– October 9, 2020

Last year, AIER published my book Financial Exclusion, which showed, among other things, that the financial crisis of 2008 was rooted in what we would today call “Woke Finance.” Bankers did not wake up one morning all saying “we should make big, risky loans;” government regulators pushing an “everybody a homeowner” political agenda induced them, partly with a carrot and partly with a stick, to lend to every Tom, Dick, and Harriet who would sign their name to the dotted line.

The result was a housing bubble followed by a financial crisis, a sharp recession, massive bailouts of the financial and automobile industries, and sclerotic economic growth that lasted through both Obama administrations.

We are still paying for that fiasco even as a second Woke Financial Crisis gains momentum under the strain of the Covid-19 pandemic and, more importantly, the senseless economic lockdowns kept in place for months even though they at best only slow, and do not stop, the virus’s spread.

Credit rating agencies played a major role in the 2008 crisis, you may recall, by inflating the credit scores of many major companies. That made the IOUs those companies issued cheaper and hence safer looking than they actually were. That allowed risk to build up until it exploded all over your house and maybe your job and life prospects too.

Well, the credit rating agencies are at it again. This time, instead of getting paid to overlook potential problems in mortgage-backed securities (MBS), collateral debt obligations (CDOs), and other financial esoterica, they are getting paid to overlook potential problems in plans to hire more racially diverse executives.

Moody’s, for example, called the plans of Lloyds Banking Group to promote more black employees to senior roles as “credit positive.” It did not boost its rating due to other problems at the bank but did signal that merely announcing a plan to increase its senior black employees fivefold by 2025 and publicly releasing its ethnicity pay gap was creditworthy. 

The problem is, to reach that goal the bank is going to have to recruit black bankers from other banks, so the pay gap will probably quickly reverse as banks compete for experienced black bankers, the number of which (because experience takes time) cannot grow quickly in the short term. In the intermediate term, higher wages should attract more blacks to banking, which is a good thing. The cost of that good thing — all good things have a cost after all — will be lower bank profitability because of the premium they pay to black bankers.

Unless, that is, black bankers are more productive than non-black bankers. If that is the case, though, why is a special recruitment program necessary? If that is not the case, how is it credit positive to overpay a significant portion of a workforce? (Will corporate governance reformers now be labelled racist for trying to do what they have been trying to do for decades, tamping down on excessive executive compensation?)

Moody’s says that Lloyd’s planned actions have reduced its “exposure to social risk.” What risks are those, exactly? If they can’t be detailed, how can they be estimated? Like a Louisiana swamper recently told me regarding Covid lockdowns, “that don’t make no cent.” (He might have said “scent” but in the context of the conversation “cent” was a clever pun about money.) Do Moody’s analysts really think the same rioters who tore down statues of abolitionists over the summer are going to make fine distinctions between banks based on announced hiring plans?

Even more troubling is the recent revelation that regulators have allowed banks to waive or automate appraisals on mortgage refinancing applications (refis). This makes it cheaper and easier for homeowners to take advantage of low mortgage rates but also allows them to edge closer to, or even exceed, 100 percent LTV (loan-to-value). That is a problem, if you do not recall from a dozen years ago, because if housing prices decline for whatever reason (fire, high taxes, dumb energy policies, murder hornets, Covid lockdown recession, etc.), people will have an incentive to walk away from the home and mortgage, bankrupting MBS holders and potentially melting down the global financial system again.

Two in every five refis are now automated according to Edward Pinto, one of the few voices of reason during the whole housing bubble shebang. Pinto points out, as I have been trying to do with a project proposal called FIIBMO (Flawed Incentives In, Bad Mortgages Out) that the Big Regulators declined to fund, that the problem is not with appraisal automation per se. Automation is good and traditional appraisal has become a farcical rubber stamp process.

The problem remains improper incentives. Most mortgage originators still sell their mortgages to investors without recourse. That means they do not care if the loans are risky so they do not care what the real LTV is. In fact, they have incentives to make the official LTV look as low as possible, which means making the property look as valuable as possible. But just because Joe Blow Appraisal Services or Automated Blockchain-Enabled Appraisal Systems R-Us says that a certain house is worth $250,000 does not mean that it is. 

If the appraisal errors were random, they wouldn’t be a big deal because they would cancel each other out. But I found, as have many others, that appraisals tend to come in high. In other words, a house really worth $225,000 (what Pinto calls market value as opposed to market price) gets appraised at $250,000. The sale or refi therefore gets done and the fees that feed the originators and appraisers flow, but risk again begins to build as homeowners take out $250,000 mortgages on $225,000 houses that may well be worth $200,000 or less after Antifa or a wildfire or hurricane rolls through the neighborhood. Again, a program ostensibly designed to help blacks and Hispanics (and the poor generally) may end up hurting them by suckering them into mortgages or refis that they should not be taking on.

What to do? Somebody has to be on the hook for something or taxpayers will again have to foot the bill for big bailouts. If mortgage originators were more responsible for the quality of the mortgages they approve, they would have more incentive to ensure timely, quality appraisals (and inspections too!). That isn’t abstract theory, either; it is how mortgage lending worked for most of the twentieth century. And the nineteenth century. And the eighteenth too, and probably before that as well but my book doesn’t go that far back.

Of course we do not have to return to quill pens and paper to recapture the proper incentive structures. Without mandating a specific appraisal methodology, a more objective appraisal regime would better align the incentives and expectations of all stakeholders, including borrowers, originators, and MBS holders. Adaptation of procedures similar to those used in the nineteenth century to value land in court proceedings would entail soliciting multiple reports from anonymous appraisers pulled randomly from a large pool of qualified appraisers with track records of making valuations accurate enough to minimize both defaults and missed transactions. Obviously, under any sort of scientific system, appraisers should be without knowledge of proposed transaction prices, the estimates of other appraisers, or other signals from lenders, firewalls sorely lacking during the last few decades.

Ideologues can claim that mathematics is merely a human construct but there really is a real world out there. It has bitten us in the keister before and appears poised to do so again, just for ignoring it. Maybe we should all wake up.

Robert E. Wright

Robert E. Wright

Robert E. Wright is the (co)author or (co)editor of over two dozen major books, book series, and edited collections, including AIER’s Financial Exclusion (2019). Robert has taught business, economics, and policy courses at Augustana University, NYU’s Stern School of Business, Temple University, the University of Virginia, and elsewhere since taking his Ph.D. in History from SUNY Buffalo in 1997.

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