okay.
Student:
Like, a plausible person would believe that.
Prof: Can we tell a
story where it’s plausible to blame the buyers?
Student: Yes.
Where they should have known
that they don’t have the income to pay the loan and they were
going to default, and so therefore they should
have not bought the home. Prof: Thank you.
And are their instances where
people are encouraged to lie about their incomes?
Student:
I think there’s a big problem with a lot of these “Jumbo
Subprime Mortgages” they called them,
where people were buying really big houses,
or second houses, with subprime mortgages and in
that case it is their fault, because they were just being
greedy, right.
And trying to take–trying to
either falsify documents or go for the type of loans that would
allow them to get these second properties without really having
enough to back it up. Prof: Okay.
So, that’s the sin of pride or
gluttony, not really gluttony, but it’s bricks and mortar
gluttony. Yes?
Student:
Well there were also NINJA loans,
which I think is a very appropriate acronym because of
the sneakiness, but it was an acronym for no
income, no job and no assets.
Professor Douglas W.
Rae: Okay,
NINJA: No Income, No Job, No Assets.
And why would anyone encourage
another human being to seek a NINJA loan?
Is it obvious?
Student:
Well, if you’re one of the three steps that profits off of
the fee of making– of having that loan go through,
then you don’t even– it doesn’t really matter to you
if it– or it doesn’t matter to you if
it defaults as much as it matters to the buyer or to the
bank. Prof: Okay.
So as long as you can
successfully pass it along to the next step,
you collect the fee and you’re home-dry no matter what happens.
Student:
Right, and your reputation>
..
Prof: Okay now,
let’s stop and see what we got for a diagram here,
Sharon. Student:
>Prof: Unpack your
diagram. Student:
Okay, so I guess this is… Prof: I knew you’d be
good at diagrams. Student:
Our game of Pictionary. So, I’m trying to map out what
exactly went wrong, and I would start with a home
in the Slavic community and then I would end,
maybe, here with Bank of Scotland.
And between “Joe six
pack” purchasing a home with a $22,000 yearly income,
which was the average I saw, that was misrepresented as
being worth about $80,000 from the broker who works with a–
I figured we could have everyone fill in the parts for
me. Like, how do we get from the
home to the international crisis?
Prof: Okay,
so who’s>.
What’s the next step in the
chain to the right of broker? Student:
Probably someone will give a rating for this mortgage so that
the broker will be able to package it with other mortgages
and sell it to an investment banker.
Prof: Okay,
so there’s a credit rating story, but there’s also another
story that’s closer to ground level.
It concerns the house itself.
Student:
Need an evaluation of the house, like, what the house
value is. Prof: Okay.
And there’s a saying in real
estate “appraise as instructed.”
And it’s not altogether false
that whoever hires–think about the incentives.
You’re an appraiser,
and Paul here hires you to do an appraisal and you’re going to
get a fee of 1,100 bucks for doing it.
And Paul lets it be known that
he thinks this house really ought to be worth something
north of $200,000. And you go out in the field,
do the comparables and the number comes up at $140,000.
Tim, what thought might cross
your mind if you were–I understand in your case it,
of course, wouldn’t, but in, say,
my case? Student:
It might cross your mind to trust all and just go with the
$200,000 prediction. Prof: Okay.
And the second step in the
reasoning is? Student:
No-one will ever know. Prof: No-one will ever
know and next time Paul goes to the Yellow Pages for an
appraisal? Student:
He’ll come to you. Prof: He’ll come to you
or he’s more likely to. He’s a damn sight less likely
to if you undercut his deal. I’ll tell you a Yale story
about appraisals: when I was in city government
we leased High Street and Wall Street to Yale for ninety-nine
years; we were broke, we needed money.
And the Mayor sat down with
Benno Schmidt, and Benno said, “Well,
the University will handle the appraisal for you,”
and they did. The two streets together leased
for one million dollars for ninety-nine years.
It should have been a lot more
than that and there were those, in city government,
who thought I was the guy who got the number that low.
I was actually pulling hard on
making the number at least one zero or a zero-and-a-half
higher. I’d allow the Law School to
build that gorgeous underground library, because the ground
rights went with the streets. And so “appraise as
instructed” is an important component in
this story. We had the appraiser there.
So, who else is involved and
what are their incentives? Paul?
Student:
Well, you’ve got the local bank that’s actually doing the
lending. Prof: Okay.
Student:
And they probably will get a fee for the loan that they take
and then if they can package and sell it off to someone else,
they don’t end up with the loan on their books so they couldn’t,
probably, care less how it performs over the long run.
Prof: Okay.
So–terrific,
so, the lender is also fee-driven and is inclined to
think that she or he can escape accountability when the property
defaults, if it defaults.
And why would that be?
What are the–what do we turn
these loans into at the next stage?
Student:
Usually it’s sold off to a big investment bank or basically a
financial powerhouse where they pull the mortgages into these
giant, collateralized debt obligations
or>Prof: Okay,
CDOs, famous acronym. Do you want to add anything to
this? Jaan Elias: Not really.
Prof: Okay.
So you’ve got the banks
creating these huge bundles, and the bundles–what story
could you tell to say that bundling these mortgages from
all across the country might be a good thing from the economy’s
point of view. Is there anything you could say?

Student:
It diversifies the risk for those who are taking them out.
Prof: Okay.
It diversifies the risk,
say a little more. Student:
Well, presumably, the people who are packaging
them can take out a bunch of– do a lot of financial analysis
and determine that the risk of the number of defaults would be
lower than the benefit of the people actually paying their
loans back. So, the people who take out the
package would have a favorable risk return.
Prof: Okay.
And part–were you about to say
something? Student:
I think it also increase the market of potential buyers,
because now, rather than owning a mortgage
and having to deal with an investor one-on-one,
you have a pooling and servicing agreement that has a
company as a servicer who handles all the collection of
payments and distribution of money into different
investments. Prof: Okay.
So, you’ve got an institutional
mechanism that makes this work relatively smoothly,
and you’re interested, when you create these bundles,
in having the risks have relatively low correlation with
one another. What would be a bad bundle is
one where we can know that some of the mortgages are defaulting
and infer from that, that lots of others are likely
to default. And a bundle that was
geographically concentrated, on Slavic Village for example,
would have that second characteristic and that would be
a bad thing. So, there is a story about risk
management that makes that work. Now, are the agencies,
like Moody’s, these outfits that judge
credit-worthiness of companies and other financial
intermediaries, are they in this story anywhere?
I don’t know if they–Jaan,
does Moody’s get into your case?
I don’t think I found it.
Jaan Elias:
Just as a kind of footnote. There are bating the CDOs.
Prof: Okay.
So, everybody know what Moody’s
and its rivals do? Anybody want to help us with
that? Student:
Moody’s and its rivals are– essentially collect a fee from
anyone who wants to spin-off an asset or a debt obligation to
actually rate the soundness of the security for whatever it’s
supposed to be. They sign a rating like Triple
A or Single A. Prof: Okay.
And if I’m–Yale was Triple A,
and I think we’re now Double A, what’s a Triple A–what’s the
advantage of a Triple A rating? Student:
If you have a higher rating then that means you can get a
lower cost of capital. So, if you actually want to
raise some money you can raise it for a lot less–a lower
interest rate. Prof: So,
it reduces the cost of capital, and it therefore has great
value to you. Now, if you could bribe
Moody’s, if you were completely amoral and you could bribe
Moody’s to make something Triple A when it was really B,
it would be worth paying a lot, right?
The actual economic value of
those ratings is huge. What keeps Moody’s honest?
Student:
Their reputation; the fact that they have,
for years, made sure that the ratings that they’re giving are
actually safe investments. Prof: Okay.
And in general,
people on the buy side are going to want the rating
agencies to tell the truth and people on the sell side will be
ambivalent about that, so there are cross-pressures
there. And there is patent evidence of
great inflation in the ratings that these firms produce.
Does that surprise you, Paul?
Student:
Not really, no, because they get paid by the
sell side not by the buy side. Prof: Absolutely.
So, they are doing–they are,
in a sense, appraising as instructed and that’s a pretty
scary part of this whole thing. Let’s reach all the way back to
Adam Smith for a minute, and Smith’s story,
not just of the invisible hand, but of the generally benign
working of markets. In everything Smith says is
embedded a basic norm of truth that I’m not selling you a false
mirage of a loaf of bread; I’m selling you an actual loaf
of bread. I’m not selling you coffee or a
substance that looks like coffee;
I’m selling you coffee. And the basic accountability in
bilateral trade, where you’re buying something
from me or I’m buying something from you,
we keep each other honest, right?
Where it’s two parties and
there’s no information asymmetry, right?
Where there are two parties
with symmetrical information. The most foundational aspect of
a market system is that buyer and seller are equipped to keep
each other honest. And where there is a huge
information asymmetry, we invent things like Moody’s
or appraisals of real estate as a substitute,
a way of creating or simulating information symmetry.
But if the third party agencies
act like sellers to the side that pays them,
the information asymmetry is actually made worse,
right. And the strongest case for
increased government regulation of the finance industry
generally, actually, is the difficulty of policing
the police; of tracking the integrity of
estimates put out there by people who are in the business
of correcting information asymmetries.
Jaan, are there aspects of the
case that you would urge us to pay greater attention to?
Jan Elias:
>Well, first of all,
on the Triple A story, and this may not be in the
case, per say, but it’s certainly part of the
thing. Not only is there a nice little
boost to the true cost of capital if you get rated Triple
A, but there are certain funds and
certain buyers, like money market funds and
other funds, that only can buy Triple
A bonds. So once you’ve crossed that
threshold, you have just absolutely increased the number
of people and possible purchasers of your funds.
Because if you put money in a
money market fund, you want a reasonably liquid
investment, you want a reasonably assured return.
These are not supposed to be
risky investments and therefore money market funds,
all kinds of other funds, are limited to Triple A bonds.
So, getting to the Triple A
level was really important. To say something,
you could go, “I’m not a big fan of
their performance in this case,” but in terms of
Moody’s & Fitch and everything,
the collusion doesn’t–there doesn’t have to be explicit
collusion in the sense that, if I give you this bond to
rate, I will never rate a bond again unless you give me a
Triple A rating. What happened in this case is
Moody’s and Fitch and others put out fairly explicit guidelines
on what they consider to be Triple A.
So, you’re the bond packager at
the iBank, you’re bringing together all these mortgages.
And you say “I have to
reach a fifteen percent threshold level,
where it’s fifteen percent over collateralized,
or I have to buy CDS, which are the default swaps,
in order to ensure this investment and get it over that
Triple A bump,” you do exactly what you need to
do to get that Triple A rating. And what happened when the
crisis hit is we had all of these people who are just
over the Triple A rating and they–
I mean, with them just over you don’t have a spread–
you don’t have a usual probability distribution.
All of these guys who were
creating these CDOs knew exactly where the finish line was,
and went just a step over that to make sure that they would get
the Triple A ratings. So, the fact that they were not
very well understood, that the historic data went
back three years and they felt very confident in doing stuff
with three years of data, I think that’s an interesting
way. Because, when you’re looking
for active collusion you expect guys in seedy bars,
trading information and dollars in brown paper envelopes,
and sometimes it’s not that explicit.
There are ways that gaming the
system without having anyone do anything that even resembles
something that sketchy. Prof: So,
it may be that legitimate cheating, cheating in a good
blue suit, is more dangerous than cheating in a seedier
setting with seedier… Jaan Elias:
Or you’re using a formula that’s really untested by a heck
of a lot of data, may be also a bad idea.
And to go on,
I’m actually kind of surprised, Doug, given that we’re at an
elite university with lots of people with connections to Wall
Street in some way or another, that everyone thought the zebra
was the people buying the houses.
If you look at the data,
and you have Mark Kellogg’s purchase list there,
if you look at the data, you begin to notice not only is
there a pattern in who the appraiser is,
but there are patterns as to who the buyer is.
We have this one buyer here,
and I’m just looking at it in a four-year period,
bought five houses, six houses, all with the same
broker, all with the same appraiser.
We go down and there are others
here, seven or eight times. Just look at the names and they
repeat themselves. So, I would put the question
back here, who’s the lion and who’s the zebra in this case?
Was it the iBanks?
They were relying on these
folks in Cleveland to do a reasonable job in appraising,
in putting out the thing, and in the end,
that’s what went into those formulas that I was talking
about. The fact that,
okay, you have houses that are appraised at this much and
historically they default at, let’s say, a ten percent rate.
But they didn’t take into
account the fact that you have people who are just jiggering
the system and going, in a six month period,
buying a house at $25,000 and selling it at $85,000 with no
evidence of any remodeling. And it just goes on,
you>go through with it.
The sell sheet is actually
fascinating if you want to play junior detective;
if you want to see how these patterns–and the data,
and you can look at the data, and go “You know,
this can’t be right. This really can’t be right in
terms of selling and how much they’re selling the things
for.” And it’s actually,
when you look at the story of Cleveland,
which wasn’t a hot market, and you can’t come up with a
story like you might for Miami or Las Vegas and think
“Well, a lot of old people are going
to move here and that’s the reason land value’s coming
up.” You can’t come up with a story
like that for Cleveland and it’s a wonderful town,
don’t get me wrong, but there isn’t…
Prof: Worst yes,
they’ve got the Indians and the Browns.
Jaan Elias:
Yes and they have the Rock ‘n’ Roll Hall of Fame but
there’s really, you know, it’s hard to come up
with a story. So, why are we getting this
kind of occurrence and so on? So, that’s the point I would
make. Prof: Okay.
Student:
So, one thing that I saw was I felt like the zebra really
represents potential profits and economic profit more than an
individual in itself. So, if you look from each of
the actors’ point of views, the zebra is really what
they’re–the profits that they’re going after under the
system that’s set up. So, rationally,
each player is acting in their own best interests but,
in the end, the big picture ends up where it hurts the
system as a whole. And so, I think that it’s very
easy to want to put blame on a specific party or a specific
group, but it’s just very difficult to
do because everybody’s working under the incentives that has
been created for that party. Jaan Elias:
And may I offer another potential zebra to consider,
which is the folks–let’s say you’re buying one of these
houses and the house next to you has been bought for $25,000 and
sold for $85,000 with no visible improvement.
You bought your home for
$30,000, you’ve put another $40,000 into it,
you have a legitimately $70,000 house,
how are you going to feel when that house next to you gets
boarded up and goes into foreclosure because someone has
been playing the appraisal game? So, there’s an externality here
to consider too in the overall community.
Prof: So,
who’s got an idea about how to fix all this?
Would it be drumming
truth-telling into three year olds?
Would it be–yes?
Student:
I think there’s a huge gap in government oversight,
particularly with regard to the ratings that,
I mean, when Moody’s is–although they have the cross
pressures that you talked about, but when Moody’s is being paid
by one side and not the other and even if we assumed that
they’re all inflated and therefore just interpret them to
be suspect, without some third party that’s
completely disinterested, like the government coming in
and telling you how to rate it, you’re not going to get
truthful ratings and therefore the whole system falls apart
from the top. Prof: Yes,
that sounds right. And one of my own inclinations
would be to compel the initial lenders to hold a given
percentage equity in each loan so that they can’t utterly
ignore the probability of default.
On Monday I’m going to,
Monday is a wildcard in the syllabus,
and I had planned to use it to do the Morys business plan,
but it turns out that there are people who think it would be a
terrible idea if the Morys business plan got to the Yale
Daily News. And while we’re 110 really good
friends, I think I’d be nuts to use that at this stage.
We’ll do that at the end of the
semester when it won’t be–when it will not cause bloodshed
somewhere in the system. And we’ll do a–I’d like to do
two things with Monday. One is: I’ll post a case on
Vioxx, the drug which was a COX-II inhibitor and did a lot
of good for people like me with knee trouble,
but it killed a few of them. And there were hard feelings
and a vast avalanche of lawsuits, and we’ll look at
that. I’m also going to post
Federalist Paper number ten. Could I–hands up if you’ve
read Federalist ten. No American,
nobody who’s going to do business in this country,
should fail to get the idea of the fundamental design of the
American political system, which is spelled out in only a
few thousand words there. See you on Monday.

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